I previously used the medical analogy of the pending heart attack:
Imagine that a man (the "eurozone") experiences severe chest pains and looks like he is headed for a heart attack ("Lehman moment"). The protocol is well defined in these circumstances. Take steps to stabilize him ("inject liquidity via the ECB") and then address the causes with a program of diet, exercise and medical treatment ("longer term solutions such as balanced budgets, pro-growth policies, possibly closer fiscal integration, two-speed eurozone, etc."). Berating him about being lazy and overeating ("you lazy Greeks, Italians...") and making him get on the treadmill to work off his Thanksgiving feast ("more austerity and IMF monitors") while he is on the verge of a heart attack ("Lehman like financial crisis") is less than helpful under the circumstances.
Coordinated global central bank intervention has stabilized the patient for now, but the longer term problems still need to be solved.
The ECB lays down the law
The outlines of the Grand Plan (what version are we on now?) came from Mario Draghi yesterday, when he gave a speech to the European Parliament. First, he held out the carrot of intervention using "non-standard measures" [emphasis added]:
As you know, the ECB’s monetary policy is constantly guided by the goal of maintaining price stability in the euro area over the medium term. And when I say this, I mean price stability in either direction. This applies to both the setting of official interest rates and the implementation of non-standard measures.
By "either direction", he meant that the ECB is aware of the risks of undershoot, as well as overshoot to the inflation rate. Should deflation set in, Draghi signaled that the Bank is willing to act. He then laid out the preconditions for the ECB to act:, namely closer fiscal integration within the eurozone:
What I believe our economic and monetary union needs is a new fiscal compact – a fundamental restatement of the fiscal rules together with the mutual fiscal commitments that euro area governments have made.Draghi wants rules to be enforceable:
Just as we effectively have a compact that describes the essence of monetary policy – an independent central bank with a single objective of maintaining price stability – so a fiscal compact would enshrine the essence of fiscal rules and the government commitments taken so far, and ensure that the latter become fully credible, individually and collectively.In return, he hinted that the ECB is willing to act to stabilize markets, but "sequencing matter":
Other elements might follow, but the sequencing matters. And it is first and foremost important to get a commonly shared fiscal compact right. Confidence works backwards: if there is an anchor in the long term, it is easier to maintain trust in the short term. After all, investors are themselves often taking decisions with a long time horizon, especially with regard to government bonds.This speech should not be a surprise. I pointed out on October 17 (see A framework for assessing a eurozone rescue) that the ECB is politically untouchable and had its own agenda. This analysis showed the top of ECB's wish list is a set of "bulletproof fiscal constraints on euro area members":
The ECB’s overarching goal is for the euro area’s politicians to establish credible European institutions working alongside the bank. It seeks, for example, bulletproof fiscal constraints on euro area members (something more credible than the Stability Growth Pact, which was widely ignored). It also wants a common euro area crisis fund to relieve the bank of the primary bailout responsibility. In addition, the ECB wants individual member states to accelerate structural reforms in their national economies.
Brussels-on-the-Rhine: The devil in the details
In recent days, the news has been full of stories of how the Germans and French are working for a plan for closer fiscal integration, or a set of "bulletproof fiscal constraints on euro area members" (see one example here). As usual, the devil is in the details.
There are several ways of tackling the problem. One way is to agree to some form of fiscal integration within the 17 eurozone countries, with the carrot of some form of eurobond that can be issued by this Brussels-on-the-Rhine. The stick would be a form of supervisory control, or receivership, should a member state miss its targets.
Imagine the kind of reaction that would set off in the streets of Athens, Lisbon, Dublin, Madrid, etc. (Maybe they should sign the papers inaugurating the new Brussels-in-the-Rhine agency in the little railway car at Versailles?) Such a move would require treaty re-negotiations and likely constitutional change at the member state level as individual countries would be ceding fiscal authority to some supra-national agency. Negotiations are going to be ugly. Already, Ireland has demanded debt relief as the quid pro quo for treaty changes. What would the other countries like? Perhaps a pony too?
If the eurocrats were to choose to go this route of fiscal integration with all of the 17 eurozone countries, then watch for some language in the proposal for exit from the eurozone to be used as a stick to beat the non-compliant countries. The risk is the blowback from a possible bank run should a member state leave the eurozone and devalue its new currency. John Hempton describes what might happen if Greece pulled an Argentina:
Now if you are Irish or Italian or Portuguese (or even Spanish) you know the rules. You get to get your Euro out of the PIGS and into the core (Germany) as fast as possible. So max all your credit cards (for cash), draw all your bank deposits and load them in the boot of your car and make the drive to Switzerland or Germany. Somewhere safe. Otherwise you are going to lose half the value the day that the rest of the PIGS do a Greece.Within a week, they will have nuked the banking system in the peripheral countries.
And this bank run – a run including tens of thousands of Italians driving their Fiats - will surely blow apart every Italian bank. And their Euro-skeloritic compatriots will sign the death knell for for all their banks too.
A two-speed eurozone?
What about a two-speed eurozone with "voluntary" participation in fiscal integration. While that may stabilize the "in" countries, what about the "out" countries? Supposing that Athens refuses to submit to monitors from the
OK, let's go back to the drawing board.
For now, all eyes are on the Marseilles summit. Angela Merkel appears to have dug in her heels and is adamantly against ECB intervention, preferring to see a Brussels-on-the-Rhine solution. We will have to see if the eurocrats can put together something better than another half-baked plan. Given the obstacles involved, I am not optimistic.
Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.
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