piigsty

After the EU-wide calamity and impending doom of the past few days and weeks, you would rightly query what exactly is now going on. Its pretty straightforward – European leaders are starting to get serious. The key element of the October 23^rd summit was a sea change in the dialogue. The Franco-German duo of Merkel and Sarkozy have stopped insisting on minor sticking-plaster solutions and have belatedly began to talk about more serious surgery including a keystone proposal to write down (haircut) a substantial portion (40-60%) of Greece’s €350 national debt pile. This would make it hugely more manageable. After listening to the weekend views of the G20 (who are, no doubt, in convulsions over the prospect of a European engineered second ‘double dip’ world recession), there is no doubt the conversation has changed.

EU leaders are not formulating a full scale multifaceted rescue plan to tackle the underlying problems. Previously, the focus was skewed to address urgent liquidity problems, with tackling solvency a long term (#2) aim. Now, the short term focus is starting to change, and with good (economic) reason.

The ‘Liquidity’ Era 

For too long, as economist Ken Rogoff outlines in Der Spiegel the discussion in eurozone circles was squarely focused on addressing liquidity problems (getting the day to day financing in order) for those countries most at risk of going bankrupt – Portugal, Ireland and Greece. Remember it was doubt over their ability to pay for the functioning of their own economies which caused their borrowing costs on the bond markets to skyrocket – and caused the creation of the EFSF and the EU-IMF bailouts. But all this has proved ineffective to stop the rot. Greek needed a second bailout less than 7 months after its first and the on-off panic encouraged by the Greek government dragging its feet on meeting its obligations. Releasing the bailout funds in tranches after regular reviews by the troika (European Commission – ECB – IMF) has injected more instability than certainty into the process.  With the Greek government promising to get its debt in order by dramatically altering labour laws enshrined in the Greek populace for generations, drastically reducing the size and cost of the public service and budgetary measures such as increased taxes and deep spending cuts – the calamitous environment is ruining investor confidence and prospects for a return to economic growth in Europe and beyond.

The ‘Solvency’ Era

So, the real problem is Greece or more accurately, Greek solvency and the interdependent solvency of the big European banks. Unlike what was believed previously (in the ‘liquidity’ phase), Greece has very weak structural economic strengths to fall back on). A disorderly Greek default would put the solvency of those indebted European banks into question (and with them, the economies in which they operate across Northern Europe). Therefore, there is no stable bottom to this crisis.

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German Chancellor Merkel and French President Sarkozy agreed Sunday (9 October) to recapitalise and therefore shore up European banks to the tune of €200bn to storm-proof them in case of another major shock to the financial system (if need be…). Is this a good or a bad move?

Well, its both.

Good

• European leaders are starting to think seriously about tackling the solvency and liquidity crises in major European banks (‘encouraged’ by last weeks collapse of the Franco-Belgian lender Dexia)
• A united Franco-German effort is a show of strength and calm amid the crisis atmosphere
• Tackling the ‘bank’ problem should, in theory, stop the bleeding quicker should a major negative financial event occur on the scale of the collapse of Lehman Brothers in September 2008.
• Overall, shoring up the banks should stabilise investor confidence (to what extent is unknown) and therefore quell some volatility in the markets

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