Europe’s three simple problems

JAMES SAFT

The plan to rescue the eurozone faces only three hurdles: democracy, reality and supply and demand.
If they can overcome those, it is going to work perfectly, and, amazingly, they just might.
Democracy reared its rather large head when the Greek government decided suddenly that it wanted a sign-off from its voters and moved to put the plan to a plebiscite.
While it is hard to argue with the idea of a people getting a chance to vote directly on a plan that will mean tough times for the better part of the next decade, the move jeopardizes not only the confidence on which the entire rescue relies but also the next infusion of much-needed cash Greece is slated to get in November.
If the Greeks vote against the plan it means a full-fledged, badly controlled sovereign default, with all that implies for eurozone banks. Is that something the Greeks will vote for, even if it means ejection from the eurozone? Just the specter of the vote makes it far harder for eurozone officials to put the rest of their plan into effect, a number of whose planks are already looking shaky.
Democracy, or whatever alternative term you would prefer to use, is also doing the rescue no favors in Italy, where Prime Minister Silvio Berlusconi is under pressure to step aside for a government of national unity. There is also precious little faith that Italy will produce credible fiscal and structural reforms. All of this is reflected most starkly in the reality of the bond market. Italian 10-year bond yields now stand at about 6.16 percent, a level that is unsustainable, considerably higher than before the grand plan was announced, and a threat in and of itself to the rest of the plan’s moving pieces.
Remember, Italy is not only the third-largest economy in the eurozone, and probably too big to bail out, but the third-largest government bond market in the world. A plan that cannot bring Italian borrowing costs back down is one that will fail.
If anyone ever wondered where the bond market vigilantes have gone, we have our answer: They have moved to Europe and are providing reality therapy to governments.
Again, sometimes that kind of therapy works, and perhaps Italy will come across with the goods. The problem is time and moving parts – too little of one, too many of the other.
[HH] EFSF, ratings and the market
The European Financial Stability Facility (EFSF), the fund that is supposed to borrow funds under government guarantees to pay for the bailout, chose to delay a planned bond offering on Wednesday, its arrangers citing market volatility. There is also the little issue that eurozone officials have failed thus far to explain exactly how the vehicle is supposed to work.
The EFSF is supposed to create friendly market conditions by being big enough and bad enough to fund weaker countries regardless of their stand-alone fundamentals. It is not supposed to be subject to the market and the fact that it is, so soon, is a bad sign.
And the larger the number of countries that might be borrowing from the EFSF rather than contributing to it, the less solid its AAA status seems, as well as the AAA status of its backing nations.
France is the case in point. As the number of strong countries dwindles, its own AAA status looks less reliable. Bond investors drove the premium France must pay to borrow for 10 years compared to Germany to a euro-era record on Wednesday to 129 basis points.
The final issue where supply and demand are working against the eurozone plan is in banking, where banks have been given a deadline of next June to recapitalize, either in the market or with state support.
That means that many banks are going to be trying to either raise capital or sell assets at the same time, driving up the price of the first and down those of the second. It also implies a rather large credit crunch in Europe, one that probably has already begun on the fringes.
That means Europe’s recession will get a kick downhill.
So, to overcome democracy, reality and supply and demand Europe is going to need a force that is immune to some degree to all three. Such a force exists in most other large developed countries with independent currencies: the Central Bank.
The European Central Bank cannot and will not play a similar role, and until it decides it should and a way is smoothed for that to happen, the odds are against the plan.
*James Saft is a columnist for Reuters in which this piece appeared Nov. 3.