The Euro Crisis: How to Stop It
I said on Monday that the bailout of Ireland would not work. I was talking in terms of Ireland itself and the future of its economy. I stand by that.
But I also asked:
what happens after this? Assuming the EU manages to come up with enough cash to keep the economy liquid, what happens next? Do the bond markets now turn on Portugal? And if the EFSF (European Financial Stability Facility) is then used to bailout Lisbon, what if they turn on Spain? The EFSF couldn’t cope with that. What long term planning is being done to come up with a long term, Europe-wide solution? It’s taken a week of leaks and denials to get to this point with Ireland, this bailout has been incredibly badly managed – I doubt much long term planning has been carried out.
It turns out I was right to be worried.
Back in May, the bailing out of Greece was met by an immediate (although now unwound) “relief rally” in Greek bonds, peripherial country spreads and the Euro.
This is not happening now.
Instead we are stepping closer to crisis.
Irish, Portuguese, Spanish, Greek and (very alarmingly) Italian spreads over German bunds are still rising.
Even more alarmingly, looking beyond the spreads – the actual yields on German bunds have headed higher too. As have German CDS spreads (from a low base).
The Irish bailout is now expected to be agreed by Sunday – after inept management for two weeks. But both Labour Party and FG are saying they will want to renegotiate it.
The Irish budget, set for 7th Dec, may not pass.
Either way, Portugal will need support with in days now. And after Portugal and Ireland, there is no cash left in EFSF.
There is an urgent need to stop the crisis before it hits Spain properly.
I’d suggest three immediate steps, I’m not sure that it would work, but I think the chances of success are higher than what is currently “planned”.
(i) The ECB should announce it is prepared to offer as much liquidity support as is needed to periphery banks if deposits continue to flee. An emergency from of QE, but one that might help stem the flight of deposits.
(ii) We need “proper” stress tests of all euroarea banks (not just the periphery). Not the confidence building exercises of a few months ago, but severe scenarios (taking into account step three below). This should be immediately followed by a full recapitalisation of those banks that fail. Give the banks 20 days or so to try and raise that capital in the private markets, if they can’t then forcibly inject it and be prepared to severely hit (or even wipe out) equity holders. In an ideal world the EFSF would be used to fund the new equity, creating a string of banks with large stakes held by the Euroland governments in common.
By these two steps the Euroland governments and the ECB can settle liquidity and solvency issues in the banks. It should hopefully lead to banks better equipped to lend to fund a recovery.
Ideally the ECB should fund this through QE rather than placing more pressure on government deficits.
(iii) Sovereign restructuring in the periphery with hair cuts around the 20-30% on government bonds. The recapitalised banks should be able to take the strain. Pension funds will be hit (on the other hand, it will lead to less taxation in the medium term, the net effect on pensioners is hard to determine).
This might or might not work. It is a medium term fix. The longer term requires greater rebalancing in the Euroland economies and a reordering of the ECB. But I suspect it is better than relying on austerity.