When you've been on the edge of having a convulsion for months, you could be excused for clutching at anything to convince yourself at least temporarily that you've turned the corner. Today, this is looking like a fair characterization of last week's big relief rally at the euro "rescue" plan that was "agreed" in Brussels.
Markets are trading significantly lower this morning, and much is being made of something that I mentioned briefly on Coffee and Markets the other day: right after the accord, Italy's government went into the bond market to sell an issue of three-year notes, and had to pay 4.93%, well above what they had paid for the same maturity just a few weeks ago. The dogs aren't eating the dog food.
It seems clear that we've averted a serious financial crisis/panic/crash for at least a few months. That much was accomplished. But on further inspection, the plans have deep flaws both from a financial/economic and a political point of view.
The key features of the plan are: to impose strict fiscal discipline on Europe's banks, in the form of sustained increases in tier-1 capitalization; to impose a 50% write down on something like 100 billion euros of Greece's outstanding government debt; to increase the size of the EFSF to about a trillion euros; and strong steps to "oversee" the austerity measures that a whole swath of non-German states in Europe will be required to undertake for the foreseeable future.
A word about Europe's banks: they matter a whole lot more to the Eurozone economy than America's banks matter to ours, which is why the immediate impacts of this situation are quite severe to the real economy. America's banks engage in a whole lot of flow trading and barely-concealed market manipulations to achieve profitability. In Europe, however, banks actually lend money to businesses, a function which in America is provided not by banks but by a very deep and liquid range of capital markets. If the US banking sector were to be cut in half overnight, most people wouldn't even notice. In Europe, economies would stop running.
So the Eurozone authorities scrambled over the weekend to partially walk back last week's requirement of roughly 150 billion euros in new capital requirements for the zone's largest banks. (Among the most affected are Commerzbank and UniCredit.) Everyone knows a bank can't sell common stock when the price is down, so they've been substituting a whole raft of substitutes (for example, allowing banks to reclassify certain equity-linked debt as tier-1 capital). Other measures will include Dodd-Frank-like restrictions on dividend payouts and executive pay.
The weakened restrictions mean that the underlying bank-undercapitalization problem arising from the poor quality of sovereign credits, is simply not getting fixed in a convincing way. But the restrictions will still hobble the banking sector's ability to generate new financing, which in turn puts a lid on growth and job creation. It's the worst of both worlds.
Meanwhile, the EFSF's "bailout fund" is being "strengthened" to about one trillion euros. That number wasn't chosen at random. Greece has something more than 300 billion euros in outstanding debt. But the far larger figure is intended to create a perception that funds would be available in case a need ever emerged to bail out ITALY or SPAIN, in addition to Greece. Those are the elephants in the room, and the question of who will guarantee their debt is first and foremost in the minds of market participants.
But a very strange mechanism is being proposed to improve the credibility of the EFSF. No one is going to make a straightforward one-trillion euro guarantee. Because whoever does, will be crucified by her (or his) country's voters. So they concocted this "super-leverage" scheme in which the first 20% of losses on any affected debt issue will be guaranteed.
This isn't satisfying anyone. Does it amount to a put option to sell debt at 80 cents to par? Well, no it doesn't. At least, that's not how I'd look at it if I were a bond buyer. To me, it looks more like a put option at 20 cents. Remember, lots of Greek debt is trading way below 80 cents right now, and from the looks of the interest-rate action in Italy, their notes and bonds are going to come under a lot of pressure too.
What I think happened is that no one was willing to write a blank check for a trillion euros, so Merkel and Sarkozy figured they could get away with one fifth that much, and supplement it by forcing banks to raise capital by a somewhat smaller but basically similar number.
It took Jean-Claude Trichet, the retiring president of the ECB, to call a spade a spade. He said that absolutely nothing can be solved unless Europe's supernational authorities (including the ECB) acquire the powers of a real finance ministry, rather than having to defer to national governments. At this, Sarkozy boiled over, because the French have been hinting strongly at this since the beginning of the crisis.
And that's something that the Germans simply can't give on, because at the end of the day it means that Germany, and Germany alone, would need to surrender to non-government entities the power to tax German citizens.
The blistering, blinding, caustic irony of this, is that this is PRECISELY what Germany is in the process of imposing on every other state in the eurozone, including France. This is the meaning of the "oversight" provisions in last week's plan. Countries from Greece to Spain to Portugal and even to Italy will be required to host "international" observers with power to impose sanctions if fiscal austerity targets aren't met.
It's not at all too strong to say this: the fourth German empire is now being established in continental Europe. If nation states must surrender their fiscal decisions to external authorities, they've given up their sovereignty. And the point of all this is to prevent exposing Germany's taxpayers to open-ended bailouts while maintaining the powerful advantages of the euro, which has given Germany 6 percent unemployment while everyone else struggles with much higher levels.
What's going to happen to Greece isn't pretty. Even with the 50% haircut on some of their external debt, the continuing austerity ensures that they won't able to grow their economy, and they'll end up in just as much fiscal trouble in a few years as they are now. What's totally hellish is that the same will happen to Spain and Italy, and this is criminal because the Italians are not in serious fiscal trouble. But with the new restrictions on their freedom to run their country, they'll get there fast. A gold curtain is descending across Europe from Berlin in the north to Athens in the Aegean.
This is why the normally-affable Berlusconi left the conference in such a sour mood. He knows he lost this battle. What's worse is that Sarkozy is starting to suspect the very same thing himself. Because the same stress will spill over into France, eventually.
The euro is now in an extremely tense position. Its value is being powerfully supported by the welter of financial guarantees that is causing huge amounts of investable funds to flow into euro-denominated government paper. (The same is happening to the dollar and to sterling, by the way.) But at the same time, the single currency is vastly overvalued relative to the economic reality in the zone. And both effects are going to get worse, as austerity starts to really bite everywhere except Germany.
So in effect, the euro is now both under- and overvalued. The tension will eventually tear it apart.