To Global Relief, Europeans Go the Trillion-Dollar-Mile to Stabilize Eurozone     Print Email

In an emergency weekend ministerial meeting, the EU launched “the mother of all rescue” plans in an effort to save itself from global lenders’ doubts about the unity and financial credibility of the eurozone. A package worth nearly a trillion dollars was announced as markets opened Monday in Asia. Unprecedented in its scale and scope, the EU action impressed analysts as a response to the international dimensions of the crisis, providing a sweeping solution of the sort that has eluded the EU leaders at every previous stage in the crisis. Announced after 11 hours of negotiations Sunday, the rescue seemed to rise to the challenge explained in this blog last Friday: “Euro’s Fate at Stake in Emergency Talks This Weekend.” By Friday, the market onslaught seemed almost overwhelming: market players said that the number and amounts of sums invested to “short” the euro had reached new records.

In finally grappling with the threat to the eurozone and perhaps the global economy, a key change in EU action was a new readiness by Germany to lead the way in shoring up the euro (and debt-burdened eurozone member states) with its own financial guarantees and those of the Frankfurt-based European Central Bank (ECB). The conclusion of EU leaders was that they were ready “to take all means necessary” to protect the unity of the eurozone with financial support for the stragglers.

Alongside the message from the markets, Chancellor Angela Merkel was also responding to political messages. By Sunday, she had already lost the important regional election in Rhineland-Westphalia and so faced no more short-term political deadlines with German voters opposed to EU loans, even to “profligate Greeks.” Germany’s constitutional court had ruled in favor of Berlin’s bail-out for Athens.

In addition, she had received a White House phone call urging her to do everything in her power to confront the crisis in Europe – and pledging some measures of U.S. help in trying to shore up Europeans’ financial stability and solvency. In contacting her (and France’s President Nicolas Sarkozy), President Barack Obama was responding to mounting fears that a financial collapse in Europe would threaten the economic outlook for the United States and for a global recovery from the great recession.

Britain (which is resolutely opposed to any suggestion that it should join the euro) added its weight to the rescue package. Prime Minister Gordon Brown, himself an economist, has defied public opinion to stay in office despite losing national elections a week ago – a tactic that enabled him to dispatch his Chancellor the Exchequer to the EU meeting with a pledge of British support for the rescue. As he explained, London was not supporting the euro, it was supporting fellow EU member-states. This distinction enables Britain’s now-defeated Labour party to respect the letter of its policy of declining to abandon the pound sterling and join the euro. Brown stepped down Monday entitled to claim “mission accomplished” for Britain and the EU in this crisis.

As the U.S. and British involvement suggests, the rescue package for floundering southern European countries (Portugal, Greece, Italy and Spain) has become a global problem. While Greece, for example, is only a tiny fraction of the global economy, the risk of contagion from its problems now weigh on the prospects for renewed international economic growth. Part of the process now will probably come at the G-20 summit meeting in June, where leaders will weigh Europe’s need for help in the context of global stability.

The crucial first steps have now been taken by the EU. Conveniently, the leaders this weekend were able to break long-standing EU rules against bail-outs for member states by invoking the newly ratified Lisbon treaty. It contains a clause authorizing such interventions “in exceptional circumstances.” Although it was put in the treaty with an eye to eventualities such as natural catastrophes, the loophole worked for the EU legal process this weekend. (It amounts to the biggest concrete benefit seen so far from the Lisbon treaty as a modernized charter for the EU.)

It opened the way to more sweeping actions than any publicly contemplated by European leaders prior to this weekend. The eurozone plan, as announced, contains three financial elements:

1. More than $800 billion in guarantees for fragile countries to borrow more money. (About a third of this will come from the International Monetary Fund.)

2. A new ECB policy to buy bonds in dysfunctional markets.

3. Swap lines with the Federal Reserve to provide U.S. dollars as the ECB works to maintain liquidity in Europe’s markets.

The boldness of the commitments demonstrates a capability to act in a crisis that European leaders had not shown until this crucial weekend. In a notable development, the ECB has been dragged, probably kicking and screaming, into promising to buy up junk bonds if necessary to keep markets working – in contrast to the hard line maintained (with good tactical reasons) by bank head Jean-Claude Trichet against any such blank check. In agreeing this weekend, he was working amid a new realization in EU capitals that the eurozone’s financial system was at risk. Financially weak countries such as Greece, Portugal and Spain were on the point of being knocked out of the euro by what the Swedish finance minister called “the wolfpack” – a term used in World War II for Nazi submarines that sank allied cargo vessels that failed to stay in their convoy.

With so much money now committed, it should be easier for Germany and the other strong countries to insist on enforcing tight fiscal policies (and true accounting) throughout the eurozone. Even with a transformed short-term outlook, longer-run questions remain about whether the plan will work and how well.

According to Simon Johnson, the British-American economist who has consistently been right about this unfolding drama in “Baseline Scenario” blog, this is a whole new level of global moral hazard – the result of an alliance of convenience between troubled governments in the south of Europe and the north European banks (and implicitly, north American banks) who enabled their debt habit. The Europeans promise to unveil a mechanism this week that will “prevent abuse” by borrowing countries, but it is hard to see how this would really work in Europe today.

His point is echoed by another prescient practitioner, Pimco fund manager Mohamed El-Erian: “We are now in unchartered waters when it comes to how all this will impact the secular workings and make-up of the eurozone,” he writes in the Financial Times.

In the same paper, another analyst, Walter Munchau, elaborated on the global context. After congratulating European leaders for getting ahead of the curve in facing what had become an existential threat, he wrote that these leaders really had no other choice and that the “real test” is yet to come.

”That said, we should also realize that by throwing money at the problem, mostly in the form of backstop guarantees, the EU has merely bought itself time to sort out the eurozone’s governance mess…There are important parallels [to EU guarantees in 2008 to the financial sector] with the collapse of Lehman Brothers in the U.S. That EU decision, almost made in dramatic session over a weekend, solved an immediate liquidity problem of the European sector, which was on the verge of a meltdown.

“But the decision did not, and could not, address the sector’s underlying solvency position, which is still a problem two years later.”

His conclusion, shared by other observers, is that a) Greece will still probably have to “restructure” its debt, i.e. partially default on its loans by extending the pay-back period and b) more importantly, the eurozone must start on structural reforms amounting to much more intrusive economic governance. That step may still be out of reach for EU leaders. Otherwise, even if the immediate pressure is relieved, the underlying causes will fester and surface again.

Now two crucial inter-related questions confront the eurozone. Can discipline work effectively in giving adequate early warning in future when member states get into fiscal peril? Can planning start immediately for an orderly rescheduling of Greece’s debts? The key to the second lies within Europe, home to the banks (notably in Germany and France) have big holdings in Greek bonds. They stand to be big losers if action is taken to extend the repayment period for the Greek bonds they hold. But their governments now have sworn that they will not flinch from doing what is needed to maintain the unity and viability of the eurozone.

European Affairs