Bail-outs chip away at France and Germany too

From Ambrose Evans-Pritchard at The Telegraph:

“Credit Default Swaps (CDS) measuring risk on German bonds have doubled since early July to 85 basis points, rising above British CDS contracts for the first time despite the London riots.

Non-EMU Sweden enjoys lower borrowing costs than Germany. This has not been seen for half a century.

“What is happening is momentous,” said Andrew Roberts, credit chief at RBS. “The more Europe steps in to buy Italian and Spanish debt, the more Germany shifts towards the group of countries that could be attacked.”

French CDS have surged 161 and are now by far the highest of the AAA club. Yields on French 10-year bonds decoupled from core EMU states such as the Netherlands, Austria, and Finland.”

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As more countries move from the bail-outer camp to the bail-outee camp, the greater the pressure felt by the remaining bail-outers.  Each bail-outer is required to fund a greater share of an ever-growing bailout package.  To see why this is so, consider two facts.  First, as the number of bail-outers decrease, each remaining bail-outer must assume a greater share of funding responsibility.  Second, as the number of bail-outees increase the package itself (currently under the auspices of the EFSF) grows ever larger.

As a bail-outer’s liabilities increase, it is inevitable that questions about its ability to redeem them arise.  Perversely, these questions only serve to weaken the bail-outer’s position, as uncertainty manifests in rising bond and CDS spreads.  Incrementally, the bail-outer moves across the spectrum to the bail-outee camp.

My sense is that the timid, incremental, knee-jerk decisions made so far by eurozone countries only kick the default can further down the road.  And strangely, with each kick, the can grows, which makes each subsequent kick that much less effective. (Yes, I know I need to work on my metaphors.)  Before all policy instruments lose traction, a large, bold and credible decision is required.  Extending the metaphor, this would require grabbing the can and crushing it through application of sheer strength.  Two bold decisions come to mind, each with potentially calamitous consequences.  The decisi0ns would, in some sense, be diametric opposites.

One would ask for bail-outers to commit absolutely and irrevocably  to guaranteeing any and all bail-outee liabilities.  This would require the EFSF to increase significantly.  It would result in some degree of fiscal consolidation of the eurozone and would take the European project irrevocably forward.  The Euro-bureaucracy would become more powerful and each individual nation would lose some sovereignty.  In the long run, national identities might even be subsumed under a pan-European one.

The other would be an immediate and absolute abnegation, by the bail-outers, of all responsibilities towards the debt liabilities of bail-outees.  By rejecting all calls towards fiscal transfer, the bail-outers would put immediate and perhaps irrevocable stress on the euro.  The bail-outees would, probably immediately, default.  Debts would, of necessity, be restructured and defaulters might be forced to leave the euro and thereby regain control of monetary policy.  In the event of the break-up of the euro, we enter a brave new world, but presumably national identities would remain intact.

In my estimation, the timid will prevail.  We will witness a continuum of incremental decisions, each chipping away at the EU core, the bail-outers.  Gradually, the number of bail-outees will increase, the remaining bail-outers will weaken and the EU’s hand will be forced.  Pushed into a corner, incremental decisions will become unviable, and one of the two scenarios sketched above will come to pass.  Probably the latter.

 

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