As the eurozone could finally agree on the deal, markets took off. The rescue fund will be multiplied. The banks will be recapitalized. Prime Minister George Papandreou said that now the Greek debt is sustainable. The euro leaders thanked each other. In the United States stocks ended up 3% up on the EU hopes, while Dow rose above 12,000.
So is everything all right? Not at all, the eurozone crisis will worsen before it will get any better.
Why the deal cannot be sustained
In order to satisfy the markets in the long term, the eurozone leaders should have achieved at least three fundamental goals:
First, the liquidity facility should have been expanded from the current EUR 440 billion ($610 billion) to EUR 1-2 trillion ($1.4-$2.8 trillion). Instead, the current deal will deploy leverage.
The “systemically critical” euro banks should be recapitalized by EUR 100-110 billion ($140-$155 billion). Now 70 major euro banks will raise EUR 106 billion ($150 billion) by mid-2012.
Third, the Greek debt reductions should be increased from the current 21% to 60-75%. Now, after two years of denial and friction, the consensus is 50%.
Each goal has its problems; nor will the deal cover for all challenges.
The devil is in the details
The first goal will prove challenging. As euro leaders could not agree on an expanded facility, they resorted to financial wizardry. Now the objective is to multiply the current liquidity facility with the kind of leverage, which is reminiscent of the derivatives that devastated the markets in fall 2008.
Furthermore, the political and popular support of the current euro leaders is eroding. In Italy, the center-right coalition almost collapsed before Premier Silvio Berlusconi reached a deal on emergency growth measures. Italy’s debt burden is close to EUR 2 trillion ($2.8 trillion); and there is no assurance that structural reforms can be implemented successfully.
In Germany, the majority support in the parliamentary vote provided breathing space to Chancellor Angela Merkel’s conservatives. However, the popular support of the government coalition has steadily eroded in the state elections and German growth prospects are slowing down.
Moody’s has warned that France’s credit rating could be downgraded in the next three months if its budget is stretched further by bank bailouts to help other debt-heavy eurozone countries. As a result, French President Nicolas Sarkozy shuns measures that would penalize investors and thus could contribute to banks’ rating downgrades; the latter could endanger France’s triple-A rating – and thus have an adverse impact on the European liquidity facility itself.
Greek bailouts: EUR 500 bn ($700 bn)
The recapitalization deal is based on the assumption that “systemically critical” big euro banks are able and willing to raise the necessary funds in less than a year. At the same time, the macroeconomic foundation of the eurozone is slowly crumbling, growth is stagnant and social turmoil continues against the financial sector.
The Greek debt restructuring is a chapter of its own. At first, Brussels and the European Central Bank (ECB) denied the very existence of the problem. When the latter was finally acknowledged, the argument was that debt restructuring is not necessary or that it is impossible. Last July, the euro leaders finally agreed on a 21% debt restructuring, which is now expected to increase to 50%.
It is not enough.
In May 2010, the eurozone supported Greece with EUR 110 billion ($150 billion). Recently Athens has struggled to complete another bailout round of EUR 109 billion. In both cases, it was argued that the bailout packages would be enough.
Now ‘Troika’ – the European Commission, IMF and ECB – have acknowledged the flawed assumptions. In addition to the existing EUR 219 billion ($305 billion), Greece will need at least another EUR 250 billion ($350 billion) in the next 10 years.
Unfortunately, Greece is hardly the only near-insolvent euro economy.
Back to stagnation
In their summit, the euro leaders focused on liquidity, recapitalization and debt restructuring, but these are only some of the dilemmas that are haunting the eurozone.
Until recently, most euro economies have engaged in severe front-load austerity measures and promises of long-term fiscal support. That has spawned violent riots from Athens to London. Instead, the euro economies need short-term fiscal support to support nascent recovery, and credible, long-term back-load austerity to sustain growth.
Along with misguided fiscal policy, many euro economies have suffered from ill-advised monetary policy. Not so long ago, ECB chief Jean-Claude Trichet sought to hike the interest rates, which was precisely the wrong thing to do. Appropriate monetary easing remains vital, especially to provide credit easing for small and medium-size enterprises, which are struggling but remain critical to employment in all euro economies.
As Trichet retires on November 1, all eyes will be on his successor, Mario Draghi, currently chief of Italy’s central bank. During the great recession, many national central banks in the eurozone embraced billions of euros of toxic debt. These central banks are no longer autonomous, but subject to the ECB system. These toxic assets must still be defused.
Finally, all euro leaders agree that the region’s problems cannot be overcome without appropriate growth. Yet, adequate structural reforms remain absent.
The euro summit came to an end with market jubilation. In the coming days, the reality will sink in. After the April 2011, the market cap of 50 major stock markets worldwide has been reduced by $14 trillion. In Europe, the market cap declined by almost 27%.
The eurozone crisis, too, will pass. But there is no return to “business as usual.” When the dust finally settles, the world will look very different.