Euro establishment isn’t learning any lessons from the crisis

Allister Heath
IT seems that €100bn no longer buys very much these days. Yesterday’s post-bailout rally fizzled out almost as soon as the markets opened, as traders’ innate over-exuberance soon turned into jaded realism. Spain and the Eurozone are still in deep trouble; these days, you can only fool the markets for a few hours.

There are many lessons to be learnt from the Eurozone’s latest botched bailout. For a start, Spain’s government bonds have largely been bought by Spanish banks and other domestic institutions of late – foreigners have shunned recent sales or cut back their holdings, very sensibly. So the Spanish state has been shifting its risky debt into the hands of risky domestic banks, not exactly a recipe for financial stability. Sensible governments have been severing their links to their banking systems; Spain has been strengthening it. The government has got closer to its second-tier banks and will end up nationalising the bulk of them; the banks have got closer to the government. So the government will end up owning institutions which themselves own government debt. The circularity of it all is enough to give one a headache.

What is even more depressing, at a time when it has become apparent to all with eyes to see that even large Western democracies can go bust, is that the world is busy implementing new financial rules – including the Basel banking agreement but also solvency measures for insurers – that still assume that government IOUs are risk-free. This intellectual error – cynics would see it as a deliberate device for governments to offload their debt cheaply – is a ticking time bomb under the global economy. Nobody has learnt much from the events of the past few years; once again, flawed rules are being imposed which will eventually help bring down the system they are meant to be strengthening.

Another problem is that the bailout funds remain deeply defective, even on their own terms. The European Stability Mechanism (ESM) – the Eurozone’s permanent bailout fund – will not be ready on time to provide the loan as the treaty setting it up still needs to be ratified by many countries. The money will therefore have to come from the European Financial Stability Facility (EFSF), the temporary fund. The “good” news for Spain’s existing bondholders is that this new loan will not therefore be senior to their own claims, as would have been the case had the ESM been used. The “bad” news is that the €100bn loan will meet far more political opposition: the Finns will demand collateral and rows will break out in other countries. The even worse news, as we reported yesterday, is that the deal will increase Spain’s national debt by about 10 per cent of GDP and push it ever closer to the danger zone. That is why Spanish bond yields hit 6.5 per cent yesterday – a critical situation given that it needs to borrow extensively on the debt markets over the next few years, even in the absence of any additional bank bailout.

Last but not least, those pundits who thought that all of Italy’s woes would go away after Silvio Berlusconi was booted out and replaced by a “technocratic” (in other words, non-elected) government have also been proved wrong. Yields on Italian debt are rocketing once again; slowly but surely, the pressure is mounting on Rome. We already know that Cyprus will also require a bailout but its economy is tiny. So far the French have escaped unscathed, despite Francois Hollande’s election and his decision to hike taxes, re-regulate the labour market and cut the pension age. But Italy now looks in serious trouble. If it too succumbs, then all bets would truly be off.