The New Eurozone Deal – Not a Game Changer

After they have exhausted all the alternatives, Eurozone leaders have finally done the right thing. Finally other countries stood up against German economic oppression, and the German austerity queen had no alternative than to climb down from her throne. Now the Eurozone’s bailout mechanism can intervene on bond markets to drive down bond yields for Italy and Spain. And money can now be directly transferred into banks, making it unnecessary for sovereigns to increase their debt burdens when their banking sectors will receive support. The growth package will kick start the European economy. This is a turning point in the crisis. Markets are now calming down. Yields will climb down and Italy and Spain will see a significant improvement in their fiscal positions as a consequence. In short, the Eurozone has now just not said – but shown – that it is prepared to do whatever it takes to save the Eurozone. Hallelujah!

Ahem. I hate to be the bearer of bad news, but the sudden blossoming in Brussels this morning is – how to put it without upsetting people – a bit late in the season. I agree that there were some unexpected results coming from the summit. There were also some good results. Most important, the Eurozone leaders showed somewillingness to make some compromises and sacrifice some strong positions held. They showed that the system is not ungovernable.

But let us put things in perspective.

Growth pact 

Increasing economic growth in the EU is imperative. The summit did not produce anything new about structural economic reforms but they came up with the much-discussed growth pact. We can debate the merits of this pact but we should at least be able to agree that it is not going to have a strong effect on the EU economy. The pact amounts to about 1 percent of EU GDP. But in terms of new money dedicated by member states to spend on growth measures, it is far less. Half of the sum is, if I understand it correctly, a reallocation of money in the structural funds, i e resources already committed by member states to the EU budget. The other big part is boosting EIB with 60 billion euro, by increasing the paid-in capital by 10 billion euro. And this sum is the new money that member states will spend. Under the assumption that it will be a gradual increase, like the expansion of the EIB in 2007-2009, and that it will entirely be allotted to finance projects in Eurozone countries, the annual increase in spending by member states in this growth compact will not amount to more than 0.0096 percent of GDP.

Bailout without conditions

The agreed policy seems to be that countries can access bailout funds without conditions forcing more austerity as long as they comply with the Stability and Growth Pact, and/or the fiscal compact. But exactly how many countries that are at risk of needing money from bailout funds do comply with those pacts? Here’s the answer: zero.

Let’s assume that Spain will need assistance to support the government (that is, external assistance in addition to the 100 billion € already committed to the Spanish banking sector). Its fiscal deficit last year reached 8.5 percent and forecasts for 2012 has suggested 5.3 percent. But it is likely to grow worse as the economy declines faster than expected. Tax revenues in the first five months of the year were markedly lower than forecasted. So, if Spain is to apply for assistance, the new approach to bailout will not mean much to them.

Italy is closer to compliance, if one only looks at the general deficit rule. Italy is forecasted to take its general fiscal deficit below 3 percent in 2012. This may happen, but not without Italy making additional cuts as more recent forecasts point to a bigger-than-expected economic contraction. So Italy may exit 2012 with a general deficit above 3 percent and a structural deficit about 0.5 percent. Italy is also not complying with the excessive deficit procedure established in 2009. According to the commitments in the EDP, Italy should close its fiscal deficit in 2012. If Eurozone authorities are generous in a likely request from Italy that the bailout mechanism purchases Italian bonds to drive down yields, Italy may pass. It seems safe to say that we will probably find out before long.

The main point, however, is this: you don’t relieve bailouted countries from austerity pressures by demanding them to comply with the basic commitments. In fact, you would increase them.

Numbers don’t add up

Expectedly, there was no agreement from the summit on an expansion on the ESM, or to give the ESM a bank license. To have calming effects on markets, the firepower of any bailout mechanism would have to be in excess of 2 trillion euros. Together, the EFSF and the ESM have the capacity to lend 500 billion euro to countries. As the Eurozone has committed itself to assist the Spanish banking sector with 100 billion euro, only 400 billion euro remains. And it is highly likely that Ireland and Portugal will need new assistance beyond their current programmes. Assuming an overall supportive economic environment, they will not need as much as they received in their first packages. But it is not to stretch the imagination too far to suggest another 100 billion euro in the Eurozone’s bailout capacity will have to be committed to Portugal and Ireland. And even in these programmes do not expire soon, decisions about further assistance will have to be taken in the next few months.

Furthermore, Cyprus has requested support and will need assistance in the 5-10 billion euro region. And, finally, Greece will need further assistance, especially if the resistance to another restructuring of Greek debt remains. But even if Greece’s debt is restructured, resources from the EFSF or the ESM will have to be committed to Greece – and possibly to other official actors (creditors) who will be affected by the debt write down. The new bailout package to Greece is yet only a few months old, but it is likely that this package will have to be revisited before the end of this year. To sum this up, it is likely that at least 250 of the existing 500 billion euros will have to cover existing or additional commitments to assisted countries.

Yet 250 billion euros will not take the Eurozone far if it should purchase Spanish and Italian bonds. Together they will have to borrow a little more than 600 billion euro from now up to the end of 2014. In fact, they need to borrow more than 600 billion euro – in total 960 billion euro for 2012-2014 – if all redemptions (including short-term debt) are accounted. But where would that money come from?

Sufficient amounts of money to cover such a scenario simply are not available in the Eurozone’s bailout structure. If all new resources recently raised by the IMF are also used – which is to stretch the amount a country can draw from the IMF relative to its quota – the total financing needs for Spain and Italy in 2012-2014 could possibly be covered. But that would exhaust all existing committed resources, and a structure like the ESM is not built to be completely exhausted. Its credibility on the markets is based on the combination of paid-in capital (only 80 billion euro of the 500 billion euro in lending capacity) and the capacity of big solvent economies to actually cover their capital-subscription liabilities if that is needed. But under the assumption that two of its biggest contributors – Italy and Spain – are clients of the ESM, and that France’s credibility till be tarnished as a consequence, it is difficult to see how that credibility could remain. Like other schemes of this kind, it is durable only so long as investors believe that countries will not be asked to cover their liabilities.

In summary, it is unlikely that summit result will be the turning point of the crisis. It may add some qualitative differences to the future structure of assistance to countries that cannot finance themselves. But it is not a game changer. Arguably, the point I made in a paper this week on the crisis remains valid: only the ECB has pockets deep enough to give the much-needed systemic guarantee of the euro’s survival.