Has ‘Super Mario’ Really Saved the Euro?

By Marshall Auerback

Germany’s Constitutional Court gave a green light on Wednesday for the country to ratify Europe’s new bailout fund, boosting hopes that the single currency bloc is finally putting in place the tools to resolve its three-year old debt crisis.

In an eagerly anticipated ruling that has had investors on tenterhooks for months, the court in the southern city of Karlsruhe insisted the German parliament be given veto rights over any increase in Berlin’s contribution to the 700 billion euro European Stability Mechanism (ESM). There were strings attached to its endorsement of the ESM and a separate European pact on budget rules, and a relief rally has occurred as another apparent impediment to a euro “solution” appears to have been eliminated.

That said, in rejecting several applications for injunctions to block the ESM and a parallel “fiscal compact”, the constitutional court warned that it would only issue a final judgment later. Officials said that could be before the end of the year or in early 2013.

Although the final judgment is unlikely to differ in substance from Wednesday’s ruling, the judges warned that they may also then investigate the legality of the European Central Bank’s move last week to resume buying periphery government sovereignbonds to reduce the excessive cost of borrowing.

So is all is not clear for the euro? Certainly, the ECB’s involvement in an “unlimited” form (to use Mr Draghi’s own words) appears to ensure that the euro fat tail risk of “vaporising” has been reduced, but at what cost?

The Daily Telegraph’s Ambrose Evans-Pritchard has the most relevant line out there … “Democracies will make or break the back of EMU.”

Yes, if the populations continue to want to stay in the Euro and take any and all the pain that is implied by entering into the modern day equivalent of a Victorian debtor’s jail, then the blow-up risk is gone.

That said, is there is a point that a population through a populist vote could well say “enough is enough” and just decides to default and/or leave the Euro? There is still a lot of tail risk out there, which is being ignored in the current euphoria.

Like forcing the Greeks to take another 14 billion in austerity which will then lead to huge further lay-offs. At some point Greece could well break.

Well, that’s just Greece, you might say, and in any case, haven’t the markets discounted a “Grexit”? It’s hard to envisage the markets discounting an event the likes of which have no historic precedent. There has never been a country which has ever left or been booted out of the Eurozone before and it is unclear as to why a Greek exit would do anything but unleash a further speculative dynamic, where traders seek to pick off the next likely country to leave. That could prove highly destabilising.

And what happens when Spain finally capitulates and submits to yet another huge austerity program? How far are we then off from a Greek scenario? And Spain is not a tiny speck of an economy. It is the Eurozone’s 4th largest. One-by-one, Spain’s regions are approaching the central government for bailouts. These are not small bailouts either, but multi-billion bailouts. Moreover, the heads of these regional governments are demanding assistance while claiming they will not accept any conditions on any support they receive. At the same time, the Spanish banking system grows more infirm by the day. In July, gross ECB lending to Spanish banks rose to a record €402 billion from €365 billion in June. This accounted for a full 33% of ECB lending to Eurozone banks and illustrates that Spanish banks have nowhere else to go to fill their funding needs.

The latter point was confirmed by the latest data on capital outflows from the banks. Private deposits fell another €8 billion in July and have fallen by €158 billion over the last 12 months to €1.58 trillion, the lowest level since June 2008 . Why would capital want to remain in Spanish banks when a restructuring is imminent? This is the same question that was asked of Greek banks before that country’s faux-restructuring, and the answer is the same – there is no good reason for any sane person or business to keep money in a bank inside a nation that is likely to default on its obligations.

I do agree Italy is in much better shape than the rest and Draghi’s plan does take a huge amount of tail risk of Italy from potential contagion from Spain or Greece or Portugal. But the pain for Spain should get worse because of the impact of the bank run on an economy which remains hopelessly overindebted. And, lest we forget, it is still a relatively young democracy.

So yes, the Eurozone could go on for a long time in a kind of underemployment “equilibrium” as long as the ECB continues to buy national government securities. The problem is that , while this is possible, politically the optics of this are such that the ECB cannot go on forever doing this in such an ad hoc fashion, with the ECB putting out the fires wherever there is need for increased liquidity, unless these countries trade balances reverse themselves. They may well do so with sufficient deflation in the crisis countries but it will take a very long period of deflation indeed, and probably a return of the “Colonels” in Greece and a Mussolini and a Franco in Italy and Spain respectively. The biggest test for the euro is yet to come.


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