Two Futures

09/12/2011 at 10:31 am

Inevitably, all the talk is of Europe – again. The top five worldwide stories on the Bloomberg terminal this morning all concerned the latest summit proposals, pushing a dull tale about the Chinese economy into sixth place. To summarise the headlines:

  • The European Stability Mechanism (the eurozone-only bailout fund originally planned to succeed the current EU-wide European Financial Stability Facility in 2013) will begin operations in tandem with the EFSF subject to a €500bn ceiling next summer.
  • EU Central banks will commit to lending €200bn to the IMF in the event that it needs to be lent back to the eurozone, of which €150bn will come from the eurozone itself.
  • Private sector bondholders will not take losses in future bailouts (i.e. after agreement of the Greek restructuring).
  • Last, and most important: eurozone governments will enact a budgetary agreement which will restrict borrowing and be subject to supranational oversight.

There was a key disappointment in that sizeable government bond purchases by the ECB did not explicitly form part of the package, so market reaction has been muted. European equity markets made a positive start; peripheral bond markets yields are a touch higher, but only a touch and remain kilometres away from their recent highs; and currency markets are unchanged.

Short term developments could transform the picture, of course. The commitment to extend the IMF’s firepower might entice reserve-rich countries (read: “China”) to make similar commitments. On the other hand, the ratings companies are seeking ever more creative ways to compete for credibility while worsening the panic. S&P has threatened to cement its US rating debacle with a raft of eurozone sovereign downgrades. In reply, Moody’s zeroed in on the financial sector and downgraded some French banks this morning. Even Fitch played a clever oblique stroke last week by warning over the solvency of the UK (who’d have thought it?)

Ultimately, however, the only short term variable of real significance remains the bond market. It will determine whether EFSF, ESM or IMF firepower is sufficient. It will determine whether or not ratings companies have the power to upset the apple cart. And it will determine whether or not the eurozone states can muddle through to the key element of the summit: the prospective agreement of a new eurozone treaty by March 2012.

In the words of Daniel Hannan MEP, Conservative eurosceptic and blogger for the eurosceptic Telegraph:

A rival treaty organisation, predicated on common economic government, would become de facto the new forum for integration. One by one, political powers would pass from the EU to the eurozone until the EU became a shell, an amplified free trade area, a kind of EFTA-plus. Which, of course, would suit Britain very well indeed.

The sovereign debt crisis would have transformed the political landscape in Europe – arguably for the better, if you are a Continental believer in the euro (i.e. in the majority) or a British opponent of it (ditto). Economically, the eurozone could come to resemble Germany: a defensive, low-inflationary and low-deficit power with an unexciting trend rate of growth and a high level of regulation. The UK would have the freedom to resemble this picture rather less, for better or for worse.

In the context of the current drama this may seem small beer but at least it would be palatable. Consider a second future: closure of the euro periphery’s bond markets, Italian and Spanish distress, and global panic culminating in a wave of sovereign defaults and an economic contraction that would be especially pronounced in debtor (western) countries. In this case the political consequences could be chilling.

This fifth EU emergency summit will have failed to bring the crisis to a sudden halt. The next few months could be just as interesting as the last. But what it has done – assuming that we get there – is give us a glimpse of what the sunlit uplands will look like.

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