Monday, August 8, 2011

Europe Update

Signals the European Central Bank will intervene in Italian and Spanish government bond markets is good news and will help soothe debt concerns, but does not add a lot to dealing with the fundamental problem.

As part of the Euro-zone summit agreement last month, the European Financial Stability Facility (EFSF) was given power to buy government bonds in the secondary market if the ECB thought it was warranted and member states agreed. That role for the EFSF is still to be ratified by individual member parliaments, but the agreement was meant to spur the ECB into action in the interim, should it be required.

The ECB intervened in Irish and Portuguese debt markets last week, but not Italian and Spanish markets. That was a key source of a source of negative market sentiment last week. Over the weekend France and Germany have pledged to get the required legislation through their respective parliaments allowing the EFSF to start purchasing bonds, probably by October.

For their part, Italy and Spain have committed to new deficit-reduction measures. In particular, Italy has committed to bringing forward its balanced budget by one year to 2013. At best that was the right answer to the wrong question. It’s not so much about WHEN fiscal consolidation is achieved as it is about the credibility of the plan. There is still a paucity of detail around exactly HOW Italy intends balancing its budget.

The bigger problem is the EFSF is not big enough to cope with a default by Italy and Spain. That concern will remain until either there is greater credibility around individual member fiscal consolidation plans and/or there is a “Shock and Awe” type strategy that significantly boosts the size of the EFSF. Neither Germany nor France thinks that is necessary…yet. Another possibility is the issuance and conversion of Euro-area national debts into Euro Bonds, but that seems likely to be a debate for a different time.

As we mentioned this morning (see below), one of the concerns following the US downgrade was that it may suggest to some governments they should implement even harsher fiscal austerity plans to maintain their ratings. One country that comes immediately to mind in that regard is France. A downgrade to France would have the complicating factor of undermining credibility in the EFSF by reducing the AAA rating on one of the important guarantees.

All harsher austerity achieves is damage to growth prospects. This raises further questions about fiscal sustainability rather than answering them. Sorry to sound like a worn record, but getting the right balance between fiscal austerity and supporting growth is critical.