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Opinion

What To Make Of The Great EU Announcement

From my piece at Yahoo.

Twenty six of the 27 European nations decided to move forward with "tighter integration" and a closer "fiscal union" which seems to have cheered markets tremendously. (The lone dissenter was the UK.) These grandiose statements provide way too little detail in exactly how such a pact would work, and be palatable to the vast electorate at the same time.

The idea is that a tighter control of both spending and taxes by a central body will ensure that no country will go overboard and thus harm the Euro. The central body would almost surely be loaded towards Germany and France, and why would a Greece, a Holland or a Portugal allow such a body to not just determine how much tax they would pay, but also how much they can spend and on what? It is highly unlikely that just because German and French banks own the debt of certain countries, that Germany and France will be allowed to violate their sovereignty; although it is a big statement, I doubt everyone will see eye-to-eye when Germany decides that Italian pensioners need to take a 10% pay cut.

The decision making process — which currently requires an okay by all Euro countries —  could be changed to introduce an "85 per cent supermajority", which means a small country can’t hijack an issue by voting against it. France and Germany want this — they are part of the 85% – and opponents are smaller nations like Finland and Slovakia.

Also, the leaders mention that there will be "penalties" for any nation violating spending or collection rules. But even Euro membership came with rules, like a 3% fiscal deficit and a 60% debt-to-GDP limit, both of which have been violated continuously, even by Germany (debt: 83% of GDP). It’s not entirely clear how a penalty can be a deterrent if it hasn’t been enforced earlier. ("If you don’t stop, I’ll say stop again, and louder!")

Finally, think about how it will work: An euro country, like Portugal, decides to spend too much on, say, schools. The European Court of Justice decides this is unacceptable by deficit considerations and refuses to allow it. The Portuguese people protest; like the Greeks are protesting now against externally enforced austerity. This sort of thing simply won’t work unless they’re all willing to be one country, and one region is willing to sacrifice for the sake of another.

The plan needs to be cobbled together into an agreement and then passed by voting in all EU countries, which they say will take three months. This sounds implausible; getting the Euro on the road took over 9 years after the first agreement. The democratic nature of the EU requires citizens to be with the program, and it’s quite unlikely the voter in Germany sees things on the same level as the one in Greece. And within three months? Don’t hold your breath.

This is only important because Europe needs a solution fast. Bloomberg says more than 1.1 trillion Euros of long and short-term debt will come due in 2012, much of it in the first half alone. Recently, Italian bonds crossed yields of 7%, only coming down as the ECB stepped in to buy bonds. But bond buys by the ECB, reek of moral hazard — the banks that bought this debt originally made a bad investment; they are getting bailed out by the ECB, which in turn is backed by every taxpayer in the Euro region. The idea that the privately taken risk — by a bank — is being transferred to the taxpayer was frowned upon by Germany, which insisted that private lenders be forced to take a part of the hit. On Thursday, though, they climbed down from that position, because of fears that if private lenders take a hit, they will contract future lending and hurt everyone in the short term.

This is a justification used often — that we need a "lender of last resort" and that the US Fed has paved the way by intervening in 1987, 2000 and 2008. Recently, it has lent $29.6 trillion in total — the maximum outstanding on any day was $1.2 trillion, which is about 12% of the total US money supply (M2). In comparison, Indian money supply is Rs 50,00,000 crore, and even in the crisis less than Rs 150,000 crore was borrowed overnight by the banks.

On Thursday, the ECB committed "unlimited" funds to banks for three years, and lowered interest rates to 1% from 1.25%. Additionally, it made collateral requirements looser — banks are supposed to pledge something in order to borrow from the ECB, but it seems that now the ECB will accept just about anything printed on a piece of paper. This, they hope, will encourage banks to buy government bonds — after all, they can pledge those bonds to the ECB for the money. This is the way the ECB intends to get away from the German opposition to actually printing money and buying those bonds themselves. (The Germans are scared of printing induced hyperinflation — they faced the specter of it in the 1920s when they printed up to 60% of the country’s money supply every day)

Additionally, the 17 Euro countries and the 10 others in the EU will provide 200 billion Euros to the IMF, in what is another circular way to invest in troubled country debt, since that is what the IMF will buy. A "European Stability Mechanism" (ESM) will be created with a capacity of 500 billion Euros to further help. There are, again, no relevant details.

But is it enough? Just Italian debt totals over 2 trillion Euros. The EFSF, with 440 billion Euros, is now considered adequate for just Greece. The magnitude of the problem is far greater than the money being readied to attack it, and taxpayers in the region are already balking at the size of the current war chest. With every increase requiring negotiation between more than 20 entities, and Germany firmly opposed to printing money, there will be consternation at every mini-crisis that happens.

One alternative is for countries to break away from the monetary union and issue their own currencies. While this seems unlikely, it will be a real decision if talks reach a deadlock — and a Euro exit may cascade into a point where the Euro ceases to exist. The uncertainty caused by such a decision will surely put much of the world into recession, but it may be a better idea than having multiple nations with vastly different economic situations attempting to have central governance.

For troubled countries, issuing their own currency and devaluing it will increase their competitiveness; who it will hurt is Germany, which hugely dependent on exports, and which will see its own currency rise in comparison and thus, hurt its exports.  But it will undoubtedly destroy the banking system as we know it today, though some would say they will only be replaced by different, stronger banks in the future.

A Euro breakup will impact the entire world, but it seems like it might be better than keeping us in limbo forever. Will the agreement, if it happens, change everything? The next three months will tell.