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EU bank bailout ploy opens up Pandora's box

EU bank bailout ploy opens up Pandora's box Anthony Harrington

With the 500 billion euros of the European Stability Mechanism (ESM) being placed at the disposal of an EU wide bailout of troubled banks in member nations and with it also being readied to buy dodgy sovereign debt that the bond markets won't touch except at exorbitant yields, the ESM has at last been brought squarely into the firing line. "We affirm that it is imperative to break the vicious circle between banks and sovereigns," the eurozone heads of state announced in their post-summit statement. The mechanism to break that cycle, as it turns out, is now going to be the ESM which, to cut a long story short, makes German cash available to bail out Spanish banks (which, of course, will go down like a lead balloon with the German public).

At a stroke this decision by the EU heads of state at their 20th Summit (28-29 June) removes the burden of bank bail outs from the books of the Spanish government, considerably improving the look of Spain's balance sheet, and puts it squarely on the shoulders of the ESM. The only thing that gives the German Chancellor Angela Merkel a prayer of selling this deal to the German public in the weeks ahead is the fact that ESM largesse will only be dispensed to troubled banks once there is a single banking supervisor - ie the ability to impose Bundesbank style rectitude henceforward - across all EU banks. In theory this should mean that weak banks won't continually drag down troubled sovereign states. It also means that the EU has collectively agreed to take another significant step forward towards a full banking union, and ultimately towards full fiscal union. It is safe to say that at this stage no one has a clue how a United States of Europe would work, so we are heading off into uncharted territory here.

Under enormous pressure from the Italian Prime Minister, Mario Monti, aided and enthusiastically abetted by the Spanish Prime Minister Mariano Rajoy, Merkel also caved in and agreed to allow the ESM to act as a buyer of last resort for troubled EU sovereign bond issuance. This is huge for Italy, since it gets Italy out from under the cosh of the financial markets and provides it, in effect, with a bailout route without having to suffer Greek-style austerity. Once the implications of this filter through to the policy makers and citizenry of those states already under the austerity lash, namely Greece, Ireland and Portugal, we can expect some interesting discussions to emerge. What EU heads cobble together in the small hours of the morning in a pressure cooker environment generally has ramifications that go way beyond what the parties involved managed to think through at the time. Expect the law of unintended consequences to come in to play big time here. The heads of state gave a nod in this direction in their communique saying: "The Eurogroup will examine the situation of the Irish financial sector with the view of further improving the sustainability of the well-performing adjustment programme. Similar cases will be treated equally."

Eh? How do we define "similar" here? Greek banks are well and truly bust, but they are kept solvent by the Greek Central Bank's ability to keep on printing euros and handing them to its banks in the form of emergency liquidity lending - which is the only reason why Greek depositors have not found their bank coffers to be empty when they have sought to pull their money out to place it in much safer, German banks. This, of course, ratchets up the Greek government's Target 2 debt with the ECB, but as we have been told before, this is just an accounting debt, "of no significance". Ah, wait a moment. The full text of that statement on Target 2 debts, as I recall, was "it is of no significance unless and until a member leaves the EU", at which point the sovereign debt to the ECB becomes real. Which is a nice joke in its own right.  A departing Greece would simply monetise any legacy ECB Target 2 debt by printing drachmas, leaving the ECB with a massive hole that the remaining states would have to plug, each according to their ECB contribution ratio. Happy days. However, now that Merkel and co have agreed that the ECB can bail out troubled banks, presumably the Greek central bank can rest its printing presses and leave it to the "Germans" (Greek term for any officialdom from the troika) to sort out its troubled banks. Good news too, for the Irish state, which may well be able to sidestep the crippling burden of its own, ill-judged bank bailout fiasco.

Whether the ESM has enough money in its coffers to back up its emerging role as Atlas, carrying the whole bankrupt EU periphery on its shoulders, remains to be seen. Cursory arithmetic suggest, not by a long shot it doesn't, but then that's what all those statements about the EU being big enough to bail out Greece, Ireland and Portugal (oh, and Cyprus as well), but not being big enough to bail out a massive economy such as Spain or Italy, were all about. The hope is that it won't come to that, since the financial markets are supposed to read the communiqué and decide that, hooray, the problem's solved. However, the reality is likely to be that the markets will now focus squarely on the ESM and will look to measure the depths of its pockets versus the scale of its commitments. It is going to be interesting to see what the outcome of this will be...

Further reading on the EU bailout:

Tags: Angela Merkel , Bundesbank , ESM , European Stability Mechanism , German chancellor , Mariano Rajoy , Mario Monti , Wolfgang Schaeuble
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