MAY 10, 2010, 11:52 A.M. ET.
Euro Zone Bets the House .
By RICHARD BARLEY
Euro-zone leaders, the International Monetary Fund and the European Central Bank have pressed the big red button marked "do not press" with a nearly $1 trillion package of loans, guarantees, swaps and outright bond purchases. Will it work?
The "shock and awe" strategy triggered a huge immediate relief rally, but key questions remain unanswered and ultimate success isn't assured. In any case, it represents a huge political gamble to restore confidence to markets, and it will have profound consequences.
The European Union agreed to an audacious $955 billion bailout plan to stanch a growing sovereign debt crisis that began in Greece and threatened financial markets world-wide. Markets responded very positively, rallying sharply in Europe and sending U.S. stock futures soaring.
The scale of the deal—in particular the size of the IMF's €250 billion ($318 billion) commitment, and the degree of international cooperation—surprised investors. At €750 billion, the package is around 8% of euro-zone GDP, an undoubtedly significant sum. Were anything approaching the full amount to be needed, it would mean that private creditors had deserted euro-zone markets: among them, Portugal, Spain and Ireland—the countries most in the markets' sights other than Greece, which has its own €110 billion package—need to borrow only around €90 billion for the rest of the year.
As a result, stocks soared, the euro surged, credit spreads screamed tighter and Greek, Italian, Irish, Portuguese and Spanish bonds racked up big gains Monday. But on the flipside, German Bund yields also rocketed, partly reflecting a reversal of last week's flight to safety, but also potentially marking the start of a longer-term convergence higher in euro-zone yields. The debt crisis has now been injected into the system itself.
But key details of the package are fuzzy. Of the up to €500 billion European Financial Stabilization mechanism, €60 billion will be available from the European Union budget, along the lines of an existing fund that was set up to aid EU members outside the euro zone facing difficulties. The other €440 billion would be funded via a special-purpose vehicle guaranteed by participating euro-area states. But how can states that might themselves be in need of support afford the guarantees? Will stronger states like Germany end up shouldering most of the burden? How will the conditionality attached to the plan work? Will funding be available when it is needed? Is this a step to a common euro-zone bond, leading ultimately to full-blown fiscal union?
Similar questions surround the European Central Bank's decision to start buying private and public debt securities, an astonishing U-turn coming just days after it had said that buying bonds wasn't under discussion. It's not clear what will be the scale and timing of purchases, or how they will they be sterilized. Is this simply a symbolic backstop bid? For the ECB to end up financing deficits that private creditors don't wish to would be a devastating blow to its credibility.
The whole package represents an enormous bet on governments' willingness and ability to implement austerity measures—and voters' willingness and ability to tolerate them—and that markets will now have confidence in these efforts. It doesn't address underlying solvency concerns.
If the bet fails, losses risk being socialized through an opaque, unsanctioned fiscal transfer mechanism. The euro zone already is being transformed. The need to prevent the European government-bond market from breaking down completely was urgent. But the price is harsh austerity, a further move toward a federal Europe, and the bailing out of private investors. Taxpayers may yet revolt at all three of those ideas.
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