The surreal logic of the eurozone crisis

18th September 2012

Yields on 10-year Spanish government debt rose 13 basis points to 5.96 per cent on Monday as investors became unsettled over the apparent reluctance of the government to apply for a bailout. In the perverse world of eurozone markets Spain may have to be seen to get weaker before bond markets regain confidence in it.

Appeasing the confidence fairy

It is clear from the market's reaction to the ECB's programme of outright monetary transactions that the general consensus is that it will be enough to assuage short term funding problems for sovereigns. Debt yields in Spain and Italy, southern Europe's largest economies, dropped sharply after the announcement.

As commentators were quick to point out, however, the devil is once again in the detail – or in this case in the conditionality. The problem for governments struggling to reassure markets that they are able to pay their debts is that in order to fall under de facto ECB protection they have to apply to the eurozone bailout funds for assistance. That is, they have to acknowledge their inability to finance their debts before receiving implicit central bank guarantees of their ability to do so.

This creates a problem for bond markets. They have been reassured by the central bank providing a backstop for sovereign debt markets but in order to gain the promised insurance they need to drive a sovereign into a bailout application.

Or as Yanis Varoufakis puts it in a post on Naked Capitalism:

"First, [Mario Monti] must decide whether Italy needs the ECB's assistance so much as to apply for an ESM-EFSF program; the prerequisite for Mr Draghi to mobilise OMT on Italy's behalf. If Mr Monti does not apply, and the markets realize that Italian bonds will not be purchased by the ECB, Italy will be consumed by the ongoing debt-deflationary spiral which caused Mr Draghi to conjure up the OMT program in the first place."

Politicians may have to size up whether it is better to capitulate to market demands and apply for a bailout (even if they do not technically require it) or continue the current game of chicken. For many of them it has become an issue of credibility but increasingly it looks like a matter of when and not if they cave in.

When is enough really enough?

One of the main difficulties facing investors is that it has been difficult to grasp what the end goal of the various eurozone crisis measures are aimed at. There has been a lot of talk about further integration of the single market, both in terms of budgets and politics, but little detail in the proposals.

Moreover Germany's Angela Merkel has suggested that there cannot be any major structural reform of the monetary union without a political union first. Many of her European partners see this as putting the cart before the horse – unless politicians are willing to commit money to save the euro project, how can electorates be expected to vote for it?

In the words of French President Francois Hollande:

"We both want to deepen economic, monetary – and in the future political-union, to arrive at integration and solidarity."

Without certainty over what these measures are designed to achieve it becomes all the more difficult to convince debt-laden countries to embark on harsh austerity. Failure to articulate a vision means that national governments face a daunting challenge of convincing those who are suffering under government cuts that their plight is worthwhile.

For investors it adds a further layer of complexity to an already opaque situation.

Words of advice

The crisis has provided plenty of excitement for eurosceptics who have seized on it as vindication of their long-held views. While many of the structural weaknesses of the monetary union have indeed been made painfully apparent, their predictions of an imminent collapse remain frustrated.

Eurozone policymakers, however, have failed to silence their critics. Bailouts and backstops may have succeeded in buying time but even in the (unlikely) event of a sudden economic turnaround these structural issues cannot be re-buried. A solution must be found.

In his book Stabilizing an Unstable Economy published in 1986 the economist Hyman Minsky argued that one of the key insights of John Maynard Keynes was that "our economic destiny is controllable". Given that, policymakers cannot simply focus on putting out fires in the hope that some spontaneous order will impose itself. As he put it:

"Economic policy must reflect an ideological vision; it must be inspired by the ideals of a good society. And it is evident that we are faced with a failure of vision, with a crisis in the aims and objectives that economic should serve."

This does not mean that even a project as noble as the euro project appeared in the aftermath of two world wars will always escape bad policy choices. Yet it is to say that without a clear vision those in charge will struggle to make sound choices.

Technocratic solutions may have proven a useful break from the folly of the past, but without an ideological purpose they cannot offer sufficient hope for the future.


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