WHY EUROPE JUST GOT WORSE

Did yesterday mark the beginning of the end of the euro crisis? The German Constitutional Court judgement removing the legal obstacles to the European Stability Mechanism (ESM), followed by the big win for pro-euro and pro-austerity parties in the Dutch general election, surely provided some good news for europhiles. Yet by the end of the day, the market euphoria was waning, and committed eurosceptics were already arguing that this was just another brief diversion on the road to an inevitable euro breakup.
 
In reality, the recent political developments in the euro zone are unlikely to be decisive one way or the other. More likely, this run of seemingly favourable events will simply continue the longstanding alternation between complacency and panic that has characterised the euro-crisis since 2009. But this latest effort to resolve the euro crisis is likely to fail for the same reasons as all the previous cunning plans-the bond-buying plan announced by the European Central Bank last week, the agreement to create a banking union, the LTRO, the creation of the ESM or its predecessor the EFSF, the idea of leveraging these rescue funds or turning them into insurance mechanisms and so on. Many technical questions can be raised about the ECB plan to buy bonds with the backing of the ESM, which has now been authorised by the German court, but the most important come down to one problem: conditionality. Conditionality is a worry that investors are just beginning to recognise, to judge by recent comments in Bloomberg, Reuters and the FT-and this risk has now been exacerbated by the German court judgement.
 
Mario Draghi has famously promised to "do whatever it takes" to prevent a euro breakup and to prove that the euro is genuinely irreversible. If Draghi were serious in making this promise, he would provide an absolute and unconditional guarantee that no country would ever be forced to exit the euro, regardless of its political and economic conditions (a commitment preferably backed by a financial insurance commitment as suggested by my colleague Louis Gave).
 

But far from providing such a guarantee, the ECB, under the influence of the German court, has in fact done the opposite. Instead of guaranteeing support to any country whose economic or political circumstances might create the risk a euro breakup, Draghi has inadvertently laid out the conditions under which the ECB would allow the euro to break up. He has done this by saying he would only buy bonds from countries that submit to ESM austerity programmes and strongly implying that he would withdraw support from any country that failed to meet its ESM targets. The implication is that the ECB will stop helping those countries at greatest risk of being pushed out of the euro at exactly the time most need support.
 
To make matters worse, the German court has now insisted that a German parliament must vote on every ESM program. Given German public opinion, this could mean even tougher demands on Spain and Italy than the austerity already imposed on Ireland, Portugal and Greece. Since extreme fiscal tightening in the midst of recession is often politically unsustainable and economically counter-productive, there is a high probability that Italy and Spain will either reject ECB-ESM support programmes or accept them and then quickly fail to comply.
 

The upshot is that the policy of strict conditionality for ECB-ESM support, now backed by the force of law in the German court judgement and the force of democracy in the Dutch election, has created a potential doomsday machine. No country will get any support from the ECB unless and until its economy deteriorates to the point where it is prepared to accept very onerous bailout conditions. And once these austerity conditions are imposed, the economy in question will surely sink deeper into recession, while political conditions become even more unstable. Does this sound like a credible solution to the euro crisis?
 
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[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice.  Click here for full disclaimer]

 

Author: Anatole Kaletsky

Recently Editor-at-Large of The Times, Anatole Kaletsky is the author of Capitalism 4.0: The Birth of a New Economy, a recently published book on the global economy after the financial crisis. He is also a founding partner and chief economist of GaveKal Dragonomics, a Hong Kong-based research group which provides macro-economic analysis, commentary and asset allocation services to over 500 financial institutions around the world. Since 1976 Anatole has been an economic and political journalist for The Times, Financial Times and The Economist, during which time he was recognised as Commentator of the Year (1992), European Journalist of the Year (1995), Economic Journalist of the Year (2001) and Financial Commentator of the Year (2010). He is a director of several investment companies and a co-founder, with George Soros, of the Institute for New Economic Thinking. Anatole was educated at Cambridge University, where he graduated with a first class honours degree in Mathematics, and at Harvard, where he was a Kennedy Scholar and gained an MA in Economics. He is an honorary Doctor of Science from the University of Buckingham. Anatole was born in Moscow, Russia in 1952 and lives in London with his wife, a film producer, and their three children. Should any reader of RedBlog be interested in receiving GaveKal Research on a free trial please contact robert.murphy@gavekal.com