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Time to ready euro zone plan B

28 November 2011 By Hugo Dixon

It is fashionable for pundits outside Germany to lambast its government, the Bundesbank and the European Central Bank for being inflexible or stupid or both. Can’t they see that all that’s needed is for the ECB to fire its bazooka by printing unlimited money, and the euro crisis would be over?

After spending a couple of days in Frankfurt and Berlin last week, my impression is that these three institutions are neither stupid nor totally inflexible. That said, Germany is still determined to try its current plan for solving the euro crisis, though it has little chance of working. And by the time the trio get round to implementing a plan B, the euro zone could be in deep recession or even have exploded.

The current plan has three elements. First, the governments of troubled countries such as Italy and Spain need to implement structural reforms and austerity. Second, the zone’s fire extinguisher, the European Financial Stability Facility, needs to be got in good working order in case the fires in Rome and Madrid become uncontrollable. Finally, governments need to agree a treaty committing them to long-term budgetary discipline.

A month ago, this plan might just have worked. But investor confidence has now deteriorated so sharply that even promising new prime ministers in Italy and Spain haven’t been able to stop their bond yields rising. Meanwhile, Belgium has become the latest country to get dragged close to the danger zone, with the yields on its 10-year bonds approaching 6 percent. Even Germany suffered a failed bond auction last week. The fire extinguisher also looks faulty: plans to leverage up the EFSF so that it is big enough to bail out Rome and Madrid have run into trouble.

Even the proposed treaty, which Germany’s Angela Merkel has been trumpeting with much ballyhoo, is unlikely to do much to restore confidence. While investors will like the idea that governments won’t rack up excessive debts in the future, they might not be so happy about the austerity needed to get every country’s debts below the promised level of 60 percent of GDP.

What’s more, there’s no guarantee that the current Treaty can be changed given that it needs unanimous approval not just by the 17 euro zone countries but also by the 10 other members of the European Union, such as the UK. In some cases, there may also be referendums, whose results tend to be unpredictable. This explains why Germany and France are now casting around for alternative ways of getting the same result – say by having new treaties signed by a smaller group of countries.

Given all this, pressing ahead with plan A might suggest that the decision makers in Frankfurt and Berlin are indeed stupid. That would be true if they were sure it would work. But they don’t seem to be. Indeed, the German finance minister called for extra resources for the International Monetary Fund on Friday in seeming recognition that the EFSF on its own won’t be enough to bail out big euro zone countries. Nevertheless, the policymakers in Frankfurt and Berlin still think that everything in plan A is still necessary or at least desirable, even if it proves insufficient to solve the crisis. It is, for example, really important to keep the pressure on the new Italian and Spanish governments so that they deliver on their potential.

What’s more, coming up with a plan B is problematic given that the ECB is forbidden from directly funding governments. This doesn’t mean that there’s no way saving the euro if plan A fails. There are, after all, various gimmicks that could be used to get round the prohibition on directly funding governments. One is for the ECB to lend to the EFSF, making its fire extinguisher fully functional. Another is for the central bank to lend to the IMF and let it then lend to Italy and Spain.

The problem is that either manoeuvre would be extremely controversial as well as possibly open to legal challenge. That’s not to say the ECB would never contemplate unusual measures if that was the only way of preventing the euro breaking apart. But it would seem that, even then, it would only do so if it had political cover.

Such cover is gradually coming. Following the scares of the past week, both Finland and the Netherlands – which, along with Germany, have been the strongest advocates of austerity – started to crack. The Finnish finance minister said that if there were no other alternatives, an increased role for the ECB had to be considered. Similarly, her Dutch counterpart said he’d prefer the EFSF to be strengthened but, if that didn’t work, other measures would have to be considered: “In a crisis, one should never exclude anything beforehand”.

Meanwhile, the ECB seems likely to offer some short-term palliatives. First, it is continuing with its programme of buying sovereign bonds in the secondary market as a way of preventing Italian and Spanish yields going through the roof – a programme that Berlin has studiously avoided criticising. Second, the central bank looks likely to offer longer-term money to banks as well as accepting more types of collateral in return for it – measures that should counteract to some extent a looming credit crunch. Finally, it may cut interest rates again in December to reduce the deflationary potential of the coming recession.

Fingers crossed, such short-term palliatives will prevent an explosion until Germany implements plan A and figures out that it isn’t working. But even in the best case, such an approach probably won’t be enough to prevent a nasty recession. Meanwhile, there’s the ever-present risk that a panic could trigger a chain reaction which even a plan B would be unable to contain.


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