Did Europe miss its chance?September 11, 2012: 8:52 AM ET
While Europe's latest plan differs from the last ECB intervention, its methods are not new to this crisis. All eyes are on Germany for the next potential shoe to drop.
By Cyrus Sanati
FORTUNE -- The latest plan to save the euro is just more of the same – delay. While the markets have responded favorably to the European Central Bank's newly polished bond buying program, the enthusiasm is bound to wear off in the coming weeks as it is implemented across the eurozone. And there is a chance that the plan may not even survive by the end of this week, as a German court rules this Wednesday on the constitutionality of that nation's participation in the various eurozone bailout programs. If the court finds that Germany's participation violates national sovereignty, the bailout would lose its biggest donor. That would not only threaten the ECB's latest program, it could also spell the end of the euro all together.
The eurozone crisis seems to have picked up right where it left off before Europe took to vacation in August. Mario Draghi, the head of the ECB, assured the markets at the end of July that the central bank was "prepared to do whatever it takes to preserve the eurozone." It was largely believed that Draghi would soon initiate another bond buying program, where the ECB would buy up eurozone member debts in the secondary market to bring down borrowing costs. The technique was first used to stabilize the Greek markets in 2010 and later used in Spain and Italy. While he didn't go into specifics, the strong statement was enough to calm the markets throughout much of August.
Last week Draghi showed his cards. As expected, "whatever it takes," was simply another bond buying program. Known as the Outright Monetary Transactions, the ECB essentially formalized the process by which it would intervene in the debt market of a eurozone member.
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At a little under 500-words, the plan's presentation was noticeably light on details. Nevertheless, it was easy to make out some key differences from the ECB's last two bond interventions. First, under the OMT, member states requiring assistance must formally apply for help. Second, it forces member states to meet certain fiscal goals, with possible help from the IMF. Next, the ECB would only be buying short term paper, or bonds that would come due in the next three years. Additionally, it was decided that the ECB would have the same status as regular investors in the event of a default, eliminating past investor concern as to seniority. And lastly, the program would go on indefinitely and it would extend "unlimited" help to member states.
The markets responded favorably to the plan after it was announced. Bond rates in troubled eurozone countries immediately fell to manageable levels, while the markets and the euro rallied. Spain was later able to sell three-year bonds at 3.63%, down from 5.09%.
So does this mean the crisis is over? Hardly. If anything, the ECB plan is just yet another Band-Aid applied to a now gushing eurozone wound. While there are some good parts to the plan, it just won't work by itself. Ultimately, this crisis needs to be solved at the political and fiscal level, not the monetary one. The ECB plan can help aid politicians in this regard by essentially buying them time to finally get their act together and solve the crisis.
But we have been down this road before. When the ECB intervenes and calms the bond markets, politicians seem to get lazy. Eurozone leaders need to be staring down the barrel of a gun that is being cocked back in order to do anything. Instead of buying time, the OMT, will simply be delaying the inevitable while increasing the money supply.
Furthermore, while the OMT differs from the last ECB intervention, its methods are not new to this crisis. Indeed, they are pretty much the same conditions that are required for obtaining cash from the EU bailout fund. They are basically the same methods crushing the Greek economy into a permanent depression. It is doubtful that Spain and Italy would want to turn over their books to the IMF so they can be told to institute harsh austerity measures and to fire thousands of government workers. While the economies of Spain and Italy are in need of serious reform, and thousands of government workers should be let go, forcing such a plan now while their economies are weak will drive them deeper into depression, setting off a downward spiral where revenues fall, forcing more cuts.
Germany's central bank was the lone dissenter of the plan. That shouldn't be surprising as it has the most to lose if this plan fails. Leading the concern is the chance of hyperinflation breaking out in the eurozone. The ECB addressed this concern by noting that all bond purchases would be "sterilized," which is an odd way of saying that they would be offset through the sale of assets from its own balance sheet.
But the ECB isn't about to mortgage its headquarters in Frankfurt to buy some risky Spanish and Italian paper. It intends to offset the cash it spends by taking an equivalent amount in cash out of the system. This is done by offering banks the amazing interest rate of 0.01% to park their excess cash at the ECB. The ECB thinks banks will jump for this deal as they collectively have around $800 billion in excess cash reserves. But you don't need a degree in economics to realize that this is not a balance sheet-neutral transaction – at least not in the long term. Money needs to be destroyed or shelved indefinitely for it to leave the economy. Acquiring new debt doesn't offset anything – it just adds more debt. One can mess around with the accounting to make it appear that it doesn't exist, but it isn't reality.
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Germany's conservative press was understandably "concerned," about the deal. "Blank check for the indebted states," was the headline splashed across the Bild newspaper following the announcement. Germany's population has been very patient throughout the crisis, but they appear close to exploding. The problem is that they aren't seeing how the any of the various bailouts will benefit them. Eurozone politicians are to blame for that as they have failed to agree to a fiscal pact that would see Germany at the top of the heap. If Germany's population knew for sure that they will be at helm of a truly unified European economy, with the power to tax and spend revenue across the zone, it could change German sentiment dramatically.
But it may be too late to act. On Wednesday, Germany's constitutional court will rule on whether or not it is legal for Germany to participate in the various bailout schemes. Those that oppose the bailouts say that Germany has given up too much of its sovereignty to Europe and the decisions made by their politicians are undemocratic. The fallout from such a ruling is hard to fathom. In essence, Germany, which was supposed to back 28% of the bailout fund, would have to withdraw. Furthermore, if the court rules that Germany has given up too much sovereignty, it would be impossible to see how Germany could participate in a eurozone fiscal pact. The government's only recourse would be to call a national vote to alter the constitution, giving the government the power to essentially give up its power to the EU. With so many Germans now opposed to the euro and the bailout, it is difficult to see how that could ever happen.