Saving the Euro?

So, once again (if you believe the Hollywood version) the USA has stepped in to rescue Europe and the Euro from imploding. Of course that it a very simplistic view of recent events. Much as the Hollywood version of the 1940s is a very simplistic take on the actualité

The US Federal Reserve has co-ordinated the actions of a number of countries’ central banks to make Dollar funds available. This was necessary because the market did not have any confidence in the ability of the EU banks. They were worried the EU banks would be unable to repay any Dollars they borrowed from it and so stopped lending any significant sums to them.

The Dollar is still the prime currency in which international trade is conducted. Hence any inability to borrow Dollar funds would leave the EU Banks unable to lend the same their customers (and other Banks). A “Credit Crunch” would surely follow.

However, this action by the Fed and other Central Banks will be, and can only be, a short term fix.

Short term fix

The markets will only lend to those that it deems can afford to pay both the interest on the debt and, eventually, the capital it borrowed. Over the past decade or so, some countries and banks have simply borrowed too much. They are crippled by interest charges levied by the market on its lending. The higher the risk (of not being repaid), the higher the interest rate. By becoming an alternative source of funding to the EU banking system, the Federal Reserve and its allies have endeavoured to take the strain out of the system.

However, ultimately, the Eurozone Governments and Banks must come up with a long term solution. They can not simply rely on short term fixes. The Euro depends on it. They have to demonstrate that they can and will honour their debts and will support ailing economies within the Eurozone to ensure continuing market support.

Confront the catastrophe

Herman Van Rompuy, the EU’s president, said that Europe’s governments needed to “confront” a looming catastrophe. “The trouble has become systemic. We are witnessing a full-blown confidence crisis,” he said.

As of now, Germany has blocked the European Central Bank from directly supporting ailing nations directly.

Germany’s stance is that:

a) the ECB does not have a mandate to do so and this can only be rectified by a change to various EU Treaties

b) in order for the ECB to have the ability to support a national economy such as Italy, it would have to literally print money. Which would have a virtually immediate effect on the rate of inflation in the EU.

Germans can only too well recall the periods of hyper inflation it suffered during the last century. It does not wish to do anything that could cause it to happen again. Also of course as Germany is effectively the only sound economy of any significant size in the Eurozone. It considers that it alone faces the risk that any policy mistakes that worsen the Eurozone economic situation. Those risks would cause it relatively more harm than other members.

What next?

So, given that the Eurozone has no lender of last resort (like the US Fed or UK Bank of England), what next? Well, apparently consensus is that the ECB cannot lend directly to ailing counties. However the ECB could lend to the International Monetary Fund which would lend to the ailing countries.

To give the ECB the funding to do this, the solvent member countries of the Eurozone would need to lend the ECB. Then the ECB would lend it to the IMF, for it to lend to the ailing countries. Sounds like a lot of paperwork and a political nightmare. Of course the solvent counties would have to go to the market to raise the funds to lend to the ECB. Yes you read that right that is what would have to happen.

If this did occur, the ailing countries could use the money that it borrowed from the IMF to, in part, repay the Market some of the money they had previously borrowed from it!

Collapse would cause an earthquake

To be sure, the collapse of a major EU bank or the default by a Eurozone member, effectively  bankruptcy, would have ramifications across the global economy. All Banks are owed money, in varying amounts, by other EU Banks and Governments. A failure to repay would have a ripple effect. Say Bank A failed to repay Bank B, then Bank B would be unlikely to be able to repay other Banks the money they were owed. Similarly, should a Country default on its debts, numerous Banks, other Financial Institutions and other countries may have to renege on their debts. So everyone has a vested interest to prevent either event happening.

One economy, one bank?

However, translation of a wish into a practical measure is not that easy. In this scenario, both finance and politics are involved. The present situation could never occur if there was full political & fiscal union. For example: a Nation State of Europe. One economy; one currency; one Federal Bank; one budget; one Central Government etc.

In that scenario, any part of the whole needing additional funds would simply borrow from the Central Bank. With the other parts, with surpluses, having deposited their surpluses with the Central Bank. It is thought that this is what Germany and France have as their objective. For this to happen could take years. Unfortunately the Market will not allow Eurozone members that long.

A solution must be found much quicker than that. A simple lack of funding will drive either a major bank or ailing economy into bankruptcy. Where will the European project be then? Olli Rehn, the European Commission vice-president responsible for economic affairs, warned that a summit of Europe’s leaders on Friday Dec 9 was now crucial.

“We are now entering the critical period of 10 days to complete and conclude the crisis response of the EU,” he said.