16 December 2011

Douglas J Elliott: Europe's crisis deal is causing a lot of infighting

There has been a lot of sparring coming out of the recent European Summit that was supposed to produce, for the fifth time, a comprehensive solution to the euro crisis. These disagreements have disturbed financial markets and made it all the more likely that there will be a market panic in the next few months.

I continue to think there is about a three in four chance that the leaders will eventually stare reality in the face and do what is necessary, but that still leaves a worrisome one in four possibility of a disaster that would spread across the globe.

The most important fight in the near-term is the one that is being conducted most subtly. The European Central Bank needs to be prepared to buy massive quantities of Italian and Spanish bonds if those nations are threatened with loss of access to private funding at acceptable rates. But the ECB and Germany, Europe's major power, do not want the central bank to step up purchases if there is any serious risk that the financial support would allow politicians in the troubled countries to backslide on necessary reforms.

The hope was that the medium- and long-term reforms agreed to at last week's summit might provide the necessary reassurance to the ECB. However, it is becoming clear that the central bank viewed the steps as progress, but not nearly enough to justify a major step-up in ECB bond purchases, despite subtle encouragement from many European leaders. That is a major reason why financial markets have reacted fairly negatively. Unfortunately, this struggle probably will not be resolved without a market crisis leading to a more definitive summit.

The more public struggle is about the role of the UK, which is one of the 27 countries in the European Union, but not one of the 17 that uses the euro as its currency. It remains to be seen whether the UK vs Europe fight is the sign of a rupture of the EU, resulting in an eventual British withdrawal, or is just part of the normal jockeying between the core of Europe and the somewhat troublesome islands off its coast. In the short run, there is a real risk of an erosion in the UK's bargaining position on the financial regulatory issues, since the European anger appears real enough for now.

The final fight sounds very technical. The European leaders proposed to lend money to the International Monetary Fund to enlarge the amount available to deal with a potential worsening of the crisis. The issue is that the initial proposal is to lend the money directly to the IMF, which would then lend it to whatever country ends up needing it. This approach leaves the European contributors with the IMF's credit risk, which is very good, but the IMF would have the greater credit risk of the troubled country.

There has been pushback from some other IMF shareholders, who want Europe to put the money in a separate fund administered by the IMF, but with the credit risk remaining with the original lenders. There are a lot of technical and legal complications, so it is difficult to know which way it will go. However, it appears very likely that something will be worked out. It could even be the classic compromise of doing it 50/50.

Full article, originally published as ‘Europe’s Sticky Wicket’, ©CNN Money

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