The day may yet come when the eurozone finally agrees a comprehensive package to end the crisis, but this was not the day. What policymakers agreed at 4am Brussels time on Thursday came close to what they set out to do. They secured a “voluntary” deal with the banks, and they agreed the outer perimeters of a system to leverage the European financial stability facility up to about €1,000bny. But none of this is going to end the crisis.
Herman van Rompuy, the president of the European Council, made a revealing comment after the meeting when he said that banks have been doing this forever. Why should governments not do so as well?
The reason is simple. Banks can only use leverage because central banks and governments act as ultimate guarantors of the financial system. There exists an implicit insurance of unlimited liability. In the case of the European financial stability facility the very opposite is the case: there is an explicit insurance of limited liability. Germany wants its exposure capped to a maximum of €210bn. I doubt that global investors will rush into the tranches of the special purpose vehicle through which the eurozone wants to leverage the EFSF. I struggle to see how this structure can lead to a significant and sustained fall in bond spreads.
Leveraging can work, but only if the eurozone were willing to provide an unlimited backstop. This would be either in the form of an explicit lender-of-last-resort guarantee by the European Central Bank, or through a eurobond – or ideally both. Now that is something I would consider to be a comprehensive agreement. It may yet happen, but not for a long time. The crisis, meanwhile, continues. Continue reading »