The euro zone’s self-inflicted killer

By Bethany McLean
November 18, 2011

By Bethany McLean
The opinions expressed are her own.

There were a lot of things that were supposed to save Europe from potential financial Armageddon. Chief among them is the EFSF, or European Financial Stability Facility.

In the spring of 2010, European finance ministers announced the facility’s formation with great fanfare. In its inaugural report, Standard & Poor’s described the EFSF as the “cornerstone of the EU’s strategy to restore financial stability to the euro zone  sovereign debt market.”  The facility itself said in an October 2011 date presentation that its mission is to “safeguard financial stability in Europe.”

That of course hasn’t happened. And the evidence suggests that the EFSF may have only exacerbated the problems.

In theory, the facility is supposed to provide a way for a country that the market perceives as weak to still borrow money on good terms. The initial idea was that instead of the financially troubled country itself trying to sell its debt to live another day, the EFSF would be the one to raise the money and lend it to the country in question. The logic was simple: country X might be shaky, but the EFSF deserved a triple-A rating.

For all of its would-be financial firepower, the EFSF isn’t much to see—it’s just an office in Luxembourg with a German-born economist CEO named Klaus Regling, who oversees a staff of about 20. Its power—and that rating—is derived from the assumption that any debt it issues is guaranteed by the members of the euro zone. Initially, each member pledged unconditionally to repay up to 120% of its share of any debt the EFSF issued. (A country’s share is determined by the amount of capital it has in the European Central Bank.)

On paper, it all sounded great. The reality is that the EFSF wasn’t meant to be an active institution; it was supposed to be a fire extinguisher behind glass: never to be used. “The EFSF has been designed to bolster investor confidence and thus contain financing costs for euro zone member states,” wrote Standard & Poors in its initial report granting the triple A rating. “ If its establishment achieves this aim, we would not expect EFSF to issue a bond itself.”  Moody’s, for its part, wrote that the EFSF “reflects the political commitment of the euro zone member states to the preservation of the euro and the European Monetary Union.” That show of commitment alone was supposed to be enough to reassure the market.

In granting the EFSF the all-important triple-A rating, the rating agencies were somewhat cautious. They weren’t willing to assume, as they did with subprime mortgages, that any subset of debt guarantees—no matter how small—made by countries that weren’t themselves triple-A rated would be worthy of the gold-plated standard. Instead, they insisted that the EFSF’s loans had to be covered by guarantees from triple-A rated countries and cash reserves that the EFSF would deduct from any money it raised before it passed those proceeds on to the borrowing country. Based on that, euro zone members initially pledged a total of 440 billion euros ($650 billion) in guarantees. However, S&P said in its initial report that the EFSF would be able to raise less than $350 billion of triple-A rated proceeds.

Of course the euro zone did break the glass: the fire extinguisher was used, first in support of Ireland, and then Portugal, and then Greece. This summer, the European Powers That Be agreed to bolster the EFSF’s lending capacity by increasing the maximum guarantee commitments of the member states to 165%, instead of 120%. That was supposed to enable the EFSF to borrow up to 452 billion euros “without putting downward pressure on its ratings,” according to S&P.

As we now know, that’s not nearly enough money to end the crisis, especially given that the EFSF’s commitments to Ireland, Greece and Portugal leave the facility with a lending capacity of just 266 billion euros, according to a recent report from Moody’s. (I found it difficult to add up where the money went.)

Hence the politicians’ latest idea: leverage the EFSF’s remaining ability to borrow. Either have the EFSF offer first-loss insurance when a country issues debt, or turn its remaining capacity into the first-loss tranche of a collateralized debt obligation, which would raise money by selling bonds to other countries like China.

Besides being undersized for the job, there’s a core structural problem with the EFSF: It is only as strong as its triple-A members—not just Germany, which according to that October 2011 EFSF presentation contributes 29% of the total value of the EFSF’s guarantees, but also France, which contributes 22%, and the Netherlands, which contributes 6%.

Some financial analysts have questioned why any European country deserves a triple-A rating, seeing as EU members can’t print their own currency to pay off their debts.  As the financial turmoil has unfolded, it’s become clear that the only EU country the market views as a bona-fide triple-A is Germany. So as much of Europe crumbles, the EFSF’s triple-A, in the eyes of the market, is supported by a lone country. As one bond market participant says, “Eventually, only the German guarantee will matter, and it isn’t big enough to cover this.”

Indeed, Germany represents less than a quarter of the EU’s GDP, and obviously the nation’s economic health is to no small degree dependent on other members of the EU buying German goods. (Such interconnectedness was the whole point of the European Union—and that helps explain why the cost to insure against a German default has more than doubled since the summer, to $93,655 a year to insure $10 million of 5-year German debt.)

Not surprisingly, the EFSF’s last 3 billion euro bond sale, on Monday, November 7, met with what Moody’s called “significantly less demand” than a similar issue last spring. The issue was originally supposed to be 5 billion euros, and the spread, relative to German debt, that was required to lure investors was over three times the spread that was needed last spring. As Moody’s wrote in its report, “the demand for the EFSF bond issuance was dampened by a lack of confidence over the credit resilience of its guarantors.” Another way to think about this is that since the strength of the EFSF is dependent on the strength of its parts, the more individual countries have to pay to raise money, the more the EFSF itself has to pay.

In fact, it’s the definition of a vicious cycle. The EFSF’s funding costs rise along with those of its guarantors, and perversely, bond market participants say that the very existence of the facility also causes its guarantors’ cost to rise. That’s because there aren’t many investors who are interested in buying European sovereign debt these days. Those who are demand a very high premium if they’re going to buy, say, Italian debt instead of EFSF debt. This is why the EFSF was going to be hurtful, rather than helpful, if it had to be used: it competes with its very creators for investment, driving spreads higher and higher. One hedge fund manager calls the EFSF  a “self-inflicted killer” of Europe’s bond markets.”

The EFSF is due to expire, and is supposed to be replaced by the European Stability Mechanism, or ESM, in mid-2013.  But the ESM looks like it’s going to have same problem the EFSF does: Its finances depend on the very same countries that it is supposed to bail out.  In other parts of the world, this isn’t called stability; this is called a Ponzi scheme.

Photo: Men climbs steps next to a share price ticker at the London Stock Exchange in the City of London. REUTERS/Andrew Winning

27 comments

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This is a very nice explanation. If investors conclude that Europe is not viable because it can’t support current consumption with the productive capacity that it has, then all these financial firewalls simply add to the flames when they go down. China has figured that out at any rate.

Posted by Jim1648 | Report as abusive

On paper, it all sounded great.

That is the problem, paper with no solid backing equals false and artificial blah, blah, blah.

Posted by Intriped | Report as abusive

Everytime I see the slight suggestion that China should or could “help” or perhaps as was suggested only a short while ago one of the other BRICS could do so… I wince.

Europe is so wealthy and has to sort it’s problems out. Fiscal union or break up. That’s it. It won’t work. How much suffering must be inflicted upon the people of Europe before those politicians actually do something? They are completely out of their depth. How bad does the situation have to get before they wake up?

This problem has not just appeared. It has been gradually emerging since the euros inception for over 10 years. They are completely out of their depth.. they are idealogical politicians who do not have the ability or the speed to act on this issue.

The problem is far greater than the ability of the politicians to deal with it. It’s the end game. And their answer is to tax people more! Tax business more!? Madness. In Brazil they have a saying, “the economy grows at night, when the politicians are sleeping”

Posted by MrRipley | Report as abusive

“I’ve been wrong so far, so I don’t have too much confidence in my view. But I think within the next 10 to 15 years the eurozone will split apart. The British government, on balance, should stay out of it.” – Milton Friedman, Financial Times, June 06, 2003

Posted by MrRipley | Report as abusive

Default early and often. Safe the youth and the workers.

Posted by warwilder | Report as abusive

Since, its well known that all money accounts are electronically created to represent wealth and debt, then why not all agree to “reset” the software to a favorable equation that restarts the process.
A European debt forgiveness conference structured in a way to allow a safe transition for member states to clear their books of past debt and return to full-employment under a more accountable system of reward and failure.
The current fix is never going to appear, because debt has been used for every conceivable alternative to real value and is at its end! After all it started from nothing and should return to nothing…

Posted by signman34 | Report as abusive

Fictitious markets driven by hyper-speculation + diminished tangible goods behind the markets + a displaced workforce who are blamed by the financial sector for not “getting” jobs when there are fewer and fewer jobs available = … a barely audible “wtf?”

Not a bang, but a whimper.

(I’m being hyperbolic in this dumb comment, but I can’t help but feel that what I’m saying is actually true).

Posted by big_winner | Report as abusive

an orderly default is the only way out for europe .
germany , and any orther triple a rated country if their is one left in europe . the world needs to pause and think instead of bail out what is required now is pain the faster it is relaised less pain longer time shall lead to more pain , unrest and even europe heading for another war

Posted by haiderhussain | Report as abusive

Amusing… a country could retain it’s AAA rating provided it maintained a policy of being able to print money to infinity.

Posted by Boomboomboom | Report as abusive

yes but the federal reserve in america is just as messed up, if not more. the western financial world is falling off a cliff because of corruption and cronyism, and the only solution is getting new people in power, and getting the crooks out and a return to justice and fair play.

Posted by barkinbob | Report as abusive

Thank you for a beautiful article. But why stop there?
Why don’t you state directly that this is surely incompetence of the highest level that should be sanctioned at the highest level.
When are we going to wake up and charge these parasite organizations with incompetence, take them to court for misrepresentation or breach of faith, and dismantle them before they can do any more damage?
They’re selling us down the river to slavery and we’re not reacting. In the end we’ll just be getting what we deserve!

Posted by Nemesis4all | Report as abusive

HISTORICAL / HYSTERICAL FEAR

The Europeans have not got their collective heads around the solution of the problem, which was first implemented by the Japanese, after their realty-bubble and then after the Swedes went through the same pain.

It is the same solution that causes the Fed to undertake Quantitative Easing, which just another word for taking the debt and dumping it into a BadBank.

Banks must accept a minimum compensation on the BadRealty debt (aka subprime), which is the problem in the US, since banks are reluctant to take a haircut on that debt. It is understandable why. That debt has an underlying support in terms of its realty value – which is presently suppressed, but none-the-less viable as the economy finally works its way back to health.

EFSF is not presently of that nature. It is mostly sovereign debt. And the Germans do not want to assume the role of Lender of Last Resort. They may or may not be right about that posture.

But that is not the point. Until Europe decides that the Central Bank must print-money in order to buy the BadDebt, sovereign or otherwise, it cannot get out of this mess. Banks that keep the debt, must also keep a certain ratio to “collateralize” it, which means they cannot lend that money.

But to print-money means, somehow mindlessly, to the Germans that the EU is back in the days of the Weimar Republic had runaway inflation. Which is clearly not even remotely the case. The Germans are WAY OF BASE as regards that historical/hysterical fear.

Which means further, in a credit economy as is that of the US and the EU, the money (as credit) cannot stimulate Demand.

Europe shall one day work its way out this problem, but the road may be long and painful. Which is goodness of a sort.

Next time they will not be so profligate in their spending as they have in the past with the hubris that borrowing based upon growth-economies will always pay the debt.

Americans need to learn the same, but the difference is that America’s Debt Overhang is due to lax market oversight that let credit institutions TO get away with bad lending practices – like predatory pricing and no stringent credit-worthiness checks. Meaning that some people just do not deserve credit because of their habit of not paying it off.

Posted by deLafayette | Report as abusive

It is buying time until 2012. The real effort is closing governmental deficit gaps, which the EU did:

OECD report government DEFICIT in % of GDP: (2010 2011 2012)

USA -10,6 -10,1 -9,1
Eurozone -6,0 -4,2 -3,0

Now, who is in trouble ?
- The USA that supports a 2 % growth with 9 % of GDP deficit or the EU that has a 1,5 % growth with 3 % deficit ?
- The USA that has a 101 % of GDP debt or the EU that has a 80 % of GDP debt?
- The USA that has 0 (as in ZERO) % interest rate or the EU that has an Euribor of 1,4 %?

Now that EU fiscal discipline is back, I actually feel more and more positive about Europe than the US. It was WELL MANAGED by Merkel no matter what you on the other side of the Atlantic say. It was difficult and noisy but she did it. We will find a way to remain liquidity on the short time. Its the nicest thing when one actually has savings. In the US, nothing happened. The situation is unsustainable. The supercommittee is not going to deliver, so much is clear. So, it is time to switch focus. Serious answers are needed. No more delays, no more charades.

Posted by FBreughel1 | Report as abusive

@delaFayette: Absolute right. Printing money returns the EU to the Weimar republic – according to Westerwelle. We have a 12,6 Trillion EU economy here. And printing one or half a Trillion would lead to hyperinflation ? It won’t even be noticed.

Posted by FBreughel1 | Report as abusive

FBreughel1
Yes OK but that printing would inevitably lead to others and to others and to others…
It’s addictive.

Posted by Nemesis4all | Report as abusive

The current US deficit has officially arrived at $15 trillion dollars which is now at a historic high of 101% debt to GDP. The SC/congress is trying to cut the budget by $1.2 trillion over 10 YEARS!!! The average cut in the deficit is only $120 billion per year and the Super Committee cannot even agree on this small cut. Overspending by the Feds is now at $98 billion per MONTH or $1.1 trillion per year. The interest alone on the $15 trillion deficit is running at $176 billion per year. I guess when you add up these numbers, even if the Super Committee comes up with a last minute deal for $1.2 trillion in savings over 10 years, this plan will not even pay off the interest on the debt. Some day all of this overspending will catch up with all US citizens.

Posted by Kibble | Report as abusive

The EFSF has to be funded by the ECB and as a bank will have sufficient firepower to control the credit spreads for Italy/Spain. This will happen once these two countries have shown their commitment to implement comprehensive reforms that in about 2 to 3 years will win back the markets and reduce the spread on their debt.
The Germans have to accept that there is currently no other solution to prevent the problems to engulf the global economy. I hope Merkel will recognise this soon and be able to convince her stubborn colleagues. If she can’t get her way, then Germany should leave the Eurozone, because it is not acceptable that Germany has benfited greatly, but now isn’t willing to stabilise the EUzone.

Posted by TB7W1B | Report as abusive

@ FBrueghel1 – yes, exactly – “The real effort is closing governmental deficit gaps, which the EU did: (OECD figures)”

Posted by scythe | Report as abusive

@FBrueghel1 – although very much conscious of the results of the inflationary phases in Germany, I think you are right. As soon as the ECB is enabled to operate as a lender of last resort, the Euro may even rise. The 7% seems to be a magic number, maybe it could be used as an inflationary target for a defined period of time.

But then, attention will turn back to the U.S., or maybe to China, where not all is gold, either. We will sleep badly in the next few years, anyway.

Posted by dingodoggie | Report as abusive

Just a reminder that 70% of the bailout money the USA “printed” went outside of the USA, mostly European institutions.

With respect to Europe being in a better situation than the US, nobody argues with that. The problem is that by not creating a Euro-bond, Europeans are telling us that they don’t trust each other to repay them. Then it is really hard to conceive in trusting ourselves what you yourselves don’t trust. That is the crux of the situation.

Until Norther Europeans feel they can trust their Southern brethren to repay their debts and control their spending, nobody outside of Europe that can think will.

Posted by spine001 | Report as abusive

The part of the article I like was, ‘a fire extinguisher behind glass: never to be used.’ It’s this kind of logic that can get you into big trouble. First, how do you know it works if you have to use it. Second, if it doesn’t work as advertised, then confidence in your system and/or credibility is shaken twice as badly.

In real life, we check our fire extinguishers at least annually. They are not cosmetic. This is the same kind of reasoning as we never practiced fire drills because we never thought there would be a fire.

So, the moral of the story is emergency financial mechanisms deserve the same scrutiny and care as any emergency equipment. Otherwise, it would be better not to have them in place at all.

Posted by rwmccoy | Report as abusive

If you consider a fragile pot as economy, the water flowing into as money, with the damage to the pot as debt.
The way to repair the pot is definitely not pouring more water into it and at the same time we cannot afford to stop the water altogether. (One of the similarity between doctor and economist is both of them have to work on live systems which cannot be shut down at any cost).
The repair team should go into the lives of the people solve their issues, create environment to work, encourage entrepreneurship.
For instance, identify the areas where money is locked either with banks, companies in the country or overseas, let the banks share the guarantee for the non-performing assets and mobilize the economy can be done in addition to reducing the spending, privatizing the sectors/industries.
In case of company, the consumer, employee, and share holder are different but in case of a country all the stake holders are the same group = people. It is easier because it is just one set of people with different roles.
The effort is so ensure that the damage to the pot can be repaired with the minimal disturbance and altogether the economy can improve will begin to evolve.

Posted by valueScreation | Report as abusive

@ Kibble: Yes that is the crux of the matter. But it also applies to most of the EU countries as each has huge debts relative to GDP. It is very difficult for countries to greatly increase their revenues and decrease their expenditures, so the prognosis for the EU countries (including Germany) is not good. Few of the non ex-communist countries have managed to avoid (annual) deficits more than occasionally since 1999.

Harsh measures by a government are not only politically unacceptable but tend to be counter productive as they depress the country’s economy and so cause the government can raise even less money than it would without the measures.

It seems to me that the US is in a far worse position than Europe because its households are also heavily in debt. But its taxes on high income earners are very low so it can increase them substantially without crunching the economy. It fact such an increase may very well stimulate confidence in the population at large and confidence is what is needed. That would be of far more benefit than the amount of additional taxes raised from the wealthy.

It is clear that western governments must change their ways of running their countries’ economies. The changes required will be many faceted and very complex and difficult to implement. It will require leadership from politicians and there is scarce evidence of that. So the world is heading into for years of “interesting times”.

Posted by GivaFromOz | Report as abusive

@scythe, @dingodoggie: Thanks. @spine001: Trust is indeed the name of the game and it won’t be solved by writing a huge blank cheque, no matter by what mechanism. It is patchwork and would have only led to temporary quieting of the markets. Before one knows it, Mr. Soros et al. would change their tune and talk about the insolvency of Germany and the other as well. Like we’re idiots.

The political/econimical path entered by the Southern countries to fiscal discipline is the correct one. The countries which we are talking about now – Italy, Spain- are already solvent and don’t expect them to fall over 7-20 % % refinancing costs in the coming period. E.g., Italy: With a 2 Trillion GDP economy they are certainly ably to carry the burden of a 14-40 bln additional interest payments. I think many investors will wake up to see they are missing a good deal on those two.

Posted by FBreughel1 | Report as abusive

So the cow stopped producing milk, and they want the grass to pay for a new one.

Posted by bboaze | Report as abusive

Just print more Euro and lower rate US style… have inflation solve the problem by itself.

Germany enjoyed a subsidized overvalued EURO to export to the PIIGS, they can live with some inflation.

In the long run the weaker EU countries will be better off printing their own money. So the exchange rates will adjust daily without the risk of another EURO distortion in the future.

Posted by robb1 | Report as abusive

A triple-A rating is awarded to a country if it pays back timely 100 cents on a dollar for a loan. The U.S. has paid back loans but with a weaker dollar. So the Euro country can use the same method: printing more money. The only problem is how the new currency should be divided among all the member countries.

Posted by jlpeng | Report as abusive