Europe’s three simple problems

November 3, 2011

James Saft is a Reuters columnist. The opinions expressed are his own.

The plan to rescue the euro zone faces only three hurdles; democracy, reality, and supply and demand.If they can overcome those, it is going to work perfectly, and, amazingly, they just might.

Democracy reared its rather large head when the Greek government decided suddenly that it wanted a sign-off from its voters and moved to put the plan to a plebiscite.

While it is hard to argue with the idea of a people getting a chance to vote directly on a plan that will mean tough times for the better part of the next decade, the move jeopardizes not only the confidence on which the entire rescue relies but also the next infusion of much-needed cash Greece is slated to get in November.

If the Greeks vote against the plan it means a full-fledged, badly controlled sovereign default, with all that implies for euro zone banks. Is that something the Greeks will vote for, even if it means ejection from the euro zone? Just the specter of the vote makes it far harder for euro zone officials to put the rest of their plan into effect, a number of whose planks are already looking shaky.

Democracy, or whatever alternative term you would prefer to use, is also doing the rescue no favors in Italy, where Prime Minister Silvio Berlusconi is under pressure to step aside for a government of national unity. There is also precious little faith that Italy will produce credible fiscal and structural reforms. All of this is reflected most starkly in the reality of the bond market. Italian 10-year bond yields now stand at about 6.16 percent, a level that is unsustainable, considerably higher than before the grand plan was announced, and a threat in and of itself to the rest of the plan’s moving pieces.

Remember, Italy is not only the third-largest economy in the euro zone, and probably too big to bail out, but the third-largest government bond market in the world. A plan that can’t bring Italian borrowing costs back down is one which will fail.

If anyone ever wondered where the bond market vigilantes have gone, we have our answer: they’ve moved to Europe and are providing reality therapy to governments.

Again, sometimes that kind of therapy works, and perhaps Italy will come across with the goods. The problem is time and moving parts — too little of one, too many of the other.


The European Financial Stability Facility, the fund which is supposed to borrow funds under government guarantees to pay for the bailout, chose to delay a planned bond offering on Wednesday, its arrangers citing market volatility. There is also the little issue that euro zone officials have failed thus far to explain exactly how the vehicle is supposed to work.

The EFSF is supposed to create friendly market conditions by being big enough and bad enough to fund weaker countries regardless of their stand-alone fundamentals. It is not supposed to be subject to the market and the fact that it is, so soon, is a bad sign.

And the larger the number of countries which might be borrowing from the EFSF rather than contributing to it, the less solid its AAA status seems, as well as the AAA status of its backing nations.

France is the case in point — as the number of strong countries dwindles, its own AAA status looks less reliable. Bond investors drove the premium France must pay to borrow for 10 years compared to Germany to a euro-era record on Wednesday to 129 basis points.

The final issue where supply and demand are working against the euro zone plan is in banking, where banks have been given a deadline of next June to recapitalize, either in the market or with state support.

That means that many banks are going to be trying to either raise capital or sell assets at the same time, driving up the price of the first and down those of the second. It also implies a rather large credit crunch in Europe, one that probably has already begun on the fringes.

That means Europe‘s recession will get a kick downhill.

So, to overcome democracy, reality, and supply and demand Europe is going to need a force that is immune to some degree to all three. Such a force exists in most other large developed countries with independent currencies — the central bank.

The ECB can’t and won’t play a similar role, and until it decides it should and a way is smoothed for that to happen, the odds are against the plan.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at and find more columns here.)


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Democracy is a word much bandied about lately. The problem is that there are so many approaches that you often get long and inconclusive debates when someone raises the subject. For example, a large majority of the Greeks want to stay within the Euro, so we may assume that they are willing to accept certain rigours to get there, meaning that the technocrat government is fully legitimate. If a plebiscite cannot be held for reasons of it jeopardising the process of remaining in the Euro, then calling off the referendum was a democratic act. Mr. Saft, let’s please try to get things done and not waste time on convoluted discussions on what exactly democracy means. It doesn’t mean much when your children are hungry.

Posted by Lambick | Report as abusive

Meanwhile, France, teetering on the brink is AAA, while the U.S. is AA+.

Posted by ARJTurgot2 | Report as abusive