MacroScope

Law of diminishing returns

By Mike Peacock
June 12, 2012

The law of diminishing returns?
The first euro zone bailout, of Greece, bought a few months of respite, the next ones bought weeks, latterly it was days. Now … hours. Spanish bond yields ended higher on the day and, more worryingly, Italy’s 10-year broke above six percent. It was always unlikely the deal to revive Spanish banks was going to lead to a durable market rally with make-or-break Greek elections looming on Sunday but there were other things at play.

Top of the list is that the bailout will inflate Spain’s public debt and the dangerous loop of damaged banks buying Spanish government bonds that are falling in value. There’s also the fact that Germany and others are keen to use the new ESM rescue fund to funnel money to Spain because of the greater flexibility it offers. That will make private investors subordinate to the ESM which could prompt another rush for the exits which Madrid can ill afford since this is the first euro zone bailout which keeps the recipient active in the bond market.
It’s for the same reason that a revival of the ECB’s bond-buying programme, which it still doesn’t fancy, could prove counter-productive.

Officials are already pondering that conundrum, suggesting that the loan to Spain could initially be made under the existing EFSF bailout fund then taken over by the ESM, though that sounds like the sort of creative thinking in Brussels that generally fails to convince investors.
Another cracking Retuers exclusive following our breaking of the Spanish bailout on Friday, showing European finance officials have discussed limiting the size of withdrawals from ATM machines, imposing border checks and introducing euro zone capital controls as a worst-case scenario should Athens decide to leave the euro, is unlikely to have settle market nerves.

Today, the ECB releases its bi-annual report on risks facing the financial system. I’d imagine it will have a fair amount to say. For now, it seems content to let governments take all the strain of crisis management. Plenty of policymakers, Hollande, Merkel, Monti and Van Rompuy included, are speaking today but having done their bit for Spain over the weekend it’s really eyes down for the Greek election now, swiftly followed by a G20 summit and a key gathering of EU leaders at the end of the month.
There, some light will be shed on longer-term plans to make the euro zone a more durable economic union, although this is going to be a long haul – too late to address the current crisis. We’re expecting French and German briefings today, the latter on the Los Cabos G20.

There’s also a groundswell behind setting up a banking union, including a deposit guarantee fund, quickly. European Commission chief Jose Manuel Barroso, ECB policymaker Christian Noyer and French Finance Minister Pierre Moscovici are all espousing it today. Germany, where the bill will fall, is much more reticent and wants to see the drive to fiscal union, which will take many months even years of negotiation, treaty change and parliamentary ratifications, completed first.

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