Bring on the Euro TARP!

So it looks like we’re headed towards a Euro TARP.    Rumors all day today make it sounds like they’re going to use something similar to the aggregator bank in the USA with a special purpose vehicle.  What does it all mean?  It means we’re essentially going to leverage up the current EFSF and broaden its influence.   This will work in several ways.  The two primary effects of this leveraged EFSF is the ability to provide increased funding for (austere) periphery budgets.  In addition, it will likely offer some form of bank recapitalization by allowing banks to sell sovereign debt for SPV/EFSF debt (in essence, swapping toxic debt for AAA debt – sound familiar?).   So, it’s a bank recapitalization plan AND an increase in the funding capacity of the EFSF.  That’s actually a good start although it doesn’t ultimately close the loop on the crux of the problem.

Deja vu all over again!

This is really similar to the American bank bailout plan.  It WILL solve the credit crisis.  But it will not solve the underlying problem.  In the USA, the underlying problem was a household debt crisis.  We thought it was a banking crisis so we focused our efforts on the banks.  We went on to fix the banks, but we never fixed the households.  So, we still have a broken economy and a balance sheet recession.  The issue in Europe is a bit more complex, but still very similar.  Europe has an inherent imbalance due to a broken currency system.  The lack of a balancing mechanism (fiscal transfer union or floating FX) results in the same sort of trade imbalances and sovereign debt crises that we used to see under the gold standard.  This plan doesn’t appear to acknowledge this as the root cause of the problem.  That’s highly disconcerting.

Will this sort of a plan work?  

Well, it depends on who you ask.  From the perspective of the core, it will work swimmingly.  Their banks will get recapitalized and saved from the brink of disaster while they also impose austerity on the periphery.  As I mentioned yesterday, this plan is incredibly bullish from a market perspective (at least in the near-term) because it removes the worst case scenario from the table for now and should be bullish for the banks which have become the epicenter of the crisis.  But it’s an entirely raw deal for the periphery nations who will still be forced into austerity and certain economic weakness.  But most importantly, it doesn’t fix the EMU.  The problem here is that the banking crisis is an extension of the currency crisis.  So, the inherent imbalance in the EMU is creating the sovereign debt crisis (by necessity) and thus leading to a banking crisis.  Fixing broken banks doesn’t fix the broken EMU.

So, it’s America 2.0.  Fix the banks, give Main Street the middle finger and move along.  Nothing to see here.  The good news is that this plan might just buy them enough time to generate a sustainable fix.  On October 17-18 the EU will discuss a potential move towards further fiscal union.  This is ultimately the direction that Europe must head in if they are going to make the EMU work.  If they can’t put together a sustainable fix then the current crisis will simply resurface at a later date as the inherent imbalances remain and continue to pressure these economies.

What are the risks?  

The largest risk is periphery revolt.  If, for instance, Greece were to recognize that the Germans are getting a bank bailout and Greece is getting FURTHER austerity, you can imagine how this might exacerbate already angry Greek citizens.  There’s no telling where this would lead.  But the risk of a citizen led default and defection scenario has to be considered.

Economic weakness is likely to persist under this plan.  That means the growing tensions will linger and boil.  Without a sustainable fix the war of words between north and south will continue to become increasingly heated.   Ultimately though, this is a stabilization plan.  It is not a stimulus.  In other words, it stops the bleeding, but doesn’t provide a transfusion per se.  And the patient is still very sick.

The ratings agencies could view this for what it is – debtors helping debtors.  Ultimately, the EMU needs to eliminate the solvency risk via a supranational entity that has no traditional solvency risk (as in not being able to pay).  That means some form of Federal Government as the USA has.  The current plan involves indebted nations helping other more highly indebted nations.  The credit rating agencies could see this as a risk to core sovereign credit (which is exactly what it is).   Ultimately, the EMU is not AAA because they do not have the ability to tax and spend at the EMU level.  This means the countries are all revenue constrained and remain currency users by virtue of politics.

Conclusion

In sum, this looks like a start, but not a fix.  Like the original EFSF, this plan will have teeth.  But let’s not sugarcoat it.  This is a kick of the can even if it’s a swift kick.  The real resolution lies in measures not confronted by this plan.  And until then, we can expect economic weakness and turmoil to ravage Europe as the inherent imbalance remains in place.

Cullen Roche

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