Eurozone buys some time

European finance ministers came out of their late-night, closed-door meeting Sunday with all guns blazing. The question is, how long will their ammunition last?

In essence, the European Central Bank will buy up the bad debt of Greece (which Moody’s said it is about to drop to junk status) and any other EU countries needing help and issue its own bonds to pay for them. In this way, the whole of the EU (along with help from the IMF) is stepping in to back up its floundering members, to the tune of nearly $1 trillion. That sounds impressive until you realize that Greece’s debt alone is over $400 billion. Greece is in the worst shape but it is also one of the smallest of the EU member economies. Throw in the rest of the PIIGS (or PIGIS as I recently saw it spelled)—Portugal, Ireland, Italy and Spain—and that trillion bucks disappears in a hurry. Oh, and then there’s Hungary, and Austria’s not looking so good, and ….

The stock markets loved it, of course, but that could change in a hurry. This mess has now cost German Chancellor Angela Merkel her majority in the Upper House and a legal challenge to the bailout in German courts is entirely possible. The UK is trying to form a new government which is almost certain to be weak and short-lived. French President Sarkozy may also soon be facing an opposition controlled National Assembly due to public anger over the bailout.

EU leaders are pedaling as fast as they can and this weekend’s plan is straining the union’s legal structure (much of it was enacted through “emergency” provisions). There is growing concern that this weekend was a dramatic push towards a United States of Europe and there is certainly no consensus for that.

Many commentators have described the EU plan as a TARP for Europe. Its goal is largely the same. TARP took bad bank and other corporate debt and put in on the Federal Reserve’s books. The EU is now taking bad sovereign debt and putting in on the books of the ECB. In short, debt is being paid with more debt but now with taxpayers' help. In both cases the hope is that over time somehow the mess will clear itself up. It is not at all clear that is the case and, even it were true, that the credit markets will give it that time. This is high stakes poker unlike anything we’ve ever seen.

Note: Good analysis and discussion of the EU bailout can be found at many of the financial and economics blogs I have refered to in the past, including: Bill McBride's Calculated Risk (always my first stop), Paul Krugman's Conscience of a Liberal, Yves Smith's Naked Capitalism, and The Baseline Scenario of Simon Johnson and James Kwak.

Note 2: Here's a succinct evaluation of the bailout's problems from Bloomberg's Businessweek:

The leaders of the euro-area countries have thrown 750 billion euros ($963 billion) at shoring up confidence in the single currency. But it doesn’t matter how many zeros you put on the end of a bad idea. It’s still a bad idea.

In reality, you can’t stabilize a sinking ship.

The new stability package suffers from the same problem as all the other ones the European Union has come up with in the months since the Greek crisis started rattling the markets last year: It tries to fix the symptoms, not the causes.

Greece has exposed deep structural problems within the euro. There is no mechanism to stop governments breaking the rules. There is no popular support for massive fiscal transfers between countries. The rules for the euro area have turned out to be unreliable. And there is no way to start stimulating economic growth again in the heavily indebted nations.

Those are the hard questions. Even 750 billion euros won’t get close to answering any of them.

Eurozone tottering (cont.)

Greece descended further into chaos today as demonstrations turned violent and deadly. Masses of protesters chanting, "Thieves! Thieves!" attempted to storm the parliament building and threw Molotov cocktails at police. Unsurprisingly yet tragically the first deaths also occurred as three bank employees died when demonstrators set fire to the bank building where they worked.

These episodes are making evident the one factor ignored in the financial and political calculations for saving Greece and the eurozone: namely, the verdict of the population at large. Greek labor leaders and others have figured out that the proposed “bailout” really only bails out the banks which foolishly gave Greece all the credit rope with which it has hung itself.

The bailout’s goal is to avoid a Greek default on its debt. In addition to billions of euros in new loans, this supposedly will be accomplished by drastic cutbacks in Greek living standards. Greek demonstrators are saying, “Sorry but we want everyone to share the pain.”

A restructuring of Greek debt is becoming increasingly likely, as market reactions are making clear. In other words, Greece’s creditors are going to take a hit. Alone this may not be such a big deal but the precedent it sets has bankers and the markets in a growing panic. The fear is that the rest of the PIIGS will quickly get in line for similar treatment and possibly other countries as well. Now we’re talking real pain for the banks which—despite the rosy claims of having “turned the corner”—are still in a precarious state.

Exposure of US banks to possible European defaults is not insignificant. In addition, such defaults would almost certainly mean a deepening of Europe’s recession and a devaluation of the euro. American exports would take a hit, further slowing or even reversing the US recovery. Despite such dire consequences, financial writer Simon Johnson says in a very pessimistic column that we should “expect nothing” in the way of genuinely constructive help from those in charge:

The Europeans will do nothing this week or for the foreseeable future. They have not planned for these events, they never gamed this scenario, and their decision-making structures are incapable of updating quickly enough. The incompetence at the level of top European institutions is profound and complete; do not let anyone fool you otherwise….

The Europeans will not lift a constructive finger. The leading emerging markets are too busy battening down the hatches (and accumulating ever more massive chests of reserves). And the White House still seems determined to sleep through this crisis. Expect nothing.

Eurozone tottering (cont.)

Greek protesters expressed their disdain today for austerity measures proposed by the government to qualify for international bailout funds. Unions marched in Athens' streets and a group broke through barricades to unfurl banners on the Acropolis.

Meanwhile, the financial world expressed its disdain for the whole EU debt mess by sending stock prices tumbling around the globe. The DOW dropped 225 points or 2%. There is growing concern that the cost of propping up all the EU's faltering economies will be more than anyone wants to afford. If so, then defaults by other EU PIIGS and beyond (Hungary?) will be inevitable and the affects will ricochet in all directions.

Eurozone tottering (cont.)

As Zerohedge says, "All you need to know in two easy words."

Eurozone tottering--updated 2x

European Central Bank HQ in Frankfurt

Standard & Poors downgraded the debt of Spain today as borrowing costs continued to rise for the PIIGS. (Reports here and here.) The current credit crisis is also spreading beyond the eurozone as Hungary also saw its bond rates going up. Meanwhile Germany, the primary source of funds for a proposed Greek bailout, continued to hem and haw about what, if anything, it was willing to do. As has been predicted for months, Greece's credit problems are spreading across the southern tier of Europe and beyond.

Mostly the US has just been watching all this out of the corner of its eye. Obviously we have plenty on our own plate right now. Yet as Europe discovered when Lehman imploded, finance and credit today is all international. A credit earthquake in Europe will inevitably send a tsunami in our direction. (See Simon Johnson’s “Wake the President.”)

The global economy is still very fragile--much more so than most people realize. Government officials, especially here in the US, have done a good job of putting out the message: "We've turned the corner, the crisis is past." They know how crucial public confidence is in reviving economic activity. Nonetheless, the 2008 financial meltdown revealed real and fundamental problems in the global economy which have still gotten little attention. Most of what ailed the system then, still ails it now.

A credit crisis in Europe could well trigger the same kind of panic as happened in fall 2008. Again, the banks will demand government bailouts to prevent a complete financial meltdown. This time, though, most government tanks are close to empty. A second massive bailout is just not in the cards, which means the economic dominoes will fall however they want.

Another option which is also a threat to the US is that the eurozone actually gets its act together and does something constructive. Most agree this would inevitably mean a significant devaluation of the euro. This is already predicted for the pound once British elections are past. The result: European goods become cheaper (wine, travel, BMWs!) and American goods become more expensive. Oops. There goes President Obama’s plan to grow the economy via expanded exports.

It’s easy to portray Germany as the bad guy in the current mess but it really is like the person trying to decide how to rescue a drowning man without himself getting pulled under. Germany has avoided many of the financial pitfalls other countries have fallen into and is still relatively healthy economically. It sees the Greek bailout, likely followed by bailouts of who knows how many other countries, as a continuation of the problem rather than a solution. It will not go in debt to finance these loans and German taxpayers have no interest in digging deeper to pay for them.

Like the US in 2008, Europe wants to push its problems down the road, hoping time will miraculously produce a solution. The US wants this to be a problem Europeans will solve by themselves. Meanwhile, many major banks have insured themselves against European sovereign defaults via the CDS market making their role in all this ever more suspicious. Thus once again for them it’s “heads we win, tails you lose.”

What tangled webs we weave.

Update: Paul Krugman wonders today whether events are making the unthinkable thinkable or even inevitable. Namely, it may well be that Greece's exit from the euro is around the corner, with others to follow. Carrying this out will be a huge mess but that's what we have already. Krugman's personal plan: "I think I’ll go hide under the table now."

Update 2: Paul better move over. Felix Salmon wants to join him.