Clouds gather over the eurozone

“Some are whispering it, some are shouting it,” says Economist.com: “the euro crisis may be over.” Bond yields, and hence implied borrowing costs, have fallen sharply in the troubled peripheral states in the past 18 months, and the economy finally began a tentative recovery in the middle of last year. But there may be turbulence ahead.

Whatever it takes?

The main reason the eurozone is no longer considered to be in mortal danger is the Outright Monetary Transactions Programme, or OMT, introduced by the European Central Bank (ECB) in September 2012.

It allows the ECB to buy unlimited quantities of peripheral debt to drive down bond yields – long-term interest rates – and thus avert defaults. The OMT has never had to be activated: simply the prospect of an effective backstop for European debt stopped the dangerous sell-off.

However, the ECB’s president, Mario Draghi, “was always sailing close to the wind”, says Ambrose Evans-Pritchard in The Daily Telegraph. Germany’s central bank, the Bundesbank, and many German economists “opposed it vehemently as a fiscal blank cheque” for periphery economies and “a fatal erosion of ECB independence”. The matter was referred to the German Constitutional Court (GCC).

This week, after mulling it over for a year, the GCC decided that the OMT did exceed the ECB’s mandate, because it would amount to financing southern countries’ debts. But it also referred the matter to the European Court of Justice.

This way, Berlin doesn’t look as if it has caved in, yet the European court, which will give its decision in a few months’ time, can give the programme the green light.

So for now, at least, OMT remains in place. But as Tony Barber puts it on FT.com, the ruling has produced a “cloud of uncertainty”. The GCC could decide to take another look at OMT, and has indicated that it wants the ECB to reduce its scope.

And even if it goes through, a nagging worry that could undermine investor confidence in the effectiveness of OMT remains: the political divide between the German establishment, which holds the purse strings, and the rest of the EU.

More useless bank stress tests

Staying on the subject of undermining investor confidence, the latest criteria for EU-wide bank stress tests (different from the ECB’s own stress tests later this year) published by the European Banking Authority are underpowered, says George Hay on Breakingviews.com. The main problem is that sovereign debt can be ignored if it’s held on certain parts of the balance sheet.

“Given that political fudges continue to allow eurozone sovereign debt to be deemed risk-free for capital purposes, this perpetuates the absurd situation where a European stress test doesn’t properly test for the big risk investors worryabout – a sovereign default.”

So it looks like the long overdue clean up of banks’ dodgy loans, which have led to a dearth of credit and growth as undercapitalised banks retrench, won’t happen. That in turn will hamper the recovery. So the periphery countries’ debt mountains will continue to grow, and, as we noted a few weeks ago, imminent deflation will make the burden even heavier: it raises the real value of a fixed amount of debt.

“Debt deflation is dangerous in a world with an unresolved debt crisis,” says Wolfgang Munchau in the FT. Many now fear that Europe is heading for Japan-style stagnation.

Meanwhile, political divisions between north and south may flare up again when Greece’s inevitable third rescue programme is put together; the euro establishment is already working on it, according to Spiegel.de. The euro is “stuck with a floundering economy, inadequate institutions and weak support”, concluded Gideon Rachman in the FT. “That does not sound like a long-term recipe for success to me.”

Merryn

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