independent

Friday 25 April 2014

Brendan Keenan: Big leap of faith can restore confidence in the eurozone

THE trend is your friend, they say in the markets. If you ride it successfully, the res- ults can be spectacular. If you decide to buck the trend, you need time, nerve and, of course, to be right in the first place.

Right now, the trend is with eurozone governments -- perhaps to a greater degree than at any time since the crisis began.

The promise of open-ended ECB support for governments applying fiscal correction; the approval, however grudging, of the European Stability Mechanism by the German supreme court; even the mooted fiscal union -- all have changed the mood towards the eurozone.

Last week, the market rate on Irish four-year debt was at levels which would allow commercial borrowing free of troika pre-conditions. That is not to say that commercial borrowing could yet be done on any great scale in practice, but one can see the thinking behind the trend.

Ireland does not require the new ECB support, because its funding comes from the troika, not the markets.

But the ECB's new mechanism holds the possibility that, when Ireland does come out of bailout, central bank purchases could set a ceiling on its borrowing costs by setting a floor on the price of its bonds.

Few traders would want to bet against the ECB, but they might be happy to lend to Ireland at a premium over German rates, backed by the ECB's OMT ("outright monetary transactions", would you believe).

The fall in Portuguese market rates is in some ways even more remarkable. Portugal's public finances are not as disastrous as Ireland's, and it too has achieved a consensus in dealing with them.

But its position vis a vis the rest of the world is a good deal worse. Portugal's public debt, like Ireland's, is meant to peak at 120pc of GDP -- a convenient figure in that it is on the limit of what is credible, but one which is vulnerable to even the slightest shock.

For the moment, the markets seem to be assuming there will be no shock or, even if there is, that Europe will stand behind national debts as well as future borrowings. Left alone, the moment will not last. It must be seized.

There were some signs that the need for urgent action had been grasped. Government leaders were determined to get the ESM up and running within weeks. The Commission wanted the ECB to take overall supervision of the eurozone banking system by January.

But already, as a British diplomat once put it, the rats are getting at it. There are two ways of looking at the trend as your friend. One, as I've said, is to press on, to take advantage of the trend. The other is to row back, on the grounds that the trend is doing the job for you.

The latter is the easier option, and there is evidence that some governments are yielding to temptation. There is little inclination to rush through banking supervision. That is bad news for the Irish Government -- not because of supervision, but because there is supposed to be a banking union before the ESM can be considered as a source of capital for banks such as the Irish ones.

A true banking union is even farther away than ECB supervision. That would include deposit insurance and a collective method of winding up failed banks so that all the costs do not fall on the banks' home country.

It would not be possible to do such a thing quickly. But it would be possible to bring in the bones of supervision and revise the agreement so that the ESM could provide bank capital on that basis. Yet the talk is that negotiations might go on for a year.

There is a mighty chicken and egg dilemma here. The ultimate objective is to create a working political structure for the eurozone. A report from EU 'president' Herman van Rompuy at the end of the year will even tackle issues of democratic legitimacy.

But the lack of a workable political structure hampers the task of creating one. Not least of the problems is that EU processes are a one-way street.

The option of creating a banking union urgently, and then changing and improving it in the light of circumstances, does not really exist.

This is the leap of faith that is required. It is to take actions now which demonstrate to markets and citizens that the eurozone is committed to collective action to create a currency with a credible entity behind it, and that this new entity can then evolve into a working political process based on a mixture of majority voting and state rights.

CURIOUSLY, the first test of this will be Greece -- although Spain will not be far behind. Even more curious is that Greece, not Ireland, will be the first country to have fixed its basic public finances.

Its revenues should match its public spending before interest by next year. That means something will have to be done about the interest bill. Otherwise, further funds from the troika will merely be paying interest while adding to the probable eventual losses on those funds. Something will also have to be done about the Greek economy, although it is hard to know what.

As an ESRI seminar heard last week, the recessions in Greece and Portugal are essentially in the productive economy while in Ireland it is essentially a function of debt-laden households and a bankrupt public sector.

There is widespread acceptance that any "Grexit" from the eurozone will risk bringing down the entire house. There is no agreement on drawing the obvious conclusion -- that it should be stated formally and collectively that no one is leaving the euro, followed by a serious re-structuring of Greek debt.

Of course, one can see the difficulties with that. To paraphrase the old poem about the payments to placate the Vikings: once you have ruled out a Grexit, you can never get rid of the Greek.

But the new regimes do allow for both budgetary control and market discipline via ECB interest rate manipulation. They don't allow for economic convergence, but that is also a problem for Italy, Portugal and Spain. It is the fundamental problem of the euro project, but it does not threaten immediate disaster.

The other issues still do. It is only three months since borrowing costs in the peripheral countries were at record levels. Short memories are one thing, but forgetting that would qualify as blackouts.

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