Monday, May 10, 2010

The Germans and the EU roll out the big guns.

So it looks like the rumors I discussed on my blog last night did not go far enough. I was off both with regard to the breadth of the measures and their magnitude. I still think they are likely to be tested but it may be some time off before they are and the sheer size as well as the speed with which they were negotiated will probably make the Bond Vigilantes take a step back. It’s kind of like the EU went into the weekend as Clark Kent and then came out of it Superman.

So what are the packages?

1.) EUR 60 billion gets added to the Balance of Payments fund by all EU governments. This was a fund that was created in 2008 to help non-Eurozone countries cope with the financial crisis by extending them credit.
2.) EUR 440 billion is provided in bilateral loans and guarantees among the Eurozone countries. This package needs to be approved by the parliaments.
3.) The IMF will contribute EUR 250 billion to the enterprise.
4.) The Federal Reserve Bank of the US has extended swap lines to the European Central Banks in order to add dollar liquidity.
5.) The ECB agreed to potentially purchase government bonds. If/when they do so they will also engage in “sterilization” so that the purchases are not inflationary.

So what does it all mean?

Well the main thing is that I think the EU successfully demonstrated its resolve and its capacity to respond to a crisis of confidence. That’s the most important thing. Behind that I would say that the most important element is the ECB agreeing to buy bonds. The big numbers involved in the package are big but the money won’t even be available for a while and as I mentioned in my previous post to even get at it a government would have to agree to some stern measures so most will not ask until it is too late to do anything else. But the ECB stepping in as a buyer of last resort for the sovereign credit markets, that’s a big deal.

So what effect is it having?

Well, interestingly after a pretty big initial rally the Euro has fallen off. This should not be surprising because what the EU is really doing is making it easier for countries to run their deficits knowing that they can access these funds if they make mistakes. Think of it as creating massive moral hazard on the national level. The weaker countries in Europe now know that they are too big to fail.

The credit markets and the stock markets love it. Greek, Spanish, and Portugese CDS markets are all massively tighter. You would expect this now that the ECB is probably out there buying their bonds with both hands. European equity markets were all up HUGE and the US is up about 3.7% right now.

What’s the big picture here?

I think in the short term the EU has scared off the speculative attackers and has given some breathing room to Spain and Portugal. On the other hand they have made it harder for the political systems in those countries to compel the kinds of austerity that they’ll need to implement in order to get out of the hole they are in. It also ties the stronger economies to the weaker ones by enabling them to tap the capital markets in the name of the stronger economies. The current crisis may abate but it is sowing the seeds of the next.

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