"Europe's EFSF - A Skyhook?"

Sydney M. Williams

Thought of the Day

“Europe’s EFSF – A Skyhook?”

July 26, 2011

I first heard the term skyhook when my father took me to Mt. Washington when I was about twelve. We stayed at Pinkham Notch and a wizened old timer told me he used skyhooks when climbing out of Tuckerman’s Ravine. I must have appeared nonplussed because my father soon afterward explained that such a piece of equipment was known for only appearing in the minds of those with the richest imaginations. Webster’s on-line dictionary agrees, defining a skyhook as an imaginary or fanciful device by which something could be suspended in the air. But it can also mean a false hope or premise based on no logical grounds. George Papandreou, Angela Merkel, Nicholas Sarkozy, Jean Claude Trichet and others appear to be in the hunt for a few skyhooks, in their search for tools with which to rescue Europe and the Euro.

Europe’s leaders, in their latest saga to right what is wrong with Greece, have granted additional powers to the European Financial Stability Fund (EFSF), providing them the ability to buy distressed government bonds on the open market and lend money to countries to recapitalize their banks. The fund has €440 billion ($632 billion) on hand. Of that, according to Monday’s New York Times, half has been committed, two thirds to Portugal and Ireland and one third to Greece. A potential problem for the fund is that Italy and Spain – both of whom may need their own rescue package – are respectively the third and fourth largest guarantors of the fund. Keep in mind that Europe and the IMF have already committed about $1 trillion to the crisis. Vince Farrell describes this latest package as “a band aid on a wound that needs more than a few stitches.” On the other hand, the lead editorial in last weekend’s Financial Times states: “They are at least now trying to equip themselves with the tools necessary for the job at hand.” Perhaps, but I find myself more in agreement with my friend Vince.

The Eurozone is the world’s largest economy with a GDP last year of about $16.2 trillion, of which approximately $6 trillion was generated by Germany and France. Supporting that GDP is roughly $13.6 trillion in government debt, placing the region in a better fiscal position than the United States. Nevertheless, the numbers are big and the stakes are large. Unlike the U.S., the cultural and social differences among the countries in the Eurozone are far deeper and more complex than those that divide our nation. And the U.S. had a political union ninety years before it had a truly unified currency. Twice, in the past hundred years, the European continent has been devastated with world wars that killed or maimed more than 50 million Europeans – ten percent of today’s population.

Without a Euro, economic outcomes for the region would have been far different, though perhaps not better. Germany, Europe’s largest and strongest economy has perhaps benefitted most from the Euro, especially as the world emerged from recession. A higher value for the Deutschmark would have stymied the exports that led that nation to recovery, even while their borrowing would have been lower. At the same time, the Drachma would have declined, as the country would have defaulted on their debts, but a lower currency value would have increased the attractiveness of Greece as a destination spot, even as their borrowing costs would have been higher. They would have had the opportunity to start anew. A month ago, Niall Ferguson, professor of European history at Harvard was asked, on a scale of one to ten, what was the likelihood of a Greek Default. He responded ten. Greece, he pointed out, has had a history of defaults going back into the early nineteenth century.

On July 11, Moody’s lowered the credit rating of Ireland to junk status, thereby allowing that country to join Greece and Portugal in this hall of dubious European sovereign nations, a status that limits their access to the capital markets. Yet the European Central Bank (ECB) stands firmly against anything that would put Greece (or Portugal and Ireland) into technical default, for they fear that such an event would cause investors and the people of Europe to question the viability of the Euro. David Mackie and Greg Fuzesi, European economists at J.P Morgan, writing in last Thursday’s Wall Street Journal, suggest that the European Central Bank has a political vision for the region – a political and fiscal union – which would leave no role for debt restructuring. The ECB appears to have more tricks up its sleeve than that Lothario of the IMF Dominique Strauss-Kahn has in an evening!

In the United States, financial institutions are required to mark-to-market their financial holdings. The ECB refuses to do so, lest the reduced values of Greek, Irish or Portuguese bonds be considered a “restructuring,” placing the affected country into technical default. Yet the EFSF is authorized to buy distressed government bonds on the open market, certainly an acknowledgement of their diminished value.

The powers given to the EFSF have not received the necessary approval for its legal changes –structure, size and financing. That requires individual parliamentary approval. Angela Merkel has said that the question will not be taken up until the second half of September, after Europe’s summer break. (It’s a good thing that Lehman went bankrupt after Labor Day!) Unlike TARP, the Times reports that every time the EFSF wants to put money to work it will have to issue a bond – backed by the guarantees of Germany and France (70%) and Spain and Italy (30%.) Should Spain or Italy require help, funding might become increasingly difficult. Additionally, the EFSF is supposed to have responsibility for the capital needs of Europe’s weak banks, an amount that today is estimated to be about $400 billion.

Even before the credit crisis struck in 2008, Europe already had long term structural problems. Peter Zeihan of Stratfor wrote on July 14 of this year: “Europe already has to import most of its energy, it already has a rapidly aging labor force [and immigrant assimilation has been difficult] and it already has very little free land on which to build.” The temptation of the welfare state, in the immediate aftermath of World War II, seemed the perfect antidote to the horrors and hard times after years of depression and war. The young and eager were more than willing to look after those that were left – veterans and seniors – never conceiving that time and a lack of population replenishment would place an intolerable burden on a dwindling workforce. Robert Samuelson wrote in Monday’s Investor’s Business Daily: “Governments everywhere are striving to protect the old order because they fear and do not understand the new.” Contagion remains a real risk, and the cost for bailing out profligate Europeans will fall mainly on the Germans. Will the Germans be willing to bear any cost? Will Greeks sell off their heritage to salvage northern European Banks? Is political union worth the cost? Is there a skyhook to grab?