DIFFERING DELUSIONS, by François Leclerc

Guest post. Translated from the French by Tim Gupwell.

Worried by the sight of the Europeans entrenched in their respective positions, Barack Obama reached for his telephone. The day after the G7 videoconference between the Finance ministers and the central bankers, of which nothing came, he successively called David Cameron, Angela Merkel and Mario Monti. With this latter, the strengthening of the discussions centered on the Euro zone and growth. With David Cameron, who is going to meet Angela Merkel in Berlin, it was about the need for an “immediate plan”. Of the conversation with Angela Merkel no details have emerged. All promised to keep in contact with Barack Obama over the coming days, before meeting up on the 18th and 19th June at the G20 in Mexico, a sign that there is still plenty of work to be done before an agreement is found between them.

Expecting nothing from the governments, tensions on the stock and bond markets eased off all the same, bearing witness to their hopes of a renewal of central bank interventions. A meeting of the Bank of England is due on Thursday, as well as the expected appearance of Ben Bernanke, the chairman of the Fed. While the ECB, which met today, is keeping its cards close to its chest in order to force European leaders to assume their responsibilities, the Bank of England may well reactivate its debt purchasing programme, which has only been temporarily suspended. Looking further ahead, the possibility of a reduction in the key ECB interest rate, and an eventual third wave of massive loans to banks, continue to raise hopes, though Mario Draghi clearly stated that they are not ready to take these steps at the current time. By opting to not renew his purchases of Spanish debt on the secondary market, he sent a clear signal that the ball is in the court of the governments.

The face-off between the Spanish and German governments on a rescue package for the banks continues. A compromise is being sought, which may result in a small scale bailout before the summit on the 28th and 29th June. Following the great, already well-established, tradition, it should allow for the buying of a little more time, and will not put too much of a dent into the remaining financial capacities of the European Financial Stability Fund (EFSF), pending the coming into force of European Stability Mechanism (ESM) at an unknown future date.

As required by the German government, the funds will indeed by directed towards the state – or paid to its banking rescue fund, le FROB – and will as a consequence increase its deficit. This in turn will lead to a need to review the operational plan, whose implementation is already totally compromised. But only a handful of measures – intended to stabilize the banking sector – will be demanded in return, with few other budgetary requirements. Finally, the audit of banking needs carried out under the overall supervision of the IMF, the results of which should be known on the 11th June, may not add too much to the bill, to help the cause.

But in reality this minimalist bail-out will only serve to worsen the Spanish economic situation, which will in turn lead to a further degradation in the situation of the banks. For as they are forced to set capital aside to cover losses that are more and more significant, their lack of resources will oblige them to restrict credit and push numerous enterprises into bankruptcy. The funds which are intended to benefit them will only serve as stop-gaps. In addition, the increase in Spanish bond rates has the consequence of reducing the value of the huge numbers of securities which they bought with ECB credit. Sooner or later, it will be necessary to depreciate their value.

The Spanish case is a perfect example of the danger which arises from the purchase of a country’s debt by its banks – when things go wrong. The second candidate likely to illustrate this is of course Italy.

What is to be done then? The speech delivered by Jean Lemierre of BNP Paribas, at the Annual Conference of the Institute of International Finance, was not entirely unambiguous. The negotiator, with Charles Dallara, of the Greek debt restructuration lectured the audience on the theme “Don’t do it again! Once is enough!! Stick to your word, stick to your commitments and pay back your creditors!” But he carried on with reflections on the benefits of negotiation and the systematic danger of imposed decisions: “I hope in the future we shall stick to that principle of negotiation”…

A new bail-out method has been born. With Spain, it will be spread out over time with the nature and extent of the compensatory measures still to be resolved – in order not to have a repeat of the Greek disaster, and to leave sufficient time to progress towards the budgetary and banking union of which the grand lines are being sketched out. It also serves to advance, in the meantime, from compromise to compromise, governed by the rhythm of the developments in the European crisis. This plan contains all the hopes of the political leaders. Each has his or her own delusions, some believing in the saving virtues of central bank intervention, others in their own capacity to manage the crisis on a knife edge.

Two major obstacles stand in their way: firstly, the scale of the funds which need to be mobilized in order to control a private and public debt reduction strategy which risks slipping from their grasp at any moment, and secondly, the recession which Europe is plunging into, which is going to further increase the costs. Financing the reimbursement of the debt with new debts is not, in the final analysis, such a good idea, even if it is likely, to some extent, to be shared mutually at a given moment of the process of European integration.

Is it going to prove necessary to remind Jean Lemierre of the virtues of negotiation and to be resigned to engaging in new restructurings of the debt? Not to mention the fact that the ECB and the national central banks, which together constitute the Euro system, have become important holders of this problematic debt, in the hope that the Spanish and Italian banks would be able to offload thanks to a new wave of ECB credits. A new debt restructuring can no longer spare the Euro system, as it did Greece, without causing it to lose much of its interest.

Still, the Gordian knot will not be cut.