Euro Crisis: Is There a Way to Stop the Contagion?

Stability"Stability"by Rickydavid via FlickrAfter Greece, the Euro crisis has spread to Italy and now Spain. 

Next on the list: France, Netherlands and Finland or perhaps Austria. 

One after the other, countries are the prey of market attacks, each worse than the preceding one. This week, the spread between German  and Spanish bonds has for the first time become as wide - some 500 points - as it is between German and Italian bonds.

500 points seem to be the magic number at which countries and markets panic. 

The point at which investors decide that a country's ability to keep paying its debt is in peril. The spread with Italy has been hovering there for some time now, causing rating agencies (in particular Fitch) to downgrade Italy's credit rating from AA- to A+ a month ago, thus signalling the beginning of the Italian crisis and the end of Berlusconi. At the same time Spain was downgraded from AA+ to AA-... better than Italy, but barely so. And lately France has been forewarned that it risks losing its prized AAA rating. 

Moreover the market for futures is tumbling while the Euro drops against the dollar.  

Conventional wisdom - repeated at nauseam in the press -  is that at this level Italy's debt (some 1.9 trillion Euros) is unsustainable. Italy's economy will implode under the weight of its debt. And this is not Greece. We're talking here of the third economy in the Euro-zone. 

Once Italy goes, so does Spain. Then Belgium (the spread here is already critically high) and next, why not, France. 

When that happens, nothing can save the Euro. With unimaginable consequences in the rest of our globalized world, as the Euro drags down with it international trade, American banks and Chinese exports.

This means that your savings, your pensions, your job in whatever part of the world you happen to live in are at risk.

Over one fiery week-end Italy has shown the world how quickly it can move

Following Berlusconi's retreat, the new government was put together in record time - a government headed by Mario Monti - here in Italy he's called "Super Mario" -  a world-respected economist and former EU Commissioner. It is purely a "governo tecnico" made of technocrats and managers plus one diplomat (the Italian Ambassador to the US was nominated Minister for Foreign Affairs). Thus Monti was careful to select outstanding personalities in the world of academia, finance and diplomacy, including three women, while maintaining for himself the key role of finance minister. He's not going to let any other economist get in his way!

Yet, in its first day of life, Monti's government was not appreciated at home. Protests planned earlier, before Berlusconi 's government fell went ahead anyway. Consisting of a general strike of public transports and student marches in most major cities (with some violence in Milano and Palermo), they struck average Italians as singularly irrelevant and off base. Give the guys a chance to show what they can do!

Sure, Monti picked some bankers in his team and he himself has a Goldman Sachs experience although that hardly means Goldman Sachs controls Monti (or controls Mario Draghi, who's also an ex Goldman Sachs). One in particular, Corrado Passera, provoked rage among the protesters - but what was Monti supposed to do if he wanted the best? Everybody seems to forget that Passera, before he headed the San Paolo Intesa bank had turned around the old, inefficient Italian Postal system and made it a remarkably efficient and well-run organization. All of a sudden, the much derided Italian Postal system had stepped into the 21st century! 

Passero may have been into banking lately but he is above all a manager, and now that he has been placed in charge of economic development, one may expect him to work wonders. And that is bound to become a key area in Monti's strategy: because debt control cannot be achieved at the expense of economic growth.

Sure Monti talked about placing a tax on the "first house" ("ICI" on the main house of residence) and seemed to bow from pressures from Berlusconi who doesn't want to see any wealth tax ("patrimoniale") - no surprise there, since Berlusconi's sole reason to enter politics was and is to defend his own interests. The richest man in Italy, he's not about to pay any tax to anyone if he can help it. And Italy and the Euro be damned! 

My hope is that Monti will in fact resist Berlusconi and will not put undue pressure on the Italian middle class (the one paying this famous ICI tax on the "first house"). Because if he does that, he'd be putting at risk Italian consumption and hence Italian economic recovery. But he's too good an economist not to know that...And he enjoys 75% support in opinion polls and easily won votes of confidence in both houses of Parliament. So chances are good that he will implement the necessary reforms and set Italy on a course to recovery.

Is the Reform Plan Monti Offers Enough to Solve the Euro Crisis?

No. The timing is off. We won't know for many months whether Monti's government will be able to operate a turn around for Italy. My bet is that it will, but markets can't wait that long. Incidentally, the same can be said of Greece or Spain. 

Reforms take time and markets are impatient.

People are impatient too. In the Netherlands, they're talking of establishing the "Neuro" - a Euro reserved to Germany and the Netherlands - the best in the class -  and just about no one else. They're ready to "shed off" all those rascally Greeks and Italians who never learned to tighten their belt. Taxpayers in those northern countries don't want to pay for rescuing their southern neighbors who in their view are only getting what they deserve. A kick in the pants, ja!

The Way Out? Get the European Central Bank to act as a real central bank - like the US Federal Reserve

Mario Draghi (another Super Mario!) is growing impatient. He just told a banking conference in Frankfurt "Where is the implementation of these long-standing decisions?" He was referring to the European Financial Stability Facility that was supposed to save the Euro and has yet to become operational.

Will it ever become operational? I don't think so. 

First, It's way too small in relation to the mountain of debt it's meant to cover (440 million). Second, it's way too shaky to reassure investors. It's meant to be a financial scheme providing insurance to investors in say, Italian or Spanish bonds. In case of default, they would only be covered at best up to 20 percent of value, and possibly not even that if France, one of the two major investors in the Facility (the other being Germany) should lose its Triple A credit rating. Because that would mean the Facility itself would no longer have a Triple A rating either. 

French President Sarkozy, on the occasion of the G20 meeting in Cannes, tried to convince China and other big players like India and Brazil to invest in the Facility to expand it. No such luck so far.

What other solutions are there? Shedding Euro partners, in spite of the Dutch desire to do so, is a non-starter. Greece has made it very clear that it wishes to stay in and Papademos, its Prime Minister - another economist with a remarkable profile,  similar to Monti's - has embarked on a reform program.

No, Euro partners must stay together or all go down together.

Which is why the European Central Bank should act as the lender of last resort - to both banks and governments. 

Which is why Europe must move to "more Europe", as Ms Merkel has recently said (lately she has unexpectedly shown more enthusiasm for the European Union). 

The Euro-zone needs to become a fiscal union, with all monetary, fiscal and economic policies aligned - the kind of policies that are precisely those Italy and Greece are working to implement.

One remaining hurdle: the German fear of inflation

Why is the European Central Bank (ECB) dragging its feet? Because the Germans don't want it to print money. They say the ECB was never set up to buy bonds or engage in any "quantitative easing" policies the way the US Federal reserve does. 

As far as Germany is concerned, the ECB was set up to fight inflation and keep the Euro stable, full stop.

The fact that there is nothing in the ECB charter that talks about a "lender of last resort" role is however a moot point. Basically a central bank should be independant from any government or political views and able to do whatever it sees as necessary, including quantitative easing. 

If quantitative easing is the only way to "keep the Euro stable", so be it. Let it go ahead and work as a Central Bank should.

Why is Germany so fearful of inflation? It's an old story, a historic fear: they remember the run-away inflation of the 1920s that brought Hitler into power. Germany is afraid History will repeat itself. 

But this is not the 1920s! There is no danger from inflation. On the contrary: look at the US! Under Bernanke's guidance the Federal Reserve has repeatedly engaged in quantitative easing and so far this hasn't triggered any inflation and as the latest statistics show, consumer prices are down this quarter in the United States...Not to mention that inflation is not an issue in Europe right now.

Given all this, it's not quite clear why the European Central Bank is still not moving. 

Up to now, I thought it was Trichet's fault. Before heading the ECB, Trichet had been France's central banker and had the usual training of top French civil servants: ENA, Sciences Po and the Ecole des Mines - a great cv that prepared him well for administrative work but he's not an economist. Mario Draghi, on the other hand, is a trained economist: he earned a Ph.D. in economics from MIT. He knows what banking is all about: from the private side (Goldman Sachs, right!) and from the public side (the Italian Central Bank, the World Bank and other international work on financial regulations). This is a man who surely understands what a Central Bank is supposed to do.

My bet is that he's dragging his feet to force governments to engage in the necessary reforms. And if and when he's going to come to the rescue, he certainly won't announce it.

Central bankers famously are the quiet sort that never tell you what their next move will be. 

But investors, in my view, would do well not to underestimate either Draghi or the ECB's clout.

What is your opinion? 

Post scriptum: Mario Monti is travelling through Europe these days, visiting Sarkozy and Merkel with a special project in his bag: Euro-bonds...And a request that the Stability Facility be established asap.

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