Legal and Political Obstacles to Euro-Area Deal Mount

It didn't take very long for it to become clear that the new 'fiscal compact' fantasy negotiated last week by Europe's political leaders may be unraveling just as fast as it was dreamed up.

It should be clear that the fiscal propriety straight-jacket Germany wants to impose on the euro-zone is the one solution least liked by the political class, as it threatens to seriously disturb the vote-buying and the dispensing of favors to a plethora of vested interest that is regarded as the main job of the modern-day short term caretakers of the government's apparatus of compulsion and coercion.

Naturally, they all prefer to violate their subjects' property rights and liberty via the expedient of inflation rather than by raising taxes. That way, it is reckoned  – not unreasonably so, from the point of view of the looting class –  the theft will go largely unnoticed, and by the time it becomes noticeable, the victims will no longer be able to link it to the policies enacted in the past. There is after all a considerable time lag between the act of inflating the money supply and the discovery of late receivers of the new money that they have been duped.

The inability to promise an endless stream of free goodies to a sufficiently large majority of the electorate is also a serious impediment to actually winning elections. One's opponent may end up winning simply by being someone else. Even worse, since said opponent has not been a signatory to the 'toil, blood, sweat and tears' treaty, he can now use the promise of altering the negotiated treaty as a campaign weapon.

This is precisely the course the main political opponent of France's ersatz Napoleon Nicolas Sarkozy has now embarked upon. The ink was barely dry on the 'fiscal compact' when the leader of France's socialists (a party that is in principle indistinguishable from the so-called 'conservatives', as both are etatiste to their rotten core), Francois Hollande, let it be known that he would immediately renegotiate the treaty if he were elected.

As Marketwatch reports:

“French Socialist Francois Hollande, one of the main candidates expected to challenge President Nicolas Sarkozy in May, reportedly said Monday that if elected, he would seek to renegotiate the fiscal agreement reached in Brussels last week. According to a report in AFP, Hollande said in a radio interview with RTL that if elected, he would try to convince his European counterparts on three fronts: the issuance of joint eurobonds to combine sovereign debt; allowing more intervention on bond markets by the European Central Bank and agreeing to stimulus measures. His Socialist party has been critical of Sarkozy for bending to Germany's will and undermining France's own policy. Hollande is leading in opinion polls in France right now ahead of a presidential election due to take place in two rounds, next April 22 and May 6, said media reports.”


(emphasis added)

Evidently, Sarkozy's signature has just become worthless – since it is fairly certain that he who promises a free lunch will get the majority of the votes. Hollande wants the ECB's printing press to 'solve' the problem, and inflationism – just like protectionism – is ever popular.

However, the deal is beginning to unravel from the opposite side of the political spectrum as well. A member of the board of Germany's Bundesbank appeared to shoot down the idea of bilateral loans to the IMF in mid-flight – this in spite of the fact that the Bundesbank had appeared amenable to the idea only a week earlier.

According to the Telegraph:


“Andreas Dombret, a Bundesbank board member, said Germany's central bank cannot take part in any form of covert funding for EMU states in trouble through the bank-door of the IMF, saying further money can be used only to support the normal operations of the Fund.

"The money cannot migrate into some sort of special pot that is used exclusively for Europe. That would be a clear breach of the prohibition of monetary financing of states. The German Bundesbank has explicitly ruled this out," he told the Handelsblatt newspaper.

Mr Dombret said the Bundesbank's share of any such IMF package would be €45bn and is "inherently risky". It would require an indemnity of some kind from the German parliament. This in turn would breach the €211bn ceiling already set by the Bundestag on EU bail-outs.

Mario Draghi, the head of the European Central Bank (ECB), raised similar concerns last week, warning that the ECB is not willing to use the IMF as a conduit for covert sovereign rescues in Europe.”


(emphasis added)

Furthermore, Germany's Bundestag president Nobert Lammert appears unconvinced of the constitutionality of the euro-zone deal. As we mentioned yesterday, the idea that other IMF member nations (i.e., non-European ones) should also step up to contribute to the IMF directed rescue seems to be little more than a forlorn hope. To even include this admonishment in the official statement required quite a bit of chutzpa. As has now become evident, this was not even discussed with other IMF nations beforehand.

The Telegraph continues:

Adding to complications in Germany, Bundestag president Norbert Lammert has demanded that the summit package should undergo scrutiny by Germany's constitutional court, warning that new powers for European commissars to intrude in national budgets might conflict with German fiscal sovereignty.

The summit item on the role of the IMF appears to have been slipped into the conclusions without full preparation and is meeting blistering criticism from IMF experts, as well as hostility in Washington.

US President Barack Obama said: "Europe is wealthy enough that there is no reason why they can't solve this problem. It's not as if we are talking about some impoverished country that doesn't have any resources."  The US said it will not contribute to the EU package. A group of Republicans on Capitol Hill want to go further and slash America's existing funding for the IMF.

Mario Bleijer, former head of Argentina's central bank and an IMF expert, said Europe should not try to shift liabilities onto the rest of the world.”


(emphasis added)

To summarize just the points above: over a single weekend after the 'landmark deal' was signed, we find out that the governments that are the main parties to the agreement are not even in a position to guarantee that the agreement will survive. Their competence as regards signing such agreements is very much in doubt. What's more, they have evidently been unable to find an acceptable compromise, as important powerful interests in their own countries remain implacably opposed to weakening their original position. In France it is held that the agreement is 'too tough'; in Germany it is held to be 'too soft' and in violation of existing legal restrictions.

Adding to the growing sense of doubt, several other governments are suddenly also not so sure if they can just sign off on the massive changes demanded by the 'fiscal integration' deal.

As the WSJ notes:

“In Ireland, the government plans to decide whether a referendum will be needed to accept the pact. Europe Minister Lucinda Creighton on Friday put the chances of that at "50-50." An Irish "no" wouldn't necessarily derail the pact, but it would place Ireland in limbo—inside the euro zone but outside its proposed fiscal pact.

The agreement likely will need to get parliamentary approval in Sweden, Hungary, the Czech Republic and possibly Denmark.

"The more you hear from the European leaders, and the less you see implemented, the more skeptical you are," said J.P. Morgan Asset Management chief market strategist Rebecca Patterson.”

Not mentioned by the WSJ is the fact that Finland regards the 'qualified majority rule' for the ESM's decision-making procedure unconstitutional. It will require a separate approval by Finland's parliament to enable it to agree to this particular provision.

In short, the very same problem that has bedeviled the handling of the crisis by the eurocrats from day one continues to rear its head: it is simply impossible to get 17 – never mind 27 –  different nation states to agree to wide-ranging reforms in a hurry. This is especially so when these reforms threaten their sovereignty and the very cornerstone of modern-day democratic politics, namely the ability of politicians to bribe the electorate.

From the German point of view, a different motive is in the foreground:  Germany wants to enjoy all the advantages that membership in the euro area brings to it, but it doesn't want to pay for them. It fails to realize that at the heart of the competitiveness problem that has brought the fiscal offenders in the periphery down are the capital malinvestments and price distortions resulting from the credit bubble that was enabled by the fractionally reserved banking cartel directed by the ECB. At least though, Germany refuses to join in the ex-post rationalizations forwarded in favor of even more inflationism by France and many others. The German 'fiscal straight-jacket' proposal is at least a tad more honest, as the theft of resources from the producers of wealth will have to be conducted overtly instead of covertly (as we have already noted, there is as of yet no plan to actually cut government spending anywhere, so budget consolidation rests mainly on imposing higher taxes).

Obviously though, it is simply not possible to bring all these widely differing viewpoints together on the same page. Whenever the financial crisis lurches to fresh extremes, there is a sense of urgency and everyone seemingly agrees that 'something must be done fast', but as soon as an agreement is reached under this exogenous pressure, it turns out that no-one really wants it.

After all, who would want to be bossed around by this clown?


Chief unelected eurocrat, EU commission president Herman van Rompuy. Nobody loves him ('Who am I, what and why? 'Cause all I have left is my memories of yesterday – Oh these sour times' – Cause nobody loves me,  It's true' ), least of all Nigel Farrage, see below.

(Image via Reuters)





Nigel Farrage's famous harangue of Herman van Rompuy (some choice quotes: “You have the charisma of a damp rag and the appearance of a low grade bank clerkWho are you? I've never heard of you. Nobody has ever heard of you. Who voted for you?” … “ I sense though that you're competent and capable and dangerous" … "I have no doubt that it's your intention to be the quiet assassin of European democracy and of the European nation state.” – Quite so.)

Rating Agencies Unconvinced

On Monday, financial markets were not only succumbing to the realization that the 'fiscal compact' was going to run into legal and political troubles, but also to the fact that the rating agencies were heaping on more pressure as well. Their assessment of the deal was quite negative.

As Reuters summarizes:

“Investors were bracing for a possible mass downgrade of euro zone countries as soon as this week after EU leaders failed to come up with decisive measures to tackle the region's debt crisis.

Moody's Investors Service said on Monday it intends to review the ratings of all 27 members of the European Union in the first quarter of 2012 after EU leaders offered "few new measures" to resolve the crisis in a summit on Friday.

Fitch Ratings said the summit, in which leaders agreed to draft a new treaty for deeper economic integration, failed to provide a "comprehensive" solution to the crisis, thus increasing short-term pressure on euro zone sovereign ratings.

Friday's historic agreement in Brussels between 26 European Union leaders to draft a new treaty for deeper integration in the euro zone gave a brief fillip to markets. But it did not last long as the announcements from both Moody's and Fitch compounded the selling in the fragile and increasingly illiquid pre-holiday market environment.

Standard & Poor's, which warned last week of a possible downgrade of 15 euro zone countries shortly after the summit, still has to announce its decision. By placing these countries on credit watch negative — which signals a possible imminent downgrade — S&P said "systemic stresses" were building up as credit conditions tightened in the 17-nation region.

On Monday, S&P's chief economist Jean-Michel Six said time was running out for the currency bloc to resolve its debt problems.

"There is probably yet another shock required before everybody in the euro zone reads from the same page, for instance a major German bank experiencing some real difficulties on the markets, which is a genuine possibility in the near term," Six told a business conference in Tel Aviv. The agency, which in August stripped the United States of its AAA rating, said it would focus its decision on political dynamics that "appear to be limiting the effectiveness of efforts to resolve the market confidence crisis." The assessment of the summit's success by rival ratings agencies does not bode well for S&P's upcoming decision.

Moody's said the outcome of the EU summit did not change its view that risks to the cohesion of the euro area continue to rise. "As we announced in November, unless credit market conditions stabilize in the near future, our ratings of all EU sovereigns will need to be revisited," it said in a weekly report. "We continue to expect to complete such a repositioning during the first quarter of 2012."

Fitch also said the summit did little to ease the pressure on euro zone sovereign debt, as leaders agreed on a gradualist approach that "imposes additional economic and financial costs compared with an immediate comprehensive solution."

"It means the crisis will continue at varying levels of intensity throughout 2012 and probably beyond, until the region is able to sustain a broad economic recovery," Fitch said. The firm reiterated its belief that the European Central Bank is the only "truly credible 'firewall' against liquidity and even solvency crises in Europe." That firewall is created by either the use of the ECB's existing sovereign bond purchase program or indirectly by allowing the European Financial Stability Facility (EFSF), or its successor the European Stability Mechanism (ESM), access to its balance sheet, Fitch said in its statement.


(emphasis added)

We have already mentioned that the rating agencies are pining for more money printing by the ECB – they already said so in their statements issued ahead of the summit. This inter alia explains why France was so eager to involve the ECB in the financing of the EFSF and ESM. The demise of its AAA rating is basically reduced to a formality by now – something French president Sarkozy seemed to admit in an interview he gave to Le Monde.

As the FT reports:

“Nicolas Sarkozy, French president, on Monday played down the importance of the potential loss of France’s cherished top credit rating, in an about-turn which raised speculation that a downgrade could be close.

A lowering of the triple A sovereign rating – which allows France to fund its public spending cheaply – “would be one more difficulty but not insurmountable”, Mr Sarkozy said in an interview with Le Monde newspaper. “We would face such a situation coolly and calmly.”

François Baroin, finance minister, who said just weeks ago that France would “do everything to avoid a downgrade”, told BFM television on Monday morning that the pronouncements of rating agencies were “one among many” judgments on the economy.  Marc Fiorentino, chairman of the Euroland Finance brokerage, said: “The government has made the French people aware of the significance of the triple A – that it’s our national treasure and that losing it would be the end of the world. Now they are having to shift 180 degrees.”


(emphasis added)

In short, it seems now all but certain that the euro-area's bailout mechanism EFSF will run into major funding trouble, as it is likely to suffer a downgrade of its AAA rating as well.

Having said all that, we still do not share the doubts of many observers regarding what the FT Alphaville blog has now colorfully termed the 'Sarko-Corzine trade'.

It briefly describes the idea behind euro area style 'QE' as follows:



“Eurozone bank borrows 3-year money from the ECB after putting up acceptable collateral. As luck would have it, sovereign debt is very acceptable. So they buy, say, short-dated Italian debt, pledge the asset (although with a graduated ECB haircut for credit risk) and pocket the difference between the ECB’s lending rate and the yield on the sovereign bond. Retained earnings at the bank improve, the sovereign has a buyer for its debt and the ECB is playing its role in solving the crisis. A certain carry trade is back to the fore.”

Well, yes, that is exactly the plan. Alphaville notes that John Hussman has termed this a 'dumb idea'. It may well be a dumb idea, but that does in our opinion not mean it won't be done. Specifically, we believe Hussman errs on a particular point. Here is the pertinent quote from Hussman's weekly missive:

“We’ve seen some theories that Europe intends to address the problem through ECB lending to banks, taking distressed debt as collateral, with the banks turning around and buying more distressed debt.

Apart from the fact that this would be the sort of “legal trick” that the ECB would be unwilling to facilitate, this would imply an increase in bank leverage ratios far beyond the 30-40 multiples that already exist (which would be a disaster when tighter Basel III capital requirements kick in). In practice, depositors would flee, and you would end up with a European banking system where bank bondholders, not the ECB, would be subject to the losses, since the ECB’s collateral claims would be senior.”


(emphasis added)

First of all, this is precisely the kind of 'legal trick' that the ECB would be willing to facilitate, and is in fact facilitating. As regards depositor flight, this is happening whether or not the banks buy more sovereign bonds. Depositor flight in the euro area is predicated on the suspicion that certain countries may leave the euro area and that certain banks are de facto already insolvent. The central bank's collateral claims would certainly be senior to the claims of bank bondholders. However, by using the banks as middlemen, it avoids precisely the problem that has come to the fore whenever the ECB buys sovereign bonds directly. In that case, the ECB becomes senior relative to all other creditors of the sovereign concerned, thereby increasing the risks and the potential loss severity for these creditors. This is why Greek bond yields keep rising every day – private sector lenders expect that there will basically be zilch for them to recover in the event of a Greek default.

So contrary to Hussman, we believe that the ECB had, among other things, precisely this 'Sarko-Corzine' trade in mind when it offered 36 month LTRO's last week. It is the only way the ECB can actually help the sovereigns without violating its statutes. Moreover, Hussman seems to forget that e.g. Italy has historically never defaulted on its sovereign debt and that contrary to several of the higher rated sovereigns in the euro area, it actually looks fiscally healthier in the long term – it only appears to be fiscally weaker because fewer of its liabilities are hidden. Lastly, the fate of Italy's banks is already inextricably intertwined with the fate of the sovereign. Taking on additional risk in the form of Italian government bonds does not represent a disincentive to these banks at all, since if Italy's government goes down, they go down with it  anyway.

In short, we believe the market continues to underestimate the potential effect  the ECB's new banking system funding initiatives will have on the demand for sovereign debt in the euro area. Since we are nearing year end when liquidity is traditionally tight, it is way too early to judge the outcome.

Meanwhile, the OECD has warned over the weekend that the developed world faces a potential funding crisis in 2012.

As CNBC reports:


“For the foreseeable future it will be a “great challenge” for a wide range of OECD countries to raise large volumes in the private markets, with so-called rollover risk a big problem for the stability of many governments and economies.

Rollover risk is the threat of a country not being able to refinance or rollover its debt, forcing it either to turn to the European Central Bank in the case of eurozone countries or to seek emergency bail-outs, which happened to Greece, Ireland and Portugal. The OECD says the gross borrowing needs of OECD governments is expected to reach $10.4 trillion in 2011 and will increase to $10.5 trillion next year – a $1 trillion increase on 2007 and almost twice as much as in 2005. This highlights the risks for even the most advanced economies that in many cases, such as Italy and Spain, are close to being shut out of the private markets. While borrowing was higher in 2009 and 2010, the risks are greater than ever because of rising borrowing costs in turbulent, unpredictable markets.

The OECD says that the share of short-term debt issuance in the OECD area remains at 44 per cent, much higher than before the global financial crisis in 2007. This, according to some investors, is a problem as it means governments have to refinance, sometimes as often as every month, rather than being able to lock in more debt for the longer term that helps stabilise public finances.

The OECD also warns that a big problem is the loss of the so-called risk-free status of many sovereigns, such as Italy and Spain, and possibly even France and Austria. The latter two have triple A credit ratings but investors no longer consider them risk-free.”


(emphasis added)

Well, no doubt about it – getting hold of nearly $10.5 trillion in fresh financing in the course of 2012 will represent quite a challenge. We should expect much more money printing by central banks as a result. What else are they going to do? The policy of propping up unsound credit and bailing out all and sundry has after all become firmly enshrined in the developed world's economic policy canon. Whatever excuses will be used to justify it, more money printing is virtually assured.



Via the German language site 'Querschüsse', below are two charts illustrating the development of the German Bundesbank's 'TARGET-2' claims vis-a-vis the other central banks in the euro system.



The Bundesbank's TARGET-2 claims on other European central banks – click for better resolution.




The TARGET-2 balance as a percentage of the Bundesbank's total foreign assets – click for better resolution.



As we have previously noted, these large imbalances denote that the BuBa is making up for the gaping hole left by fleeing depositors and the lack of access to wholesale funding in the euro area periphery's banking systems. It is basically a stealth bailout of the periphery's banks. In principle this does not represent a problem, since most of the deposits have fled to Germany where they are now funding the German commercial banks. However, this imbalance is bound to become a huge headache in the event of a break-up of the euro area.




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6 Responses to “The Great Unraveling”

  • Outlaw:

    Well I’m not buying the bull case on the Sarko-Corzine trade. Bank managers will never deliberately wreck their balance sheets by buying PIIGS debt with 3 year LTRO funding. If banks ever want to return to the stock market to raise capital, they’re going to have to have zero toxic assets and junk debt the markets hate.

    The “eat drink and be merry for tomorrow we die” rationale for buying PIIGS debt doesn’t fly IMO. The banks that are deep in the hole having a lot of PIIGS debt already are just as desperate to get rid of it as all the other banks. If nothing else but to reduce the size of the bail-out or recap they’re going to need. The European sovereigns have no money, and there are soon going to be too-big-to-bail banks just like there are now too-big-to-bail sovereigns. Just look at how hard it is for Belgium and France to choke down Dexia. That’s only one bank. The bankers know this. They know that their public sector backstop is weakening. ECB printing might yet save the day, but bank managers don’t have the luxury of waiting and hoping for that. They’re all going to do everything possible to clean up their balance sheets so they can return to the private capital markets as soon as possible. The Sarko-Corzine trade would be taking them in the wrong direction, because PIIGS debt is now considered toxic crap on the balance sheet by the markets.

    Sarko-Corzine is also unlikely to work because the trade depends on a sense of cooperation or coordination among the commercial banks that doesn’t exist. “If the banks all decided to buy PIIGS debt with 3 year LTROs then governments would have a buyer for their bonds, etc”. Yeah well, wishful thinking. Banks will put the money into winners, not losers, as Bob Hoye has astutely mentioned. There’s stuff out there with better risk vs. reward (like short positions, heh) than buying PIIGS debt and waiting for it to default.

    • I certainly agree they would not buy ‘PIIGS’ debt as such. But I do think the Italian banks will consider buying Italian debt for instance. The spread is large and Italy has never defaulted. This would potentially remove what is the gravest concern in the short term, although I definitely concede that one can by no means be certain of this. Also, non-Italian banks will likely remain net sellers.
      It seems however that this is the plan – whether or not this new Ponzi idea will actually ‘work’ remains to be seen.
      However, I think one should not make the mistake of underestimating the ECB’s recent measures – they are very significant.

  • roy_partridge:

    Pater –

    How would this end?

    As you stated what seems to be happening (or will be) is countries will keep spending, the deficits will be financed by the banks, banks make money from the spread, ECB keeps loaning against this debt, and this can keep the game going for a long time.

    The ultimate impact would be seem to be very gold friendly.

    • It will be gold-friendly immediately if monetary inflation actually accelerates in the euro area. We will however have to wait a bit for the data to emerge – by January-February 2012 we should know more.
      If the measures fail to halt the deleveraging process then it would not be gold friendly in the near term, but gold’s quality as a hedge against systemic collapse by dint of being a monetary asset that is not dependent on the web of promises that make up the current financial and monetary system should then come to the fore. So long term a negative outcome regarding halting the deleveraging process (negative from the point of view of the intervenionists that is) should still prove positive for gold.

  • It appears to me this stuff is blowing up faster than they can create it. I wonder what they are waiting for to downgrade these countries. Weiss already has all of them a notch or 2 above junk. Looks more like a deflation from hell in the near term than hyperinflation.

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