Europe’s future on a knife edge

15/05/2010 | Taimur Ahmad, Sid Verma and Phil Thornton

Europe’s economic and political future hung in the balance this weekend after the most turbulent week in the history of the union saw the eurozone spared at the eleventh hour from outright collapse but left the credibility of its key institutions in tatters

Europe’s economic and political future hung in the balance this weekend after the most turbulent week in the history of the union saw the eurozone spared at the eleventh hour from outright collapse but left the credibility of its key institutions in tatters.

As European politicians scrambled to rush forward radical plans to uphold monetary union and push for far-reaching integration, leading experts warned that its future would remain bleak for years to come – with far-reaching global consequences.

European Central Bank President Jean-Claude Trichet today called for more action by euro-zone governments to pool fiscal governance, amid concern in financial markets that the debt crisis could still break apart the single currency.

But economists said the ECB’s authority had been sapped after it was forced last weekend by European politicians into a humiliating u-turn on buying sovereign debt – a move that experts say, while necessary, has undermined its legitimacy in the eyes of financial markets while opening the door to widespread market dislocation.

Willem Buiter, chief economist at Citi, told Emerging Markets. “They are politicizing themselves in a major way. They’re doing quasi-fiscal policy through monetary and financial instruments without proper transparency and accountability. That is not the task God made them for. This will undermine the legitimacy of the ECB.”

Buiter added that the manner in which government debt purchases had been introduced “after many denials” was “likely to cause a loss of faith and to undermine the authority of the organisation and indeed of the president as well. They did the right thing, however they did the right thing in the worst possible way.”

As a result, he added: “The ECB has allowed itself to be put in the position of being hostage to the political determination to tackle budget deficits forthwith of the Ecofin ministers of the euro areas. It’s not a place I’d like to be given that this area is not known for its ability to discipline itself or anybody else.”

Barry Eichengreen, economics professor at the University of California, said Europe’s economic gloom would be compounded when the ECB attempted to restore its shattered image. “A double dip [recession] in Europe is a done deal,” he told Emerging Markets. “There will be no fiscal support for growth and no monetary support because the ECB is going to want to repair its image by getting out of the bond market and tighten sooner rather than later.”

Charles Wyplosz, economics professor at the Graduate Institute in Geneva, hinted that the bank would not be able to regain credibility until Trichet stood down in October next year. “The ECB has been compromised,” he told Emerging Markets. “On paper it is fully independent and that is where its strength is. It will be for the next President to show that the ECB can be made independent again.

“The institution is excellent and its independence is well known but it has proved to be weak. They are only human beings. They can fail and they have failed. The only only hope us that the next generation will exercise better judgement.”

Eichengreen said what he called the ECB’s “misjudgement” to purchase Greek, Irish and Portuguese bonds meant that its balance sheet was also on the line.

“Every commercial bank holding a Greek bond wants to lay it off on the ECB. And if you think there’s going to be a significant haircut on Greek debt, as I do, then there is going to be a hit. A line should have been drawn. They should have asked ‘if Greece is going to restructure, why are we supporting its bond market?’.”

Arnab Das, head of strategy at Roubini Global Economics, said the sovereign debt on the ECB’s balance sheet could “ultimately eat into the capital of the ECB because the adjustment may not work.” If sovereign debt of Greece and other weaker eurozone economies is restructured, “instead of it being borne by the banks and creditor countries, it’ll be borne by the ECB. Instead of the fiscal problem in the north being a question of recapitalizing the banks again, the fiscal problem will be a question of recapitalizing the ECB.”

There is also a growing concern that the actions by the ECB – and the EU’s move to make E750 billion of liquidity available to troubled states -have added to the confusion over when governments will withdraw the extraordinary stimulus packages put in place to prevent financial Armageddon.

Buiter said most advanced industrial countries were in need of “drastic and early fiscal tightening”, adding: “Everywhere from Greece to the US, policymakers are dragging their feet and the people are in denial over this. Europe is being forced into tightening earlier than others.”

Eichengreen said Europe’s moves would “complicate” the desire of the US Federal Reserve to exit and normalize the level of interest rates. “The signals are quite conflicting at the moment. Most everything indicates that the recovery is gathering pace in the US. On the other hand, now there’s Europe,” he said.

William White, former chief economist at the Bank for International Settlements, told Emerging Markets monetary policy itself had become a political issue. “Everyone now has to be concerned about moral hazard since central banks now find themselves purchasing bonds that are seen to favour one country over another,” he said.

Economists said the danger was the failure to engineer an exit could fan the flames of inflation and a new asset price bubbles. Hung Tran, head of capital markets at the Institute for International Finance, said monetary policy in Europe and the US was trapped between the need to stimulate growth and the desire to quell inflation expectations.

“There is strong need to tighten in the medium to short-term to address the nature of asset bubbles,” he said. Tran, former deputy director of the IMF’s monetary and capital markets department, said: “The speed at which many assets have swung back to pre-crisis levels in the face of a fragile economic recovery and weak banking systems is worrisome.”

But in the short term, politicians and bankers are waiting to if the eurozone bailout will succeed. “It’s a very big ask. The credibility of the eurozone and the ECB have been hammered. All the rules have been violated and the statements about-faced,” Das told Emerging Markets.

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