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Why the euro zone's last chance may have slipped away

Mark Renders/Mark Renders/Getty Images

European summits -- more than 20 at last count -- have produced little. The summit on Dec. 8-9 was billed as the last chance for euro zone leaders and Euro-crats to avoid a financial disaster. European leaders succumbed to their long standing common sense deficit, which is as intractable as any budget and trade deficit.

The last comprehensive and final plan -- the fourth in the last 18 months -- failed to mollify investors and markets. The crisis is now engulfing Italy, Spain and now re-infecting Ireland and Portugal. Stronger countries like France and Germany are increasingly vulnerable.

The most recent summit made no attempt to tackle the real issues -- the level of debt, how to reduce it, how to meet funding requirements or how to restore growth. Most importantly there was no new funds committed.

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The summit's new Fiscal Treaty will not work. Austerity (draconian budget cuts and tax increases) to bring budget deficits and public debt under control cannot deal with the problem: the deflation of the debt-fuelled bubble.

Fiscal union - greater integration of finances where Germany and the stronger economies subsidize the weaker economies combined with jointly and severally guaranteed euro zone bonds - was explicitly rejected. The European Central Bank ("ECB") is reluctant to embrace debt monetization (the ECB prints money and uses it to buy bonds). Neither option was realistically feasible, economically or politically.

The European Financial Stability Fund ("EFSF"), the European bailout fund, soon to be replaced by the European Stability Mechanism ("ESM"), is now largely irrelevant. With only a maximum of €500-billion, some it already committed to existing bailouts, it lacks the resources to quarantine Spain and Italy as well as, increasingly, Belgium, France and Germany from contagion. Spain and Italy alone need around €1-trillion to meet their financing requirements over the next few years.

Schemes to increase the capacity of the EFSF - borrowing to leverage the fund or partial guarantees or seeking Chinese funding – are simply far fetched or incomprehensible. The EFSF's attempt to raise money to meet existing commitments has run into problems, meeting lack lustre support and a sharp increase in costs. In the event that the AAA guarantors are downgraded, the EFSF structure, as originally envisaged, becomes unworkable. Rating agencies have signalled that the EFSF's AAA rating is under threat. The risk that the cost of funding for the bailout fund is greater than the rate that it can charge is now increasingly evident.

European central banks will provide money (€200-billion) to the IMF to provide money to beleaguered nations. But unless increased substantially, the IMF may be only able to muster €300-€450 billion, which will be insufficient. Whether all members will support IMF involvement is uncertain. Countries like the U.S. and China are reluctant to assume the risk of bailing out Europe.

Europe doesn't have a "liquidity" problem which can be alleviated by substituting fleeing private sector lenders with official lenders such as the European Union ("EU"), ECB or the International Monetary Fund ("IMF"). European countries have a "solvency" problem – they have debt that they can never seriously expect to pay back. Stronger nations cannot save the peripheral nations without ultimately destroying their own credit and ability to raise funds.

There has to be realistic writedowns of the debt of countries like Greece, Portugal and Ireland and a preparedness to do the same for Italy and Spain quickly, if necessary. An aggressive program for recapitalization of European banks and the ECB is needed. Weaker countries may need assistance in recapitalizing banks. None of this was addressed

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Without growth, Europe cannot deal with its debt problem. Weaker nations should leave the euro. The devaluation of the new currency in conjunction with structural reforms will provide some chance of regaining competitiveness. Within the euro, the only option -- internal devaluation entailing a sharp fall of incomes and living standards -- cannot work on its own.

The reality is that the solution now may be beyond Europe's ability and there is simple not enough money (€2.5- to €3-trillion that would be required). Europe is rich at one level, but a lot of this wealth in invested in government bonds that are increasingly risky.

Germany and France are unwilling and unable to increase the size of their commitments. Restricted by the German Constitutional Court's decision, for the moment, Germany cannot and will not go above €211-billion in guarantees for the bailout funds already committed – about 7 per cent of its GDP. Fiscal integration would have a higher cost than Germany is willing to pay or can sustain without affecting the country's creditworthiness. Chancellor Angela Merkel's spokesman Steffen Seibert put the matter plainly stating that Germany doesn't have "unlimited financial strength."

France is at the limit of its financial capacity and at risk of losing its AAA credit rating. Fragile coalition governments in Netherlands and Finland are increasingly reluctant to increase their commitments to the bailout process. These constraints make full fiscal union difficult..

Standard & Poor's are reviewing the ratings of a number of 15 euro zone countries with with negative implications. This action was "prompted by … belief that systemic stresses in the euro zone have risen in recent weeks to the extent that they now put downward pressure on the credit standing of the euro zone as a whole." The rating agency highlighted tightening credit conditions across the euro zone, higher funding costs for many euro zone sovereigns, high levels of government and household indebtedness, the rising risk of an European recession and a lack of agreement among European policy makers on tackling problems.

The curious pas de deux between European banks and sovereigns has reached a critical stage. Needing to raise money and keep interest costs down, governments are pressuring banks to buy their bonds and use them as collateral to raise fund from individual central banks and the European Central Bank ("ECB"). At the same time, European banks exposed to the risk of large losses on holdings of sovereign bond, which would render them potentially insolvent need governments to support the banking system.

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Time is running short. European Sovereigns and banks need to find €1.9-trillion to refinance maturing debt in 2012. Italy alone requires €113-billion in the first quarter and around €300-billion over the full year. European banks need €500-billion in the first half of 2012 and €275-billion in the second half. This means they need to raise €230-billion per quarter in 2012 compared to €132-billion per quarter in 2011. Since June 2011, European banks have been only able to raise €17-billion compared to €120-billion for the same period in 2010.

The ECB has reduced Euro interest rates and lengthened the term of emergency funding of banks to three years with easier collateral rules (a lottery ticket is now acceptable as surety for borrowing). All this does is alleviate funding pressure on banks without dealing with the fundamental problem.

What happens in Europe will not stay in Europe. The shock will be rapidly transmitted through trade, investment and inter-relationships within the financial system to the rest of the world.

Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (November 2011)

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