How to judge the nth European agreement ''to save Greece'' stipulated on Thursday 21st July? The financial markets have already provided their verdict: on Friday 22 the spread between the Italian ten-years Treasury Bonds and the German Bunds was still 258 basic points (2,58%), a level unsustainable for the Italian public finances. The next week begun (at the time of this writing) with Moody's downgrading the Greek sovereign debt again, and even higher spreads on the Italian and Spanish bonds. These had jumped over 300 points at the beginning of July, and did not fall much after further restrictive fiscal measures by the Italian government. The markets realise the uselessness of these manoeuvres that only depress the economies in a Sisyphus' effort to rebalance the situation, far from solving the European imbalances that are at the origin of the crisis.¹

The two main aspect of the agreement are the following:

1. the involvement of the private banking sector in alleviating the burden of the Greek debt;
2. the extension of the activity range of the European Financial Stability Facility (EFSF) created in May 2010 with better lending conditions to the three small periphery countries, Greece, Ireland and Portugal (GIP), and new tasks.

I will not say much on the first point. European banks have accepted a limited restructuring of their credits and a small haircut. That the cost of the adjustment will bear on banks' profits is positive. I am not sure this will happen, not anyway on the required scale. Funnily, most of the losses are imposed on the Greek banks, and very little on the German and French banks.

The EFSF (and the European Stability Mechanism-ESM that will replace the former in 2013) is a fund financed by the European governments and created in order to sustain the European periphery sovereign debts, as it did with Greece, Ireland and Portugal since last May. Notably, last year the ECB also intervened to sustain the PIG's sovereign debt, but in 2011 it has refrained from taking action (in principle forbidden by the European Statutes). After the recent agreement the EFSF will in the first instance provide a further loan to Greece and reschedule past loans to the GIP lowering the interest rate to 3.5%. This would be positive, were it not for the fact that Italy and Spain have to increase their own debt, paying interest rates of the order of 6%, to lend to the GIP at 3.5% (by contrast the German Treasury can collect money at 2% and lend at 3.5%). The fragile nature of the EFSF is indeed patent: indebted Greece is kept alive by increasing the Italian and Spanish debt, a vicious circle. This is why, last May, we said that the only novelty in Europe was that the ECB was timidly starting to intervene (but, as we said, for a short while).

On these fragile foundations, the ESFS has been assigned new tasks: to sustain banks' capitalisation, whenever necessary, and to intervene in the open market to sustain sovereign bonds whenever the ECB reputes necessary - supposedly in case of dramatic financial turbulence. In this the European governments have completed their masterpiece of putting the world upside down: traditionally it is the fiscal authority that calls on the central bank, with its unlimited weaponry, to intervene. In Europe it is the opposite - unbelievable, but true. Finally, to complete the capolavoro, the EFSF has even to guarantee the ECB that it will cover any capital loss that the ECB might incur if the Greek bonds it has bought last year (when it timidly intervened) would default. Usually it is the central bank that guarantees the sovereign debt, not the other way round (with the Treasury guaranteeing central bank assets). Quos Deus vult perdere, dementat prius (whom the gods would lose, they first make mad).

So the real winner in the European agreement, a Pyrrhic winner of course, is the ECB (see NYT). The ECB can definitively wash its hands of intervening to sustain, as is proper for a central bank, the European sovereign debts. It can thus return to its role of hunter of any inflation ghost around, particularly in Germany, a role that this country wants the ECB to preserve since it is essential to safeguard her mercantilist model. In an notable paper, Guido Tabellini (here and here) broke the ranks of the conservative Chicago-Harvard-Bocconi Italian connection (Alesina, Perotti, Zingales, Giavazzi), who support the idea of the ''expansionary fiscal retrenchments'', purporting the cause of an active role of the ECB in calming the markets. I put this paper in my blog under the title ''Tabellini visits the Levy Institute''.

As plainly argued by Mallaby in the FT commenting the European agreement:
''The truth is that, even in America, crisis lending is mostly done by the central bank. In the dark days after the Lehman bust, Hank Paulson, Treasury secretary, begged Congress for $700bn of bail-out funds. He got it - but not before panicking the markets by being rejected the first time. Even then, the Treasury's intervention was massively surpassed by the Federal Reserve, which pumped $3,300bn into distressed markets. It turns out that the best lenders of last resort are, in fact, the traditional lenders of last resort; central banks that do not have to deal with sluggish parliaments, but can print money. Their responsibility for financial stability is arguably equal to their responsibility for fighting inflation. Indeed, Europeans who gaze enviously at the US should recall that, when the Fed was established in 1913, its central purpose was crisis lending….

If Mr Trichet's ECB really did emulate the Fed, the ring fence for Italy and Spain could be established instantly. He could simply declare that he stands ready to buy sovereign bonds issued by both. The combined net sovereign debt of Italy and Spain comes to around €2,200bn. Mr. Trichet could plausibly promise to buy the whole lot - which would guarantee he would never have to.'' ²

So, not only did the recent nth European accord not provide a satisfactory solution, but it was also a step back in letting the ECB to remain in its splendid isolation. Expect further, irresponsible, increases of the ECB interest rate in the next future.

Many clever solutions have been put forward to plug the European crisis, including that by Varufakis-Holland. The basic idea is to transfer a substantial part of the member states' debts to a European authority, transforming it into a European debt. This would lead, according to the proponents, to lower interest rates both on the new European joint debt (that would be re-financed by issuing the famous Eurobonds),³ and on the by now more manageable remaining local debt. We are not sure, however, that without the guarantee of an accommodating monetary policy by a new ECB even this solution would properly work. Only a proactive central bank, lender of last resort of states and banks, can protect a sovereign debt from moments of financial panic (and a huge European debt without a federal state behind it, with a proper taxation power, would likely be fragile). Be as it may, paradoxically, to plug the financial crisis would be the easiest part of the solution of the European crisis.

Indeed, clever plans and a proactive central bank can tampon the situation, but cannot solve the fault at the origin of the European Monetary Union (EMU) failure: locking a number of quite diverse economies, that historically relied on exchange rate adjustments to rebalance their trade relations, into a sort of gold standard scheme. To readdress this situation would require much more: a European investment plan,⁴ proactive fiscal and monetary policies, a change of the German mercantilist model. Only a rebellion, especially of the educated youth of South Europe, could move things into the right direction. But a collapse of the EMU might be faster.

July 26, 2011.

[1] For those who can read Italian, a number of contributions of mine and of other non orthodox Italian colleagues on the European crisis are on http://politicaeconomiablog.blogspot.com/ and www.economiaepolitica.it. More academic contributions in English are here and here.

[2] To confirm this, on Thursday 12 July, rumours of an ECB intervention checked a speculative attack against the Italian sovereign debt. The ECB did not actually intervene.

[3] The member states would of course continue to pay the interest on the portions of their debt they have transferred to the European poll.

[4] In this respect, the European accord rhetorically mentions a Marshall plan for Greece: put your money were your mouth is, as Anglo-Saxons would say.