Brussels Sprouts False Hope

10/27/2011 9:16 am EST


Igor Greenwald

Chief Investment Strategist, MLP Profits

Europe’s financial rescue plan will never look better than it does today, writes senior editor Igor Greenwald.

This is as good as it gets for Europe. After months of arguments, false starts, and drama bordering on farce, its leaders have finally agreed on a new financial rescue plan.

By the time French President Nicolas Sarkozy went before the press this morning at 4 a.m. Brussels time, the world knew that the all-nighter summit had succeeded. There will be a “voluntary” 50% loss for private holders of Greek debt, a bank recapitalization plan that will force the most endangered institutions to raise €106 billion ($148 billion), and up to €1 trillion of leveraged bond insurance to help Italy and Spain refinance at rates they can afford.

To get here, France had to fight Germany tooth and nail, with time off for petty spats with Italy and the UK. The Italian prime minister was heard insulting the German chancellor in unprintable terms on a wiretap. Sarkozy missed his daughter’s birth to argue with his ally in an opera house. Greeks rioted. Italian parliamentarians came to blows. The Slovaks and the Finns played hard to get.

The intramural squabbling and general buffoonery had driven expectations so low that the very fact of an agreement, no matter how inadequate or misdirected, has overnight futures on cloud nine. The dreaded “Lehman moment” has, for the time being, been averted. Nor did the Brussels summit turn into the sort of disaster that ensued in 2008 after the House of Representatives initially voted down the bank bailout.

Let’s treasure this moment, because the plan announced will never look better than it does today. In fact, it’s likely to look much worse down the road, as reality intrudes and tests the hurriedly assembled defenses.

The Maginot Line must have looked mighty fine when first erected. The Brussels bailout might work no better.

There are many ways this deal is likely to backfire.

The Greek haircut is actually just 28% of Greece’s public debt, because institutions like the European Union, the European Central Bank, and the International Monetary Fund are not forgiving anything owed to them. Because of this, the restructuring merely aims to get Greece’s debt-to-GDP ratio down to 120% by 2020.

In other words, even if all the structural reforms demanded by Europe work as advertised, the Greeks can still expect to find themselves in an untenable situation after nine more years of economic depression.

The write-offs faced by the big European banks on Greek debt and the increased capital requirements they’ll face have already forced a credit squeeze across the continent. This promises to depress growth, further fanning credit fears.

The recapitalization announced isn’t big enough to ease worries about the banks’ long-term viability. The number is entirely based on what public budgets in Europe can support, not what the grossly overleveraged banks really need.

The partial insurance against losses of up to 20%—meant to entice buyers of Italian and Spanish bonds—is likely to prove insufficient. First, sovereign debt defaults usually take a much greater toll. Second, many of the troubled states are also underwriting the insurance fund that will be covering their debt. The scheme’s more likely to drive up the yields on French bonds than to meaningfully lower them for Italy.

Worst of all, the agreement reinforces Germany’s insistence on austerity for its trading partners, the very policy that, by undermining growth prospects, has turned investors away from Italian and Spanish bonds. It also perpetuates the fiction that massive “structural reforms” can help Greeks, Italians, and Spaniards compete with Germans without exiting the euro.

The net result is that the deflationary trend remains entrenched. Deflation is a profoundly destabilizing force, and poison to banks. Come recession, credit downgrades and commercial defaults are likely to follow, swamping Europe’s new defenses.

Today, none of this matters, because Germany has cut France a minimum of slack, and let Paris inflate it into a Grand Plan. Today, we can pretend that the IMF and China will bridge the gulf between Europe’s means and the mounting cost of its policies.

Now the focus shifts from things the politicians can control—how much money they’ll spend, how much pain they’ll inflict on banks—to matters beyond their reach, like the performance of the markets and the economy. And it’s a lot easier to arrange summits, even European summits, than to drive down Italian bond yields. It’s easier to devise labor reforms than to grow economies afflicted by layoffs and a shortage of credit.

The shorts out there can’t wait to sell the news that Europe’s rescue plan exceeded low expectations. If the scheme doesn’t work, neither the expectations nor today’s market close will matter.

Europe has promised a lot and committed what it could scrounge up without printing euros. But since it’s still in denial about the root cause of its troubles, what it has scrounged up won’t be nearly enough.

Strikes, protests, and elections loom. Banks remain cut off from traditional sources of funding in the US and are lending as little as possible. Now that the political circus has folded its tent, expect the spell it cast over the markets to be broken.

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