The euro-area rescue plan: The price of pragm...

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Tuesday May 11th 2010

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Finance and Economics
The euro-area rescue plan
The price of pragmatism
The euro zone’s rescue scheme is big and bold but leaves the ECB looking compromised
May 11th 2010 | From The Economist online

FOR weeks there have been calls for the euro zone's policymakers to get ahead of the sovereign-debt crisis, which started in Greece and was in danger of engulfing other countries with big budget deficits and poor growth prospects. In the early hours of May 10th, such a plan finally emerged. After a lengthy summit in Brussels, European finance ministers agreed on a “stabilisation fund” worth up to €500 billion ($640 billion) over three years. That sum would be supplemented by a further €220 billion or more from the IMF. In addition, the European Central Bank (ECB) said it would purchase government bonds to restore calm to “dysfunctional” markets.
The market response was euphoric. Germany’s stockmarket had risen by more than 5% when it closed on May 10th. The CAC 40, the main index in France, was up by almost 10%: big French banks are heavily exposed to Greece, so they stand to benefit from a cast-iron rescue package. The yield on ten-year Greek government bonds plunged from more than 12% to less than 8%. The yields on comparable bonds for Portugal, Spain, Italy and Ireland also fell sharply. The euro rose a bit against the dollar.
Markets had become sceptical that Europe could respond with enough scale and speed
The response is a sign of how sceptical markets had previously been that Europe could respond to the deepening crisis with enough scale and speed. Even so, the rescue plan has a patched-together feel to it. One part is based on an existing €50 billion fund for non-euro countries with balance-of-payments problems, which is financed by European Union bonds that can be sold fairly quickly. The EU is to create a similar, €60 billion fund for euro member countries—as much money as could be raised without breaching its budget ceiling. This proposal had to be signed off by countries, like Britain, which do not use the euro, because their taxpayers would also be on the hook were the money not paid back in full.
The mainstay of the rescue fund, an additional €440 billion if needed, will come from a new vehicle to be set up by the 16 euro-zone countries, which will control the money disbursed by it and guarantee its financing. Details on how this would work are sketchy but an EU official said the scheme could be enacted in a week or two. The IMF is expected to chip in with funding worth at least half as much again.
The ECB's participation was vital
These elements of the rescue plan satisfy the need for a big response but would take a while to be fully operational—too long, perhaps, for jittery financial markets. That is what made the ECB’s participation so necessary: it is the only institution that can react rapidly enough. Market chatter suggests that much of the fall in European bond yields on May 10th was down to the ECB, already in the market, buying bonds. Doing this has the effect of pumping cash into the economy but the bank says it will "sterilise" this by other means (such as selling instruments of its own, to soak up the cash), so that monetary policy will not be loosened.
Jean-Claude Trichet, the central bank’s head, denied that the bank had been pressured into buying bonds, even though it is only a few days since he said publicly that the ECB's governing had not even discussed buying bonds at its regular monthly meeting. He insisted that the ECB was “fiercely and totally independent.”
The ECB looks a different animal to when the fiscal crisis began
However, for all his protestations, the ECB looks a different animal to when the fiscal crisis began. Having balked at buying government bonds last year when other central banks were doing so as part of their monetary policy, the bank now finds itself involved in an explicit support operation to European governments' fiscal policies—which is a far bigger threat to its self-image. This is not the only sharp U-turn Mr Trichet has had to perform in recent weeks. He opposed IMF involvement in the Greek rescue, then welcomed it. And he said the rules would not be changed to suit one country, only to change them to ensure that Greek bonds could be exchanged by banks for ECB cash. The central bank's credibility relies in part on a reputation for living up to its pledges and partly on its disdain for political expediency. On both counts, then, it has lost something.
Even so, it is wrong to conclude that, in trying to get ahead of the crisis, euro zone's policymakers have gone too far. The threat that Portugal and Spain might be cut off from credit markets, triggering a meltdown in Europe’s financial system, was all too real. The rescue effort will dent the ECB’s reputation as a single-minded inflation-slayer. The insurance provided by the rescue scheme may leave countries that benefit from it a bit less minded to cut deficits and reform their economies. But those faults, real as they are, must be set against the potential costs of doing nothing.
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