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EMRE DELİVELİ > Merkel gets the full Monti

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If expectations are set very low, even mediocre results will lead to euphoria. This is what happened to markets after European leaders surprisingly came to an agreement on how to “save” the eurozone in the wee hours on Friday, after German Chancellor Angela Merkel was quoted on Tuesday as saying there would be “no shared debt liability in her lifetime.”

Although it was Italy that beat Germany on and off the pitch Thursday night, with Balotelli scoring brilliantly and Italian Prime Minister Mario Monti threatening to block talks until he got what he wanted, the Spanish were the big winners. Eurozone bailout funds will be injected directly into the country’s teetering banks. In effect, 100 billion euros of Spanish government debt suddenly vanished, a much better magic trick than a clown making a 1 euro pencil disappear. No wonder the country’s bond yields plunged 0.51 percent to 6.44 percent Friday morning.

Monti surely got what he wanted as well, with Italy expected to take advantage of a new arrangement that will allow the bailout fund to purchase sovereign bonds without subjecting the issuing government to Greek-style monitoring programs. He noted that this result was a “double satisfaction for Italy,” adding insult to injury to Frau Merkel, who is a devoted supporter of the German national team. Italian government bond yields fell 0.30 percent to 5.85 percent on Friday.

But the markets’ euphoria was much more widespread. Standard & Poor’s 500 Index capped its biggest June rally since 1999. Emerging markets (EMs) were equally jubilant, with the MSCI EM Index jumping 2 percent. This is not that surprising, either: The European Union purchases nearly one-third of the exports coming from the 21 countries (including Turkey) that make up the index, and eurozone banks are the biggest lenders to EMs.

There is definitely reason to be cheerful, especially on the long-term implications of the agreement. For example, Spanish banks will be rescued after the creation of a single banking supervisor to be run by the European Central Bank. This is an important step towards a banking union, which many experts have deemed necessary to fix the eurozone’s problems.

But I don’t think bond purchases would be of much use, although I have heard several economists, most recently Richard Portes, argue strongly for them. For one thing, as my blog’s host Nouriel Roubini tweeted on Friday, the proposal suffers from the Bulow-Rogoff critique: The two economists argued in an influential paper back in 1988 that creditors, not sovereign debtors, are the main beneficiaries of debt buyback programs.

More importantly, after the Spanish bank rescue, the bailout fund will have 400 billion euros left in the coffers. Italy and Spain have more than 2.3 trillion euros of government bonds, so you should not expect miracles from the fund, especially if the Italians and Spaniards decide to tap it at the same time. Maybe, the winner of Sunday night’s game could earn seniority.

Therefore, it is likely that markets will sober up soon. As for Frau Merkel, there are still no Eurobonds in sight, so she doesn’t yet need to start planning her exit from this world. And there is the World Cup in two years.

July/02/2012

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