Martin Wolf warns that the agreements reached at the latest eurozone summit, though they move “towards breaking the mutually destructive links between banks and sovereigns”, are not sufficient to bring an end to the crisis. The main deficiencies are the lack of eurozone-wide deposit insurance to prevent bank runs and the absence of a lender of last resort to protect member countries from runs on sovereign debt.
The outstanding debt of Italy and Spain is close to €2.8tn, or a little less than six times the size of the ESM. It is well known from the work on currency crises of Paul Krugman, the Nobel laureate, that speculators can bet safely against a fund known to be too small to stabilise a market. The only credible stabiliser is an entity with infinite firepower. In the case of sovereign finance inside the eurozone, the only entity able to protect a country against self-fulfilling runs on its sovereign debt is the ECB [European Central Bank]. Since the ECB is unwilling to act in this role and leaders are unwilling to give the ESM [European Stability Mechanism] the powers to force it to do so, these proposals amount to spitting in the financial winds. Markets may have worked this out: while bond spreads have fallen, they remain dangerously elevated (see chart).
Martin Wolf, “A step at last in the right direction“, Financial Times, 4 July 2012.
Martin’s analysis, sadly, is correct. Unless policies change very quickly, the future is not bright for the eurozone. This updates last Saturday’s post, injecting a note of pessimism.