Eurozone Policy Response in Suspended Animation

Europe’s policy response to the ongoing sovereign debt and banking crises on the continent’s periphery appears to be in suspended animation. There is a conflict between short-term expediency and long-term strategy, as was clear from the most recent European Council summit.

Spain, Italy and those debtor countries locked out of the bond markets are pushing for a speedy resolution that brings their financing costs down to sustainable levels. Among their desired outcomes are a mutualization of sovereign debt at a Eurozone level and / or unlimited ECB bond purchases on the secondary market.

The German-led creditor bloc is understandably reticent. It is they who feel they will foot the bill, after all. Their concern is ‘moral hazard’: if they give in to debtors’ demands, they fear all impetus for discipline and reform will be lost. One way of putting it might be that they are as yet unwilling to buy the first round of drinks, in case others fail to do their duty.

What we are left with is a half-way house that falls between two stools: limited capacity for ESM purchases of sovereign bonds in return for ceded sovereignty and direct bank bailouts that break the bank-sovereign link in return for a banking union… some time in the future. Markets are not convinced, as evidenced by Spain’s still precipitous sovereign yields. By failing to sufficiently address this short-term challenge, the long-term strategy may well be undermined.

Meanwhile, Spain has been given more time to bring down its budget deficit while Greece labours under its current commitments. Cyprus has joined the ranks of the bailed out, and speculation mounts that others will follow.Wu

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