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By Anthony Harrington

The behavior of the major European stock markets has been distinctly odd through January. All through 2011 every time the markets got some forward momentum the eurozone sovereign debt crisis would raise its head, or the ratings agencies would weigh in with a downgrade here and a downgrade there, and the markets would slip back again. In 2012, at least up to the first week in February, it has been a very different story. If you were looking at the markets alone over that period, you could have been forgiven for thinking that the eurozone had solved all its problems, that Greece was back on track and that the euro economies were growing wonderfully.

In fact, of course, at the time of writing, Germany was almost certainly experiencing a second consecutive quarter of contraction (the very definition of a recession) and the prospects of Greece securing agreement from its private sector investors (PSI) were looking grim. Moreover, beyond Greece, the deep seated problems of Portugal and Italy were being signalled once again by rising CDS spreads (i.e. the cost of securing insurance on Portugal and Italy’s sovereign debt, versus German bunds, was increasing).

What has boosted the markets in the teeth of all this structural bad news is that investors, notably Europe’s banks, appear to have rediscovered their appetite for high yielding Italian, Portuguese and Spanish debt. Recent debt auctions by Europe’s more troubled economies have gone well and been achieved at much more modest rates by comparison with the unsustainable rates of 7% and more being demanded a few months ago.

In reality there is little mystery about this rediscovery of appetite for debt by the European banks. The European Central Bank chief Mario Draghi appears to have told the banks, in private, that the ECB would give them as much cash as they liked for as long as they liked (repayments have shifted out to three years) provided they bought their own and other EU government debt. This is a kind of sleight of hand funding of sovereign debt by the ECB – which then accepts that same debt as collateral from the banks – in the teeth of ECB insistence that it will not go against its founding charter by acting as the lender of last resort for European sovereigns.

Since the markets have been clamoring for the ECB to step in and smooth the way for countries like Italy and Spain to refinance the mountain of debt coming due through 2012 and 2013, it is no surprise to find the ECB’s latest moves coinciding with something of a mini bull run by the markets. Yet it is worth reminding ourselves that Europe is very far from being out of the woods.

In the latest issue of News from the Frontline the market commentator John Mauldin makes the point that “Europe has problems that are structural and can’t be fixed with just another treaty or more ECB liquidity.” Specifically, what is needed in Europe are “stable labour and productivity markets” which can generate even balance of payment flows between member states. This is a near impossible Holy Grail, but without it what do you have? Greece cannot fix its problems when it consistently generates new debt every year by importing a lot more than it exports.

As Mauldin says, where the euro is really not working for a country that country’s exit from the eurozone should be expedited, with debt forgiveness and financial assistance if necessary. The bankers’ fudge of “extend and pretend” cannot be a permanent policy unless the EU wants to move to a United States of Europe with proper and continuing transfers of funds from strong to weak states year in and year out. At the moment all the signs are that the German public would not tolerate that for long – if at all. As an aside, it should be noted that as a major export economy Germany has a vested interest in other countries consuming as much as possible, and for years now a large chunk of its exports have gone to its European partners, adding significantly to their balance of payment issues. So the German public’s resistance to stumping up bail out cash fails to recognize that, in a manner of speaking, the country is simply securing its own export markets for itself. This suggests that a permanent transfer of funds on a regular basis from stronger to weaker states may actually be a viable way forward in the longer term, once all the chatter about “profligate Greeks” dies away.