Breaking up is hard to do. One cannot unscramble scrambled eggs. These are some of the cliches about the difficulties of a euro break up, now a real possibility. But there is a better way. First, a quick survey of the problems.
While Syriza, the anti-bailout party didn't win, there is still no functioning government (at the time of writing). Even if one arrives soon, its tasks are daunting. The prospect of a Syriza win and possible euro exit has basically frozen the economy. Even companies in good credit standing couldn't order supplies without paying first. Credit virtually ceased to exist, companies couldn't even get trade credit.
Deposits fled the banks, and although this seems to have been halted by the election outcome, it can resume at any moment. All the while no measures have been taken while the economy has deteriorated further. Soon, the troika (IMF, EU, ECB) is going to visit to see whether conditions have been met for the next tranche of payout from the bailout, but this is going to be a disaster.
Forcing Greece to stick to the bailout program isn't going to get us anywhere but a bad place. The anti-bailout parties won a majority of the vote (although not a majority in parliament, due to an election system quirk). They will tear into the program without bearing responsibility, and mobilize opposition and street protest.
Any punishment for non compliance, like halting the bailout tranches or the ECB withdrawing funding of Greek banks is likely to backfire on multiple fronts. In the markets and on the streets of Athens. Greece is also facing a 3.9B euro bond redemption in August, but its hospitals can't even pay for medicines.
Spain is hardly in a better spot. Its economy is also tanking, its house prices just racked in a record fall (12.6% in the first quarter), unemployment is at nearly 25%, 10 year bond yields at 7%+ and the public deficit at 9% and every indicator is turning south.
The euphoria about the 100B euro bank rescue deal lasted a few hours at most, as it has numerous silly aspects. Since the European rescue funds cannot lend directly to banks, the money is added to public debt - not only worsening that considerably, but also subordinating private debt holders (the European rescue funds are priority creditors, not suffering from 'haircuts').
You also have rather curious aspects that Italy, as one of the EFSF guarantors, has to borrow at 6%, in order to bail out Spanish banks at 3%, and clearly more burden is shifted on Italy as Spain's role as guarantor of the EFSF is a rather empty promise now that it is using the funds.
So Spanish and Italian yields were rising to levels where they're not sustainable, especially in conjunction with shrinking economies. So just about everybody (including us) were screaming for the ECB to intervene. The markets are actually expecting it:
'Nobody is short Spanish debt right now because they are expecting ECB intervention,' said Andrew Roberts, credit chief at RBS. 'If it doesn't come -- if we take out 6.8pc -- we're going to see a hyberbolic sell-off,' he said. [The Telegraph]
Well, we've taken out 6.8% and went up all the way to 7.3% in a matter of hours. But since then, rates have given back a bit; what's up? Well, it certainly isn't the ECB. But the ECB, already stuffed with 210B euro of sovereign debt, accumulated under its bond buying program (SMP), flatly refused.
So what explains those (marginally) falling Spanish and Italian yields?
Having excluded all other options and faced with a rather pressing urgency to come up with some kind of impressive bazooka (no doubt helped by the pressure at the G20 meeting from other exasperated countries). So the euro area rescue funds will be used to purchase Spanish and Italian debt directly in the market, or so is the plan.
We have said before that this can only work if it is credible. To be credible, it has to be massive. The problem with previous ECB interventions was that the ECB was a very reluctant buyer, and visibly so. The ECB does have the balance sheet to stun the markets with massive force. But as it was seen as not willing to use that, the markets were distinctly unimpressed, and these interventions didn't achieve a whole lot.
Much better would have been a public stance of the ECB, stating that they will act as lender of the last resort, and buy debt if it exceeds a certain yield. Its actual intervention needs would almost certainly have been much smaller.
Can those rescue funds achieve what the ECB didn't? Almost certainly not. For starters, their balance sheets are not nearly large enough. The permanent fund, the ESM, hasn't even been ratified. In order to operate, the ESM has some capital from member states coming in but most of the financing comes from issuing debt themselves.
As previous bond sales by the EFSF have shown, selling debt to the markets isn't likely to be easy, or cheap, and can only be done piecemeal. Not quite the massive firepower that is required to awe the markets.
Buying before debt sales
Another idea that has been discussed is that the ECB concentrates its interventions to just before when Spain and Italy auction off new debt, as to influence the rates. After all, what matters to them is the rates on the paper they sell, not how the market prices them thereafter.
The rescue funds could do the same, or even buy debt directly in auctions, putting in better bids. There are likely to be legal obstacles to this, but legal obstacles have a habit of melting by the full weight of the emergency.
But however tactical the bond purchases of the rescue funds might be, it all looks pretty weak, even if it is a significant shift in Germany's stance. A much better idea would be to give the ESM a banking license, as that enables it to borrow from the ECB, drastically lowering its funding cost and giving it much more and much faster ammunition. But don't count on the Germans to cross that bridge any time soon, although in an acute crisis, many things that look solid have a habit of melting.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.