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4 Reasons Why the European Stability Mechanism Won't Work

Apr. 08, 2011 6:58 AM ET
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Before we begin, let me address the question on your minds: What in the world is the European Stability Mechanism (ESM)?

The ESM is the bailout fund program due to replace the 

European Financial Stability Fund (EFSF) in 2013. It's designed to provide financial assistance to European Union members who have come under hard times. It plans to do this mostly through granting loans, but it may also buy government bonds from the primary market in rare cases.

Piggy bank

Sounds like a noble effort, right? It's just like that piggy bank your parents let you take money from when you're out of dough to buy goodies from the ice cream man! But believe it or not, this fund has come under a lot of fire lately. What with European debt issues coming to light again, it seems not all are convinced the ESM will do the trick.

Let me discuss a few of the ESM's flaws that nitpickers have been pointing out:

Flaw #1: On and on the insolvency cycle goes...

Under the ESM, the European Commission will first assess if a euro zone nation is insolvent or not. Being insolvent means that you don't have enough assets to meet your financial obligations. In other words, if you're insolvent, you can't pay yo bills!

So what will happen if the European Commission declares that a country is insolvent? Naturally, because its government is deemed hardly capable of paying its debt, creditors would demand a higher return on the funds they loan to the government. That means the government will eventually have to pay higher interest rates to sovereign bondholders, but what if they still don't have enough funds by then?

And so the insolvency cycle begins. Government bond yields of insolvent countries go up, making it more difficult for them to refinance their debt later on and burying them even deeper into insolvency.

Flaw #2: Wherefore art thou funds?

Did you know that the European economies aren't even coughing up the whole ESM fund in cash?

In their simple agreement, the European leaders decided that the ESM would have a total capital of 700 billion EUR with a loan capacity of 500 billion EUR, but only 80 billion EUR would actually be paid up front. The remaining 620 billion EUR is allotted as "callable capital," or funds that the euro zone economies finance by guarantees instead of real money, at least until the original 80 billion EUR runs out.

Lemme tell you why the setup bothers me in two ways. First is the fairness of the agreement. Word on the street is that the ESM only needs guarantees from strong euro zone economies, like France and Germany, but economies with lower bond ratings would have to pay up in case the initial fund dries out. Talk about preferential treatment!

Another issue with the funding system is the dependability of the guarantees. It's a trust-based business after all. Are investors willing to take the handshake promise of weak euro zone economies like the PIIGS that they would pay up when needed? Remember that Italy's public sector debt already runs at a whopping 120% of its GDP. Where would they find the money necessary to contribute to the fund?

Flaw #3: Vote must be unanimous, or else...

Unlike the process of voting for your prom king and queen in high school, the euro zone finance ministers can't simply drop their votes in a box. You see, each of the finance ministers is given veto power over the Board, making it more difficult to reach a unanimous decision on issues like interest rates on ESM loans.

What if a finance minister wakes up one day and decides to act like a jerk by vetoing all suggestions made by other leaders? Or, in a more realistic scenario, what if a finance minister of a pretty stable economy trades his vote in exchange for lenient trade policies in less stable euro zone countries?

Considering the European leaders' reputation for slapping and bickering (okay maybe not slapping, but close!) during their meetings, it's not difficult to imagine that they would have trouble with the current voting system.

Flaw #4: It's a wee bit little and a wee bit late, mate!

The doo doo has already hit the fan for some of the union's most debt-troubled nations. Just two days ago, Portugal became the third country to ask for financial aid from the European Commission, joining Ireland and Greece at the bailout counter.

To make matters worse, 502 billion EUR-worth of PIIGS debt is due to mature this year. Compare that figure with the 500 billion EUR loan capacity of the ESM, and it's easy to see how the ESM is too little, too late.

Yeah, it's true that euro zone nations do have to option to accelerate their contributions and pool together their funds earlier in case a financial disaster strikes before 2013, but it's unlikely that these nations will want to speed up the process of parting with their money.

If this is what European leaders mean by doing "whatever it takes" to save the euro zone, then I'm worried that the entire region might be in grave danger. Although they claim that the ESM is geared at making the euro zone strong enough to weather future problems, the flaws of the mechanism could do the opposite and expose them to an even larger crisis.

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