Farewell to the E.U. Superstate

Politics / Euro-Zone
Dec 08, 2010 - 01:19 AM

By: Mike_Whitney

Wednesday's press conference with ECB President Jean-Claude Trichet turned out to be a real jaw-dropper. While Trichet didn't commit himself to massive bond purchases (Quantitative Easing) as many had hoped, he did impress the gathering with his magical skills. The Financial Times recounts Trichet's what happened like this:

"...as Trichet started to speak, his ECB troops stepp ed into the market to buy as many peripheral bonds as they could, particularly Portugal and Ireland. Started evidently in bidding for 10 -25 mln € clips and then moved onto 100 mln € clips … which is very rare indeed."

Nice trick, eh? So while Trichet was somberly reading from the ECB's cue cards, his central bank elves were beating down bond yields to convince investors that the contagion had been contained. Not bad for a 70-something bankster with no background in the paranormal. And it seems to have worked, too, at least for the time being. But, unlike the Fed, Trichet can't simply print money. He's required to "sterilize" the bond purchases, which means he'll have to mop up the extra liquidity created by the program. And, that's the hard part. If he pushes down yields in Ireland and Portugal, he has to tighten up somewhere else.

Trichet's critics, like Bundesbank President Axel Weber, think he's gone too far by buying up the bonds of struggling PIGS. (Portugal, Ireland, Greece and Spain) But these countries borrowing costs have skyrocketed and they're quickly losing access to the markets. The more it costs to borrow, the quicker the slide to default, which is trouble for the EU, because it means a wider meltdown across the continent. So what better time for Trichet to stretch the rules?

Maybe Weber hasn't noticed, but the EU is disintegrating, and if Irish voters reject the budget in the December 7 elections or if Spain starts to teeter, the dominoes could start tumbling and bring down the entire EU project. That's why Portugal, Spain and the rest are counting on the ECB to lend a hand despite Berlin's relentless fingerwagging. Here's an excerpt from the Telegraph which gives a good summary of what's going on:

"Spain's former leader Felipe Gonzalez warned that unless the European Central Bank steps into the market with mass bond purchases, the EMU system will lurch from one emergency to the next until it blows up....

Arturo de Frias, from Evolution Securities, said the eurozone will have to move rapidly to some sort of fiscal union to prevent an EMU-break up and massive losses on €1.2 trillion of debt lent by northern banks to the southern states....

The market will keep selling until the yields of Spanish and Italian bonds (and perhaps Belgian and French also) reach sufficiently horrendous levels. ("Mounting calls for 'nuclear response' to save monetary union", Telegraph)

The Irish bailout solved nothing. Brushfires are breaking out everywhere. Bondholders have figured out that Ireland and Portugal are broke and their debt will have to be restructured. Its just a matter of time before the haircuts. That's why bond buyers have gone into hibernation. It's not really a panic; it just shows that investors know how to read the financial tea leaves and make rational choices. Here's more analysis from Michael Pettis who points out the inherent contradictions of the one-size-fits-all currency (euro) and the urgency of settling on a remedy:

"If Europe is going to “resolveâ€