Panic abates but Europe teeters at edge of abyss

COMMENT:A slew of problems continues to fester. As we look to both US and Chinese advice, our crisis is merely on hold, writes DAN O'BRIENEconomics Editor

IT CAN’T go on like this. It will go on like this. And lurching from one bout of panic to another looks increasingly like a best-case scenario. The worst is for the European economy to topple into that yawning abyss, the bottom of which cannot be seen from the current vantage point.

Yesterday, politicians and policymakers were out in force seeking to prevent the worst. Statements came thick and fast. Markets appeared reassured.

Despite a downgrading of two very big French banks by a credit ratings agency, the currency and sovereign bond markets were stable. So, too, were equity markets, including bank shares, as the French central bank brushed off the downgrade.

So has the latest bout of panic abated? Certainly not. It’s just on hold. More talk, if not more action, from policymakers amounted to pushing the pause button.

Greek default is not an option said Angela Merkel, publicly scolding her own economy minister for suggesting last Monday that it should be.

Last night, the leaders of Germany, France and Greece collectively reaffirmed that the latter will remain in the euro.

Earlier, the European Commission sought to provide leadership by saying it is preparing the ground both for further cuts in Irish and Portuguese bailout funds and for eurobonds. But the commission only proposes. The Council of Ministers disposes.

Commission sources say they expect the interest rate cuts to be okayed by other member countries. But the eurobond proposal is another matter. Ministers are not about to issue a collective bond.

A huge deepening of European integration by the creation of a fiscal union is not something any euro zone country wanted before the crisis. Moving in that direction now would spread the weak countries’ debts across the entire zone. Avoiding default by Greece, or any other country that runs out of cash, by spreading the burden would not be fair, something many people in creditor countries feel strongly about.

But people in those countries whose banks lent to peripheral governments are going to pay one way or the other. Default would involve core countries having to recapitalise their banks.

Taxpayers would pay again, indirectly, as contagion resulting from default generates – almost certainly – even larger costs. And those costs could be almost incalculably large if the entire financial system collapsed.

Even if the creditor countries swallow this unpalatable logic and buy into eurobonds as the best/only option of avoiding the very real risk of a depression (and the break-up of their common currency), there are huge hurdles to be overcome before such bonds could be issued.

Complex changes to the EU treaties would be needed to form a fiscal union. Such treaty changes usually take years from start to finish. Europe may not have a fraction of that time.

Expectations are high that measures will be announced when Europe’s finance ministers start a two-day meeting in Poland tomorrow, in part because the US treasury secretary will be joining them. Timothy Geithner was centrally involved in handling the worst of the US crisis in late 2008 (when he was a central banker) and in 2009, after Barack Obama brought him into his cabinet.

As US banks appear in better shape than their European counterparts, Geithner can claim that he knows how to sort out banking crises. There are rumours he will urge his EU counterparts to follow the 2008-2009 US model and that global financial support – from the US and big developing countries – would be put behind the effort. China’s prime minister Wen Jiabao did not rule this out yesterday when taking the opportunity to tell Europeans to get their house in order.

If some of the hundreds of billions of dollars his countrys central bank holds in reserves were put to use in Europe, it would be a shot in the arm.

However galling it may be to be lectured by a leading autocrat, well-funded intervention by the Chinese would be helpful in its own right and in the signal it would send to fearful investors.

But there is still reason to fear that divisions among Europeans will lead to disaster. The European Central Bank has been intervening in Italian and Spanish bond markets for over a month. This is among the most powerful policy weapons available and it has been underdeployed, mostly because Germany has an aversion to straying from the path of ultraorthodox central banking.

On Tuesday night, the new German central bank chief Jens Wiedmann said he opposed the bond-buying to date and wanted no more of it. It had been hoped that he might take a more pragmatic position but, even in the face of meltdown, the new Bundesbank president prefers inaction to the unconventional. It hardly chimes with repeated German pledges “to do everything to save the euro”.