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Germany's Chancellor Angela Merkel, left, talks to Italy's Prime Minister Mario Monti during a European Union leaders summit in Brussels, June 29, 2012. Euro zone leaders agreed on Friday to take emergency action to bring down Italy's and Spain's spiralling borrowing costs and to create a single supervisory body for euro zone banks by the end of this year, a first step toward a European banking union. (François Lenoir/Reuters)
Germany's Chancellor Angela Merkel, left, talks to Italy's Prime Minister Mario Monti during a European Union leaders summit in Brussels, June 29, 2012. Euro zone leaders agreed on Friday to take emergency action to bring down Italy's and Spain's spiralling borrowing costs and to create a single supervisory body for euro zone banks by the end of this year, a first step toward a European banking union. (François Lenoir/Reuters)

ERIC REGULY

Italy’s euro victory over Germany tops its Euro 2012 win Add to ...

It is hard to say which displayed more flair and prowess: Mario Monti’s searing attack on German Chancellor Angela Merkel at the European summit, or Team Italia’s searing attack on Germany in the Euro 2012.

The Italian media on Friday hailed the victory of the two Super Marios – Italian Prime Minister Monti and Italian striker Mario Balotelli, whose twin goals utterly destroyed Germany early in the game. Most of the Italian papers gave Mr. Balotelli’s victory more prominence, though a few bestowed that honour on Mr. Monti.

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Both victories were needed, for Italy has been in a morale-busting slump for at least a year, when the recession made a rude reappearance, the jobless rate shot past 10 per cent, consumer and business confidence crumbled, Italy’s sovereign funding costs soared and shaken investors and politicians mentioned the B-word – bailout. Italy’s lacklustre start in the Euro Cup didn’t help.

Mr. Monti’s victory is pretty big, not huge. But symbolically, it was a monster. Using his veto power, he broke the iron will of Chancellor Merkel, who had said Nein to every short-term effort to take the edge off the European debt crisis.

He did so by stalling all agreements at the Brussels summit, keeping the leaders stuck in the talking shop until Ms. Merkel finally relented in the wee hours of Friday morning. She will now allow the European bailout funds to recapitalize banks directly, instead of funnelling the bailout loot through the national governments, and allow countries to apply to the bailout funds to buy sovereign bonds.

Global markets surged Friday on the news, posting gains on investor confidence that Europe is closer to getting its financial house in order.

The victory is not huge, because plans were already afoot to allow the funds to capitalize the banks directly and buy bonds – it was just a matter of time. For Spain and Italy, of course, sooner was better than later. The victory would have been sweeter if these new crisis-fighting measures were ready for action. They will not be for another six months, if then.

Also, crucially, the firepower of the permanent new bailout fund, the European Stability Mechanism, which is to come into effect in July, was not increased. The ESM and the existing temporary fund, the European Financial Stability Facility, have about €500-billion ($645-billion) between them, minus about €100-billion that is to prop up the ailing Spanish savings banks.

That leaves €400-billion, which is pocket change compared to the theoretical cost of saving Italy and Spain, the euro zone’s third- and fourth-biggest economies, respectively, should they find themselves shut out of the debt markets.

The crisis is not fixed, even though Mr. Monti has shown the world that, when pushed (or tired or dejected by Germany’s soccer loss), Ms. Merkel will change her mind. The existential threat to the euro zone still exists not just because she hasn’t repealed her demands for harsh austerity in the recession-struck countries, but because the threat of a full-blown bank run hasn’t gone away. Allowing the bailout funds to recapitalize the banks directly won’t end that threat.

A slow-motion bank run under way now is seeing deposits and capital flee the euro zone’s Mediterranean frontier to alight in Germany and the other strong northern countries, or leave the continent entirely. The Greek banks’ deposit base dropped to €150-billion from €240-billion in two years.

Before the June 17 Greek election, the run was as high as €700-million a day (though has probably slowed a bit since then, because a pro-bailout coalition is in power). In May, Spain revealed that €100-billion in capital has departed the country in the first three months of the year.

Bank runs can kill economies and could kill the euro zone. As deposits vanish, the cost of bank funding rises, forcing the banks to liquidate assets, which in turn creates a debt-deflation spiral, and to rely on the European Central Bank as the lender of last resort. In the worst case, the banks would have to be bailed out at huge expense. Bank runs, even in a slow-motion state, are bad news psychologically. Yanking deposits from your bank means you don’t trust your bank and the government that allegedly backstops the deposits. Bank runs are the symbol of a sick economy.

The bank runs are under way because depositors fear that Greece and Spain might leave the euro zone. If that were to happen, the euros in those countries would be converted into drachmas and pesetas, which would immediately lose half their value, or more, the moment they came back into circulation.

If the bank run is building momentum, why hasn’t the euro plunged? To be sure, the euro has come down considerably, from about $1.60 (U.S.) before the debt crisis started three years ago, to about $1.27 now. Some economists and strategists think the ECB is dumping foreign assets to support the euro, though it’s hard to tell because the ECB might be doing this covertly, in effect, through the U.S. Federal Reserve’s dollar swap lines.

As long as Greece and the other weakest euro zone countries – including Italy, where former premier Silvio Berlusconi is campaigning for the lira’s relaunch – are potential non-members of the euro zone, the bank run will continue. Taking your money out of these countries is eminently rational behaviour.

Stopping the slow-motion bank run before it becomes a stampede would require guarantees that no country would leave the euro zone, no matter how dire its economic or fiscal shape. The EU summit didn’t address this issue, at least not directly. Keeping the euro intact means keeping Greece, Ireland, Portugal, Spain and Italy intact. How much money is that going to cost?

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WHAT’S IN PLAY, AND WHAT’S TO COME

1. Employing EU bailout money to capitalize banks directly. Good idea, but the plan won’t be approved for six months (if then) and the funds’ €500-billion ($640-million) of firepower may be insufficient if a lot of banks get into trouble.

2. Using bailout funds to buy sovereign bonds. Another good idea, especially for Spain and Italy, though the purchases could artificially inflate bond values. And (see above) is there enough fund firepower to handle the job?

3. A growth pact worth €120-billion. The EU needs growth to offset austerity. But the size of the initiative is deceiving, because much of the money was already lying around, unused.

4. Reaffirmation that euro zone leaders will “do what is necessary to ensure the financial stability of the euro area.” That’s a strong statement not backed by strong actions, such as a commitment to euro bonds.

Eric Reguly

Follow on Twitter: @ereguly

 
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