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Report: Germany Set to Allow Direct Purchases of Eurozone Debt, to Stabilize Yields

Markets have surged on a report in The Guardian (UK) that Germany will acquiesce to outside pressure and allow the current Eurozone bailout fund, which holds about €750 billion, to purchase bonds from troubled Eurozone countries like Spain and Italy.

Germany has long opposed allowing the eurozone’s rescue fund, the European Financial Stability Facility, to lend directly to troubled eurozone countries, fearing that Berlin would end up paying the bill, and the beneficiaries would escape the strict conditions imposed on Greece, Portugal and Ireland.

But Merkel has come under intense pressure as financial markets have pushed up borrowing costs for Spain to levels that many analysts see as unsustainable.

Analysts are likely to see the decision as the first step towards sharing the burden of troubled countries’ debts across the single currency’s 17 members, though it falls short of the “eurobonds” proposed by the European commission president, José Manuel Barroso.

The bailout fund was designed to backstop the worst from happening in the Eurozone. But I think investors are reading a lot into this report. First of all, it doesn’t have any firm agreement from Merkel or the Germans in it; basically it’s just something that has been discussed on the sidelines of the G20 summit (although President Obama has apparently been alerted, and you can see the urgency among the elites in this Larry Summers op-ed from today). Second, while it does represent a new frontier of direct purchases for Spanish and Italian debt, and while it should lower borrowing costs simply through supply and demand, the ECB started to do this in Greece two years ago until they got cold feet. So even if this gets announced, you’d have to wait and see if the Germans had the stomachs to keep it going. Third, even if this morphs into Eurobonds, there are a host of unresolved issues, the biggest being the need for economic growth across the member countries, which would require much more than this, like higher inflation targets, transfer payments, and a real fiscal integration.

Fourth, €750 billion is probably not enough to rescue Spain and Italy, along with the other commitments for the bailout fund. It simply wasn’t designed for this purpose. And we’re seeing Spanish bond yields rise in a kind of runaway fashion, making this rescue more expensive by the hour. Spain delayed its independent audit of its banks today, on suspicions that a bank bailout will cost more than the expected €100 billion. Spain paid 5.07% for a 1-year note on debt today, an astronomical figure.

Like all other solutions to the Eurozone crisis, this looks like a half-measure, although an important one. We’ve seen the half-lives of half-measures get smaller and smaller in recent months; sometimes they don’t last through the trading day. There’s still a ways to go here.

UPDATE: Tyler Durden at Zero Hedge gets at what I was saying, with the addition of a chart. The point is that the bailout fund doesn’t have the cash to cover Spain and Italy’s needs:

There’s also the issue that the European Stability Mechanism, part of the bailout fund, doesn’t even exist yet because it has not been fully ratified by member nations. And that the Lisbon Treaty which brought about the Eurozone explicitly rejected sovereign bailouts of this nature.

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David Dayen

David Dayen