Mark Blyth and Stephen Kinsella in Harvard Business Review:
The latest Euro crisis summit was different from the 19 others that preceded it in one very important respect: The PR department of the EU played this one very well. Rather than hopes being raised only to be dashed, this time they were dashed before the summit only to be raised after it ended.
And yet hopes are now slowly deflating once again, even as the Eurogroup works out the final details.
The idea behind the latest maneuver is that recapitalizing European banks will reduce the correlation between the creditworthiness of a state's banking system and the creditworthiness of a State itself. If a state's banks are highly levered and filled with rapidly devaluing government debt (as they are in Europe), then the risks borne by the banks becomes risks to the state, and vice versa, as Greece, Ireland, Portugal, and now Spain are learning. This occurred thanks to the flawed design of the Eurosystem. Being deprived of a currency printing press, Euro-bound states cannot credibly commit to bailing out their banks, so when their banks inevitably get themselves into trouble, this shows up in their sovereign's yield.
The creditor countries hence decided to allow the use of the European Stability Mechanism (ESM) to directly recapitalize the damaged balance sheets of Europe's banks, specifically the Spanish banks. And market participants were initially thrilled. Yields on sovereign bonds fell immediately following the deal's announcement. For example, the generic yield on Ireland's nine year sovereign bonds fell from 7.1 to 6.4% in one day, an unprecedented drop. Similar drops took place in Spain and Italy.