A week ago we said that Europe would pay dearly any policy mistake, but we did not think it would be so much so soon… The size of the potential financial package known yesterday exceeds most expectations, which is the reason of its success. In terms of the ‘theory of crisis management’ it is a well-established fact that rescue packages have to overwhelm. The probability of success is positively correlated with ‘shock and awe’. EU policymakers have applied this theory satisfactorily. Two questions remain: implementation details, and structural reforms aimed at avoiding the next crisis.

Let us deal with short-term issues first, then details, then medium-term ideas.

In the short-term we expect markets to recover, probably close to that seen a bit over a week ago. We expect country and regional differentiation trends to exacerbate.  Given that the recent announcements should stabilize markets without solving Europe’s structural issues, we continue to expect capital reallocation towards markets in the US+Asia+Latin America. Thus, we should see lower US rates, a stronger dollar versus the euro, and higher growth. We expect the euro to trend towards an exchange rate closer to 1.1 dollars per euro than to where it is today. Though the announced package aims to save the euro, it does sacrifice its short-term value (sounds paradoxical, but it is not). All this assumes the actual formal announcements follow what is known today.

Though we just learnt big picture ideas and numbers about the rescue package, it is already possible to conjecture about a few details. One such detail is the assistance mechanism to be used with countries like Spain and Portugal. Would they have to fail issuing debt before they can tap that assistance? What tenors would the EU debt be issued in? What specific rules would the EU on lending follow? How would the ECB really sterilize this? We believe these short-term details are less relevant than the structural reform agenda the EU should be embarking in. Obviously, markets will react to details, but our medium term-view will depend more on the approach to those structural issues.

This rescue package (not yet officially announced) means the EU is moving towards fiscal consolidation or unification, which is what still differentiates the US economy from the EU. This package does also expand the role of the ECB. There will obviously be cross-subsidies within the EU in terms of this new debt issued by the central authority. But this is only a short-term mechanism, not a permanent fiscal scheme. The design of a new set of fiscal rules for the EU is what matters for the medium-term, whether there would be a mechanism to expel a country, other sanctions, etc. Thus the title of this commentary.

We see this rescue package as buying time for the EU to kick-start the debate on the more relevant fiscal structural reforms that should save the credibility of the euro in the medium-term. We see the size of this rescue package as buying sufficient time. The concerns about those medium-term reforms are what should push the euro down towards 1.1, despite an expected recovery in debt markets. The euro should not be seen as the barometer for the success of this rescue package, as it is designed to sacrifice its short-term value.

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