Europe’s bailout is short-term panacea

By Prieur du Plessis, on May 11th, 2010 posted in: Economy, Europe, Guest Bloggers

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This post is a guest contribution by Asha Bangalore of The Northern Trust Company.

The colossal rescue package from Europe announced today to stabilize markets is a coordinated contribution of euro-zone governments (€440 billion in loans), the IMF (€250 billion), and an EU (€60 billion) emergency fund amounting to a sum total of €750 billion ($955 billion). There is support also from the European Central Bank (ECB) through its purchase of euro-zone government bonds and private bonds to “ensure depth and liquidity”. The actions of the ECB would be “sterilized” or offset by other bank operations.

On the other side of the Atlantic, the Fed reopened swap lines with the ECB and central banks in Japan, U.K., Canada and Switzerland. Essentially, the Fed extends loans to foreign central banks, which in turn use these funds to make U.S. dollar denominated loans to financial institutions in their home markets.

This is the gist of the actions announced today to stem the financial crisis in Europe. World markets have responded positively and markets have moved to calmer waters from the recent turbulent market sessions.

But, it is only a short-term respite; markets are bound to get jumpy again. The longer term issues will haunt financial markets eventually. The industrialized world is awash with public debt at levels not seen in peacetime. It is well known that the fiscal house of the industrialized world is in dreadful shape compared with less advanced world (see table below). If members of the euro-zone facing dire fiscal problems fail to put their house in order following the historic support program, moral hazard issues will creep in the short-term.

More compelling are the medium to long term problems not only of the troubled euro zone nations but the entire industrialized world arising from the pressing fiscal situation. A failure to address the explosion of public debt in the advanced economies will translate into higher interest rates, set backs in productivity and capital formation. In other words, the standard of living in the industrialized world is threatened by the rapid growth of public debt. The likely market response to the fiscal challenges ahead, after the dust settles, is the true dragon to slay. Or will the industrialized act soon and decisively to prevent another financial storm?