Financial markets were swept up in a frenzy of optimism overnight, as rumours swirled that the eurozone was preparing to radically boost the powers of its bailout fund and the French government was preparing to inject extra equity into the large French banks.
Traders now believe that Europe’s political leaders -- who they estimate have six weeks to stop the eurozone debt crisis from triggering a global financial crisis -- are finally being forced into action.
As Goldman Sachs Asset Management chairman Jim O’Neill told clients overnight, "markets are now looking for broader solutions ... with a number of policy makers suggesting that the November G20 will be a major event".
Although there is little clarity as to what these "broader solutions" will be, traders have been heartened by unconfirmed media reports that eurozone leaders have agreed to leverage the eurozone’s €440 billion bailout fund in order to give it €2 trillion in firepower. This approach appeared to be endorsed by European Union commissioner Olli Rehn, who told the German newspaper Die Welt
that officials were considering a plan to equip the eurozone’s bailout fund with additional instruments to give it "greater force" to combat the debt crisis.
At the same time, French bank shares rallied even though officials from the French government denied a newspaper report that it was preparing to inject between €10 billion to €15 billion into the major banks, while the head of the Bank of France, Christian Noyer, said there was "no plan".
But while traders speculate on the various ways in which the eurozone’s bailout fund could more than quadruple its firepower, they are conveniently ignoring the fact that such an expansion will spark a massive rise in contingent liabilities for Germany and France. So large, in fact, that both countries could find their precious triple-A credit ratings under threat.
And markets are also turning a blind eye to the tough struggle that European politicians already face as they try to get national parliaments to approve the much more modest plan for expanding the powers of the bailout fund, which was agreed in July.
German chancellor Angela Merkel faces her major test on Thursday, with the Bundestag set to vote on measures to boost the size of the bailout fund, to allow the fund to inject capital into banks and to purchase bonds of distressed eurozone countries. As part of the new arrangements, Germany will boost the guarantees it provides to the fund from €123 billion to €211 billion.
But the decision is highly controversial, with opinion polls suggesting that around three in four Germans are opposed to the idea of increasing Germany’s commitment.
Merkel even faces a revolt from some within her centre-right coalition, with some deputies threatening that they will vote against the new measures. Merkel’s political authority will be severely dented if she is forced to rely on opposition support to get her measures passed.
The market’s belief that eurozone leaders will find a definitive solution to the region’s raging debt crisis in time for the next G20 meeting in Cannes appears wildly optimistic. Europe’s political leadership spent the past 18 months in a fumbling attempt to prevent the sovereign debt crisis from spreading.
There’s little to suggest that the next six months will be any different.
*This article first appeared on Business Spectator