People react as they take part in a casserole march to protest against the government's austerity reforms and the public payment of bank's debts on Oct. 13, in Madrid. Recent violence and insurgency in countries such as Spain overshadowed the winning of the Nobel Peace Price by the European Union. (Pedro Armestre/AFP/GettyImages)

The Nobel Peace Prize went to the EU for the six decades of stability it has fostered. Markets did not celebrate, however, due to sovereign debt concerns and related riots on the streets of Spain and Greece. 

Eurocrats were undoubtedly happy with the award, and not just because of the $1.2 million in prize money. While the contributions of the European project to peace and prosperity are undisputed, the timing of the award is at least a bit odd, as violence and insurgency have recently erupted across the Atlantic.

People in Greece and Spain have been protesting—some peacefully demonstrating, some outright rioting—over the last two years, ever since the sovereign debt crisis erupted. They protest what they think is in essence a loss of democratic empowerment and sovereignty, as their countries have to implement austerity programs mandated by the EU to “save” the euro, the EU’s flagship project of peace and integration. Unemployment in both Greece and Spain is now higher than 25 percent. 

Citizens in Greece and Germany alike booed Angela Merkel on the two public appearances she made this week in Athens and Stuttgart. The euro project has gone pear-shaped because structural imbalances that were concealed for a decade could not be hidden anymore in 2010 when Greece received its first bail-out, which mostly German taxpayers are paying for either directly or indirectly. 

Financials Markets Vote With the People 

Certain groups of protesters are against free markets, so they will be surprised to see that this week, markets also gave a negative verdict on the eurocrats efforts to contain the crisis and did not celebrate the award of the peace prize. 

The euro lost a modest 0.6 percent to close at $1.29, but equity markets sold off all week, with only Thursday providing some relief. The EURO STOXX ended the week down 2.5 percent at 2,469 points. Spain and the banks lost more, as they are leveraged because of the crisis. The Ibex lost 3.8 percent and a basket of European banks went down 3 percent, languishing around a level that was last seen during the darkest days of the Great Recession in 2009. 

One does not have to look far for explanations. While the people of Spain and Greece are unhappy over a loss of power and cuts in public services and spending, markets are unhappy that there is still no definitive solution for the crisis and another recession, despite the efforts of the European Central Bank.

Rating Agencies Spoil the Party 

Markets this week had to grapple with action by rating agencies underlining the problem of bad sovereign credit. The Standard & Poor’s rating agency downgraded Spain to BBB- with a negative outlook, one notch above junk grade. The rating agency cited a lack of support from other countries as the main reason for the downgrade. 

Spain is dependent on its relatively wealthier neighbors, but it was seen at Merkel’s rally in Stuttgart last week that support for their southern brethren is indeed faltering among the electorate in Germany, Finland, the Netherlands, and Austria.

To make matters worse, research by Bloomberg uncovered that France and Italy are significantly overrated by the agencies, as market pricing suggests lower credit quality. A study done on the price of different credit default swaps—an insurance contract against debt default—shows that the CDS prices of Italy and France trade in a range that implies sub-investment grade (BB+) for Italy and only “A” for France, much lower than the BBB+ that Italy carries and France’s AA+. 

European Stability Mechanism Slapped With Negative Outlook 
The ESM was supposed to be a panacea to solve all the sovereign debt problems. Eighty billion euros of paid in capital ($104 billion) are supposed to be immediately available to help Italy or Spain. 

Moody’s ratings agency, however, thinks that the credit quality of the whole structure can only be as good as the credit quality of the countries that supply capital to the fund. Germany, France, and the Netherlands all have a negative outlook on Moody’s AAA rating, so the agency decided to also give the ESM a AAA rating with a negative outlook.

Giving the ESM AAA rating might have been too generous altogether, as not only countries with relatively sound finances are contributing to the fund that supposedly has a total firepower of 700 billion euros ($906 billion). 

ESM Is a Circular Financing Facility 

The first 80 billion euros are the most important tranche, as that money will actually be paid into the fund, available for immediate disbursement, but as usual, there is a catch. First, the countries can pay in three installments and only 40 percent needs to be paid within 15 days of the inauguration, until Oct. 23. The balance of 60 percent is due within two years, which might be too late if the crisis escalates again. 

Second, even countries like Spain also have to pay some money—$4.9 billion in Spain’s case—within that deadline. Since Spain is one of the countries that is supposed to benefit, it just shows some of the irony of European Union crisis management. 

Let us suppose for argument’s sake that the 80 billion euros will be funded in full and on time. There will still be a problem, as 80 billion is not enough to save Italy and Spain. The fund will have to draw on the 700 billion total size, or 620 billion euros in callable capital that will not be paid upfront, but is supposed to be funded within seven days should there be the need.

This callable capital, however, is funded by all eurozone members, including already bankrupt ones, such as Greece, Ireland, and Portugal. Greece is committed to fund 19.7 billion euros ($26 billion) in case of an emergency, money that neither of these countries have now or can raise in the foreseeable future. 

The Week Ahead 

The most important event this week is the EU leaders’ summit on Oct. 18 and 19. They will review a report on Greece’s progress on budget cuts, which judging purely on the country’s track record so far cannot be good.

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