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Bad Money to Drive Out Good: Strategist

The European emergency rescue package is impressive in scale, but fails to address three key questions, according to Simon Derrick, chief currency strategist at Bank of New York Mellon, Monday.

The first is practicality and how these funds are going to be approved, Derrick said.

"This is no small matter," he said. "If approval demands that the proposals are dragged over the coals of member state judicial scrutiny, then it is unclear how they will fare in Germany given that the government has just lost its majority in the upper house thanks to defeat in Sunday’s North Rhine-Westphalia election."

That defeat was in part due to the bailout of Greece and Germany is now facing a far bigger bill for the stabilization fund, Derrick said.

Second, there is the European Central Bank balance sheet. After telling the market only last Thursday that it was not even discussing buying bonds, the market crisis has forced a massive u-turn by the central bank.

The European Debt Crisis - See Complete Coverage
The European Debt Crisis - See Complete Coverage

Derrick said he is concerned the move will simply crowd out the good money.

"The ECB’s assurances that it will responsibly sterilize these purchases brings to mind Gresham’s Law, which as commonly stated, is ‘bad money drives out good,'" he said. "In other words there is a risk that the ECB obligingly mops up poor-quality debt, resulting, increasingly, in the sale of higher-quality assets and a markedly deteriorating (its) balance sheet."

Finally, one of the assumptions behind this rescue package is that highly-indebted countries like Greece, Spain and Portugal will not drastically cut spending, he said. As last weeks riots in Greece showed this may be easier said than done.

"The ECB has agreed to such a program on the basis that governments have assured that they will meet strict budget targets and step up consolidation efforts," Derrick said. "Aside from the questionable politics behind smaller states being ‘inspected’ by their larger brethren, the new-improved pact’s Achilles Heel will nonetheless remain the same: governments resisting expansionary deficit financing once its economic fortunes begin to falter."

Contact Europe: Economy

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