Despite a deteriorating economic picture in Europe, sentiment on the continent’s bond markets is not yet showing signs of distress. Overall, interest rates for Spanish and Italian sovereign bonds remain at levels not seen for many months and bigger corporations, such as Italy’s car manufacturer FIAT, are successfully tapping the bond markets. Many reports are even suggesting that the European Central Bank (ECB) is already thinking about an “exit strategy”, one that is designed to scale back its “non standard measures” and push banks to start to operate without the ECB’s exceptional financial support.
The ECB has now effectively discontinued two of its ‘crisis’ programs: it has stopped buying distressed sovereign bonds on the secondary market and it is scaling back covered bond purchases − a program launched before the arrival of Mario Draghi at the helm of the central Bank in Frankfurt and designed to allow distressed banks to access credit by issuing bonds. However, it would be a mistake to read too much into these recent steps undertaken by the Eurotower. Both programs had failed to calm markets and have been successfully substituted by the longer term refinancing operation (LTRO), which flooded banks with cheap three-year loans. To date, despite the growing uneasiness with which the LTRO is viewed by the German ‘Bundesbank’, it remains the best weapon that the ECB has deployed in the fight to contain the crisis. The euro zone has a lender of last resort and markets have recognized this very simple fact. Politicians across Europe, including the German leadership in Berlin, are very thankful for that.
Politicians are acting too, albeit more slowly. Recent media reports in Germany suggest that the government in Berlin is finally moving to address calls for a stronger firewall. By allowing the European rescue funds − the current European Financial Stability Facility (EFSF) and the future European Stability Mechanism (ESM) − to operate side by side for at least a year, German Chancellor Angela Merkel is about to finally bow to international pressure. Of course, once she announces how much Germany is willing to contribute, critics will quickly point out that a rescue mechanism with a capacity to loan just about 700 billion euros (this is the figure circulated by the press), and only for a limited period of time, falls well short of what is actually needed to shield the larger European countries. Many experts have repeatedly pointed out that for a firewall to have the desired effect, it needs to be strengthened to the tune of up to 2 trillion euros. Perhaps this is the case. However, those skeptics forget to mention the impact of the intervention by the ECB.
In the future, if massive injections of liquidity will be needed to stabilize distressed sovereigns or the euro zone banking system, the European rescue funds (EFSF and ESM) will not operate alone. Instead, they will be helped by the ECB and, most likely, by a more muscular International Monetary Fund (IMF). A high-ranking former German government official recently suggested that, if needed, the ECB would once again flood the system with money. He expressed surprise at the fact that many still harbor doubts about the capacity and willingness of the ECB to act. He compared the ECB’s role to the FED, and he concluded by saying that the German government will always implicitly endorse such ECB actions. If he’s right, liquidity needs for those in distress are being addressed.
The picture gets much murkier when it comes to the growing divergence between the economies of the so-called periphery and the core of the euro zone, namely Germany. It is clear that the short-term effect of a combination of austerity and structural reforms is pushing the economies of Portugal, Spain and Italy into recession. It is still unclear when and how growth can be restored. How can the economies of those countries be stimulated while their governments and banks are still deleveraging?
Some economists − who are convinced that history has shown that fixed exchange rate regimes are doomed − have suggested extreme measures for those countries, such as leaving the euro and letting their reinstituted, old national currencies float. Others have said in all seriousness that Germany should become less competitive, allow higher inflation to take hold, and import more while exporting less. In other words, Germany should weaken its economy in order to close the gap with the European periphery. Of course, and not surprisingly, both arguments have gained no traction in Berlin. However, the German government is very aware of the fact that something needs to be done to help the periphery. Stimulating German consumer demand for goods from the South would help.
Perhaps something is already taking place. Big, successful companies, such as Volkswagen, are rewarding their employees with very substantial bonuses. In a country that still sees the economy through a moral prism, this money is both a reward for good behavior, as well as a sign that the company is strong. Employees in Germany are much more inclined to spend part of their bonuses and more of their salaries if their personal outlook improves. For Volkswagen’s employees, that is clearly the case. Of course, the positive effect for the whole economy, and in particular consumer demand for goods from Europe’s struggling economies, can only be felt if most successful German companies followed into Volkswagen’s footsteps. The company’s decision is only a small step.
Nevertheless, the German government also knows that too much austerity can strangle the economy. The cabinet in Berlin has now approved a bigger than expected budget deficit for the current year. Germany’s finance minister Wolfgang Schaeuble spoke of a budgetary consolidation that is “favorable to growth”. When Spain rattled European partners by announcing that it would miss its deficit targets, the German government chose not to openly criticize Madrid. Berlin now talks of the need to address ‘structural’ deficits rather than reduce any deficit at any cost. If a country that is undergoing the necessary, but painful, reforms faces short-term budgetary shortfalls, Merkel’s government will accept it. Even Berlin now wishes to avoid a dangerous feedback loop of austerity and recession in the periphery of the euro zone.
Germany will continue to try to strike the right balance between necessary pain and solidarity. Some will no doubt continue to call it another way of kicking the can down the road. However, for the German government, it is the only strategy that will tackle some of the root causes of this crisis over time.