Judging from the prevailing mood in financial markets, this was a good week. The Dow Industrial stock index continued its flirt with the 13,000 points mark. Economic data in the U.S. continued to look encouraging despite some cautionary words from the Chairman of the Federal Reserve (FED) Ben Bernanke. Overall, U.S. buoyancy and the launch of the second tranche of the European Central Bank’s (ECB) cheap loan program for banks largely offset bad economic data (particularly on unemployment) in Europe. Overall it was the bulls that carried the week.
However, widespread relief about brightening economic skies could be followed by a cold shower, particularly if politicians let their guard down now. Looking at Germany, this week already offered enough worrisome developments to chew on. It all started with the vote on the latest Greek rescue package in the German Bundestag on Monday, which offered both good and bad news. German lawmakers overwhelmingly endorsed the latest Greek bailout package of 130 billion euros. However, it is now clear that German Chancellor Merkel’s government majority is shrinking, and that resistance to the series of deals to rescue the euro is still growing. Seventeen lawmakers within the Chancellor’s coalition opposed the latest Greek package, and others failed to turn up to vote or abstained. Merkel had to rely on the main opposition parties to obtain an absolute majority of the votes necessary to carry the day convincingly. Tellingly, thanks to Germany, the week ends on a low note with a summit in Brussels that will fail to deliver on the only decision everybody is waiting for — strengthening Europe’s firewall. Merkel needs time to regroup and assess the political damage. German media have started painting the picture of a Chancellor suddenly weakened, both at home and abroad.
To be sure, for all those Europeans who insist that a bigger firewall is a crucial mechanism to halt this crisis, the delay was a setback. However, if there was disappointment in the capitals of the old continent, it did not show. Italian Prime minister Mario Monti confidently told Bloomberg News that he still expected an agreement by the end of the month. In a separate interview, the head of the Euro Group, Luxembourg’s Prime Minister Jean Claude Juncker, echoed Monti’s words. The French government chose to keep quiet. Europeans are still behaving as if they have received assurances from Merkel that she will agree to what, in Germany, is still a very controversial step. And crucially, financial markets have already priced in a larger firewall. All leading political actors involved in this delicate kabuki dance know that it would be unwise to disappoint investors now that they are just beginning to regain some level of confidence.
For those anxiously waiting for a German decision, it must have been heartening to read German papers on Thursday March 1st. Quoting unspecified government sources, the daily Sueddeutsche Zeitung reported that Merkel told her government allies that the discussion on a bigger firewall, specifically about folding the financial firepower of the temporary European Financial Stability Facility (EFSF) into the permanent European Stability Mechanism (ESM), can no longer be avoided.
But if the firepower of the rescue mechanism is to be boosted to 750 billion euros, this implies that Germany’s contribution would be increased. It is currently capped at 211 billion euros, a limit that Merkel’s junior coalition partners, at least publicly, have said they are willing to defend tooth and nail. In fact, the head of the Bavarian Christian Social Union (CSU), Horst Seehofer, admitted that if such a decision is taken, he might have to seek the approval of his party at a special convention. And it is far from certain that the party would be prepared to endorse a bigger firewall.
Merkel’s task in the coming weeks will be to find the right strategy to force her European partners to make some concessions. These would have a soothing effect on her own lawmakers as well as allow her to face the German public and sell her capitulation on the firewall as a success. It’s a tall order.
Overall, triumphalism about the recent achievements on imposing fiscal austerity is slowly being replaced by a growing sense among Germans that the terms of the rescue are being dictated by others. They are not in control after all. Uneasiness is on the rise. Not surprisingly, the trigger for the shift in mood was Greece and the latest, very controversial effort to put the Mediterranean country back on track.
To make things even more complicated, a parallel confrontation is taking place. Old cracks within the ECB’s governing council are reappearing as the actions by its new head, Mario Draghi, come under increasing public scrutiny in Germany. After a period of relative calm, the restive Bundesbank is taking its gloves off and is doing so very publicly.
The German central bank has had to swallow a series of setbacks in the past four months, including the decision to shield the ECB’s bond holdings of Greek debt from a possible haircut. The head of the Bundesbank Jens Weidmann, who talks regularly to the German press, has clearly decided that it is payback time. He criticizes the easing of the ECB’s rules, in particular those on the collateral banks must offer in exchange for ECB funds. In a letter that was leaked to the German daily, the Frankfurter Allgemeine Zeitung (FAZ), Weidmann says he would like to see those rules tightened. He is also deeply concerned about raising imbalances in the euro zone’s cross payment system TARGET2. While the crisis has led to a build up of huge liabilities in the national central banks of Europe’s periphery, the Bundesbank has accumulated a mountain of claims, now amounting to more than 500 billion euros. According to German experts close to the Bundesbank, such a buildup could have a potential inflationary impact in Germany. To make matters worse, say these critics, it also amounts to a bailout of weaker euro zone members. Draghi has dismissed the criticism by saying that the imbalances only reflect malfunctions in the interbank market. “I cannot see any bailout here,” he explained to the FAZ. “The fact that these imbalances arise at all is because of the disturbed conditions in the money market, in which banks distrust each other.” Since one of the main objectives of the ECB’s lending program is to restore trust between banks, Draghi believes that, “imbalances recede whenever the situation improves.”
The spat between central bankers suggests that while Draghi is waiting for trust between banks to be restored, Germany’s trust in him is being put to the test. If too many Germans reach the conclusion that their political and central bank leadership is being pushed around by outside forces, it is likely that paranoia about being encircled by morally reckless neighbors will resurface once again. This would make it increasingly difficult to coalesce around common, but sometimes controversial, decisions, both at a political level in Brussels and in Frankurt at the ECB.