A New Dawn, or Just a New Phase of the Crisis?
Angela Merkel’s approach to solving the Euro crisis misses the mark. While all around her, governments are toppled and a new class of European leaders prepares their people for more “blood and tears”, the German Chancellor still appears to believe that she can keep Germans shielded from the turmoil. By delaying an open debate on Eurobonds, and refusing to publicly signal that she would accept a massive intervention by the European Central bank (ECB) on bond markets, Merkel’s stance has had a familiar effect.
Once again, only a few days after a European summit, the varnish has begun to wear away and EU leaders look like they may be forced back to the drawing board sooner than they had hoped.
The summit was undoubtedly a political victory for Merkel. She has forced her partners (save for the United Kingdom) to accept her cautious step-by-step approach, now coated in the dramatic language of an integrated, tight fiscal pact. But the agreement failed to convince markets, because Merkel’s approach does not tackle the underlying and more pressing problems of this sovereign debt crisis, namely the inability of a growing number of EU nations to fund their country’s debt at sustainable interest rates.
Even after the latest summit, the markets remain at odds with Merkel. While, for domestic reasons, the Chancellor still needs time, for both financial markets and the United States administration, the crisis can only be contained by a firewall of liquidity now. Markets need the reassurance that their investments will not suddenly become worthless. And the White House wants to prevent a never-ending crisis in the euro zone from jeopardizing President Obama’s hopes of re-election.
However, Merkel is apparently ignoring such concerns. Instead she focuses on closer fiscal integration, which unfortunately is nothing more than what the Financial Times calls “a stability pact on steroids.” As we argued in the last Advisor, the outlines of the fiscal compact agreed upon by 26 European Union (EU) leaders does little more than put on paper what is already happening on the ground. But even in its present form, the EU’s plan for a closer fiscal union should go hand in hand with the introduction of Eurobonds. Building one without the other is like putting a new car on the road without providing it with the necessary fuel.
Regrettably, due to the British veto, the pact will stay outside of the Lisbon treaty, which defines the role and powers of EU institutions. Prime Minister Cameron’s decision to veto the fiscal compact will have the unintended consequence of making it easier for Merkel to stick to her vehement opposition to Eurobonds. She has calculated that she must avoid making a decision on what is a very thorny subject for at least two more years – Germany takes to the polls for its national election in late 2013. While many partners continue to talk about Eurobonds as one necessary answer to the crisis, she has now successfully reframed the debate almost exclusively around the need for a tighter fiscal regime.
The Chancellor seems to be convinced that if some of the institutional flaws of the euro zone could be removed quickly, markets would regain some level of confidence. Mario Draghi, the President of the ECB, seems to share her view. He speaks of a three pillar system needed to solve the crisis. First, he argues, member states must implement urgent structural reforms to reduce debt and spur growth. Second, the EU needs to build its institutional framework to enhance fiscal integration. And third, according to Draghi, the European political leadership must provide the financial muscle to stabilize the current situation, through a combination of sources for liquidity offered by member states, such as bailout funds, the International Monetary Fund (IMF) and, but only to a limited extent, the arsenal of the ECB. He expresses surprise and dismay that public debate is so narrowly focused on the third pillar, and argues that all three components of the plan must be equally considered.
While Merkel embraces the first two of Draghi’s pillars, she is still very reluctant, at least openly, to address the third. She seems to believe, or at least hope, that if member states do their homework and agree to the fiscal compact that should be finalized by March 2013, the need to craft some new costly, financial ‘bazooka’ to defend struggling partners from market attacks could evaporate. It is true that markets need clarity. It is also true that a fiscal pact should make it clear to everybody that a break-up of the euro zone is an extremely remote possibility. But Merkel’s entire strategy now rests on the assumption that institutional engineering will eradicate the incentive to bet against the euro zone.
In this rosy scenario, spreads on sovereign bonds will move back to more manageable levels over time. The ECB would mainly concentrate its firepower on keeping the weakened banking sector afloat. Strenghtened by their easier access to liquidity, the banks could, in return, start buying sovereign bonds.
This could be sufficient to contain the sovereign debt crisis. The only euro zone patient still on life support would be Greece. Ireland and Portugal would probably need to stay in intensive care for some time, but would be out of any immediate danger, while Spain and Italy would be able to stay at home with a prescription for expensive and bitter medication and a rigid exercise regime. Closer fiscal integration would act as the firewall that so many have invoked. The acute phase of the crisis would effectively be over.
For a cautious politician like Angela Merkel, this strategy is a huge bet. Too many things could go horribly wrong.
Some ominous signs are already out there. Markets, shaken by months of uncertainty and bouts of outright panic, seem unwilling to embrace her strategy. Banks are in dire straits and will remain vulnerable for some time. It is very unlikely that they will start buying significant amounts of distressed sovereign bonds now. A number of EU countries could have their credit ratings downgraded, including some triple-A rated nations such as France and Austria. A downgrade could make European debt even costlier to finance, and it would expose the core of the euro zone to additional pressures.
Furthermore, legal experts in Brussels are facing significant challenges integrating the intergovernmental agreement into the EU framework – Britain may well attempt to torpedo the process. The Bundesbank has deep misgivings about its role in propping up the IMF with additional funds and wants to involve the German parliament.
German legal experts close to the Constitutional Court in Karlsruhe have already voiced misgivings about the results of last week’s summit. There is a chance that the proposed fiscal compact might be challenged in front of the high court.
The fiscal straightjacket agreed on last week could push some EU countries, such as Spain and Italy, into a deep recession. Peripheral euro zone members may try to water down the tight fiscal rules contained in the agreement before the treaty is finalized in March. Northern Europeans, such as Finland, have already warned that if that were the case, they might withdraw their support to the treaty.
In fact, the biggest danger to the new agreement is a potential backlash amongst some European countries. Most leaders of euro zone nations directly affected by the crisis have been quite honest and forthcoming with their own electorate. The Italian Prime minister Mario Monti has been almost brutally straightforward about his country’s shortcomings. He has pushed through a reform package that will no doubt hurt many Italians and push the country into recession.
Once reforms begin to bite, in Italy and in other countries, the public mood is likely to sour. Germany, as the main architect of the new order, may become the focus of much of the public rage. In countries such as Greece and Ireland, anti-German sentiment is already pronounced and openly expressed. The image of “der haessliche Deutsche”, the ugly German, is creeping back into the imagination of many Europeans. Even in France, Germany’s main partner, the opposition socialist party is playing with anti-German sentiments.
Regardless of how one views the role of Germany in the present crisis, the power of public perception is a dangerous tool in the hands of politicians looking for a scapegoat. Merkel should recognize that she is not just trying to convince Germans and her European counterparts, but a wider audience of European citizens and financial markets.
Obsessively focusing on the so called fiscal compact could too easily be perceived as a diversion, designed to avoid the real decisions about Eurobonds and a more active role of the ECB in bond markets. Merkel and the Eurozone don’t have unlimited time.
Financial markets will be a painful reminder that last week’s decisions fall far short of what is needed.