Heroine or Villain?
Earlier this week, the White House was visited by the heads of the principal European institutions. It was a sobering affair. US President Barack Obama and Secretary of the Treasury Timothy Geithner sat across the table from the President of the European Commission, Jose Manuel Barroso, and the President of the European Council, Herman von Rompuy, who updated their anxious American partners on the latest twists and turns in what has become the worst European crisis of the past fifty years.
The American news media barely mentioned the gathering, and if they did, they painted the picture with the usual colours — the President once again urging his European partners to find an immediate and urgent resolution. The President’s words were sensible, but will have little effect. The hard truth is that neither the US President nor his European visitors have any real power to solve the crisis. Obama and the delegation from Brussels are merely bystanders in an unscripted drama that now has only one star, German Chancellor Angela Merkel. The next few days will reveal whether she will play role of the heroine or the villain in the battle to rescue the Euro from collapse.
Most commentators outside of Germany have repeatedly asked Merkel to change her attitude dramatically in order to save the common currency and the European Union itself. Her repeated appeals to keep Europe intact have begun to sound somewhat hollow when coupled with the now familiar “NO” as her answer to any kind of unconventional response to the crisis, such as issuing common European bonds and/or a stepped up role for the European central bank. Merkel is seen as, at best, too timid and stubborn, simply unwilling to give up her measured, step by step approach, and at worst, intent on establishing German domination over Europe.
In fact, in the German media and business community, some are even starting to suggest that a break up of the Euro would not necessarily hurt Germany’s export driven economy dramatically. For many Europeans, these are worrying signs for a return of some kind of German exceptionalism.
Jacques Attali, the first President of the European Bank for Reconstruction and Development (EBRD), recently stressed that Europe committed suicide twice in the 20th century and “once again, it is Germany which holds the weapon for a collective suicide.”
Many on both sides of the Atlantic are, therefore, invoking a “shock and awe” approach to quell the crisis. On Wednesday of this week, financial markets finally had a reason to believe that big things were about to happen. Nevertheless, it was not a decision made by politicians that caused the rally, but rather that central banks across the globe pulled out the heavy artillery. By taking coordinated action to shore up the financial system, the US Federal Reserve Bank (FED), the European central bank (ECB), the Bank of England, the Bank of Japan and the Swiss and Canadian central banks effectively prevented a looming financial meltdown.
However, they only bought time. The fundamental problems of the sovereign debt crisis still need to be solved by Europe’s political leadership. Angela Merkel’s insistence on making some rapid, but limited, treaty changes to allow euro zone members to coordinate their fiscal policies more closely only makes sense if they are part of a wider plan that would free the ECB from its political shackles and enable it to play a bigger role in stabilizing the situation.
The rapid deterioration of market sentiment in the past several weeks is, in part, Merkel’s own fault. Her insistence during the last European summit at the end of October to ask more of banks has clearly worsened the situation. Already weakened, financial institutions were forced not only to write down 50 per cent of Greek debt, but also to mark to market all of their sovereign debt holdings and quickly recapitalize.
While public opinion celebrated the ‘punishment’ of the reviled financial institutions, banks reacted by offloading large chunks of their sovereign bonds, particularly those of peripheral euro zone countries. Not surprisingly, the yields for both Italian and Spanish sovereign debt papers rose dramatically. Financial institutions across the globe dumped more bonds. The markets dried up.
A new study undertaken by Deutsche Bank concludes that the ECB should now buy all the sovereign bonds that banks are no longer willing to keep on their books. By strictly limiting its interventions to the secondary market, the ECB would not break any rules, the study argues, but would ensure that bond markets continue to function properly. The paper is a plea for help. In essence, banks believe that decisions made by Europe’s politicians just a month ago can only be carried out with unlimited help from the ECB.
Another study by a German consultancy group, Kiel Economics, argues that buying unlimited amounts of bonds from peripheral euro zone member states could very well turn out to be a good investment for the ECB. Of course, the scheme rests on the assumption that countries will continue to pay interest on their bonds, rather than be forced to restructure their debt. While this is clearly not the case for Greece, Italy and Spain are still in a different league − but for how much longer?
In essence, these studies point to the same conclusion: the Eurozone has approached its Lehman moment and it needs the help of its central bank. If Germany continues to focus solely on fiscal rectitude and austerity, the euro could collapse within weeks.
Given these extraordinary challenges, is Merkel likely to do an about turn? Some have suggested that the time has come to override domestic politics. These commentators believe that if the Chancellor shows decisive leadership, over time voters will be forgiving. But Merkel’s problems go beyond fighting her own instincts or a possible revolt within her government coalition. She has consistently proved that she is quite able to deal with such challenges. Her true problems lie elsewhere.
Merkel feels constrained by two powerful German institutions, the Constitutional Court and the Bundesbank. The former is regarded by most Germans as the guardian of post war democracy and the latter as the guardian of German prosperity. Both have taken a hard line on Europe. The Constitutional Court is putting up roadblocks to further integration of the Union, including sharing more sovereignty with Brussels. Appearing before the court this week, German Finance Minister Wolfgang Schaeuble was forced to defend the limited involvement of the Bundestag in European crisis negotiations. He felt compelled to spell out a very simple truth in politics: negotiations sometimes have to be kept confidential in order to be successful. However, Chief Justice Vosskuhl was not convinced. The ruling, which will be decided in January, could once more restrict the government’s maneuvering room. It is not surprising, therefore, that Merkel is advocating only very limited treaty changes. The court in Karlsruhe may be an even greater obstacle for her than reluctant governments in EU member countries.
The tradition of the Bundesbank is another complicating factor in the current struggle to save the euro zone. Its mandate is price stability − at any price. The German Urangst (primal fear) of hyperinflation may be too simplistic a way of explaining the country’s descent into Nazism. After all, it was the depression and the deflationary policies of Chancellor Heinrich Bruening in the 1930s that finally pushed the Germans into Hitler’s arms, not the inflation experienced in 1923. But historical myths are hard to dismantle, and inflation is still what most Germans fear most.
For the hawks in the Bundesbank, it is the more recent experience of the 1970s that proves that sticking to a hard line is a winning strategy. In those years, high inflation blew like wildfire across the West – with the exception of Germany. Thanks to the Bundesbank, Germany managed to avoid the worst. While countries including the US, France, the UK and Italy were struggling with high inflation and the devaluation of their currencies, economic stagnation and rising unemployment, the Bundesbank’s policies kept German inflation at an average of around four per cent and turned the Deutschmark into a strong reserve currency. Today, the Bundesbank hawks believe that they are fighting that very same battle again. They see a decisive clash between a French Euro and a German Euro, between a soft currency at the mercy of politicians and one that is fiercely independent, stable and strong. It is a decades old ideological fight. The louder French President Sarkozy screams for unlimited ECB intervention, the more Merkel is forced to push back and defend the central bank’s independence.
The European summit on December 8th and 9th will put the Franco-German alliance to the test. These are the options on the table:
Euro or stability bonds
The Commission and some member states believe this is the answer to the crisis. Issuing such papers would eradicate doubts about the long-term commitment to the Euro. But Merkel says NO and would only consider Eurobonds when other goals are met.
Closer fiscal integration
This is what Merkel and French President Nicolas Sarkozy are advocating, although they both would only go as far as incorporating in the treaties what is already happening on the ground. All the countries that are currently receiving financial assistance, and even those, like Italy, that have not yet asked for help, are already under strict surveillance by the Commission and EU member countries. But new rules, whatever shape they take, would only be acceptable to smaller and weaker euro zone member states if they are also applied to bigger partners, like France and Germany. Furthermore, for an integrated fiscal union to work, the budgets of all euro zone countries would need some stamp of approval from their partners and European Institutions such as the Commission or the European Parliament, not just those of weaker countries. But so far, Germany has not shown any willingness to have its budget supervised by anybody.
Boosting the European bailout fund, the European Financial Stability Facility (EFSF) by leveraging it dramatically
This approach, one revisited regularly by euro zone ministers, has already shown its limits. Turning the EFSF into an investment vehicle makes it vulnerable to rapidly changing market conditions. In fact, in its heavily leveraged form, the EFSF’s funding mechanism is pro-cyclical: if liquidity dries up, the EFSF can’t fund itself; if conditions improve, it may be able to, but it could very well be too late.
A greater role for the ECB
Media reports are suggesting that the EU is now exploring ways to establish closer links between the EFSF and the ECB − one covert way to allow the ECB to step into the fight more forcefully.
More involvement from the International Monetary Fund (IMF)
EU Finance Ministers have recently started to examine the possibility of an intervention by the IMF. But given the limited funds of the IMF, even in this scenario, a greatly enhanced role for the ECB would still be necessary.
This all leaves Merkel with very few palatable options.
In the short term, the ECB must be allowed to step in. ECB President Mario Draghi has hinted that he is prepared to do so. Now he needs the green light, at least implicitly, from Angela Merkel, even if that means challenging the Bundesbank’s doctrine. Of course, Merkel could once again dig in and wait for financial markets to stop their attacks. But her position would be quickly overrun. She would definitively find her place in the history books, but not as the heroine, rather as the villain who allowed Europe to be destroyed.