The State of the (European) Union
According to some German media reports, old cracks between finance minister Wolfgang Schäuble and his boss Angela Merkel have reappeared. It’s a déjà vu moment all over again, as the two powerful euro crisis managers seem to disagree on the best way forward in Greece.
The country that triggered the first existential crisis of the common currency will soon face a funding gap that needs to be plugged by its many creditors, including Germany. It is fair to assume that Greece’s funding needs will be addressed–in some way or another. On the tactics however, Schäuble and Merkel take a different approach.
Greece, Schäuble vs Merkel
The finance minister wants to signal now to Athens that Germany will show solidarity, while Merkel is reluctant to promise anything at this point. Schäuble is worried about the outcome of the European election in May and the danger that its result could spell the end for the current, fragile government in Athens. He wants to support the political campaign of his Greek counterparts. Merkel is more worried about a strong showing at the polls from the German anti-euro party the “Alternative für Deutschland” (AfD). Her political instinct tells her to do nothing for now, but Schäuble thinks in the longer term and primarily in a European context. Merkel is still in domestic campaign mode.
None of this would really matter if the euro zone had really left the crisis behind it. If Europe’s recovery was more robust, renewed Greek turbulence would probably do very little to deter investors from pushing yields for sovereign bonds of peripheral European countries further down. Unfortunately, 2014 could be a year of heightened volatility– and not just in emerging economies. The recent calm in Europe should not be taken for granted.
Fighting Deflation: the Role of the ECB
For one, there is the danger of deflation in the euro area, which even some German officials concede, is real. Then, there is the reluctance by the European Central Bank (ECB) to act, despite assurances by its President Mario Draghi to the contrary. Recent contradictory data don’ t allow investors to take the launch of any further unconventional monetary policies for granted. It would be a gross mistake to interpret Draghi’s assurances that he is ready to act as a sign that he is preparing the ground for new dramatic steps.
The governing council could of course stop sterilizing its bond purchases activated under its now defunct Security Markets Program (SMP). This would inject some liquidity into the financial system but fail to fight a broad further fall in prices. It could take the baby step of a further interest rate cut, but–again–this would do very little to address the problem of dis-inflation or outright deflation. Indeed, it would merely raise expectations about the central bank’s willingness to soon embark into a massive program of asset purchases, a European version of quantitative easing. I outlined further reasons for the ECB’s reluctance to go down this path any time soon in a recent column and will therefore stop here. We only need to remind ourselves that of course the ECB is ready to act. It has always been and will always be. The real question is about thresholds for action. Barring a sudden meltdown of financial markets in Europe and/or abroad and a sudden drop in inflation to a level close to zero, we still seem to be a long way away from reaching them.
Political Risks: What is Happening in Rome
Then, there is political risk–the kind of risk that Schäuble is so obviously worried about. If Greece is on top of his list, Italy cannot be far behind. The recent end of the short-lived Letta government did not come as a complete surprise. He was merely a caretaker, a guarantor for sticking to a pro European course of fiscal consolidation and very mild structural reforms. What is surprising, however, is that the man that is responsible for Letta’s end, the young shooting star of Italy’s left, Matteo Renzi, is now trying to inject new life in a legislature that he himself considered on its last legs only a few weeks ago. Rather than forcing new elections, Renzi is currently trying to form a government with the same coalition that he described as fragile, unstable, and unable to address the real needs of his country. His plan is to stay in power with this loose alliance for at least three more years. Many observers describe him as the last chance for the traditional parties in Italy to regain some trust, reform the economy and institutions, and, last but not least, defuse the danger of euro skeptic demagoguery–embodied by the former prime minister Silvio Berlusconi or the former comedian Beppe Grillo–from taking over the country.
It is only logical that Renzi wants a relaxation of the strict European budget rules. He needs to free some capital needed for example to drive down labor costs. The European commission has agreed to grant Renzi some maneuvering room in principle, but only if he can show that he is serious about structural reforms. Don’t expect any fireworks–my fellow Italians. The pain is far from over, and renewed frustration could soon replace the hope that Renzi is the real thing. The European fiscal straightjacket can be loosened–but not shed.
And, the sooner Renzi and Italians realize and accept this harsh reality, the better for the rest of the continent. The alternative is a collision course with Brussels and its biggest stakeholder, Germany.
Which brings us back to Berlin. Merkel is once again watching all this with the apparent detachment of a cat, waiting for a clearer picture. A less benign interpretation could suggest that perhaps she is paralyzed by multiple worries, not least of which is the weak start of her new government coalition. Schäuble is looking at his European legacy and is willing and determined to act, but the Chancellor still prefers to wait. It has served her rather well so far.