I had thought previously that the European Central Bank and/or the new European Stability Mechanism (ESM) would end up financing the problem EU economies by printing the money to buy their Bonds in order to keep afloat both the European banking system and the Euro. But political developments in Germany look to be ruling this out.
The three Coalition Parties in the Bundestag have rejected, categorically, Bond purchases by the ESM – also endorsed by the Bundesbank – and a letter from 189 German economists has been in the German papers, denouncing the ESM and calling for immediate bankruptcy proceedings of insolvent Eurozone States. The Bundestag is demanding a vote on any accord reached at the forthcoming EU Summit.
Behind this lies the German view that the European economies which cannot compete with Germany while sharing the Euro as a currency, must cut their pay levels and living standards until they can compete. Apart from the political pressures this would involve, it ignores the points that a crucial element of restoring their public finances and being able to honour their debts and sustaining their banking systems, is for their economies and tax revenues to grow. Indeed without growth in these economies, there is no escape from fiscal deficits and banking excesses.
I had also thought previously that Germany would be prepared, ultimately, to pay up to preserve the Euro and the “European experiment”; but it would seem that the cost and strain of financing the former East Germany over the last 20 years has become the stronger influence. It is clear the “hardliners” are gaining strength right across Northern Europe. What is not clear, is whether Germany and the German Government understand that the position they are taking makes Bond restructuring/default by the weaker Eurozone States and the break up of the Euro virtually inevitable. At its simplest, as investors wise up to Germany’s position and that neither the ESM nor ECB will be allowed to buy a problem economy Bonds – who will buy them? The existing resources of the Bail-out Fund are not sufficient.
A failure of the Crisis Resolution Strategy thus looks probable without agreement on substantially larger ESM Bond purchases. The German-inspired Competitiveness Pact (driving down pay and living standards until problem economies are competitive) is no deal by itself and unless Germany is ready to provide credit guarantees and/or agree Pan-Eurozone financial support. But Germany has made clear its opposition to any form of Transfer Union Bonds. Not only would accepting such German economic direction represent a loss of sovereignty by the countries in trouble, but there would also be little point in their agreeing to it, unless it is accompanied by both a larger increase in ESM financing and/or common, Eurozone Bond support.
Where China now appears to have understood that it cannot continue to prosper relying on rising export surpluses with the West, on the back of a cheap currency; Germany has not understood that it cannot enjoy strong growth in a Pan-EU context, based on what has become its super-competitiveness under a common Euro currency, without providing the finance to keep the uncompetitive economies afloat.
There is the probability of a fudged March, EU deal, initially delaying the crisis. But the very lack of current market pressures may kill off any deal at all. Moreover, the EU’s Crisis Resolution Strategy seems intended to draw attention away from the underlying causes. These are first of all that the highly competitive Northern European economies cannot share a currency with the uncompetitive, largely Southern, peripheral European economies, without major Pan-EU transfer payments; the Euro is cheap in the North but very expensive in the South, worsening the economic and financial problems. Secondly, you cannot have nationally controlled and under-capitalised banking systems in a monetary union with major structural, current account imbalances, without busting the banking system.
Yield spreads on vulnerable economies’ 10-year Government Bonds, relative to Germany, are widening, making the cost burden of debt finance heavier than ever, and representing a growing premium for the growing risk of default and/or devaluation. The oil price hike will also cut EU growth this year to around 1% only, and have the toughest impact on the vulnerable, peripheral European economies.
If little or no financing help is offered in return for the harsh competitive restoration model proposed by Germany, the economies with problems might end up concluding that they would fare better, following something like the Argentina model, when it devalued substantially and dropped its Dollar link in late 2001, and the economy, thereafter, boomed. But whether or not with their agreement, such may be forced upon them if they are unable to finance themselves.
The case is growing that what is needed in the Eurozone is Debt restructuring and a competitive currency for the uncompetitive economies as soon as possible – implying the break up of the Euro. To engineer a reduction in the 5.9% rate of interest Ireland is being charged on the EU chunk of its bail out loan, the new Irish Government may threaten the sort of “hair cuts” on senior bank creditors, suggested last year by Chancellor Merkel, if the EU refuses to compromise, thereby setting off EU-wide contagion.
The most worrying factor is, arguably, that while the Eurozone crisis continues to be averted, the underlying economic and financial problems mount, threatening an eventual even larger blow up and banking crisis. The exposures to Portugal, Greece, Ireland and Spain of German banks are $524bn and of French banks, $385bn equivalent. The European banking system is heading for significant write-offs which will require major Government bail outs. Moreover, European Pension Funds and Life Companies are heavily invested in Spanish, Portuguese and Greek Bonds, where EU Pension Solvency II will oblige both to increase their Bond exposure yet further.
As Wolfgang Munchau argued in the Financial Times (£) on 28th February, "the best outcome would be a failure of the current Crisis Resolution Strategy followed by a complete 're-booting'. A never ending stand-off would be followed by a financial cardiac arrest."
The easiest solution would be for the super-competitive Northern Europe to adopt a new, “strong DM”, leaving the rest of the Eurozone with a competitive, weak Euro.