From what seemed like a very low bar on expectations, last week's summit headlines surprised modestly on the upside, even if the details remain far from clear - and implementation even murkier. Political talk of wanting to break the link between sovereign and banking risk was well-received by markets - but we remind all that talk-is-cheap with these Euro-pols. As Goldman noted this weekend, "we do not see the outcome as a game changer", rather can-kicking until one of four possible endgames are realized. The absence of any explicit commitment to plans for fiscal or political integration; the lack of reference to any pan-European deposit insurance; and Ms. Merkel's limited concessions (to ensure passage of the growth compact) to the terms on which the existing pool of EFSF/ESM resources are offered leaves the underlying issue - the terms on which mutualisation of financial risk is offered by Germany in return for mutualization of control over fiscal decisions throughout the Euro area - remaining inharmonious. German tactical concessions at the summit do not change their basic position on this issue: that discipline, reform and consolidation must be achieved and cemented first before mutualization of financial obligations is possible. Looking to the future Goldman sees four paths for the Euro are from here - and short-term too many crucial issues are left unresolved.
Huw Pill, Goldman Sachs: European Views
Looking to the future, we see four paths (albeit ones that are connected by cross streets) for the Euro area from here, around which scenarios for the market outlook can be developed:
- The Cultural Revolution. While unlikely, it is possible that European politicians recognize the error of their previous ways and collectively jump to a more constructive approach, exploiting the strengths of the consolidated Euro area in pursuit of a solution, rather than focusing on the weakness in individual countries that represent obstacles to one. In short, the European leadership could start to ‘think continental’ (to use a phrase originated by Alexander Hamilton in not dissimilar circumstances). In principle, this would offer a rapid and effective resolution of the crisis. But the likelihood of this outcome is low. The European authorities are inevitably in thrall to their national political constituencies (which, after all, elect them): thinking national rather than continental is the therefore the most likely result.
- The Long March. More realistically, one can characterize the June EU summit as another step forward in the long and slow process of necessary adjustment and governance reform in the Euro area, bringing national constituencies along in a step-by-step manner. Announcement of plans for banking union can be seen (for good reason) as part of the development of the new institutional architecture needed to make the Euro area workable. But however necessary, these measures are far from sufficient. Only over time will successive summits, each resulting in individually modest forward steps, lead to an accumulation of institutional advances sufficient to underpin the Euro adequately. The slow cumulative construction of a workable governance structure has been (and will remain) initially under-appreciated by the markets, but eventually be recognized, leading the market to support convergence rather than divergence across economies within the Euro area. Of course, aside from the politics of institutional reform, this ‘long march’ is likely to prove economically challenging: economic activity in the periphery will be hamstrung by the lack of a more comprehensive resolution, especially as the underlying necessary adjustments to competitiveness, external imbalances and public finances will proceed slowly, if at all, in this environment.
- The Great Leap Forward. We are skeptical that either financial markets or domestic political constituencies will have the patience for a ‘long march’ lasting as long as a decade (as Ms. Merkel has repeatedly predicted). More realistically, intensifying market pressure is likely to short-circuit this process, forcing Europe to an earlier decision point. For example, should Spain be denied market access and be forced into an explicit external financing program, additional fiscal demands will be placed on the rest of the Euro area, weakening the public finances of Italy and, via a domino effect, France and ultimately Germany. Relying on a slow, cumulative improvement in governance is inadequate in these circumstances. The ‘Big 4’ countries will quickly be presented with the question of whether or not they are prepared to take the steps necessary to underpin the Euro. Measures will need to be taken quickly and aggressively: acting outside the existing institutional framework will be required. Germany and France will have to decide to whether they are prepared to take substantial steps forward in economic and political integration in order to preserve the Euro. Muddling through will no longer suffice. In these circumstances, we think such a ‘great leap forward’ is the most likely response.
- Disintegration. That said, we cannot rule out the possibility that, faced with an ‘existential threat’, the political process does not allow such a ‘great leap forward’ to be taken. At that point, Monetary Union would become untenable—and a rapid and costly unraveling of the Euro area would result.
Using these four paths as a framework, we see the most likely scenario going forward as follows:
the European authorities continue their ongoing ‘long march’ of cumulative reform until, at some point—probably not imminently, but over the coming one to three years—market and/or political dynamics force the choice of whether to make a ‘great leap forward’ on the key Franco-German axis that has driven European integration since the 1950s.
Sketching this baseline scenario raises two questions:
- When will the Euro area switch from the slow, cumulative path of the ‘long march’ to confronting the pressing question of whether to take a ‘great leap forward’? We believe Euro area can continue on its current ‘long march’ for some time yet. The institutional machinery of monetary union—notably the balance sheet of the ECB and the ability of its TARGET2 balances to accommodate intra-Euro area cross-border stresses elastically—has proved remarkably robust to market pressure: by its nature, monetary union has greater resilience than the fixed exchange rate systems with which it is often compared. Moreover, for different reasons, the key players are not facing immediate pressures: ample liquidity in the Euro area is keeping French government bond yields at close to historical lows, while the German economy continues to show resilience at the lowest level of unemployment seen n for a generation. And procrastination is the path of least resistance for European politicians, lending inertia to the process. This makes a continuation of slow, incremental reform—rather than a comprehensive and rapid resolution of the crisis—more likely. But this approach does not come without its own costs. Macroeconomic performance in the periphery is set to deteriorate further in 2012H2, as market dislocation continues to weigh on credit creation and economic activity. And market participants are losing patience with the slow pace of adjustment: this adds to the tensions in financial markets.
- When facing the existential choice of whether to take the ‘great leap forward’, will France and Germany be prepared to do so? Yet ultimately we doubt that the ‘long march’ can be pursued to a conclusion. Other forces—such as a fiscal policy mis-step in France that undermines investor confidence or a populist political shock in the Italian elections—would force an ‘existential crisis’ for the Euro. At that point, we believe Germany and France will demonstrate the courage and commitment to move forward. Failing to do so in those circumstances would not merely imply acquiescence with the status quo, but rather a disintegration of the Europe built over the past 60 years, something neither country is likely to countenance. Yet making this step will not be without its own political challenges, especially in Germany where taxpayers are understandably reluctant to take on yet greater burdens that such a leap forward would imply.
Viewed in this light, the decisions taken at last week’s EU summit are best seen as part of the cumulative and incremental process of institutional reform inherent to the ‘long march’. While elements were surprisingly positive and important in themselves, in our view these decisions do not represent the ‘great leap forward’ required to resolve the crisis. They leave too many crucial issues—not least, the central question of how mutualization of financial risk and the debt overhang is traded off against loss of national fiscal sovereignty to German-inspired Euro area-wide fiscal and regulatory institutions—still unresolved.
Source: Goldman Sachs