Authored By UBS' Larry Hatheway,
The Merkel-Draghi wager: Will it pay off?
Tracking the evolution of the Eurozone crisis has been like hacking your way through a dense jungle. The number of countries, political actors, policy institutions, and policy responses - not to mention acronyms! - makes seeing the forest for the trees all but impossible. In what follows I propose a framework to lift the field of vision and thereby gain some perspective. That perspective ought to help put into context the importance of last week’s Italian elections for Europe’s future.
When the Eurozone crisis first broke some four years ago, most analysts quickly and correctly concluded that the Eurozone was an incomplete monetary union. Two camps then emerged - those that thought that saving the Eurozone required extensive political and fiscal integration, and those that believed that integration on the scale required would be impossible, with the result that the Eurozone would have to shrink via exit of one or more countries. Politics, however, is the art of the possible. And neither rapid integration nor breakup were or are politically feasible options for Europe’s political classes. Instead, what has evolved is what I dub the ‘Merkel-Draghi wager’. To be sure, it is not simply the creation of German Chancellor Merkel and ECB President Draghi. However, they are the chief political and policy protagonists in Europe and, surely, without their backing the policies now in place could never have been adopted.
The ‘Merkel-Draghi wager’ began with the determination that capital markets would not dictate Europe’s future. The realities of huge external imbalances, sovereign stress, and financial insolvency would not be allowed to manifest in either bank runs or sovereign default that would then precipitate a Eurozone breakup.
As a consequence, a series of increasingly robust lender-of-last-resort facilities were introduced, which have prevented either a Lehman-style bank collapse or a sudden stop in sovereign financing. For banks, the ECB’s balance sheet replaced disappearing wholesale funding markets, thereby bridging the financing gap between deposits and loans. For sovereigns unable to borrow in capital markets, support was provided by the troika under the framework of EFSF (now ESM). And, as of last year, the ECB’s balance sheet also stands at the ready with its yet-to-be-activated Outright Monetary Transactions (OMT) program.
In short, the policy response has not been one of explicit fiscal or political integration, but rather the establishment of two massive and effective lender-of-last-resort facilities.
So where’s the wager? The bet is embedded in the rest of the narrative. With growth-supporting fiscal transfers or debt mutualisation ruled out by national politics, the remainder of the story is about an ‘Austrian’ solution to cleanse Europe of excessive fiscal deficits, narrow gaps in competitiveness, and shrink external imbalances. Countries with large budget deficits are mandated to cut them swiftly, virtually irrespective of the scope and depth of the recessions that ensue. Structural reform is advocated for uncompetitive countries, though in the absence of such policy initiatives soaring unemployment and falling wages will act to restore competitiveness—the internal devaluation.
The consequences are plain to see in the extraordinary declines in per capita incomes in much of Europe (though, notably, not in Germany), as shown in Chart 1.
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Consistent with collapsing output and domestic demand, current account deficits in ‘peripheral’ Europe have narrowed or disappeared, even if Germany’s current account surplus has largely remained intact (Chart 2, preceding page). And consistent with soaring unemployment, unit labour costs in ‘peripheral’ Europe have begun to decline, narrowing previously large gaps in intra-Eurozone competitiveness (Chart 3).
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The ‘Merkel-Draghi wager’, then, is political gamble of historic proportions. It is a calculated bet that a policy prescription of robust liquidity buffers coupled with internal devaluation and fiscal consolidation will work. Equally, it is a view that the historical, cultural, economic, financial and political forces that have brought Europe together in the post-war era will prove stronger than those unleashed by the wrenching social dislocations associated with ‘Austrian’ economics that could one day threaten to rip apart the Eurozone.
So far, the ‘wager’ is working in economic terms, as the preceding charts attest. Indeed, if the same policies can be kept in place for another few years, relative unit labour costs will revert to their positions at the beginning of the millennium, restoring the competitiveness of ‘peripheral’ Europe and quite possibly initiating a re-direction of investment flows and economic activity to Europe’s most depressed economies.
Or at least that’s the hope. And that’s also where the recent Italian elections come into play. While the protest votes registered in Italy one week ago were multi-faceted, it is also clear that they included a repudiation of austerity and structural reform, plainly evident in the poor showings of Prime Minister Monti and his centrist supporters.
The relatively muted response of markets to the Italian elections is, in that regard, somewhat puzzling. Perhaps market participants view the outcome as uniquely Italian, with little significance for possible political change elsewhere. If so, investors need not be overly concerned, insofar as political paralysis in Italy, where fiscal adjustment is already well advanced, is not as concerning as it might be in, say, Spain.
But to the extent that the election outcome in Italy portends similar political backlashes elsewhere against the ‘Merkel-Draghi’ policy prescription, the implication is that investors and politicians alike will have to reconsider the odds that the ‘wager’ will succeed and, if not, whether Europe has a ‘Plan B’ to replace it.
And what might ‘Plan B’ look like? One variant would be explicit fiscal transfers and debt mutualisation. Another might be debt monetisation. Put in those terms, it’s pretty easy to see why Merkel and Draghi preferred to roll the ‘Austrian’ dice.