Despite another weekend of hope-driven chatter of a support-the-profligacy, print-til-we-die, mutually assured destruction game of chicken, we remain as far from the fiscal federalism, that we discussed earlier in the week (and the four critical questions that need to be answered) as ever. As we embark on yet another critical week in Europe's (and perhaps the world's future), ING addressed a critical aspect of the conundrum - that of Merkel's (read Germany's) reluctance to step on the gas and save the known universe. While attempting to quantify the price of break-up and the pay-now or pay-later perspective, they describe perfectly the 'Paradox of Merkelism' in that the core countries' attempts to limit their exposure have served only to increase it. They further worry that while a plan for a Grand Bargain may appear, this may rapidly give way to the recognition that the reality is not so grand - the bargain would still have to be delivered.
ING: Break Up. Pay Now Or Pay Later
The Paradox Of Merkelism - Risky Caution
Amid the rising sense of panic in the financial markets, there is frustration at the hesitant response of policy-makers in the core countries, led by Germany. Although German Chancellor Angela Merkel continues to proclaim “if the euro fails, then Europe fails”, she remains reluctant to sanction the dramatic fiscal and monetary measures that many see as essential to prevent EMU fracturing. The general perception of the financial markets has been that Eurozone policymakers’ actions have been “too little, too late”.
The key to this has been the reluctance of Germany and the core countries to commit more resources. In part, this reflects the political challenge of persuading their electorates of the need to support their peripheral brethren, who are widely portrayed as having brought their debt problems upon themselves.
However, Merkelism is not just about the awkward politics of burden-sharing. It also reflects deep-seated German convictions about the economics of the sovereign debt crisis. It is viewed as largely a result of fiscal ill-discipline on the part of the peripheral economies. The Germanic prescription is therefore fiscal restraint. Coupled with this is Germany’s long-standing antipathy towards inflation, rooted in its past episodes of hyperinflation. As a result, Germany and its core partners have consistently chosen the most austere policy options:
1) reluctance to increase the bail-out packages for Greece and the other peripherals. This culminated in the agreement to try to extend the firepower of the European Financial Stability Fund (EFSF) not with bigger commitments from the member governments but with additional borrowing.
2) an insistence on tough fiscal austerity measures in the peripheral economies. The notion that this ought to be offset by fiscal relaxation in the core countries is rejected.
3) a resistance to the notion of the becoming a ‘transfer union’, in which tax revenues flow from the richer core to the poorer periphery.
4) a rejection of the idea of a common Eurozone government bond, which would entail members becoming liable for each other’s debts.
5) insistence on private sector involvement (PSI) in the restructuring of Greek public debt. The proposal that private holdings should be written down by 50% (while leaving official holdings unimpaired) damaged investors’ perceptions of all Eurozone sovereign debt.
6) objection to sanction the European Central Bank (ECB) acting as ‘lender of last resort’ to Eurozone governments. The fear is that such ‘debt monetisation’ would both create moral hazard by weakening the incentives for governments taking the necessary actions to reduce their debts and pose long-term inflation risks. The Bundesbank, supporting this position, has argued that the ECB’s securities market programme (SMP) to buy peripheral government debt should be limited and temporary.
7) support for the ECB sticking to its anti-inflation mandate, which was manifest in its support for its decision to raise its refinancing rate from 1.0% to 1.5% earlier this year. With headline inflation remaining embarrassingly high at 3% the ECB only grudgingly agreed to cut interest rates to 1.25% at its meeting on 3 November, despite manifest signs of a sharp slowdown in economic growth.
With the core creditors in the driving seat, the net effect of this has been a powerfully contractionary fiscal and monetary stance across that has pushed the Eurozone into the deleveraging doom loop pictured above (Fig 4). Far from instilling confidence, fiscal austerity has led to a downturn in growth, now in the core as well as the periphery, raising further doubts about fiscal solvency and so driving up bond yields further.
This is not to say that German policy-makers are unaware of the need for economic growth. Aside from the so far abortive attempts to restore confidence through fiscal austerity, they point to the need for supply-side and governance reforms. On this score, there is near-universal agreement. The failure of peripheral economies both to liberalise their labour and product markets and to tackle government inefficiency and corruption has certainly weighed on their competitiveness and performance.
But, as Angela Merkel herself is prone to say, supply-side reforms are not a quick fix. Implementation is politically challenging, and the benefits take years to come through. Unfortunately, with austerity biting harder and faster than reform, the financial markets are not prepared to wait for years.
So the paradox of Merkelism is that the core countries’ attempts to limit their exposure have served to increase it. A cautious step-by-step approach to fiscal integration designed to put the euro on a surer footing has so far served to undermine it. With the peripherals increasingly confronted with the prospect of long term austerity, exiting EMU becomes correspondingly more appealing.
And yet the media, and every hopeful long-only manager in the world, is talking up the 'Grand Bargain' that is about to be struck this week to save the Euro. ECB to provide more support, a super-sized EFSF, a common Euro-bond, all in return for tougher (and potentially enforceable) fiscal rules. Of course, all 17 nations will jump at the chance and ratify instantly...while many assume this is the holy grail-like case, we suspect any relief will be short-lived since not only will the process likely be too long-winded (and leave too much uncertainty for an increasingly risk-averse and career-risk-anxious buy-side), fiscal solvency will take years to restore and is for surer a recipe for slow, stagnating growth (at best).