EU summits come and go, and so do EU soccer championships. It seemed like the soccer crown is firmly in the hands of Spain. More so, three out of four teams who reached the semi final were countries of the South of the Eurozone, and thus the conclusion that the South reigns Europe. This opinion is shared by a group of 170 so-called German top economists who just published an Open Letter in which they postulate that the decisions of the June 29th summit were utterly wrong and that Chancellor Merkel was hijacked by the ‘Southern countries’ that anyway have the majority in critical committees and thus will continue exploiting Germany.
First reactions by financial market actors seem to contradict such a view when they showed a welcoming reception tothe paltry Euro Area Statement presented by the heads of state. Following the argument of the German economists financial market actors should be full of joy as the overall vague and meager three bullet statement offered quite some goodies for financial markets. The Open Letter rightly points out that the policies proposed are a first step towards a banking union that ultimately would establish the principle of joint liability. They are also right to hint to the principle that creditors went open eyes into risky transactions, and should thus carry the consequences.
They are utterly wrong, though, that those creditors should follow the Lehman route. Allowing a large-scale bankruptcy may have been an option in the very early stage of the crisis but is no viable option today. Until very recently, the public and most of the academic attention was directed towards public debts. Only recently it began to dawn that besides the case of Greece the ‘real’ problem of the critical crisis economies of the Eurozone (and also economies outside the common currency area) is the build-up of huge private debts that were so easily financed in the past by financial institutions across Europe. Given the sheer amount of troubled credits and the high level of financial market interdependence in the EU, it is politically irresponsible to demand a radical policy of market clearing. Such a decision would not only jeopardize the existence of the Euro but simultaneously kick-start a global crisis. I don’t know about a hidden agenda of the open letter writers but for sure there is a safer way to get rid of the unloved Euro, if this is what the Open Letter is all about.
After the usual brief positive sentiments financial market actors seem to have found time to read the summit statement more carefully, and they already start changing their sentiments. This was not so obviously when the Irish government tested waters with its first treasury bills auction since it had to flee under the umbrella of the Troika. It easily could sell three-months bills for Euro 500 bio (with an oversubscription ratio 0f 2.8) at a yield of 1.8% – no big deal given the short maturity of the bills. The Spanish government sold overall government bonds for Euro 3 billion, and all the different maturities (from 3 year to 10 year bonds) came with slightly higher yields than before. The relatively high yields indicate the post-summit sentiments of financial market actors. And this sentiment continues to be sceptical. And there are good reasons to be sceptical. Unlike the German economists argue the vague decisions of the summit are less a victory of the South but again the proof of a political failure to come up with a proper crisis management program. This lack of political willingness adds to the troubles and makes the Euro crisis as much a political crisis as it is an economic crisis.
First critical responses already demonstrated in which ways the two main elements of the summit statement have the potential to aggravate the crisis.
- ‘We affirm that it is imperative to break the vicious circle between banks and sovereigns”. The appropriate instrument is seen in affective single supervisory mechanism with the possibility to recapitalize banks directly, and it will include the ECB. It is not clear yet how such a body will look like nor whether it will be housed in the ECB or be established with the help and input of the ECB. Why the heads of state were not clearly pushing for a simple structured regulatory body as part of the ECB that would allow for turning the ECB into a truly lender of last resort is not understandable. If they really intend to break the vicious circle between banks and sovereigns then it needs a competent and well-instrumented actor like the ECB to handle the task. This includes handing over unrestricted intervention power to the ECB.
- “We reaffirm that the financial assistance will be provided by the ESFS until the ESM becomes available, and that it will then be transferred to the ESM, without gaining seniority status”. The reversal of the seniority status can be seen as a good message for financial market actors. However, allowing the ESM to directly recapitalize troubled banks of the Eurozone as well as to buy government bonds on the secondary markets without drastically increasing the available ESM funds is an invitation to disaster. It doesn’t even need a calculator to understanding the failure. Outstanding government bonds for Italy (about Euro 2 trillion) and Spain (about Euro 800 billion) alone amount to about Euro 2.8 trillion. Compare this to the available funds of the ESM of about Euro 500 billion. If the Italian and Spanish governments would ask the ESM (under conditionalities) to buy government bonds in order to bring down yields to manageable and sustainable levels a financial market-ESM race gets started: Government bond traders will know without using calculators that the disparity between outstanding bonds and intervention funds is so big that it is only a question of (brief) time that the ESM will planished. Such a straightforward conclusion is nothing else than an incentive to sell off government bonds in order to reduce losses. It is well-known that such a herd behaviour will result in a huge price drop, and consequently in a further rise of yields. The medicine kills the patient.
We may not have to wait for financial market actors to make use of the offer and thus to start a self-fulfilling funding crisis. This may come sooner rather than later, not least due to quite dramatic events that play off against the economic crisis dynamics. The Open Letter of German economists feeds further into the negative opinion of the German public towards financial rescue packages for troubled Eurozone economies. According to a representative poll that was organized for the German weekly Der Spiegel 54% of the electorate feel that it makes less and less sense to invest billions (of German tax money) in order to rescue the Euro. Such attitudes will make it even more difficult for Chancellor Merkel to organize majorities in Parliament, not to speak about winning over the sceptical attitudes of the electoral pool of her party.
Already on June 29 the centre-right coalition missed (again) the so-called Chancellor majority in its (successful) attempt to ratify the fiscal compact and the ESM. Despite the wish of Chancellor Merkel that the law should be quickly signed off by the German President this will not happen. Due to a very unusual request of the German Supreme Court, Federal President Gauck decided to wait until the Court has dealt with the speedy law suits put forward by German parliamentarians and citizens, some of them also signatories of the Open Letter. The political and legal trouble for the Merkel coalition piles up and further restricts the room of political manoeuvre. Bad and sad prospects for the future of the Eurozone.