The Caravan Moves On – Politics Needs to Catch Up!

Greece’s fate is decided. It will be only a question of time until the country leaves the Eurozone, in an orderly or an disorderly manner. The newly enthroned three party coalition will run into the political problem created by the voters who expressed their wish to stay inside the Eurozone and simultaneously getting relieve of the terms of austerity, and more so into the economic problem that further austerity only means ongoing and even more severe economic pain.

This contradiction cannot be solved, and time is running out anyways as new money is urgently needed in order to avoid an open default whereas negotiations need time. For the moment, the troika will offer an extension for reaching fiscal targets but will not move away from established austerity measures. Unlike the EU and some national governments, financial markets long have accepted such an outcome, and already moved on to Spain. The situation of Spain is dramatic, not so much due to an alarming high level of the public debt ratio but due to the dynamics that play out in Spain and will eventually drive the country onto the abyss.

Staggering high unemployment, negative economic growth and an ailing banking industry are providing an economic situation that is not at all favorable to accept further austerity. The ill-designed bank bailout for Spain may have saved the fate and assets of bank creditors but the price was a further increase of public debt  - no surprise then, that financial market actors are getting worried about the solvency of Spain. The short-term need of Euro 62 billion as capital injection is well covered but it is not sure whether such a move returns trust into the viability of the industry. The country needs to refinance about $280 billion over the next two years, and the markets are not confident that this can work, at least not with interest rates that are seen as sustainable. Thus the increase in yield for one-year as well as for ten-year bonds, and the increase is such that Spain has been moved to the abyss.

Italy, Portugal and even France may follow swift. Contagion may not be justified by bleak economic data but financial market actors’ views are less based on fundamentals rather than on narratives, and those narratives tend to kick-start self-fulfilling processes, upwards as well as downwards. This irrationality has become a crisis-trigger by itself, and needs to be dealt with in time. Plans of the ECB to no longer rely on the credit quality assessments of the big rating agencies are in principle a promising concept but may come with the danger of a further aggravation of the debt dynamic as creditors will interpret such a policy change as a way to avoid ‘industry standards’. Adding new seeds of moral hazard is risky and may have the effect of an acceleration of downgrading. On the other side, it makes sense to give the ECB a higher degree of independence from the irrationalities of ratting agencies.

It is well known that refinancing needs are not restricted to Eurozone economies but are actually part of ‘regular’ economic interactions between financial markets and states. Refinancing needs are high in Italy, Portugal, Spain, and also France but are dwarfed by Japan, and also the US has to refinance substantial amounts that equal in terms of shares in GDP easily he ones of Italy and Portugal. Of course, the absolute amounts are staggeringly high in case of large economies. Global liquidity can easily deal with those refinancing needs. However, who is getting what kind of new credits at which conditions is up to financial market actors to decide. Distrust runs high against some Eurozone economies, and despite the one-sided exaggerations of financial market actors for good reasons.

One risk assessment feature plays a key role for financial market actors, and this is the political constitution of economies. Japan, the US, the UK and Canada are nation-states and enjoy independence from absolute and relative debts and thus have to pay low interest rates. Troubled Eurozone economies are in a different league as they are indebted in money they do not control. In contrast, a nation-state with its own money cannot run into default, at least as long its central bank is allowed and willing to make use of its unlimited liquidity creation capacity. In this regard, member states of the Eurozone differ, and so does the financial-political architecture of the Eurozone. Germany seems to violate this rule as currently it pays extremely low rates for its government bonds despite the fact that the Euro is not ‘German money’. The reason for this aberration can be found in the ongoing capital flight inside the Eurozone where Euro deposits are moved to stay in the Eurozone but outside the troubled Eurozone economies. In any case, the ‘original sin’ calls long-term for the formation of European political unification and already short-term for political substitutes for such an unification.

Refinancing Needs of States, 2012-2014, in % of GDP (IMF data)

It is astounding to read that in such a dramatic situation German Chancellor Angela Merkel continues to stick to her policy of austerity and the virtues of the fiscal pact. Sure thing, Merkel has to act under severe domestic political constraints. In order to get a majority parliamentarian approval of the fiscal pact she was (legally) forced to engage in negotiations with the two big opposition parties, the Social Democrats and the Greens. As a result she will get a majority for her favored fiscal pact and only had to offer the trade-off of a financial transaction tax that will be mild in terms of scope and range. The most recent decision of the German Supreme Court advises that the parliament needs to be informed on everything related to the EU and must be included in decision-making cannot explain her obduracy.

On the contrary, legal decisions by the court as well as overarching political considerations should be an incentive for developing an encompassing strategy that has the chance to get broad parliamentary support as well as the applause of the European and global public. Such a plan would have to offer an alternative narrative for the public at large that had the chance to become a game changer. Of course, this would require quite a policy shift – a shift, however, that would bring her government in line with an emerging European and international consensus in terms of crisis management. Even the head of the Austrian Central Bank and thus member of the Council of the ECB made the comparison with the 1930s when the social fallout of strict austerity stirred political extremism. At the G20 meeting in Cancun Merkel signaled some flexibility without going off tracks. Changing policy trajectories is a complex business, and nothing speaks at the moment that the Merkel government is up to the challenge. Rather than stressing the obvious by pointing out again and again that Germany can’t shoulder the rescue of the Eurozone, Merkel should start explaining to her electorate that it needs a joint effort of strong and weak economies, inside and outside of the Eurozone – and that such a joint strategy is costly, in particular for Germany.

In a worst case scenario in which Greece, Italy and Spain plus Portugal would default the direct costs for Germany due to its share in the ECB  TARGET 2 claims as well as its commitments to the EFSF and ESM respectively could easily run up to 2 trillion Euro over a period of two to three years. A breakdown of the Eurozone would also have negative effects on European integration as it surely would generate protectionist measures of all kinds, not least the appreciation effects in case of the return of the Deutschmark. A return to a fragmented Europe where desperate governments seek refuge in exchange rate policies would hurt German export sectors as well as its financial industry. In brief, the breakup costs for Germany would be prohibitively high.

The point has been made that Germany benefitted largely from European integration in general and from the Eurozone in particular and thus should have an not only an intrinsic interest in saving the Euro but also an obligation to pay-back. In terms of trade and making use of the European economic space to maximize its value chain in order to improve price competitiveness, the EU indeed turned out to be a huge plus for Germany. Direct and indirect wage effects due to the Europeanization of value chains are probably more important to explain Germany’s current economic state than the often-mentioned labor market reforms and the stiffening of welfare state services. It is difficult to tie numerical values to such benefits. Still, given the strong role of export sectors in Germany’s regime of accumulation and its trade share with Eurozone economies it seems reasonable to assume net benefits, and thus to see a strong dose of German self-interest in a functioning Eurozone. This interdependence moved in the background in the last two years as German exports were striving despite the crisis, not least due to the compensating demand of economies outside the Eurozone. This compensation mechanism is under threat as China, India, Brazil and in particular the US are running into growth problems of their own making. In other words, in the current situation Germany’s interest in a working Eurozone should be as strong as never before.

Political decisions are usually not made by looking into the past but by looking to the present and into the future. The costs of sticking to the current crisis management are getting higher and higher, for the troubled economies as well as for the ‘Northern saviors’. If governments want to keep a lid on crisis costs they need to act now, and they need to act in ways that thwarts all policies of the past 24 months or so. It is in the German interest to rethink its blockades and to turn towards a responsible and viable crisis management that combines short-term effects with long-term goals. Instead of leading the Merkel government acts as a Eurozone-wide brake by pushing for a policy sequence that is out of line with crisis dynamics.

Demanding first a political union, then a banking union and eventually a fiscal union may make political sense but does not respond to the urgent needs of controlling the default crises. Sometimes it seems that even sticking to principles gets combined with ignorance: When Chancellor Merkel recently was asked by a journalist about the possibility to make use of the EFSF fund to buy government bonds on the secondary market in order to reduce the yield she responded that this was only a theoretical question without practical relevance. It needed an intervention of ECB executive board member Coeure to remind her that the EFSF was allowed to make such purchases and that it would actually be a good idea to go forward with exactly such action. This episode may not tell us too much, even though it indicates the level of expertise of the German crisis manager. It tells us a lot, though, about the state of European crisis management where too many voices utter too many ideas at all times. All this adds to the narrative of financial market actors where the dissatisfaction runs high.

Spain being under serious attack makes a turn of crisis management unavoidable, at least if a disorderly collapse of the Eurozone should be avoided. It is true that the Spanish Conservatives play an ugly game by trying to capitalize on the sheer size of the Spanish economy and more so by pointing to the imbalance of Spanish bailout needs and available funds. Of course, the EU can’t afford a default of Spain as this would accelerate contagion and Italy, Portugal, Ireland and more would fall like dominoes (did I already mention Cyprus?). However, the EU can’t afford to concede extra conditionalities to Spain without risking immediate demands from other troubled Eurozone governments. What is needed is a complete policy change that cleans up the current situation by providing a base for future sustainable economic growth, and this includes financial sector sustainability.

Given the dynamics of financial markets and the deteriorating economic environment it should be a straightforward conclusion that the emerging public debt ratios of Italy, Spain, Greece and Ireland are not sustainable. Debt restructuring is a must, and needs to be started as soon as possible. This has to go hand in hand with a bailout of banks on a vast scale. In both cases, the ECB will have to play a large role as lender of last resort – and it will have to carry quite a share of the adjustment costs. It is up to Germany to accept and propagate the role of the ECB as a true lender of last resort, as it is up to the Merkel coalition to express support for a version of Eurobonds that was already suggested by the German Economic Advisory Committee some time ago. The proposed ‘redemption fund’ would be applied for government debt above the 60% level which would be pooled and jointly refinanced until getting retired after a 25 year pay-off period. This may not be a Plan A instrument and it would also lift Germany’s refinancing cost above its current low level. However, already by signaling such a policy shift financial market actors would have to readjust their narratives and consequently change their risk assessments. Refinancing the ailing European banking industry is a parallel undertaking. This has to become part of the EFSF and ESM respectively, and conditionality for bailouts should be negotiated with those funds in cooperation with the ECB that should become the sole banking supervisor of the EU.

Those two economic policy decisions are key but may not convince financial market actors to re-think their decision-making. In the last weeks some hedge funds announced to short German Bunds. This decision may be seen as rational given the negative implications a breakup of the Euro on Germany and German’s public finances. At the same time, though, such a move increases the fragility of the Eurozone and makes crisis management more expensive. Speculative power of financial market actors is just that – destabilizing speculation that generates economic and political fears, or alternatively anger. It does neither add stability nor any extra value to the financial industry. Dealing with this industry needs patience, resources, strategy and a well-designed game plan. All those elements are in scarce supply. The launch of a encompassing crisis management narrative may be a good start to change the game.