Eurozone poker – Monti calls Merkel’s bluff

At last week’s EU summit, Mr Monti refused to agree to anything until Germany made a key concession. He wanted the bailout monies for the Spanish banking system not to be structured as debt of the Spanish government.  In the end, Mrs Merkel gave in although this will not occur until a European banking supervisor has been established for the Eurozone banking system.

This concession is hugely significant in terms of a principle to which Germany has long held fast, in that it appears to contravene the Maastricht “no bailout” clause – recapitalising a banking system requires equity capital not debt capital. Europe will now use its emergency funds to inject new equity into the Spanish banks. This cannot be portrayed as emergency lending to fellow European sovereigns as all previous rescue loans have been. Providing equity capital to bankrupt institutions is inherently a far riskier proposition than lending to a sovereign state, and so it is impossible now to maintain the facade that German taxpayer money is not being put at risk.

As time moves on, Germany and others will find themselves facing the classic sunk cost problem – if more money is required to keep these banks afloat, then the capital provider feels under greater pressure to do so, to avoid writing off the previous investment. This is the first step down a slippery slope – the second step will come when a more rigorous and independent audit reveals that Spain’s banks require far more than the E62bn currently mooted in order to recapitalise. Next Ireland and Greece have already made clear that they want to get (retroactively) the same terms as Spain for their banking recapitalisations, and finally the Italian and French banks will be looking enviously at the cheap equity capital Spanish banks have now secured.

Mrs. Merkel does have a cooling-off period though. The principle has been conceded subject to agreement within 6 months of a new European banking supervisor. This leaves many vital areas of disagreement over details and, probably, ratification in all 27 EU states. Key areas still to be resolved are which banks fall under the direct supervision of the European regulator, what will  be the role of the current national banking supervisors, and most importantly of all, who has responsibility for deposit guarantee insurance. It would seem obvious that any deposit guarantee scheme would have to fall under the auspices of the European banking regulator, but it is not clear where the money would come from. Most politicians do not wish to provide their own taxpayers money to bail out bank depositors in other countries – instead they are hoping it will be funded by the banking system itself via a Financial Transactions Tax. In the long term this may be a viable solution, but in the short term the fund would be empty for several years and the potential demands on it huge given the fragility of European banks.

One further factor which should not be ignored is that in September 2013, Mrs Merkel faces re-election. Should she concede too much to the rest of Europe over the next 12 months, she faces huge domestic political problems. There is talk that a possible way out of her dilemmas is for Germany to hold a referendum on whether it should continue to support its European partners to enable them to remain in the single currency. German public opinion is currently split on this and such a referendum would leave European financial markets paralysed until the matter was resolved.

The markets have rallied strongly on the abandonment of the Maastricht “no-bailout” clause, and the first move towards more integrated European institutions. However history suggests that there are many more late-night summits and games of brinkmanship to come while negotiating the details of what has been only agreed in principle. Investors can afford to wait and see before concluding that Europe is solving its problems.

Dear Diary – possible reflections of some of those at the G8 meeting

The G8 meeting achieved nothing, despite the sense of crisis in the markets. The communiqué was bland and meant different things to different people. Below are what the leaders may well have really thought  about the summit.

Barack.  Re-election chances continue to drop – only 6 months to go. Have to say that Angela has some backbone, kept going with the German Nein all weekend long despite all of us ganging upon her to open her wallet. Played at being best buddies with Francois, the new boy in our club – it keeps David and Angela on their toes. Anyway he and I do have a lot in common, the rich should be paying a whole lot more towards getting us out of this mess, and it shouldn’t be the ordinary Joe who takes the hits all the time. Europe really worries me though – if it all blows up this summer, it could send our economy back into recession just about election time and I’ll be a very young ex-President.

Angela.  Re-election chances continue to drop – only 16 months to go. Well, that goes down as one of the most miserable weekends of my life. I know I’m still at the top of Barack’s European speed-dial, but it was horrible to watch him buttering up Francois. At heart though neither of them believe in balanced budgets and sound money like I do; they just want the money and public expenditure to keep on flowing and keep their supporters sweet. I am now only really left with David as a true right-of-centre ally in Europe; at least he is backing our drive for a political union as the best option to save the monetary union. Even so, he joined in with the others that Germany must spend lots of money we don’t have and let the ECB print and cause inflation – I was totally alone on this but stood my ground.

I thought it was a pretty smart idea to take 3 hours off from our discussions to watch the Champions League Final – it would be 3 hours not having to defend sound economic principles and a chance for Germans to show the football world how good we are (again) – but it didn’t work out. Bayern lost (on penalties – Germans never do that) and the symbolism was so awful – a team of foreign imports on huge salaries from the part of London inhabited by investment bankers, managed to overcome the bulk of the German national team, who were so strong, courageous and disciplined, and from Munich, the most successful centre of the German export industry. Worst of all that photo of us all watching the game has gone viral thanks to Twitter.

David. Re-election chances starting to drop – though still have 36 months to go. Politics is a rum old game. Who would have thought that a British Conservative Prime Minister would be telling the nations of Europe that their best (and only) hope was to move toward a full-on political union led by Germany? Yet George keeps on telling me that really is the best hope for our economy until the next election. Maybe, but it would be terrible for Britain’s influence with the US and China if Europe was truly one country with an elected President. I really can’t see it happening though, but I just don’t know if that is a good or a bad thing. That photo should do me the world of good with all the ordinary footy supporters in the country though – not many Posh Boys really like association football. Like Angela I had to be grovel a bit to Francois.

Francois. Chances in the parliamentary elections in 4 weeks definitely on the up. Life is amazing right now. Two weeks I was M. Normal, a French Socialist leader that had never had responsibility for anything in my life except for other Socialists, and now the President of the United States of America is telling me and the others what wonderfully interesting ideas I have. Also quite a nice feeling for Angela and David to have to be extra nice to me right now – I shall make good use of that back home in the next few weeks ahead of the elections.

Mario. Politicians are so transparent, always worrying about their election prospects.

Vladimir. Why are these guys so afraid of elections? Everyone’s beating up on Angela. I reckon she needs a good friend like me, and then just maybe we can get Germany to see Russia as their best European ally, instead of always looking westward.

The Super Mario Brothers – changing European politics

Last November saw the two Marios, Draghi and Monti, take on key positions within the Eurozone; Mario Draghi as President of the ECB succeeding Jean-Claude Trichet and Mario Monti succeeding the Silvio Berlusconi as Prime Minister of Italy. Both were appointed rather than being democratically elected but importantly both are hugely experienced within European politics and highly regarded and trusted by their peers. Both have moved fast to create change in their respective areas and together can be seen to be challenging the old power balance within the eurozone away from a Franco-German dominated politics towards a more truly European version.

November was also the period of greatest intensity in the sovereign debt crisis, when Italian 10 year government bond yields exceeded 7%, threatening a global banking and financial markets disaster. Mr Draghi acted decisively in December, cutting the ECB’s key interest rate and then announcing a new policy of Long Term Repurchase Operations, offering unlimited liquidity to Eurozone banks for a 3 year period at only 1%. This new policy has turned out to a marvellous euro-fudge. To German-minded Central Bankers a LTRO is not equivalent to the Anglo-Saxon policy of Quantitative Easing (aka printing money) that they loathe so vehemently, but is a liquidity-management tool which Central Bankers would be expected to deploy at times of crisis. The liquidity is merely lent to the banking system on the basis of collateral, it is not the creation or printing of new money. However (a) the scale of the operation, being unlimited, (b) the long time period involved, prior to this the ECB had never offered such facilities for longer than 1 year and then only in the darkest days of the 2008-09 crisis, and (c) the 1% rate, a zero premium to the official rate and thus creating no stigma for a weak bank being forced to pay higher rates for emergency liquidity, all meant that the short-term effects of this policy are remarkably similar to those of a policy of Quantitative Easing. The financial markets have certainly responded in such a fashion as the dangers of a eurozone banking crisis have receded.

Mr. Monti was effectively installed by Merkel and Sarkozy after they forced the departure of Berlusconi. Despite having enormous wealth and a population and an economy equivalent in size to France, the lack of growth in the Italian economy and its enormous level of national debt meant that it was seen as the weakest of the large European economies. Monti earned his stripes as the EU Competition Commissioner, taking on and defeating both Microsoft and Hewlett Packard in well-publicised battles over their monopoly powers. He has surprised many with the speed and ambition of the fiscal and economic changes he has forced through the Italian parliament, taking on many of the protected special interest groups which benefit from rigidities in the regulatory system. He is clearly aiming at delivering the significant structural reform to the Italian economy which is so badly needed and which Berlusconi failed to deliver.

Having gained credibility with his actions within Italy, Monti has used the fact that Merkel likes and listens to him to argue with Germany about its single-minded focus on austerity as the only tool to restoring the European economy. In recent weeks the tone of German thoughts on the European economy has changed towards the need for greater pro-growth policies. Italy now has a seat at the top table when these matters are discussed.

Sarkozy and France appear to be the losers in this power shift. Sarkozy was very quick to ensure that he maintained a French presence at the top of the IMF by getting Christine Lagarde to replace Dominique Strauss-Khan, but that has cost him a key voice within Europe, where she was well regarded but it has not really helped in terms of getting the IMF to be pro-Europe. It is noticeable how much quieter Sarkozy has been since Monti’s arrival at the top table. This may reflect his domestic political weakness – he faces re-election in May and with current polls suggesting he is set to lose, he has been forced to ask Merkel to campaign for him in France. The Franco-German axis in Europe which has dominated European politics for the last few years is breaking down as Germany is now the clear leader and then below are a newly-weakened France and a newly-strengthened Italy. A greater Southern Europe perspective is just beginning to have an effect on the way in which Europe is now being run.