Investors face a European policy trifecta on September 12: European Commission President Jose Manuel Barroso is due to unveil his draft for a unified banking supervision system; the German Constitutional Court will rule on whether the European Stability Mechanism can legally buy sovereign debt; and Dutch voters will go to the polls in an election that could produce big parliamentary gains for anti-European parties. Just two days later, European Union Finance ministers will meet to figure out what to do about Greece — again.
In contrast to the urgency of these events, Chancellor Angela Merkel’s political plan to preserve the euro zone with “more Europe” will take months, or possibly even years, up to and beyond the German parliamentary elections in September 2013. Like all trained physicists, Dr. Merkel knows that time isn’t a constant like the speed of light: clocks can and do shift relative to each other. She knows that she needs to speed up the political clock and slow down the financial clock. What are the odds she can pull it off? “Just because it is in the best, long-term interests of the euro area to preserve the single currency doesn’t mean that it will happen that way,” says Tom McGlade of Prologue. “It is difficult to rationalize with voters who are experiencing anger, fear and national pride.
Most but not all of Europe hopes the financial clocks give her enough time to pull off the politics. The British and the City of London are doubtful, and not just the euro skeptics, of which there are plenty in Whitehall. Brussels is nervous about the timing problem, but pleased that Merkel is advancing greater European unification, which the Eurocrats believe she will subcontract to them to manage, in order to keep the euro zone together. “We’re supposed to have a banking regulation plan in place by January 2013. That’s just four months from now,” one Brussels-based euro expert marveled to me. “Nothing has ever happened that quickly in the European Commission. Never.”
In Berlin, the late-summer atmosphere was serene, with people flocking to the trendy bars and restaurants of the Mitte district in the former East German sector, but there was plenty of hard-edged politicking going on behind the scenes between the Chancellor, her coalition in the Bundestag, the German opposition (which controls the Bundesrat, or upper chamber of parliament) and the Bundesbank. There was also some polite but steely diplomacy with the French, the Spaniards, the Greeks and the Italians.
A widely circulated Reuters photo showed Merkel and the Italian prime minister, Mario Monti, on the terrace of the Chancellery building, cordially sipping sparkling water after their bilateral meeting. In an amusing journalistic error, the Financial Times’s European edition the next day ran the photo with the caption, “A quiet word: Angela Merkel, German chancellor, and Mario Draghi, ECB president, talk in Berlin yesterday.” Like many readers, I took a double take and then laughed out loud. As one of my German friends quipped, “Ah, the English: they see Monti and they think Draghi.”
First, the political clock. Merkel’s calculus is pretty clear. And it’s breathtakingly ambitious.
In a weeklong visit to London, Brussels and Berlin, roughly 80 percent of my interlocutors expressed a confident belief that Merkel has a carefully thought out plan to advance banking supervision and fiscal integration (or at least fiscal discipline) to keep the euro zone intact. Another 10 percent or so think she has a rough idea but would abandon “more Europe” in a heartbeat if it threatened to bring down her government, just as she reversed her government’s nuclear energy policy after Japan’s Fukushima disaster. The other 10 percent think she has no strategy at all and is simply reacting to events.
I think she’s sincere when she says she wants more Europe. And now I think she’s ready to bet her government on it. This will be her legacy. “Who wants to be remembered in history as the Chancellor who sank the Euro?” one Brussels official suggested to me over an espresso near the European Parliament.
But the Bundeskanzlerin needs to keep her CDU/CSU coalition intact to make these critical next steps. So far, what the Germans call Fraktion Disziplin is tight with regard to her European strategy. Few party members are willing to cross her ahead of next year’s election. Just take a look at the homepages of Bundestag members, including some who are privately skeptical of Germany footing the bill for “more Europe.” The vast majority of content is posted from CDU/CSU headquarters and toes the party line perfectly. If there is a comment about the euro crisis, it’s usually Merkel’s latest press release.
As for the opposition SPD, they are ideologically more in favor of more Europe than Merkel’s party, so the odds of being blocked by them, even in the Bundesrat, are slim. The German public is restive but still on board. Opinion polls show support for more Europe slipping, however. She has time, but it is not moving in her favor.
Always reasonable and measured, Merkel hasn’t told the public in plain language just what’s at stake for Germany. “Why doesn’t she just go on TV and explain how terrible it would be if the euro broke up?” asked one German official friend. But there is a very good reason for that ambiguity. In fact, there are three good market reasons.
Sharp movements in three asset markets could upset Merkel’s plan. “Explicit talk by the Germans about default and euro zone breakup would surely scare the market sheep,” observes a Connecticut-based trader friend.
The most important market is the one for sovereign debt. Government bonds yields have fallen significantly since Draghi announced in a late July London speech that the ECB would do “whatever it takes to preserve the euro.” He fleshed out that promise last week by announcing a new mechanism, called Outright Monetary Transactions, under which the ECB would be prepared to buy unlimited amounts of short-term debt from any country as long as that the country reached an agreement with EU authorities that provided aid from European bailout funds in exchange for economic policy reforms. Draghi is clearly determined not to preside over the euro’s demise, given that the ECB was created expressly to manage the single currency. Yields on ten-year Spanish bonds, which had flirted with the crippling 7 percent level recently, tumbled 39 basis points the day after the announcement, to 5.64 percent. Italian bonds also rallied, dropping ten-year yields to 5.18 percent. Still, some really big auctions are coming in the next month, and these markets could go south (and yields soar) very quickly.
The second market to watch is the one for household deposits, which are fleeing the Mediterranean euro periphery in unsettling amounts. Spanish bank deposits fell by 5 percent in July alone. The ECB is keeping this in check with the Target 2 payments system, which recycles deposits removed from a Spanish bank and placed with a German bank. The system keeps the cash flowing even as faith in peripheral banking systems slides. But Germany’s claims on the Target 2 system, which some economists fear could be devalued massively if the euro breaks up, is massive and growing on a daily basis.
The third market to watch is the interbank funding market itself — short-term lending, repos and so forth — which is rapidly drying up. U.S., British and Asian lenders have been scaling back their exposure to euro zone counterparties for more than a year now. So interbank funding, too, is being propped up by the ECB, by means of its long-term refinancing operations, which have pumped €1 trillion in liquidity into the banks, and by a host of other indirect measures. This clock is accelerating, and European banks’ cross-border lending books are shrinking on a monthly basis. A full-scale crisis could shut down what’s left of the interbank funding market completely.
Some Wall Street mavens suggest Merkel is willing to let Greece go as the price of ring-fencing Spain and Italy, but all of the European experts I consulted with dismiss that thought. First, they point to all the financial gear-grinding such a move would cause, especially the shock it would impart to the European banking system, which is at the core of the problem. Until European leaders can break the link between the sovereign debt problem and bank solvency, Europe’s economic recovery is on indefinite hold. In addition, they note that Germany is now in so deep as a creditor to the euro periphery that the cost of a default would be much higher than just putting more money into the game.
So for now Berlin and Paris appear to be on the same page: No sovereign default, no forced Greek exit. Official statements after Greek prime minister Antonis Samaras visited both capitals recently used similar, clearly coordinated language. With Germany and France in apparent agreement, much of the treaty and legal machinery to advance the banking supervision and fiscal integration process is already in place. It is not widely appreciated in the U.K. and the U.S. how much the commitment for more Europe has already been made by EU governments meeting in the European Council. Finance Ministers likes Germany’s Wolfgang Schäuble rarely approve Council bills that would fail a vote in their home parliaments.
Merkel and Monti politely disagreed on whether the ESM should get a banking license from the ECB to get more fire-power for sovereign market intervention, but otherwise read from the same general script about “collaboration and fiscal discipline.” Schäuble politely disagreed with Barroso on whether the Europe-wide bank supervisory system should cover all 6,000 euro zone banks or just the two dozen systemically important banking institutions, but otherwise agrees that Europe must “get the next step right — the creation of a truly effective European banking supervisor to enforce a robust single rule book for the sector,” as he argued in an op-ed in the Financial Times.
Draghi has skillfully complemented Merkel’s narrative to the German public. In a carefully crafted op-ed in Die Zeit, Draghi laid out the case for expanded ECB intervention in financial markets while preserving fiscal discipline, in language tailored to ease the fears of the German public and the arguments of conservative German economists.
“The challenges of having a single monetary policy but loosely coordinated fiscal, economic and financial policies have been clearly revealed by the crisis,” he wrote. “As Jean Monnet said, ‘coordination is a method which promotes discussion, but it does not lead to a decision.’ And strong decisions have to be made to manage the world’s second most important currency.”
After invoking that classic phrase by Jean Monnet, the revered father of the European Project, Draghi went on to narrow the policy sphere that requires European level actions, in the process cleverly situating ECB policy within Angela Merkel’s broad political strategy.
“We do not need a centralization of all economic policies. Instead, we can answer this question pragmatically: by calmly asking ourselves which are the minimum requirements to complete economic and monetary union,” he wrote. Those minimum requirements include “true oversight over national budgets” and European supervision to limit excessive risk-taking by banks.
Then he justified ECB sovereign debt purchases with the most persuasive case that resonates with German voters — economic growth with price stability: “Fulfilling our mandate sometimes requires us to go beyond standard monetary policy tools. When markets are fragmented or influenced by irrational fears, our monetary policy signals do not reach citizens evenly across the euro area. We have to fix such blockages to ensure a single monetary policy and therefore price stability for all euro area citizens.”
Reaction in Germany to Draghi’s column was generally positive. Even some thoughtful observers in London liked it. “Euro governments cannot print `gold’ so they must live within their means, but the single market means there are spillover effects onto the neighbors,” says London-based financial commentator Graham Bishop. “So I agree with Draghi’s op-ed statement that 'Where necessary, sovereignty in selected economic policy fields can and should be pooled and democratic legitimation deepened.’ The core of the debate is now about what is 'necessary’, and we have already gone a very long way — much further than most investors realize.”
Draghi’s announcement of the bond-buying mechanism stirred some criticism in Germany that the central bank would be monetizing government deficits, something the Maastricht Treaty prohibits. Bundesbank president Jens Weidmann cast the sole vote against the plan for that very reason. But Merkel robustly defended the ECB, indicating that she and Draghi were singing very much from the same hymn sheet. “The ECB is an independent and very strong institution,” she told reporters in Vienna. “Conditionality is a very important point. Control and help, or control and conditions, go hand in hand.”
So for good or for ill, “resolution of the euro zone crisis is now firmly in the hands of the politicians,” says Michael Hintze, chief executive of London-based hedge fund firm CQS. “The good news is there appears to be acknowledgement among policymakers that the euro zone is structurally challenged. The question is whether politicians in a democratic system where they must seek re-election will be able to demonstrate the leadership required to take the tough decisions to address the euro’s structural flaws.“
Draghi’s use of the phrase “democratic legitimation” is a code word for the unpleasant reality facing Merkel and other euro zone politicians: that many citizen-voters are waking up to the amount of money at stake in keeping the system together. “A group of political, central bank and policy elites have been managing the euro crisis ineffectively for two years. During this period, the magnitude and reality of the austerity required of the peripheral, and the hard currency costs to the core states has steadily become apparent to the general public,” says Prologue’s McGlade. “The sacrifices required of both the periphery and the core, especially the transfer payments to the periphery to correct imbalances in a single currency system with unequal economic members, are going to inflict real pain on the man on the street.”
Merkel hopes Draghi’s ECB can slow down the financial clock even as she speeds up the political timeline. When push comes to shove, I think the Germans will give the ECB more firepower and more latitude to intervene, especially in sovereign debt markets. There are many moving parts in the decision-making machinery, a shifting cast of politicians — all facing elections — and a complex timeline. And as Bishop observes, the euro zone political process further advanced than the markets realize. But so are the stresses testing the financial system.
“It’s been decades since the markets tested and broke a central Bank,” mused a trader friend of mine in London on Monday. “Nobody is looking forward to really testing the ECB. Even if you make money on the big short, it will be armageddon for the rest of your portfolio. Let’s just hope the Germans know what they’re doing.”
James Shinn (jshinn@princeton.edu) is a lecturer at Princeton University’s School of Engineering and Applied Science, and chairman of Teneo Intelligence. After careers on Wall Street and in Silicon Valley, he served as the national intelligence officer for East Asia at the Central Intelligence Agency and then as assistant secretary of Defense for Asia at the Pentagon. He sits on the advisory boards of Oxford Analytica and CQS, a London-based hedge fund firm.
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