Tuesday, September 27, 2011

What Germany Wants From an EFSF ECB Deal

The markets are enjoying a relief rally at the moment in the expectation that the latest proposals to fix the Eurozone Sovereign Debt crisis by leveraging up the EFSF via the ECB. Besides all the legal difficulties in carrying out this plan, there are also significant political issues to overcome. Putting aside the issue of Slovakia for a moment-where according to most reports the July 21 EFSF expansion plans are not likely to be ratified- the key questions relate to the quid-pro-quo benefits to the Northern European nations. In other words, what is in it for the Germans?

Leveraging the EFSF, What's in it for Germany?

And it’s not just the Germans interest that needs to be satiated. Austria, Luxembourg, Netherlands and Finland are all believed to be closer to the German position at the ECB. Therefore, it is worth taking the time to try and see what the Germans want out of an EFSF ECB deal.

Frankly, the only way that this deal can be sold to the Germans, Dutch, Austrians and Finnish is if it comes attached with a significantly stronger legal framework that is commensurate with fiscal union. Herman Van Rompuy is due to put forward proposals on fiscal union at an EU summit on Oct 17-18 and this meeting will be crucial to the future of this kind of EFSF leverage deal.

If measures towards fiscal union are not approved and, this sort of deal is approved, than the potential for a long drawn out period of difficulties in Europe is assured. We will have low growth for many years to come and potentially tumultuous circumstances.

Moral Hazard and the Debt Crisis

The danger here is the same danger that caused the financial crisis. Moral Hazard. Unfortunately, we have not dealt with this in financial sector but that doesn't mean we have to encourage it in the Public Sector too. The Germans are right. The debt problems are structural and need to be dealt with in this way. If you keep bailing out Governments and institutions, then they will not change. It is a symbiotic process. If Governments don’t structurally reform, they will be punished by the bond markets and end up going towards unsustainable debt paths.

Jens Weidmann's Speeches

In fact, Bundesbank Chief Jens Weidmann articulated this point in a few speeches recently..

The European Council therefore agreed that financial assistance should be granted to countries with severe refinancing problems, a substantial part of which is provided by Germany. This financial support is intended to buy time for the affected countries to conduct necessary structural reforms and implement consolidation measures in order to regain market participants’ confidence in the soundness of their public finances and their competitiveness. The assistance is therefore bound to adjustment programs, which each recipient country has to fulfill.

However, the reduction of interest payments on the financial aid has weakened the incentives for countries in an adjustment programs to re-establish sound public finances via fiscal and economic reforms and return to the capital market. Furthermore, the conditionality of the support measures has been loosened by the recent decisions of July 21st. This weakens the underlying principle of European Monetary Union that each country has to bear the full consequences of its own fiscal policy.  Contrary to what is actually needed in order to overcome the sovereign debt crisis, we risk seeing the propensity for excessive deficits rise even further in the future

The last point is critical.

If this is how Governments are reacting to the limited bond buying program, than what will it be like when the EFSF is expanded to E2 trillion?? Will Berlusconi carry on making austerity measures or, will he figure that it’s all ok now because someone else is going to backstop Italy's debt?

Germany Rejects Eurobonds

As Weidmann puts it..

A communitisation of debt would be sure to result in a substantial redistribution from sound to unsound countries. In addition, Eurobonds, in and of themselves, would actually be rather counterproductive to solving the fundamental problem that led to the outbreak and spread of the sovereign debt crisis. In short, I believe that the risks associated with Eurobonds far outweigh their potential benefits.
...and in itself this is nothing more than a restatement of the principle of rejecting the notion of privatizing profits (Berlusconi et al and their political popularity) and collectivising risk (the rest of Europe pays Italy's bills) and, we know how that strategy ends up.

Hence the calls for fiscal union...

In my view, enshrining strict deficit and debt limits for national budgets in EU legislation is pivotal to achieving a stable fiscal union and reliably shielding the Euro system’s single monetary policy from unsound public finances. These limits would then apply to all levels of national government, including central, state and local government and the social security systems; the EU would need to be granted ultimate powers of intervention to ensure that the limits are effectively implemented in practice.

In a fiscal union, these powers of intervention would have to be extensive enough to ensure that national governments lose their sovereignty over fiscal policy when deficit and borrowing limits are breached, if not beforehand. Consequently, the national parliaments would no longer have ultimate decision-making authority over government budgets; their decisions would be subject to approval by a central body.

So, clearly, Germany wants moves towards fiscal union. Let's hope they are successful.

Weidmann, Jens Public Speeches

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