ECB is euroland’s last hope as bail-out machinery fails to resolve crisis
by Ambrose Evans-Pritchard
International Business Editor
Posted 14 Aug 2011
THE LEADERS OF GERMANY AND FRANCE HAVE THREE BAD CHOICES AS THEY DECIDE whether to save EMU this week, or pretend to do so. German Chancellor Angela Merkel and French President Nicolas Sarkozy will meet Tuesday in Paris. They can agree to fiscal fusion and an EMU debt union, entailing treaty changes and a constitutional revolution. This implies the emasculation of Europe’s historic nation states.
They can tear up the mandate of European Central Bank and order Frankfurt to go nuclear with €2 trillion of `unsterilized’ bond purchases until the M3 money supply in Italy, Spain, Portugal, Ireland, and Greece stops contracting at depression rates and starts to grow again at recovery speed (5pc). This might destabilize Germany. Or they can try to muddle through with their usual mix of half-measures and bluster. This will lead to a rapid disintegration of monetary union and a banking collapse. It risks a repeat of 1931 if executed badly, as it most likely would be. They have days or weeks to make up their minds, not months.
The EFSF rescue fund was never more than a stop-gap device to avoid grappling with the core issue: the economic chasm between North and South. It has failed. Insistence that it could handle a dual crisis in Spain in Italy was a bluff, and last week that bluff was called when France too was sucked into the maelstrom.
Escalating bail-out costs are eroding French debt dynamics. “Bad” is contaminating “good”. The EFSF has itself become a source of contagion and this would turn yet more virulent if the fund were quadrupled to €2 trillion as some suggest. “The larger the EFSF, the faster the dominos fall,” says Daniel Gross from the Centre for European Policy Studies (CEPS).
“Only Germany can reverse the dynamic of European disintegration,” writes George Soros in the Handelsblatt. “Germany and the other AAA states must agree to some sort of Eurobond regime. Otherwise the euro will implode.” Mr Soros knows that the trigger for the denouement of the pre-euro ERM in 1992 was a quote from a Bundesbanker in the same Handelsblatt hinting that sterling and the lira were overvalued. That was all it took. The Tory government that had tied Britain’s fate to an over-heating Germany was destroyed.
Once again we are all reading the German press, and what we see is subversive commentary once again from Frankfurt, and bail-out fatigue and simmering anger among Bavaria’s Social Christians, Free Democrats (FDP), and Angela Merkel’s own Christian Democrats in Berlin. If Germany is about to immolate itself for the sake of EMU, this is not obvious in the Bundestag.
What German politicians want is yet more Club Med austerity, even though Euroland growth has wilted. The demands have become ideological, going beyond any coherent therapeutic dose. The effect of such fiscal tightening at this stage is to repeat the error of the 1930s Gold Standard when the burden of adjustment fell on weaker states, pushing them into a downward spiral that eventually engulfed everybody. Fiscal cuts make little sense for Italy, where the output gap is 3.1pc. “Increasing potential growth should be the main policy goal. Fiscal tightening could further depress aggregate demand” said the IMF in its Article IV report.
Italy does not have a debt problem as such. Its budget is in primary surplus this year. Total debt – the relevant gauge — is under 250pc of GDP: similar to France, and lower than Holland, Spain, Britain, the US, or Japan. Italy is one of the few EU states to have sorted out its pension liabilities, by linking payouts to life expectancy
What Italy has is a growth problem, rooted in currency misalignment. Having lost over 40pc in unit labour cost competitiveness against Germany since EMU, it is trapped in slump. Per capital income has contracted for a decade. So why is Europe forcing Italy to tighten drastically and run an even bigger primary surplus within two years, and doing so just as the world flirts with a double-dip downturn? Why too is the ECB’s Jean-Claude Trichet acting as the enforcer? His leaked letter to Italian premier Silvio Berlusconi is a diktat, a long list of measures imposed as a condition for the ECB’s action to shore up the Italian bond market.
Mr Berlusconi has capitulated, with a “bleeding heart”. He is slashing payments to regional authorities, though he has resisted wage cuts. “They made us look like an occupied government,” he said. Northern League leader Umberto Bossi accused the ECB of “trying to blow up the Italian government.”
Mr Trichet is moving into dangerous waters dictating budgets to sovereign parliaments. It matters enormously whether citizens have political “ownership” over austerity, or whether it is imposed by outside forces. His former colleague Otmar Issing fears that Europe is becoming a deformed union where officials run roughshod over nations and fiscal power lies beyond democratic control. Such encroachments have “brought war” in the past, he said.
The bank should correct its own errors first. It was ECB tightening that choked Europe’s recovery. “Eurozone monetary weakness has been the key driver of the recent deterioration in global economic and financial conditions,” said Simon Ward from Henderson Global Investors. Real M1 desposits are not only collapsing across southern Europe, they have turned negative in the North as well. This signals big trouble. “It was astonishing that the ECB, which trumpets adherence to monetary analysis, chose to rein back its longer-term repo lending in late 2010 and raise interest rates in April and July. This was a repeat of its error of 2008,” he said.
Mr Ward said the ECB should stop choosing which nations to rescue through “quasi-fiscal transfers” and stick to neutral central banking. It should launch quantitative easing for the whole of EMU.
“At this point the Eurozone needs a massive infusion of liquidity,” said Dr Gross from CEPS. Otherwise there will be a “break-down of the interbank market that would throw the economy into an immediate recession as after the Lehman bankruptcy”.
HSBC’s chief economist Stephen King said the ECB must print money a l’outrance in “exactly the same” way as the Fed. “At the heart of the problem is the ECB’s unwillingness to be seen ‘monetizing’ government debt. Yet if the alternative to QE is the collapse of the euro or a descent into depression, then massive expansion of the ECB’s balance sheet seems a small price to pay.” Such views are rarer in Germany but at last making themselves heard. Kantoos Economics said the ECB has been “extremely tight” and lost sight of its essential purpose. “It is therefore an important cause of the current mess.”
“European policy makers and central bankers are wrecking one of the most fascinating projects in human history, the unity and friendship among the countries of Europe. This is beyond depressing,” he said. The path of least resistance for Angela Merkel and Nicolas Sarkozy on Tuesday is surely to force the ECB to change course, by treaty power if necessary.
Or kiss goodbye to the Kanzleramt, the Elysee, and monetary union