EU Bailout: Germany Is Cornered

Includes: ERO, EU, EWG, EZU, FXE, IEV, VGK
by: Firat Ünlü

So we have a deal now. The exact details will become clear throughout the day and as the package will be put into use. What's become evident is how Europeans still haven't come to grips with the market mechanism. To be fair, sentiment in some Asian countries during the Asian Financial Crisis of 1997 mirror the contemporary European one. Media coverage then and now was full of people blaming everything on speculators who 'attacked' a country's currency. Mahathir Mohamad, then Malaysian Prime Minister, stood out amongst the politicians in his criticism of bond vigilantes.

What we see today is the reaction of people who believe that markets did not perform rationally during the last few weeks. In their opinion, yields are high because sentiment among traders is negative. ‘Wolfpacks’ are supposedly attacking the euro. It has been evident to anyone who had a mere glance at sovereign balance sheets that the day of reckoning was inevitably going to come. The US and UK benefit from having control of monetary policy and accommodating central banks as well as temporary ‘flights to safety’.

Could a scenario more disastrous than the Greek one have been invented? A country that lied its way into the eurozone, cooked its books and looks politically unable to push through the needed austerity package to stay in the monetary union. How could you lend money at interest rates just slightly higher than German bunds to a country which is facing horrendous debt-deflation from a high level, anaemic growth for years and political uncertainty?

Of course, interest rates had to rise given these conditions. Had the market had its way Greece would have defaulted, restructured its debt and maybe even left the eurozone. To Greece as a country that outcome would have been much more beneficial than the current one where it is going to, at best, muddle through. If spending one’s way to prosperity worked we should send credit card companies abroad rather than aid organizations.

Yet fear about contagion, bank capital and a ‘second Lehman’ caused a bailout package of gigantic proportions.

What exactly is the purpose of staying in the EZ? Looking at economic fundamentals, I see no case for Spain, Italy, Greece and Portugal sharing the same monetary policy as Germany. Putting aside cultural explanations for a moment what’s the point of a monetary union in an area which quite simply does not seem to be coherent enough.

Why do yields spike? Because investors fear for their money and need to take default risk into account. From now on with the EU backstop investors can be quite certain to receive their money, as it stands even the ECB is ready to engage with QE in bond markets.

For all the size of the package economic fundamentals are weak in certain countries and investors would be foolish to part with their money for anything less than adequately compensated risk premia. Nonetheless, now that investors can be sure to receive their money, yields can fall and we should see a harmonization of interest rates throughout the EZ.

Greek debt is as good as German debt now since it is backstopped by the whole EZ. Unfortunately economics has the habit of not giving anyone a free lunch. The price for being able to sell their bonds at German rates is that their equities are bound to suffer.

As was said above economic fundamentals remain weak, there’s little prospect for domestic growth as austerity measures curb into demand. The only way to compensate for this would be a weaker euro to boost exports but everyone’s trying to play that game. Thus companies remain locked in a shrinking environment whilst citizens face reductions in benefits and wages. External devaluation is far easier to implement as the example of the UK shows. Despite the pound falling immensely there was hardly any reaction, in fact the value of the pound wasn’t even a topic during the run-up to the election last Thursday.

A key pillar of this package is deficit reduction but now that Germany has shown political weakness despite its alleged strength moral hazard is alive and well. Why not spend that 1% of GDP more than initially said now there’s that alluring backstop? If push comes to shove talk about conditionality and austerity is just that, talk.

France is siding with the printers, Germany is left almost alone, cornered by the three other giants of the EZ, Spain, Italy and France, who are much more benign towards softer monetary and fiscal policy. Angela Merkel is one of the weakest Chancellors in German history; her list of domestic accomplishments is rather short. A weak Germany is supplanted by an also increasingly cornered Bundesbank. The ECB can hardly stand on the outside when record debt is being issued by EZ members. This package relies on ECB compliance.

That’s hardly a confidence-inspiring combination for deficit hawks. Quantitative Easing has its day in Europe now and there’s nothing Germans can do about it.

Disclosure: No positions.