Yesterday the leaders of Germany, France, and Italy came together, offering a commitment to work toward new fiscal rules in Europe while keeping a leash on the European Central Bank. From the Wall Street Journal:
The leaders of the euro zone's three largest economies pledged Thursday to propose modifications to European Union treaties to further integrate economic policy and crack down on profligate spenders, but they played down suggestions that the European Central Bank have a greater crisis-busting role.
It should be painfully evident at this point that any process toward greater fiscal integration will be a years-long process. Financial markets, however, move at something much closer to the speed of light - as fast as traders can hit the "sell" button. As such, the European political process is grossly incapable of addressing the fiscal crisis. Apparently, however, market participants continue to hold out hope:
Investors were quick to register their disappointment that the leaders hadn't produced some sort of breakthrough to address the bloc's protracted sovereign-debt crisis. European stocks lost ground while the euro fell to its lowest level in seven weeks.
Seriously, who believes a breakthrough is coming? I imagine some thought the disastrous German bund auction would force Chancellor Angela Merkel's hands, but it appears to have only deepened her resolve. Obviously, one interpretation of the auction is that the crisis is spreading to Germany, making its debt more risky. But risky how? The specter of Eurobonds, in my opinion, argues for shying away from Eurobonds as investors need to price German debt at that of the eventual Eurobond, which will almost certainly be greater than current German prices. This would help explain Merkel's objection to Eurobonds:
Germany vehemently opposes creating such commonly backed bonds before a natural alignment of euro-zone economies is achieved through sound economic policies, the introduction of so-called debt brakes to restrict deficits, and creating the ability to severely punish profligate euro-zone members.
Ms. Merkel, addressing the issue during the news conference, said the recent widening of the gap between euro-zone interest rates reflects the strengths of countries such as Germany and the structural weaknesses of those such as Greece and Portugal. The introduction of euro-zone bonds would create artificial convergence of interest rates and not address the root cause of the crisis, she said.
"It would be a completely wrong signal to allow these different interest rates to become ineffective because they are an indication of where more work is needed," said Ms. Merkel. "If we all work responsibly, convergence will take place all on its own. But to impose convergence on everyone would weaken us all."
The message is that you can't identify the bad actors without differential yields, which is possibly reasonable with respect to solvency issues but less so when considering liquidity crisis. Germany is looking for hard and fast rules that would force the periphery debt down to German yields rather than the latter up to the former. Does this suggest that Germany would insist on some sort of convergence criteria as a precondition for the issuance of Eurodebt as well? Something to think about. Calculated Risk directs us to an even more disconcerting Merkel quote via the Telegraph:
Ms Merkel instead used a three-way summit with France and Italy in Strasbourg to insist that new treaty powers to intervene and punish sinner states remained the key focus of Europe's rescue efforts. She said: "The countries who don't keep to the stability pact have to be punished – those who contravene it need to be penalised. We need to make sure this doesn't happen again."
Similarly, Germany needed to be punished via the Versailles Treaty - and look how well that worked. It is tough to advise anything other than to sell Europe as long as Germany insists on this morality play.
The Irish government has suddenly complicated the picture by requesting debt relief from as a reward for upholding the integrity of the EU financial system after the Lehman crisis, though there is no explicit linkage between the two issues...
..."We are looking at ways to reduce the debt. We would like to see our European colleagues address this in a positive manner. Wherever there is a reckless borrower, there is also a reckless lender," he said, alluding to German, French, British and Dutch banks.
"We have indicated to Europe's authorities that it will be difficult to get the Irish public to pass a referendum on treaty change," he said.
The EU's new fiscal rules would be legally binding and "justiciable" before the European Court, he said. This raises the likelihood that Ireland's top court would insist on a referendum.
Translation: If you want to move forward on fiscal unity, we need a quid-pro-quo in the form of debt relief. Ultimately, Portugal will want the same. And Greece will eventually ask for more as well. True, the imminent standoff on the next tranche of aid has been alleviated as the ND opposition party offered its written commitment to the October summit deal. Of course, the commitment is predictably soft, with the money quote:
On the evidence of the budget execution so far, we believe that certain policies have to be modified, so as to guarantee the Program’s success. This is more so, since according to the latest European Economic forecasts, Greece in 2012 will be the only European country with 5 consecutive years in recession!
The agreement is crushing the Greek economy, so modifications will be needed. But does anyone believe that only minor modifications will suffice? Anyone? Bueller? Still, given the clock was ticking down on the next aid tranche, policymakers probably believe it best for all parties to back down a little and kick the can down the road for another three months, when we can expect another "voluntary" haircut after the deteriorating economic conditions further erodes the Greek fiscal situation.
While European leaders continue to pretend there exists a timely political solution to the crisis - that the crisis will end the instant sinner states offer up enough political commitment to the ever changing goal of austerity - Germany continues to insist the ECB be kept on a short leash, pushing Italian debt pack above 7%. Via the Telegraph:
“The three of us want to indicate our support to the ECB and its leaders,” Mr Sarkozy said. “The three of us have indicated that we will respect the independence of this essential institution and we agreed that we should refrain making any demand, positive or negative, on it. That is a position that we have elaborated together.”
The statement appeared to contradict comments from senior French politicians earlier today that the country was seeking a greater degree of involvement from the area's central bank in tackling the debt crisis.
Like it or not, the ECB is the one institution that can act quickly. To be sure, arguably it is now too late to act "quickly." Now quick action is needed to just limit the damage as financial conditions across Europe freeze solid as a block of ice.
This is not shaping up to be a festive holiday season in Europe.