A Spate of Recent Positive Events in the Euro Area
The euro area's efforts to stabilize its financial picture got a boost from several developments in the last week, as the effects of the outright monetary transactions (OMT) announced last summer by the European Central Bank (ECB) continues to take hold. At the European Union Council, for example, leaders confirmed their political commitment to a banking union and affirmed that Greece's political normalization in the European Union is under way. The Spanish electorate returned Prime Minister Mariano Rajoy's party to power in Galicia. And Germany's election campaign began with its two conservative parties, the Christian Democratic Union/Christian Social Union (CDU/CSU), firmly behind Chancellor Angela Merkel.
Banking Union: A Surprisingly Speedy Timetable
EU leaders broadly got it right on the banking union. They agreed on a timetable establishing the legislative framework for the Single Supervisory Mechanism (SSM) by January 1, 2013 and implementing it by the end of the year [pdf]. Even if the timetable slips three to six months, the EU political leaders will have gone from recognition of the need for an overhaul of banking regulation this last June at the EU Council [pdf] to an agreement on how to proceed with such a regulatory revolution in six (or maybe 12) months.
Any talk about EU "foot-dragging" on banking reform, or Germany slowing the timetable down, is thus wide off the mark. This is especially true when you compare Europe's reform timeline with the Dodd-Frank Wall Street Reform and Consumer Protection Act, which passed the US Congress in early July 2010, 21 months after Lehman Brothers went bust. It is equally true when you look at the 20 months it took for the United Kingdom to adopt its new approach to financial regulation [pdf] in late July 2010, following the bailout of the Royal Bank of Scotland (RBS). Considering the scale of the undertaking, the European Union is actually moving forward at breakneck speed for major financial reforms in advanced economies.
The EU Council's endorsement of the comprehensive European Commission proposal for an SSM covering all banks in the supervised area is similarly encouraging. So is the focus on making the SSM compatible with the EU Internal Market, enabling non-euro members to join. Of course, "going big" in this way poses political, legal, and practical near-term obstacles for the euro area and non-euro area members, the ECB, and the European Banking Authority (EBA). These obstacles could delay the timetable. But delays are acceptable when the longer-term benefits of integration and comprehensive banking supervision in Europe are so great. The costs of a mistake made by a future integrated banking supervision in Europe are likely to exceed by far the costs of a mistake in Europe's existing integrated competition policy, which requires approval for mergers of companies. A blocked M&A (mergers and acquisitions) deal, in other words, is benign compared to allowing banks to go broke over bad loans, as the case of Ireland has demonstrated. A commitment to a gradual phase of a comprehensive banking union is therefore encouraging. Because of the repeated political commitment to all elements of a banking union, it is safe to assume that integrated resolution and deposit guarantee schemes in the euro area (+) will follow in the medium term.
Spain and Ireland: More Progress Despite the Rhetoric
Chancellor Merkel's rejection of direct recapitalization of (Spanish) banks by the European Stability Mechanism (ESM) was seen as bad news for Spain and Ireland. But such recapitalization after an accord on the Single Supervisory Mechanism would not constitute forward-looking "risk sharing" in the European banking union. Rather it would be backward-looking "loss sharing" of countries' legacy banking assets—something that has now been ruled out as a principle in the euro area. Yet policy principles are one thing and politically necessary individual exceptions to them is quite another in the euro area. Thus one can make too much of Merkel's rebuff. It was seen as intended mostly for German domestic political consumption, i.e., the German's insistence on "tough love"—austerity and economic reforms in return for aid.
The financial goal of all the euro area/International Monetary Fund (IMF) rescue packages is to restore and maintain market access of the program countries, enabling them to finance themselves among private investors. Direct recapitalization of banks by the ESM is only one of several ways in which a euro member can achieve that goal. Many of these methods are less at odds with desired policy principles for European financial assistance than "loss sharing" of countries' legacy banking issues. Do not underestimate the political significance of the German government's acceptance of the transfer of more than €300 billion in bad assets from Germany's banks to the public German balance sheet since 2010. Germany's gross government debt levels have risen 8 to 10 percentage points as a result.1 After taking over that many domestic bad assets from German banks, Merkel is understandably reluctant to do the same for Ireland and Spain.
Two days after ruling out loss sharing for these two countries, Merkel agreed with the Irish prime minister that Ireland is "a special case" that should be re-examined in light of its "well performing adjustment program." Because the Irish government has already transferred the Irish taxpayers' money to the Irish banks, euro area financial assistance to help Ireland return to market financing need not come in the form of ESM direct recapitalization of Irish banks. Other channels will be considered, and Merkel has not ruled any of them out.
Similarly, focusing on Spain's alleged need for direct bank recapitalization from the ESM misses the broader point. True, many market analysts assumed in June that direct ESM recapitalization of Spanish banks was as the only tangible financial outcome from the summit to Spain. But that assumption took hold before it was clear that the ECB's OMT program could accomplish the same objective of potentially supporting Spain on its path to full market access. The OMT program makes direct ESM recapitalization of Spanish banks less urgent, even if the recapitalization of Spanish banks by the ESM would reduce Spanish debt levels.
Greece: Discounting a 'Grexit'
As for Greece, several of the financial world's prominent euro doomsters have been compelled to moderate their "Grexit views." Citibank, which coined the "Grexit" term in May, said it was a 90 percent sure thing by early 2013. The giant bank, which is going through its own internal turmoil, is now saying it is only 60 percent sure of an exit by the first half of 2014. Crow can of course be eaten in many ways. Citibank and its euro doomster peers are still completely wrong. One need only read the euro area leaders' communique [pdf]:
We welcome progress made by Greece and the troika towards reaching an agreement on the policies underpinning the adjustment program and look forward to the conclusion of the ongoing review. The Eurogroup will examine the outcome of the review in light of the troika report and will take the necessary decisions.
We welcome the determination of the Greek government to deliver on its commitments and we commend the remarkable efforts by the Greek people. Good progress has been made to bring the adjustment program back on track. We expect Greece to continue budgetary and structural policy reforms and we encourage its efforts to ensure swift implementation of the program. This is necessary in order to bring about a more competitive private sector, private investment and effective public sector. These conditions will allow Greece to achieve renewed growth and will ensure its future in the euro area.
This is not language signaling a Greek exit at any point. Prime Minister Antonis Samaras' government has been accepted as the least bad political option in Greece. The euro area knows it must deal with him. The true risk today of a Greek departure from the euro area has effectively dropped from a very low probability to zero!
Whatever the Troika (the European Union, the ECB, and the International Monetary Fund) says for political consumption in various world capitals, the political reality in Greece is that future missed deficit targets (of which there will likely be many) in a country that has already suffered a 20 percent cumulative decline in GDP will not be sufficient political reason to cut off funding. This is the most important practical outcome of the IMF World Economic Outlook's recent box on the size of fiscal multipliers [pdf].
A political decision has accordingly been taken in the euro area (not least Berlin) that it is cheaper politically and financially to keep Greece in the common currency. This does not mean that the process will be smooth, that drama can be avoided, or that Greek debt is sustainable. But it means that Greece stays in the euro. At some politically expedient point, euro area governments will agree to restructure its debt to ensure that it stays. Indeed, the upcoming IMF Debt Sustainability Analysis (DSA) for Greece can easily be made to show this politically desired outcome. It can do so by assuming a growth rate here, privatization proceeds there, and an end-year beyond 2020.
Spanish Elections: A Win for Rajoy
In Spain, Prime Minister Rajoy managed to win the Spanish regional election in his native Galicia, while his Peoples Party (PP) did about as bad as expected in the Basque Country. He thus dodged a regional political bullet. Several takeaways from these Spanish regional elections provide political comfort for Rajoy, not least the dismal showing of the Spanish Socialist Party, which lost heavily on both regions. If the Socialists cannot profit from voter dissatisfaction in the current economic climate, they have an obvious political leadership and platform problem.
The voting suggests that the Spanish population grudgingly accepts Rajoy's austerity policies, despite the general strikes by labor unions. Hobbled by 25 percent unemployment, Spain is nonetheless not limping towards a social explosion. The country will remain governable for the four year duration of Rajoy's term, allowing for an eventual return to growth. Second, the fact that his political opposition is channeled toward regional parties (rather than the national center-left/left parties) will enable Rajoy to position the PP as the party of Spanish unity, a more desirable political platform than being labeled the party of austerity and unemployment. Rajoy is likely to be comfortable embracing that identity in the upcoming Catalan elections in late November.
The election results will also likely reduce the political price of Rajoy approaching the ESM/ESB for help in lowering the cost of capital for the Spanish government and private sector. As discussed earlier here on RealTime, it therefore still seems likely that such an approach will occur in November.
Germany: A More Confident Merkel
The opening shots have started in the German election campaign. Merkel was attacked by the Social Democrats' (SPD) candidate for chancellor, Peer Steinbrück, over her European crisis policies. Importantly, however, he criticized her for timidity and an unwillingness to help other euro area members in distress. Indeed, Steinbrück said from the Bundestag podium that Germany and other euro area members "will have to take over more Greek commitments."2 So the principal political clash over Europe and the euro between Germany's two largest parties will be over how much more Germany should do, not less. This is unambiguously good political news for Europe.
Of equal importance, Merkel spoke at the annual conference of the Bavarian CSU party, winning a sound endorsement for her tough love approach in that alleged hotbed of euro skepticism.3 She also made an emphatic case for the euro as a political project, in which Germany must continue to play its role and provide financial assistance to other euro area members in return for necessary economic reforms. There is consequently no real political threat to Angela Merkel on her right flank when it comes to European policy.
The often repeated charge against Merkel is that she has not prepared the German electorates for upcoming further financial costs to Germany. But that charge is increasingly not true.
With the SPD's more positive position on Europe and the lack of a challenge on the right of the CDU for Merkel, whoever wins the elections in Germany in September, the current de facto grand coalition between the SPD/Greens and CDU/CSU on European policy in Germany will continue. Continuity in German European policy is certain. This is also important because major steps forward in European integration will likely require a change in the German constitution and approval in a popular referendum. Agreement by all the main parties is thus essential.
The hordes of New York and London-based economists are mistaken yet again on their political predictions. The German political system has provided the critical though conditional political and financial support for the euro area, and it will continue to do so in the future.