Shifting Agenda and Ideological Rigidities

Over the weekend, Germany's I.G. Metall reached an agreement with employers in Baden-Wuerttemberg for a wage increase that will likely set the tone for other regions and industries. The 4.3% pay increase covers the year from May 1. However, the previous contract expired at the end of March, so the new deal really covers 13 months, which puts the annual pay increase at just below 4%. Initially I.G. Metall demanded a 6.5% pay increase.

German officials, including Fin Min Schaeuble called for stronger pay increases. The I.G. Metall deal follows the Ver.di (the largest non-manufacturing union) deal that got state workers a 6.3% pay increase over two year.

The Ver.di deal is estimated to cost tax payers 7 bln euros, which is the same cost to employers the I.G. Metall deal if it covers all 3.6 mln workers. However, the degree that this boosts domestic demand rests on what workers will do with the pay increase. If it is used to boost savings, the direct impact may be minimal.

However, there is another channel to consider. Since 2007, nominal wage growth in Germany has average 1%, whereas the euro zone average is nearer 2.7%. Higher German wages can, if not offset with productivity gains, will boost Germany's unit labor costs. This is turn will help other countries become relatively more competitive. This rather than the BBK softening its anti-inflation resolve, as the Financial Times recently claimed, seems more promising. 

More broadly, the substance and tone of the political rhetoric from Europe is changing. For the first time, there seems to be a broad recognition the seemingly one-dimensional push for austerity has reached its political limits. Moreover, a bloc appears to have emerged that can check Germany. The leaders of this bloc appear to be Hollande and Monti from the heads of state and Barroso and Rehn at the EU.

It is all fine and good for Merkel to maintain that growth and austerity opposite sides of the same coin, and of course, she is right to some extent. However, they can also be sending opposite impulses and in short-run austerity can undermine growth. 

Midweek European heads of state meet. Hollande's election appears to re-opened issues that were previously thought to have been resolved. Hollande, like Sarkozy before him, apparently pushing again for a collective bond There is also new talk of allowing the ESM to recapitalize banks. It was intended that only sovereigns can borrow from the ESM with conditionality. The issue of a collective guarantee of bank deposits is also back in discussion.

However, Germany strategic interests have not changed. It cannot allow a collective bond without tighter fiscal rules, otherwise Germany is handing a blank check to its neighbors. Germany cannot allow banks to borrow directly from the ESM, because this would deny the ability to use the funds to ensure reforms are adopted.

There is room on other issues to compromise. We continue to believe that investors are not fixated on a particular fiscal target in a particular time frame. Ultimately, we believe investors are interested in a plan and a commitment to implement it. There is the political desire and legal scope to allow countries another year to reach the 3% deficit/GDP target. There is also room to compromise on the EIB, structural funds and even project bonds.

Investors must jettison ideas that renegotiation is grounds for expulsion. Greece is not the only country that seeks to renegotiate. Italy and Spain have already indicated they will not achieve this year's agreed upon targets. Indeed, Spain's news at the end of last week that its 2011 deficit came in at 8.9%, not the 8.5% it previously estimate and well above the 6% agreed upon target making this year's new target of 5.3% unlikely to be reached without additional herculean efforts. No one is talking of ejecting Spain or Italy 

Ireland wants to renegotiate the terms of its bank bailout, but there is no effort to eject it from EMU.   In the Netherlands, the latest polls suggest the tide is turning against additional austerity measures. Wilders' Party of Freedom participated in the previous government, yet he continues to object to what he calls "subservience to Brussels". There is no talk about forcing the Dutch out.  

Whereas the institutional rigidities in the euro zone are widely recognized, the key rigidity may be in the realm of ideology: the sanctity of contract. As the Keynes scholar Lord Robert Skidelsky (and professor Marcus Miller) reminded us in last week's op-ed in the Financial Times, this willingness to sacrifice everything in the name of contractual agreement bedeviled Keynes both at Versailles and later. In 1918 Keynes wrote that "We shall never be able to move again, unless we free our limbs from these paper shackles. Even stronger still, Keynes writes in 1923: "The absolutists of contract...are the real parents of revolution." 

We anticipated the corrective/consolidative phase in the foreign exchange market and expect it has not run its course yet. However, over the medium and longer term, we expect the euro's decline to resume--not only as the crisis grows, but a weaker euro will help in the resolution of the crisis as well.