Ten Observations on Europe

Currency in Crisis

1.  The fact that access to the EFSF/ESM requires unanimous approval from the seventeen participants means that Merkel preserved the German veto.  This circumscribes the victory claimed by Hollande, Monti and Rajoy.   Germany also successfully resisted pressure to increase the size of the funds, even though many, if not most, observers suspect they are not be sufficient.   There was no agreement to give the ESM a banking license, which is another way resources could have been boosted.    

2.  It is unreasonable to expect the ECB to be the bank supervisor in Europe.  It does not seem to welcome this role.  Instead, what is likely to emerge is the ECB becomes the supervisory of systemically important banks.  The problem with this formulation is that, depending on the definition of "systemically important", Greek banks, possibly all of Ireland's banks, and most of Spain's banks, including Bankia, would probably not fall under the ECB's supervision.

3.  The fact that EFSF/ESM will not claim seniority status in Spain is interesting but not very convincing.  The ECB and the EFSF did not claim seniority status when the loans were made.  The willingness of European officials to innovate, which in part means making up the rules as you go along, means that investors cannot be sure that this is an ironclad decision.  

4.  Allowing the direct recap of banks rather than going through the sovereign is not a defeat for the creditors.  Access still must be formally requested, must be agreed upon unanimously, and will come with conditions, codified into a memorandum of understanding.    This is not so much a retreat by Germany as a replication of the creditor/debtor debate in a new terrain.  

5.  The deal for Spain could help Ireland by shifting some of the government's bank obligations to the EFSF/ESM.  However,  Merkel, with pressure from the Social Democrats, appears to be insisting that access to the EFSF/ESM requires support for other efforts to boost the area's integration, include the Financial Transaction Tax.  This puts Ireland in a difficult position.  It would put Irish banks at a competitive disadvantage, as the UK will not adopt the FTT. 

6.  Monti may herald the summit as a victory, but the real, material concessions seem few.  Saying there was an agreement helped push Italian rates lower.   Monti had been facing increased criticism as rival parties jockey for position.   Monti's domestic pressures were reportedly a factor encouraging some face-saving compromise.  Yet, more important for Monti was the fact that his labor reform package overcame four votes of confidence to be approved by parliament. 

7.  In Spain, five months into the year and central government deficit is nearly at the annual target.  Most of the estimates of future financing needs are not taking into account the fiscal overshoot that is already largely backed in the cake.  Monti was able to report better news.  The state sector registered a 5.8 bln euro surplus in June compared with a 1 bln euro surplus last June.  The first half deficit  was a little over 29 bln euros compared with almost 44 bln a year ago.  One of the costs of the austerity is the economic contraction.  Italy's June PMI, for example, was the 11th month below the 50 boom/bust level.  The forward looking new orders component has been falling for thirteen months. 

8.  Many observers claim that Germany is isolated, but we continue to argue that this is a misreading of the situation.  The crisis has weakened old relationships, for sure, but has strengthened the "cash nexus".  The creditor countries face a similar threat in the crisis.  The debtors outnumber the creditors and want what the creditors have.  Democratic institutions and processes give the more numerous debtors leverage over the creditors.  Finland and the Netherlands are taking a tougher stance than Germany.  They can less afford the losses that may eventually have to be borne than Germany.   

9.  Attention shifts to France ahead of the ECB meeting.  The audit that Hollande has had conducted since he took office has reported its results.  He must deliver 7.5-8.0 bln euros in savings in order to meet the 4.5% deficit target, down from 5.2% in 2011.  Prime Minister Ayrault will outline how the Socialists, which dominate the French government (presidency and both houses of parliament), will plug the hole.   The fact that Hollande remains committed to the targets Sarkozy had agreed upon says something about his degrees of freedom.  His "freedom" is to chose the austerity measures.    The early reports indicate the Socialists will rely heavily on taxes rather than spending cuts, even though the French state spending accounts for roughly 55% of GDP.  

10.  Hollande's support appears to have peaked.  The power that the Socialists have seems to outstrip their public support.  A recent poll showed Hollande's support has slipped to 51% from 58%.   Ironically, Hollande's ability to vocalize and press for the interests of the debtors depends in a great part on his ability to keep the wolf away from France's door.   Increasingly, as we have argued, sovereignty will go hand-in-hand with solvency.   The political calculations and the policy response to the crisis would also fundamentally change if Merkel and the CDU and turned out of office in next year's German election.  The SPD are more sympathetic, for example, of joint bonds.