The Four Key Issues that are Dividing Europe

Currency in Crisis

The ECB settled the purchase of almost 8 bln euros of sovereign bonds in the past week. This is a noticeable increase from the almost 4.5 bln euros settled in the prior week and it has managed to push Italian bond yields back below 7%. Nevertheless, funding pressure (the cost of swapping from euros to dollars, for example) remains elevated and the pressure on European bond markets have broadened to include core bond markets of France, Austria and Belgium, where the spreads over bunds are their widest since EMU began.

A solution in Europe remain elusive for a number of reasons, but one that seems under appreciated is that German and French interests and views are diverging. There are four main issues that divide them and by extension Europe. Germany and France are the two pillars of EMU and their disagreement reflects a larger split in Europe.

First, there is a disagreement about whether the ECB should be buying a significant amount of European bonds. Buying even small relatively modest amount of European bonds, less than 200 bln euros all told has seen to ECB members resign in protest (Weber and Stark).

Some have argued the ECB should act as a lender of last resort. We argue it is the lender of last resort to banks, not to sovereigns. As the BOE's King noted last week (courtesy of the FT) as he supported the BBK's stance, lender of last resort cannot be used to justify the purchases of sovereign bonds (and the purchases, he argues, are funding current account deficits. "And that is why the European Central Bank feels, I think--and with total justification-- that it's not the job of a central bank to do something which a government could perfectly well do itself, but doesn't particularly want to admit doing."

Second, there is a disagreement over whether the ECB should declare that is it buying bonds for an extended period or unlimited amounts. Some countries, led by France, but includes several others, appear to want to some pledge by the ECB. However, the disagreement over the first issue makes this issue contentious, to say the least.

Third, the ECB currently sterilizes its sovereign bond purchases. Some want the ECB to refrain from doing this. This is to embrace quantitative easing more directly. The ECB, Germany, and several other countries resist such pressures. France appears to be more sympathetic to QE.

Fourth, there is a dispute over whether Greece is a unique event. In particular, the issue is if the private sector will share in the adjustment process in other peripheral debtor countries. Part of the reason that the "voluntary" haircuts were acceptable for Greek bonds was the apparent signal from European officials that a haircut is not being contemplated in the other countries.

France and most of the peripheral countries want Greece to be unique event. Germany and others seem to be on the other side of the issue. As recently as last week, German officials were talking about private sector participation in the future. That is, after all, one of the functions of the European Stabilization Mechanism (ESM), when it comes into existence.

When will European officials provide the closure to the debt crisis? When will they deliver a comprehensive solution ? When German and France agree on this fundamental issues. Until then, the risks are asymmetrically on the down side.