European Policy Shifting Before Key Elections

ECB President Draghi's support for a growth pact for Europe is important, perhaps under-appreciated by the market. This is not simply a tactic to deflect attention from the IMF's call that the ECB ease monetary policy further. Draghi is among the authoritative voices endorsing what some, mostly left of center, politicians, including the moderate socialist French presidential candidate Hollande, have advocated.

The ever politically adept Merkel recognizes the push toward a growth pact but will not allow Germany to be out maneuvered. While the growth pact may be on the agenda, she will aim to drive its shape. This is the way this level of European politics works.

The German notion of a growth pact will likely focus on structural, largely supply side reforms (take a look at the "Doing Business" series by the World Bank for examples). Yet those countries that are contracting, and to be sure they are not all limited to the periphery, will find little consolation in such a growth pact. Making it easier to start a new business, or making labor markets more flexible, as Spain, Italy and others are attempting, may not offer much succor to the rising unemployed.

The potential growth pact is the tip of the iceberg. Six months ago, we facetiously suggested that Europe take a page from the NY Mets baseball team. After hitting the least amount of home runs in major leagues, they moved in the fences. This ostensibly will make it easier for them to hit home runs (time will tell). We suggested that given the economic weakness, the euro zone should push out the time when fiscal objectives need to be met. Countries stay on the same path, but move along it more slowly.

The UK Telegraph, whose views on the euro zone typically are skeptical at best, reports that there is precisely this kind of discussion taking place now, either on a country-by-country basis or on an overall level. Making a blanket move may reduce the threat of a stigma, though the some of the creditor countries, like Germany (though perhaps not the Netherlands given their straits), are bound to resist providing such cover.

There is another initiative that has not made it onto the radar screens of many observers yet, but it will likely rise in salience in the coming week or two. The mid-May European finance ministers meeting will likely debate letting banks borrow directly from the ESM. This could be big.

As it is currently construed, only sovereigns can draw upon the EFSF and ESM. If banks could, this could be a vehicle for bank recapitalization that severs the problematic public-private sector linkage that is the bane of Ireland and the threat in Spain and Portugal.

Germany is likely to oppose. Like getting funds from the IMF, tapping into the EFSF/ESM necessitates conditionality, which often requires the sacrificing of sacred domestic cows (vested interests) and measurable reforms and performance reviews. If banks can borrow, would sovereign conditionality to apply? And if not, what does that mean?

One of the important governance moves in Europe has been toward qualified majority voting. This is part of what is behind the UK decision to opt out of the fiscal compact. When decisions are made unanimously, the UK wielded a veto. The shifting of more issues to a qualified majority basis, limits the ability of any one country to be an obstructionist.

This explains why the markets have not responded much to the Irish unions calling to reject the fiscal compact. Unlike earlier treaties, a rejection by Ireland will not in itself jeopardize the compact.

The decision to allow banks direct access to the ESM appears to fall into qualified majority voting bucket. This works against Germany. In fact, the qualified majority voting ironically is a force that may work increasingly against German interests. Its purse and economic prowess means it is more than the first among equals. Yet under qualified majority voting, its ability to defend its economic interests may be lessened.

Perhaps it is the qualified majority voting that offers the greatest check/counter-weight to Germany. Individually there appears to be no country in the euro area that can provide this function.