The Thermidor: Push Back Against Germany

European officials found a compromise between those wanting to allow the ESM to recapitalize banks directly, until the bank financed resolution funds has adequate resources, and those that who were opposed.  German opposition was most vocal and the compromise was to allow the German parliament veto power over any direct aid from the ESM. 

Others may find comfort in the Bundesbank's monthly report that appeared to endorse the ECB's accommodative stance, despite reports suggesting that BBK President Weidmann and Asmussen, the German representative on the ECB's Executive Board, opposed the recent rate cut.  

Yet, below the surface, there appears to have been a shift in the balance of power between the creditors and debtors in the euro area.   First, the EC and ECB joined forces to defeat the German push to exempt the landesbanks from the ECB's regulatory authority.  

Germany can argue that the landesbanks are not systemically important, but this is to give too much credence to the superficial populist coverage as opposed to the more rigorous analysis.  Much ink has been spilled on too-big-to-fail.  While there is much to be concerned about, the fact of the matter is that in the euro-area, the substantial threats emanated not from the TBTF, but from the smaller, arguably, less supervised banks, such as Allied Irish in Ireland, the cajas in Spain and Laiki in Cyprus.  German regional banks have received among the largest bailouts in the euro area. 

Second, as noted, the ECB cut rates over German representatives' objections.  Compounding the injury with insult, the French representative on the ECB's Executive Board has been touting the possibility of outright bond purchases by the central bank.  Recall that in protest to the ECB's bond purchases under then-President Trichet, two German (Weber and Stark) ECBers resigned.  Weidmann has objected to Draghi's Outright Market Transaction (OMT) scheme, which while not deployed, has helped bolster sentiment and helped diminish the existential nature of the euro area crisis.  We do recognize that OMT was conditional on a program with the Troika and was not as subjective as Trichet's SMP effort. 

Third, the EC announced it would initiate a formal review of the German current account surplus, which is above monitoring levels.   This seems to have irked the German establishment more than the rate cut, which Asmussen assured that the real issue was only about the timing. 

The EC review follows on the heels of similar misgivings from the IMF and the US Treasury report on the foreign exchange market last month.  One of the perennial German fears, that of being isolated, has been borne out.  For its part, German officials see the current account surplus as evidence of its economic prowess and competitiveness.   

Others see the German surplus as a symptom of its compression of domestic demand, through miserly wage increases, reluctance to boost public infrastructure investment, and the failure to liberalize services.     Essentially, this view sees Germany as unwilling to offset the austerity in the periphery by pursuing more stimulative policies at home.  

This pressure on Germany reflects a shift in the balance of power in Europe.  Although France's Hollande is terribly unpopular at home, Brussels and the ECB seem to be taking up his charge in trying to get Germany to pursue policies that benefit EMU as a whole.  Separately, note that France will be selling bonds this week for the first time since last month's S&P downgrade (to AA) on Nov 8. 

France had wanted the ESM to be available to direct recapitalization of European banks if needed, especially following the ECB's asset quality review and stress tests.  Several of the creditor nations were reluctant, wanting national backstops, if banks could not raise capital through retained earnings and capital markets.  If those national authorities could not act as the backstop (again not too big to fail, but too big for national officials to aid), then it would have to accept conditionality associated with a memorandum of understanding with the Troika.  

An agreement before the end of the year was seen as important in order to give the European parliament sufficient time to approve it before dissolving ahead of next May's election.    The resolution mechanism needs to be in place prior to the results of the asset quality review.  Without it, the risk is that the reports trigger a new crisis of confidence.  The German ability to negotiate appears hamstrung by the lack of a government (CDU and SPD a moving toward a grand coalition government but it is not yet in place).  While the ESM will be able to lend directly to the banks, German parliament has retained the veto.  

This may look like a German victory, but it may not really be one. Consider a situation where Country X is in a crisis, and several of its banks no longer have access to the capital market.  The amount of funds it needs outstrip the sovereign's ability to deliver, without risking its fiscal objectives.  Many of the periphery countries want to it go to the ESM and relieve the pressure they may be feeling as well (collateral damage).  Would the German parliament really prevent this and risk a widespread crisis in Europe?   

With the UK re-thinking if it wants to be in the EU any more, and the US pivoting toward Asia, Germany can be the unchallenged hegemon in Europe.   However, it is finding it increasingly difficult.  We had anticipated that it would seek to exert its influence through European institutions.  Weber's resignation prevented Germany from taking the helm of the ECB.  In the more democratic institutions, it has been frustrated by the fact that a majority are debtors.