Eurozone building blocks are falling into place

Germany's court decision seems to combine some of the country's worst nightmares, but it also lets the ECB rescue Berlin from earlier investments in troubled neighbours. It's a major building block in Europe's future.

FT.com

Today’s decision from the German Constitutional Court in Karlsruhe is a major victory for Angela Merkel and for Germany’s preferred approach to handling the eurozone crisis. The court has approved the ratification of the ESM treaty, with only minor conditions attached.

It looks like a comprehensive defeat for those trying to mobilise political opinion inside Germany to block the treaty. As a result, the ESM and the fiscal compact can now be safely launched, and any immediate obstacle to Mario Draghi’s bond buying plan at the ECB has disappeared. What has emerged from this messy process is, in effect, an ESM leveraged by the ECB, something which seemed impossible this spring.

This represents a very large building block in the rescue strategy which the eurozone has gradually pieced together in the last three months.

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The acute phase of the crisis peaked in mid June with the Greek election, which reduced the probability of a disorderly Greek exit.

Then, the eurozone summit in late June announced a roadmap for the long-term reform of the eurozone. Draghi was a co-author of the plan, and in retrospect it was a very important step, not least because he deemed it to be so.

These steps did not immediately settle the markets, and at times during July it seemed that the capital outflow from Spain would reach unmanageable proportions. However, at that point, Draghi crucially said that the ECB considered it to be within its mandate to eliminate 'convertibility risks' in the eurozone,  and that statement basically turned the crisis around. Since then, for example, Spanish equities have risen by 30 per cent.

The eurozone has now bought itself some time. But it is still very doubtful whether ECB action, along with the arrival of the ESM, will be enough to defuse the crisis on a permanent basis. The German strategy remains essentially an austerity strategy, and without growth it may still eventually fail in the ultimate court of democratic opinion.

Those who worry about this, and there are many of them, also worry that there may be limits to the willingness of the German political system to make the cross-border transfers which are inherent in the ESM/ECB support operations, especially if the troubled economies, following the example of Greece, fail to stick to the necessary policy conditions. The concern is that Germany might pull the rug on the eurozone rescue operation. Although this remains a possibility, it is now hard to see it happening before the 2013 election.

In any event, this would not be in Germany’s self interest. According to Dirk Schumacher at Goldman Sachs, Germany has accumulated net investment credits of €2,700 bn in other eurozone economies, mainly in the past decade. Of this, over €1,000 bn have been accumulated in the five most troubled economies:

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If the euro were to break up, these credits would instantly be devalued by some 30-50 per cent, imposing costs on the German private sector which are much larger than any losses which are likely to be incurred under the current and contemplated rescue programs. In this sense, Germany is not only rescuing other economies; the German public sector, and now the ECB, are rescuing Germany’s private sector from the consequences of their huge earlier investments in the troubled economies.

German politicians, led by Merkel, have never really tried to use this self-interested narrative to justify the support operations to their electorate (though finance minister Wolfgang Schauble has published estimates of the large output and employment losses which Germany would suffer in the event of a break-up). Instead, the political story has been one of 'feckless southerners' who need to adopt some financial discipline in order to deserve financial support.

This may partly explain why more than half of the German electorate said before today’s decision that they hoped the Constitutional Court would impose stricter limits on the ESM. Another reason is that the Bundesbank president is clearly having some popular traction with his campaign against the ECB’s bond buying program.

But the key is that Merkel is definitely not siding with Jens Weidmann on this question. From her point of view, the ECB’s balance sheet has come to the rescue at a very tricky time. It seems as if Draghi’s style as a central banker fits her re-election needs much better than Weidmann’s.

There are some ironies in all this. By setting limits on the size of the ESM well below the potential calls on its resources, the German government has in effect forced the ECB to use its balance sheet to make the cross-border transfers which the political process has balked at. Although the ECB claims that it is not bailing out governments through monetisation, which was the reason it originally declared proposals to leverage the ESM to be against the treaties, it has ended up doing almost exactly the same thing. It will now increase its balance sheet to buy government bonds, alongside the ESM’s activities. What is the difference between this and a leveraged ESM? Not much.

And why is Merkel supportive of the current plan, while she was against the leveraging of the ESM? The answer is political saleability, both to the electorate and to Karlsruhe, which has declared the ECB to be outside its jurisdication. As a result, Germany has ended up with a plan which seems to combine some of its worst nightmares, including the monetisation of deficits and the underwriting of its share of some very large ECB support operations, over which it has little or no control.

This will cause a great deal of political griping, and noise from the Bundesbank, but it will find little voice among the main parties before the 2013 election. For as long as Merkel believes that she has found the right strategy to win re-election next year, which she does, it is hard to believe that Germany will pull the rug on the eurozone.

Copyright the Financial Times 2012.