Three questions vex nervous financial markets/banks around the world: Is Frau Merkel?s belligerently vociferous departure from common sense temporary or permanent? Is she unhinged or deranged? Is typical Teutonic obduracy (the immovable object) colliding with immense pressure (the irresistible force) to accept the only solution that will extricate Europe from its dire predicament? That pressure comes from global markets and knowledgeable experts who have dealt successfully with debt crises before. Frau Merkel has not.
If she is unhinged momentarily, salvation may be at hand. Frau Merkel will say NO until she changes her mind and says YES?as she has done for two years! If she is deranged by what she confronts, then she may be about to trigger a recession that will hurt Germany (as emerging economic data suggest) and the EU, and last a long time. She will lose the next federal election for doing what she thought her electorate wanted; but trusted her to know better. Leaders are supposed to lead, not pander to, their electorates?a concept Frau Merkel is unfamiliar with.
In response to growing calls for the Eurobond solution, the German Chancellor has launched a vituperative counter-offensive, casting aspersions on the idea of swapping unwanted sovereign bonds for very much wanted Eurobonds?jointly/severally guaranteed by all Eurozone members and issued by a single Authority (call it EUROFISC for convenience). Such a swap would pacify financial markets and avert banking system failure in Europe and elsewhere.
Frau Merkel has denounced the idea as ?negligent?, irresponsible, untimely (i.e. premature) and likely to destabilise rather than stabilise the Eurozone and Euro. She believes Eurobonds will entrench a ?debt union? rather than a ?stability union??whatever that means. She has suggested that Eurobonds might not be constitutional ?when the EIB and EFSF are already issuing these ?unconstitutional? instruments. None of this makes any sense, except in the context of Frau Merkel playing at leading a Germany whose public does not wish to pay for the profligacy of its neighbours. That opinion may change when Germany finds itself in a recession of its own making by negligently beggaring all its neighbours.
What Frau Merkel does not accept is that she and Monsieur Sarkozy (whose country is now as vulnerable to a market-induced debt disaster as Italy) have failed. The attempts they have made to stem the Eurozone?s debt haemorrhage have made things worse. The good Frau refuses to stop digging after she has already dug Europe into a very deep hole. What Merkel & Sarkozy are trying to do now, to delay the inevitable, will not work either. They have not helped by coming up with daft ideas like imposing a levy on EU banks, introducing a financial transactions tax, and harmonising Eurozone taxes at Germany?s high rates rather than lower, more competitive ones. These ideas will kill Europe, not revive it when it is convulsing. If these are the gimmicks they think will work to get Europe out of its mess, it would be better if they stopped thinking.
All their previous attempts have been too little too late because they refuse to acknowledge what the problem is or how big it is. Consequently, they have made what was a manageable debt problem much larger and much worse. They have caused global markets and banks holding EU debt to realise that the peripheral PIG debt problem now infects the EU?s core: i.e. Italy and Spain, soon to be followed by France and Belgium (FIBS). If allowed to keep unravelling, global market concerns about EU sovereign debt unsustainability will endanger the Netherlands, UK and new EU countries (NUKES) as well. The process will not stop until all of Europe is put at risk, a number of banks collapse, and a long recession (possibly depression) ensues.
The problem is this: Peripheral PIGs owe less than euro 650 billion in aggregate. Core FIBs owe nearly euro 4.3 trillion. Other countries in the debt unsustainability danger zone owe a further euro 3 trillion. That amounts to nearly euro 8 trillion. EU countries in which public debt is sustainable owe another euro 3 trillion or so. Thus, 73% of the EU?s debt is ?troubled? and in danger.
If the problem were confined to PIGs, it would be manageable if not inconsequential. Haircuts of 30-40% would have to be taken. The ECB would take a heavy hit (for which Germany would pay disproportionately) for holding so much PIG debt. EU banks would have to write down euro 120 billion, and provide for another euro 50-60 billion on residual sovereign risk. That would weaken their balance sheets at a time when their share prices have been depressed to artificial lows (thanks again largely to Frau Merkel and Monsieur Sarkozy). Some banks would go under. They would find it difficult to raise new capital from existing or new shareholders. Governments are in no position to provide further public support for bank recapitalisation. They are all under severe austerity pressure (thanks largely to Frau Merkel).
As a result, the ability of EU banks to extend credits to existing and new customers for working capital or investment will be severely curtailed. That will translate into a sharp investment and consumption slowdown, the loss of more jobs throughout EU economies, the widening of public deficits that are supposed to be narrowed, and the reintroduction of uncertainty and risk in economic decision-making on the part of households and corporates that would reduce the EU?s present anaemic growth rate of 0.1% to -3% or so. In short, an implosive spiral will be triggered.
If that is what might happen when the debt of only the three PIGs is dealt with as it should be, then what will happen when the problem includes FIBS and multiplies eight-fold? Even if the haircuts that need to be taken in these countries are reduced to 20-25%, EU banks are in no position to take hits on their equity of over euro 1 trillion or provide for another euro 500 billion. The EU?s banking system will sink. No one will be able to bail it out. EU banks? share prices have fallen dramatically over the last month. Markets are clearly aware of the arithmetic. But it seems to be beyond Frau Merkel to fathom arithmetic at all.
Her political aversion to Eurobonds notwithstanding, the debacle now unfolding is like a train wreck occurring in slow motion. We watch helplessly while EU ?leaders? play silly rhetorical games. The wreck can ONLY be avoided if the increasingly high-risk, contaminated sovereign bonds that EU and global banks now hold are replaced by instruments that markets deem to be relatively risk-free. The train wreck is then stopped from occurring in its tracks.
Bank balance sheets are relieved of stress instantaneously. The need to write down capital or make further provisions disappears. Then banks need not constrain credit needed to keep economies growing, however anaemically. Recession and depression can be avoided.
Those are the stakes. But Frau Merkel appears not to comprehend the simplest rules in the most rudimentary game of poker being played. Instead she sees it as a war of politics vs markets. Being stoutly German, she refuses to do what ?markets? want. She seems oblivious to the reality that what markets want is what Europe desperately and urgently needs.
Though she is wrong about almost everything in condemning the ?Eurobond solution?, she is right about one thing. A swap of Eurobonds for national sovereign bonds cannot occur without strings attached. If such a swap is done?as it inevitably must, the only question being after how much more damage is done by Frau Merkel?s obstinate stonewalling?Germany must ensure the same fiscal discipline over national budgets of Eurozone members that it applies to itself.
Institutional arrangements must be put in place so that EUROFISC has the authority and enforcement powers to act as a Eurozone treasury. Eurobonds provide Frau Merkel with the opportunity she wants: i.e. to convert her ?debt union? into a ?stability union?. By dismissing Eurobonds, Frau Merkel is contradicting herself. She is bypassing the opportunity this crisis provides to put in place the structures of Eurozone-wide fiscal discipline that monetary union demands. As a US Treasury Secretary recently said, ?A crisis is a terrible thing to waste.?
Obviously such institutional arrangements cannot be put in place overnight. Left to the EU?s byzantine procedures they would take years to negotiate. But the debt crisis has put Frau Merkel?s Eurozone partners over a barrel. She can extract a swifter quid pro quo from them by agreeing to Eurobonds being swapped for their own debt. They would cede fiscal sovereignty to EUROFISC because they have no other choice. If they did not agree to such arrangements for budget-setting, surveillance, monitoring and enforcement of the kind that Germany would wish to see, for underpinning the creditworthiness of Eurobonds, they would face a future of no growth, growing unemployment, deteriorating competitiveness and indefinite austerity.
What is essential now is for Frau Merkel and the Eurozone to provide a clear signal to markets and banks that their investment in Eurozone debt (encouraged by political authorities earlier) is safe and will not need to be written down or provided for. Reciprocally, they could also assure markets that fiscal indiscipline and profligacy in the EU are things of the past. They would not recur. That would change the market?s mood. It would also change Europe?s prospects from a slow lingering death to hope and growth.
For the last two years, Frau Merkel, Monsieur Sarkozy and EU summiteers have said and done all the wrong things. They have destabilised markets every time they have met. They need to consider doing the opposite of what they have been doing so far; simply because what they have done has made things much worse. They might wish to consider keeping their more mendacious thoughts to themselves. They must realise that, instead of saying what is counterproductive, silence is golden. They must give markets a reason to support?and not punish?the EU and its banks for the risks/uncertainties that EU ?leaders? keep exacerbating instead of ameliorating.
The author is chairman, Oxford International Associates Ltd