This is what Mario Draghi said on the ECB press conference last week. Although the ECB has always emphasized the importance of budgetary discipline, Draghi’s insistence indicates that the ECB might be getting a little nervous about the eurozone’s shifting views on austerity. This would be quite understandable - to accomplish its mission to keep the eurozone intact (and itself relevant), the ECB needs clear and agreed policies on fiscal deficits and structural reforms. Differences of opinion about fiscal policies are dangerous - not only because of potential political animosity, but also because they could weaken the commitment towards structural reform. Especially since the main threat to the ECB succeeding is a Germany becoming less supportive of the euro.
Perhaps the most acute concern for the ECB is that less fiscal restraint by eurozone members would undermine the feasibility of a full banking union, including a cross-border resolution mechanism. Since Germany currently holds the view that the creation of such a supra-national authority to shut down banks is premature and unwise, the last thing the ECB needs is dissent on budgetary discipline to validate the German apprehension. The ECB cannot do without a proper resolution capability to complement its new supervisory responsibilities. Without it, individual governments might refuse to close insolvent banks or have a lack of funds to do so. ECB board member Yves Mersch has pointed out that supervisors cannot give objective verdicts on the viability of banks if they can only be closed in a disorderly way.
But the current state of affairs does not look very promising for the ECB. For the time being, Germany continues to prefer an approach where individual eurozone members remain liable for their own costs. Only when local funds are insufficient and only after an official request is made by a national government (i.e. after the surrender of sovereignty), is Germany prepared to step in. It’s the old story: Germany wants to avoid putting its taxpayers on the hook for the resolution of banks whose problems are largely caused by deficient policies elsewhere. When Germany has to ride to the rescue, at least it wants to control the process. In addition, Germany may also want to avoid any outside mingling with its own thinly capitalized banks.
Professional ‘insiders’ don’t seem to give the creation of a binding framework for cross-border resolutions much of a chance either. This is what Simon Johnson recently wrote in Slate after attending the IMF spring meetings in Washington (my emphasis):
Opening the door to more flexible austerity would also make the ECB’s OMT program politically (even) more difficult to deploy. Any ECB funding for a beneficiary country that would not be subjected to strict budgetary restrictions comes awfully close to the ‘verboten’ monetization of government debt. Given that the ECB is already seeing the bottom of its instrumental toolbox, a hollowing out of the OMT
Whether austerity is an appropriate policy or not, it is the political glue that has held the eurozone together until now. It was a simple common denominator that could be clearly specified and agreed upon, whilst providing political cover to governments for unpopular but necessary reforms. Most importantly, austerity complied with the fundamental political and economic beliefs of Germany. The moment the austerity doctrine is significantly watered down, the political cohesion within the eurozone will be diluted as well. This is particularly dangerous this close to the German elections with German politicians even more nationally oriented than usual - any showdown between Germany and countries demanding more fiscal leeway runs the risk of forcing an explosive existential outcome.
The Pandora’s Box of more fiscal flexibility has now been opened. Germany will tolerate an extra year here or there for countries to reach the three per cent deficit limit, but it is unlikely to go much beyond that. At the same time, the economic decay in the rest of the eurozone will continue, and so the pressure on Germany will mount, also by Brussels, to give more fiscal leeway to its fellow eurozone members. This will feed into the growing euro skeptic movement in Germany, that, unlike in most other countries, is supported by credible intellectual figureheads that carry a lot of weight (think for example of Hans-Werner Sinn, the President of the IFO Institute and, since recently, Oskar Lafontaine, finance minister at the time the euro was introduced).
Germany has principles and Germany has real options. The big market expectation is that a newly elected government in September will be more euro-minded than is suggested by the current rhetoric coming from German politicians. This remains very much to be seen. In the end, Germany faces a stark choice – either it accepts that it will be transferring money to the periphery for many years to come, or it leaves the eurozone and pays a price through a stronger currency and the recapitalization of its banks (including the Bundesbank). The debate on austerity is bringing the moment closer that Germany will have to make this fundamental decision. My expectation is still that Germany will opt for the ‘certainty’ of the past and will not accept the mutuality and unlimited liability consequences of a true monetary union.
If you take the view that the eurozone can only succeed with a full-fledged banking union and fiscal policies supported by Germany, it follows logically that the euro project in its current form is living on borrowed time. The years ahead will bring disorderly defaults of banks and possibly countries, with the bail-in danger for bank creditors depending very much on the nationality of the insolvent institution. Euro redenomination risk will rear its ugly head again; spreads between Bunds and peripheral debt seem way too tight.
Mayo42 signing off.