Nothing fundamental has changed in the Eurozone. The region is sputtering, alternating between sluggish growth and outright recession. Inflation is below target and trending ever downward. Imbalances between surplus and deficit countries remain unsustainable. European banks are still stumbling along with unknown equity buffers, and it falls on the fiscally strapped governments of the periphery to backstop their own institutions. Austerity fails to deliver on debt reduction, since moribund economies can’t generate enough tax revenue, and the denominator in the debt/GDP ratio refuses to grow. So it has been, and so it is.
The only barrier standing between the current mess and a return to the sovereign debt crises of a couple of years ago is Draghi’s pledge to do whatever it takes to keep the bond vigilantes at bay. What has always been unknown is the extent to which this promise (Outright Monetary Transactions) is a false front. If there were new runs on the weakest sovereigns, would the ECB go on a buying binge to keep prices up? Germany has been explicit in its opposition to OMT, which it regards as illegal and, in its version of macroeconomic moralism, sinful. Still, financial markets were reluctant to take on the ECB for fear that Draghi would do what he said, and that bets against the sovereigns would not pay.
Nevertheless, the longer the bleeding continues in the EZ, the more likely it is that OMT will be tested. Greece, with SYRIZA spooking the moneyed class, is already seeing a runup in its interest rates, and contagion is not out of the question. The problem of the hour, however, is that the credibility of OMT hinges on Germany backing down in the confrontation over austerity.
Here’s why. Throughout the zone, governments are challenging the 3% cap on fiscal deficits. In the face of a potentially devastating triple dip recession, they have no choice. Moreover, the steady rise in the popularity of Euroskeptic parties aligns the politics with the economics. Bond issues will expand, and as they do, markets will wonder whether the rising debt still has Draghi’s backing, particularly since it will be in explicit defiance of Germany’s demands—and Germany, in theory, has the power to prevent Draghi from carrying out OMT.
Put this way, it all seems rather obvious: the cost of permitting a renewed run on the debt of weaker sovereigns is so great that surely Germany would have to back down, implicitly if not overtly. So one would think, and I hope this happens. But sometimes political commitments can take on a life of their own. Germany has clearly drawn a line in the sand, and the domestic credibility of Merkel—and her coalition partner, the SPD, as well—would collapse if she were seen to do an about-face. Up to this point, domestic German politics has entirely dominated external relations in German policy-making.
Given enough time and further economic deterioration in Germany itself (which will persuade business interests to demand a change in direction), I expect Germany to accede. The problem is one of timing. Here is the scary scenario:
1. Talks between Germany and the expansionistas break down. France and its Mediterranean allies begin expanding their fiscal deficits, while Germany publicly rebukes them and indicates that it will not permit the ECB to support “irresponsible” deficits with bond purchases. There is a temporary surge in support for Merkel within Germany, as she shows herself to be principled and tough.
2. Investors, sensing new weakness on the part of the ECB, start shorting sovereign debt, first in Greece, then perhaps again in Spain and, crucially, Italy.
3. The moment of truth for OMT, delayed for two years, now arrives. Either Draghi follows through or he doesn’t. To back up his pledge he needs Germany to go along. But Merkel has drawn a line in the sand, one which has overwhelming popularity at home, and if she allows Draghi to go forward she faces a political catastrophe. Moreover, neither the CDU nor the SPD wants to be the party that breaks ranks and allows the other to play the role of the steadfast defender of economic virtue. Germany says “no” and......
You can take it from there.
If you think such a disaster ought to be kept at as great a distance as possible, what you should hope for is that Germany backs down now, before a crisis materializes, and that serious attention is given to the underlying structural and institutional factors that make Eurozone finances so precarious in the first place.