How to shift Germany out of 'can't do' mode
Comment of the Day

June 27 2012

Commentary by David Fuller

How to shift Germany out of 'can't do' mode

This is a very interesting column by George Soros for the Financial Times (subscription registration required, PDF also provided). Here is the opening:
At a meeting in Rome last Thursday, the heads of state of Germany, France, Spain and Italy agreed on steps towards a banking union and a modest stimulus package to complement the fiscal compact. But Angela Merkel resisted all proposals to provide relief to Spain and Italy from the excessive risk premiums prevailing in the market. This threatens to turn the EU summit this week into a fiasco that may well prove fatal because it will leave the rest of the eurozone without a strong enough firewall to protect it against the possibility of a Greek exit.

Even if a fatal accident can be avoided, the division between creditor and debtor countries will be reinforced and the "periphery" countries will have no chance to regain competitiveness because the playing field is tilted against them. This may serve Germany's narrow self-interest but it will create a very different Europe from the open society that fired people's imaginations. It will make Germany the centre of an empire and put the "periphery" into a permanently subordinated position. That is not what Ms Merkel or the majority of Germans stand for.

Ms Merkel argued that it is against the rules to use the European Central Bank to solve the fiscal problems of member countries - and she is right. ECB president Mario Draghi has said as much. There is a missing element in the current plans for the summit: a European Fiscal Authority that, in partnership with the ECB, could do what the ECB cannot do on its own. It could establish a debt reduction fund - a modified form of the European debt redemption fund that was proposed by Ms Merkel's council of economic advisers. In return for Italy and Spain undertaking specified structural reforms, the fund would acquire and hold a significant portion of their outstanding stock of debt.

It would finance the purchases by issuing European Treasury bills and pass on the benefit of cheap financing to the countries concerned. The bills would be assigned a zero-risk rating by the authorities and would be treated as the highest quality collateral for repo operations at the ECB. The banking system has an urgent need for risk-free liquid assets. Banks hold more than €700bn of surplus liquidity at the ECB earning only 0.25 per cent interest. This assures a large and ready market for the bills at 1 per cent or less.

Should a participating country subsequently fail to live up to its commitments, the EFA could impose a fine or other form of penalty that would be proportionate to the violation so that it would not turn into a nuclear option that cannot be exercised. This would provide strong protection against moral hazard. For instance, it would make it practically impossible for a successor government in Italy to break any commitments undertaken by the Monti government. Having practically half the Italian debt financed by European Treasury bills would have an effect similar to a reduction in the average maturity of its debt. That would make a successor government all the more responsive to any punishment imposed by the EFA.

David Fuller's view This is the best of the recent ideas that I have seen for containing the current crisis, as a necessary step towards the essential goal - if the euro is to survive - of a combined political, fiscal and banking union.

The pressure on Mrs Merkel, her Party and some of her Bundesbank advisors is intensifying within Europe but it also comes from the USA and some Asian leaders. All wish to head off a global economic crisis, which a disorderly break-up of the Eurozone could too easily trigger.

Some opposition to Mrs Merkel's stance is even coming from within Germany. A former colleague and Italian friend told me today that both previous Chancellor Gerhard Schröder and his Foreign Minister Joschka Fischer have contributed articles to Italian newspapers that are critical of the current German government's stance.

In conclusion, Mrs Merkel is being isolated and I would not be surprised to see her shift to a less doctrinaire stance in Eurozone discussions over the next few days. That would be progress.

Meanwhile, here is George Soros' conclusion:

The main obstacle is in German politics, which is mired in a "can't do" mode. Ms Merkel insists that a political union should precede a fully fledged fiscal and banking union. That is both unrealistic and unreasonable. The three have to be developed together, step by step.

There can be no treaty or constitutional clause preventing the establishment of the EFA if the German electorate as represented by the Bundestag approves it - otherwise there could have been no European Stability Mechanism. If the rest of Europe is united behind this proposal and the Bundestag rejects it, Germany must take full responsibility for the financial and political consequences.

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