Stockholm
The short-term direction of world markets has now become a bet on the true character of the
new ECB President Mario Draghi. As discussed here last week (GREED & fear – Action time?, 1
December 2011), the key issue for investors ahead of this latest EU summit is whether
sufficient consensus can be achieved on the path to fiscal integration to give the ECB an excuse
to start monetising debt. For such a move would clearly be as bullish for equities as it likely
would be bearish for the euro.
The reason why the character of Draghi has become all important is that it is clear that the
compromise agreed by Nicolas Sarkozy and Angela Merkel in Paris earlier this week does not
establish the groundwork for a credible fiscal union. For this reason a conservative ECB boss
would not view it as a reason to pursue debt monetisation. But if the ECB boss is a politician,
looking for an excuse to monetise, then the central bank’s reaction to the new agreement will
be different. Note last week that Draghi said more could be done from a monetary policy
perspective if a more resolute approach to fiscal integration was agreed. To be precise, Draghi
told the European Parliament in Brussels on 1 December that “a new fiscal compact” is
definitely the most important element to start restoring credibility, and that “other elements
might follow, but the sequencing matters. And it is first and foremost important to get a
commonly shared fiscal compact right”.
This leads on to the point why the latest Franco-German compromise is not really credible
assuming, as is likely, the same sort of deal is agreed at the coming summit to be held on 9
December. The main reason why is that the new framework is not so different from the
Eurozone’s old “Stability and Growth Pact” which proved such a failure in maintaining fiscal
discipline. The reason why it is not so different is because national governments will still have
the final say on budgets. The reason this is the case is because Frau Merkel has seemingly
backed off from her earlier demands that the budget rules be policed by a supranational body
like the European Commission or the European Court of Justice. In this respect, the clue as to
Germany’s more conciliatory approach is that Frau Merkel travelled to Paris to meet an
obviously delighted Sarkozy for their Monday meeting ahead of Friday’s summit.
This raises the issue of why Frau Merkel has agreed on the above approach. The answer, based
on the information gleaned by GREED & fear during a visit to Berlin last week, is lobbying from
Germany’s own financial establishment that the crisis in European banking has become systemic. This financial crisis also has a German aspect. To cite just one example, the current market capitalisation of Germany’s second largest bank, Commerzbank is only €7.3bn, and this is after a 21% rally from the recent low reached on 23 November (see Figure 2 in report).
True, the German demand for greater collective fiscal discipline will derive some comfort from
the agreement that each Euro state will be required to incorporate so-called “debt brakes” into
the constitution. The concept of a “debt brake” is borrowed from Germany’s own federal
system, where the debt brake essentially prohibits the Federation and the Länder from
borrowing to finance their budgets. This rule has been enshrined in Germany’s constitution. The
European Court of Justice will also be empowered to rule on individual countries’ behaviour in
achieving fiscal discipline. It is these sorts of points which may give Draghi the excuse if he is
looking for one to hail a so-called “fiscal compact”.
The other major development this week again involves a concession from Frau Merkel. She has
reportedly agreed that private sector bondholders, most notably Eurozone banks, will in future
not be compelled to take losses on their sovereign lending in the Eurozone, as they have been
in the case of Greece. This marks in GREED & fear’s view a massive retreat from the German
leader’s previous stance driven by moral hazard concerns, and also by demands from the left
wing of German politics that banks should take losses. Again, concern about financial sector
systemic risk appears to have driven this Merkel backdown. But it is, of course, much easier
asserting the principle that there will be no sovereign defaults than deciding who is ultimately
responsible for all the sovereign borrowings. And here the likes of Mr Sarkozy, and his friends in
the periphery, will be looking to Mr Draghi’s printing press to relieve them of the burden. Does
Frau Merkel really agree to that? GREED & fear doubts it.
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