Aug 7, 2012
Ten days ago, when predicting what may and likely will be the outcome of the August ECB announcement, we said that it is virtually certain that it will follow in the trailblazing footsteps of what Mario Monti did at the June 29th meeting. To wit: “The bottom line here is that Draghi most likely pulled a Mario Monti (and his hanger on Mariano Rajoy), and spoke up before pre-clearing with Buba’s Weidmann. Draghi thinks that, like Monti with Merkel at the June 29 summit, he can bluff the Bundesbank into submission, and Germany will agree to monetization, especially if markets have risen enough where nothing out of the ECB next week leads to a market plunge. The problem is that as we patiently explained, Monti got absolutely no concessions our of Merkel, as was seen in the bond yields of Spain after the June 29 summit.” Sure enough, the market soared in the days after June 29 as well, giddy with optimism that Germany would never settle for being bullied publicly and had implicitly agreed with the Monti and Rajoy. Euphoria promptly turned to despair as it became quickly clear that Monti had bluffed without preclearing with Merkel and Buba. Fast forward one month, and what we expected to happen is precisely what did happen.
The WSJ explains.
During an all-night European summit in June, Mario Monti, the Italian Prime Minister, gave German Chancellor Angela Merkel an unexpected ultimatum: He would block all deals until she agreed to take action against Italy’s and Spain’s rising borrowing costs.
Ms. Merkel, who has held most of the euro’s cards for the past two years, wasn’t used to being put on the defensive.
“This is not helpful, Mario,” Ms. Merkel warned, according to people present. Europe’s leaders were gathered on the fifth-floor of the European Union’s boxy glass headquarters in Brussels, about to break for dinner.
“I know,” Italy’s premier replied.
The nine-hour confrontation between Italy and Germany that night led to a compromise that wasn’t the sweeping action Mr. Monti wanted. But it has helped pave the way for a possible intervention by the European Central Bank to stabilize the teetering bond markets of Italy and Spain—a high-risk step that could be Europe’s last chance to save the euro.
The Italian-German conflict has also exposed a deep philosophical fissure at the heart of the euro zone: Are painful reforms and austerity in countries such as Italy and Spain enough to restore confidence in the common currency, as Germany has insisted? Or do they need Europe’s collective financial support while they fix their economies, as Mr. Monti argues?
And therein lies the rub: Germany, which arguably got the long end of the Eurozone stick for a decade and now has the best economy (albeit rapidly deteriorating, which as we explained before is why the periphery’s leverage is collapsing with every passing day), got the best deal of all European nations. As such, it is relatively easy for it to preach fiscal responsibility, reform and austerity: after all it itself does not have to succumb to what it preaches.
The periphery on the other hand, realizes that it is unable to engage in painful bouts of fiscal reform: by the time any one cycle is complete, the electorate will be so furious, the politicians in power will have been long swept away, replaced by socialists and other anti-austerians, who will undo everything that has been done (see France). Thus, for them the motivation of game theory is vastly different: short-term stop gap measures at all costs, while praying a Deus Ex Machina appears on the doorstep and fixes all problems. Naturally such a thing will never happen, but when it comes to the mechanism to provide short-term bridging, it is precisely the one that Germany is disinclined to pursue: the ECB’s, and the threat of runaway inflation.
After all, recall that it was 4 short months ago that Europe saw all time record Brent high priced in EURs. All it will take for a continent-wide spike in inflation will be another LTRO, or some other ECB intervention.
Germany knows this, and it knows very well that from the periphery’s point of view this form of Apres Moi, Le Deluge makes perfect sense, even if it means destroying the quiet, cozy lifestyle of 80 million Germans. It also knows that stopgap measures will achieve nothing, will not resolve Europe’s fiscal problems, and that all such interim steps are for nothing.
What it also knows is that it is best to give the impression that the periphery has “won” if it means delaying the inevitable day of Eurozone unwind, even if it means losing face in the court of popular opinion if only for a week or two.
Because as we will not tire of saying, for Germany the only upside from now until the inevitable unwind, funded via Bundesbank’s sunk TARGET2 liabilities to the tune of €1-2 billion/day, is to keep pressure on the EUR and see the European currency get weaker at any cost: after all boosting its private, export-driven sector is the only trade off Germany has to funding Europe’s unrepayable current account deficits via public funds. Even if it means appearing to be bluffed out month after month by Europe’s beggars who are now consistently choosers.
Neither Monti, nor Draghi grasp, that even in a game of Mutually Assured Destruction, ultimately he who has the gold, and the best prospects for survival at Day T+1 is who orders the music.
Last week, ECB President Mario Draghi disappointed markets’ hopes that the bank would act right away. But he said the ECB “may” soon buy bonds of crisis-hit countries that meet certain conditions established by European authorities.
“If I were Draghi, I would feel morally and politically protected in making bold moves at the right moment,” thanks to the June 28 summit outcome, Mr. Monti said in an interview soon after the summit. In a conversation on Monday, Mr. Monti described Mr. Draghi’s comments last week as a “bold move” that is starting to define the “operational terms” of the late-June summit.
Mr. Monti didn’t comment on Mr. Draghi’s condition for ECB aid—that Italy and Spain first apply for bond-market support from Europe’s bailout fund and sign a list of economic-policy promises. Such a move could be politically risky for Rome and Madrid, since it would likely be construed as tantamount to a loss of national sovereignty.
Monti’s assessment of the situation is precisely what we said would happen back in May of 2010 with the first Greek bailout: soon everyone would realize that they can push Germany until the breaking point, but not any further.
“What we ask is that European authorities certify Italy’s good conduct by translating that into interventions to keep spreads within reasonable limits. I have often told Merkel that, if this isn’t done, she risks finding herself before an Italian parliament that repudiates Europe, monetary stability and the euro and is not friendly toward Germany,” he said.
And as we showed over the weekend that breaking point may be arriving faster than anyone expected:
Ms. Merkel, through her spokesman, declined to comment for this article. Yet senior German officials admit Mr. Monti has a point. Investors are fleeing Italian and Spanish debt, even though Rome and Madrid are shaking up their economies. That means Europe needs to do more to help its two large Southern members. But the cautious chancellor fears massive bond-market intervention could trigger a political backlash in Germany—and might not work, according to people familiar with her thinking.
The cognitive bias got so bad even Obama got involved:
Contrary to the bailout fund’s present rules, Mr. Monti didn’t want Rome and Madrid to suffer the stigma of applying formally for aid or signing a list of policy demands written in Brussels, fearing this would undermine his public standing at home, as well that of his ally, Spain’s premier Mariano Rajoy.
At a late-night discussion in Mexico with key European leaders, U.S. President Barack Obama supported Mr. Monti’s plan, according to people present. But Ms. Merkel dismissed the idea. Over the past two years, she had justified financial help for other euro nations to skeptical German voters by promising there would be a quid pro quo of tough, internationally supervised reforms. Now Italy wanted Germany’s money with no strings attached.
Mr. Obama couldn’t talk the euro-zone leaders into agreeing.
Mr. Monti didn’t give up.
Here, as we showed over the weekend, is where the weakest link of the ECB plan is: it will mandate that Spain and Italy throw in the towel sooner or alter, and demand a bailout. Because the central planners’ attempts to make discounting future events irrelevant and offset purely by loud speeches and even louder promises is doomed to failure.
Yet the events of the evening of June 29 is precisely why not only the ECB, but the entire European experiment will fail:
The evening before the meeting, Mr. Monti hatched a plan to hijack the summit. Unless Ms. Merkel accepted his proposal on bond-market intervention by Europe’s bailout fund, Mr. Monti would veto the growth pact—stymieing Ms. Merkel in her parliament.
Italy had previously lobbied for the growth pact, so Mr. Monti’s threatened veto—announced just before Europe’s leaders were due to sit down for dinner—was a bombshell.
“But we need this result this evening,” Danish Prime Minister Helle Thorning-Schmidt said about the growth pact. “This is a dark moment,” EU Commission President José Manuel Barroso said.
The summit was at an impasse. French President François Hollande briefed reporters on the closed-door events, adding that he sympathized with Mr. Monti’s stance.
Mr. Monti’s blockade lasted until 4 a.m., when leaders finally agreed to a text hashed out by their aides. It promised that Europe’s bailout funds would be used “in a flexible and efficient matter” to stabilize the bond markets of vulnerable euro members.
It didn’t go as far as Mr. Monti had originally wanted: Italy and Spain would still have to apply for any aid and sign a policy memorandum. But by planting the need to stabilize bond markets in the declaration, Italy had convinced Germany to recognize Italian reform efforts and pushed its approach for tackling the crisis into the spotlight.
We have bolded the key word above: “hijack.” That word makes total mockery and sheer irony out what is now the biggest oxymoron in existence: European Union. Because one can not hijack a union. One can not force, bluff or otherwise intimidate borderline willing partners who rightfully believe they are being taken advantage of into submission. It just doesn’t work : it certainly didn’t work then…
Markets weren’t fooled for long. Italy’s borrowing costs rose to as high as 6.6% in late July, in new signs that investor demand for Italian debt was shriveling. Skeptical investors know the euro zone’s bailout funds aren’t big enough to prop up Italy’s huge bond market on their own.
…And it won’t work this time. Only it will be Monti’s this time oddly prescient words that will finally release Europe from the shackles of an experiment that is becoming hated everywhere, both at the core and the periphery:
“I have no doubt that the night before the disintegration of the euro, the ECB will do whatever is necessary to save it,” Mr. Monti says. “The question is: Do we need to get to the night before?”
Goldman’s alumni Mario Draghi and Mario Monti certainly feel the answer is no. After all there are bonuses for Goldman partners that can be paid only if there is visibility into the future. For Germany, the answer was, is, and will be a resounding yes as explained. The only problem is that, just like Hank Paulson showed, when the time to actually commit and act, the ECB’s action of “whatever is necessary” will be proven completely and utterly hollow and futile.
It will also be the moment of Europe’s salvation through fire: because after several years of acute pain, an entire continent full of “Icelands” will be reborn, even as America continues to stick its head ever deeper into the sand of denial.
This article was posted: Tuesday, August 7, 2012 at 3:14 am