Germany at Heart of Europe’s Political Predicament; Squaring the Circle; When is the Breaking Point?

Germany is at the heart of Europe’s political predicament. Although the status quoa cannot and will not work, there is no incentive to change.

Germany’s Constitutional Court has strengthened the Eurosceptics and eliminates further moves by Germany towards debt mutualization.

Some think debt mutualization, eurobonds, and combined fiscal budgets are a good idea. Others, like myself, don’t. Regardless, and as noted in Rethinking “Paper Tiger”, those options remain off the table.

What remains on the table are policies that fuel high unemployment and undermine living standards says Brigitte Granville in Poking the Eurozone Bear.










Germany’s Pyrrhic Victory

Also on Project Syndicate, please consider Germany’s Pyrrhic Victory by Marcel Fratzscher.

The German Constitutional Court has ruled against the European Central Bank’s pledge to buy potentially unlimited quantities of distressed eurozone countries’ government bonds, and has called on the European Court of Justice (ECJ) to confirm its decision. Until that happens, the “outright monetary transactions” (OMT) scheme is effectively dead, weakening the ECB’s ability to act as an effective and credible financial-market backstop at a time when European governments remain unwilling to fill the void.

How financial markets will digest the German court’s ruling remains uncertain. There may be little initial reaction to the news, as there is no immediate threat to financial stability in the eurozone. But the big question is how markets will react in the future to bad news, whether about sovereigns or banks.

The tight feedback loop between sovereigns and banks in eurozone countries has become even more salient in recent years, as banks are holding an ever-larger share of their home countries’ government bonds. The ECB’s impaired ability to address sovereign and currency risks means that it will have to break the feedback loop via the banks – a more difficult and less effective approach that increases the likelihood of a market panic and a deeper crisis.

The German court’s ruling jeopardizes the ECB’s ability to act as an effective lender of last resort, thereby reducing its independence and ultimately undermining its ability to deal with market panics and crises – and thus to fulfil its primary mandate of price stability. The ruling makes it more urgent than ever that European governments establish a viable and effective banking union and strengthen the ESM as a backstop for countries in crisis.

When is the Breaking Point?

Notice the silliness of Fratzscher’s last statement. He begs for a viable and effective banking union, when it should be perfectly clear the German constitution court won’t allow for one.

Eventually something is going to break, and most likely at the worst possible time. Yet no one can say when. Meanwhile the imbalances continue to grow as complacency rules.

Spain 10-Year Government Bond Yield

That decline in yield looks like a good thing. But it comes with a huge risk. Spain’s banks have plowed more and more into its own bonds. When yields rise, those banks are going to be in a huge amount of pain.

Here are some charts from Squaring the Circle.

Sovereign Bonds Held by Domestic Banks

Sovereign Bonds Held by Domestic Banks as Percentage of Assets

As long as yields decline, there are no problems. The crisis will be even bigger than before if and when yields rise. When that happens is anyone’s guess. That it will happen is a near certainty.

One way or another Germany is going to pay a huge price. Theoretically, there are two solutions.

  1. Germany can pay the price by debt forgiveness and mutualization of debt
  2. Germany can pay the price via default when the eurozone breaks apart

If Germany will not allow option number one, the only viable choice is option number two. It would behoove Germany and the eurozone to have this discussion. Instead, Merkel has her head in the sand.

Mike “Mish” Shedlock