13 Feb 2012

Endgame II: Europe’s Faustian pact

So we now have a thumping vote in favour of the EU/IMF austerity package. Mass rioting in Athens. One in seven Greek MPs thrown out of their political parties. And a snap election set for April. On Wednesday Eurozone finance ministers should sign off Greece’s new bailout, and then the “voluntary default” for Greece’s bankers can be signed off too. But will they really stick to the promises made to the Troika amid the tumult of an election campaign?

As I said in Endgame (part 1), Greece has been cauterised. The decision made by politicians now needs to be backed by the Greek people at April’s election, if Greece is to remain in the single currency. Some of the words from likely PM Samaras, suggest a plan to renegotiate the deal in April.

He even suggested that MPs should vote yes to staying in the euro, because “eurobonds are coming”, even though Chancellor Merkel is implacably opposed to pooling Europe’s debts. In November the troika forced Mr Samaras to write a letter confirming he’d stick to the negotiated plan. The combination of electioneering and a five way negotiation still sounds pretty fragile.

To understand where this is going however, you need to get to know what exactly it is that Germany and those driving the EU are trying to achieve. A senior figure in Chancellor Merkel’s CDU party referred to it as “spreading the stability culture throughout Europe”.

1. This is not just about German sado-austerity. The “fiscal compact” is an almost pointless fig leaf in policy terms. But it is a piece of marketing aimed at northern voters. The more significant policy changes are the reams of changes aimed at bringing down unit labour costs in the Mediterranean economies. Germany sees this as exporting the “stability culture”, as Germany itself has cut such costs since the euro’s creation. That is why the adjustment measure in Greece stresses things like cutting the minimum wage by 22 per cent.

In Italy, Spain, Ireland, and Portugal too, we see a host of measures meant to cut labour costs. Many economists in Germany see this as fair, given the sharp 30 per cent rise in real labour costs in many of these countries since the creation of the euro. That is one part of the Faustian pact: on average labour costs surged in these nations during the boom years. One leading former ECB figure I spoke to last year was actually offended by that trend. Now they have to come down. A type of hell, to pay for the better times.

2. This is as a direct result of the perceived success in Germany of a series of reforms started by Chancellor Schroder, which saw average real wages in Germany fall. The Hartz IV reforms help explain why unemployment has nearly halved in Germany in the past five years. It’s not just about classic labour market flexibility.

Chancellor Merkel also used billions of euros of taxpayers’ money to keep people in work during the financial crisis recession. They reaped the benefit over the past year and a half with a boom during the recovery. The rest of Europe can, and is, copying these reforms – but they fundamentally mean lower real wages.

3. The Draghi bazooka known as the LTRO, will be repeated in a fortnight, again aimed at the eurozone banking system. The ECB is effectively pursuing a variant of QE. The LTRO’s effect is almost the same as QE. But importantly it is QE that does not look like QE to an inflation/debt/money-printing averse German voter/politician. (There is a difference: banks have to post collateral for these loans, but eligibility is very wide including all sorts of mortgage binds and corporate loans).

The fact that he has done this and cut interest rates twice within weeks of arriving as the ECBs Italian boss in Frankfurt, and that he’s done this without inviting a mass German revolt, is very impressive. Will Germany rebel eventually? The popular wisdom says yes – I say no.

4. The market is beginning to discern the G from the PIIS. Greece is in a separate division. My market intelligence has many of the hedge funds closing out their shorts of the euro in the sovereign Credit Default Swap market. The risk here is that Greece’s politics become contagious, and Portugal and Ireland ask for some of the same deal that Greece gets. The ECB will find a legal way to share the burden of the Greek bond haircut.

5. As we get to the end of the year the German elections in 2013 will come into focus. Watch German politicians such as Per Steinbruck, who have been withering about Merkel’s dithering. Watch out for who the German SPD choose as candidate for chancellor. They have suggested they are far warmer on eurobonds than is commonly suggested about Germany.

All roads lead to the German elections next year.  If it is clear that Europe’s sado-austerity is not working in Portugal, and Spain as well as Greece, then expect some form of eurobond. The euro will very much still be with us until then.

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