Open Europe: If Italy needs a bailout, sentiment in Germany will change

Pieter Cleppe from London based think tank Open Europe expects the ESM to get started despite growing political concern in several Euro countries. However, he thinks the ESM is too small to save the Euro.

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German Business News: Do you think that the ESM will come to existence at all? It seems thee is many uncertainties as a result from the last EU summit?

If Italy fails, Angela Merkel will have a lot to explain to the German public. (Photo: consilium)

If Italy fails, Angela Merkel will have a lot to explain to the German public. (Photo: consilium)

Pieter Cleppe: Unless the German Constitutional Court breaks with its tradition of letting eurozone bailouts pass, despite some tinkering at the margins, I think the ESM will indeed come into being. It is more questionable however if the changes to the ESM Treaty which were decided at the last Summit but which haven’t been implemented yet, will see the light, but also these I expect to be implemented. The first hurdle are the statements by Finland and Netherlands that they would veto bond purchases by the ESM, but the ESM’s emergency procedure allows decisions to be taken by 85 percent of the votes, so these countries will likely be outvoted. Secondly, for the ESM to directly finance banks, there is the condition however that a supervisory mechanism for the Eurozone is installed and that will take a year, according to officials, but eventually some deal will be brokered.

Southern Europeans want direct funding for the banks, Germany does not want that. As it is now – what can the ESM deliver?

It looks like Germany has given in here. European Commissioner Olli Rehn has now made clear that the ESM will take on its balance sheet the risk of the equity share it will acquire in rescued banks. Rehn thereby directly refutes claims by officials of member states that this risk would lie with the member state concerned. Still a deal on banking supervision need to be reached, of course.

The EU banking regulator is one of the conditions for Germany to agree upon bank aid: How can this brought into the existing ESM legal framework?

The version of the ESM Treaty which is currently being passed provides the possibility to provide aid to banks, but only through member states and with conditionality attached. They now want to change this by using article 19 of the ESM Treaty, which allows the ESM Board to review the list of financial assistance instruments provided for in Articles 14 to 18, but doesn’t allow to change article 12, which sets out the principles of the ESM. Those principles are that support can be provided to “an ESM Member subject to strict conditionality”, meaning it can’t be provided to a bank without strict conditionality. This position was also defended by legal advisors to the Dutch Senate, amongst others, but the Dutch government has made clear it wants to avoid a new parliamentary ratification.

Is Europe running out of time?

Not necessarily. So far, the European Central Bank has kept the eurozone together, through providing financing to banks in return for questionable government bonds as collateral, through its buying up of government bonds on the secondary market, through its massive LTRO operation and through allowing Greece, Ireland and Cyprus to make use of emergency liquidity assistance (whereby the central banks of these countries have been allowed to fund their banks for around 150 billion euro in total). On top of it all there is Target2. This has been instrumental to exposing eurozone member states, including Germany of course, for almost 500 billion euro to Greece alone. There is no reason why the ECB wouldn’t just continue with this in case a new emergency breaks out. At a certain point, the consequences of all this are likely to show up in either inflation figures or economic data and German political resistance can then be expected to increase.

Some analysts say Germany is winning all the time: At the summit they didn’t give away anything substantial. You agree?

No. Germany has clearly conceded that the ESM would be able to buy up bonds in practice, not only in theory, and that banks would be directly financed by the ESM. Of course there is always the usual discussion after every Summit on what has exactly been agreed, but how much clearer can it be?

After all the ESM is too small to bailout Spain and Italy. What needs to be done to save the Euro?

In order to keep the eurozone together, the current massive bailout commitments are still not sufficient. It can be estimated that to keep the eurozone together for only a few years, until the end of 2014, the bailout funds would need to be able to lend at least 2000 billion euro, given the refinancing needs of major periphery countries like Spain and Italy. At the moment, the combined firepower of EFSF and ESM will only be around 500 billion euro.

These massive fiscal transfers, whether they occur through bailout funds or Eurobonds, are however unlikely to do anything to make the currency union sustainable on the longer term. The money will only serve to pay unemployment benefits in the periphery countries. In theory those countries can pull off an internal devaluation, as Latvia has done, but in practice it looks like a very hard task.

Even then the problem remains that for the ECB it is virtually impossible to decide a single interest rate level which is optimal for a whole set of different economies, which has brought Spain and Ireland, who both have respected the stability pact, in deep trouble, with a real estate boom and bust leading to very high private debt levels. It’s of course possible that the eurozone economies would converge, but that didn’t happen in the last 10 years. Germany’s ageing problem which will strain its own welfare state will furthermore limit Germany’s economic ability to serve as a backstop for the whole eurozone. Therefore, in the longer term, it’s important to start a debate on which countries are able to share a sustainable currency union.

There is a lack of confidence in politics: Markets simply don’t trust the governments. Could this kill the ESM?

A lot of political capital has now been invested in the ESM, not just in Germany, so it is unlikely to be killed off just because it wouldn’t work.

Money funds are withdrawing from the Euro: Do you see the possibility that sovereigns run out of funding?

Unfortunately, that has already happened. Italy and Spain had to be rescued by the ECB in the Summer of 2011, meaning all of the 5 concerned periphery countries and Cyprus are now being taken care of. Italy’s financing needs on the short term are likely to be covered, but continued negative economic growth will put a serious strain on its budgetary situation. Italy still has a strong manufacturing base meaning big competitiveness reforms can accomplish there but it needs to do this in a very difficult context. If Italy fails and would need a full blown bailout, I expect the debate in Germany to change.

With the ESM structure there is no accountability, no transparency. Where will this lead to?

Several European Courts of Auditors have been criticizing the ESM as not transparent enough. This is a justified concern, given the fact that this institution will be able to decide on hundreds of billions of taxpayer’s money. Nevertheless, the ESM still looks too democratic to be effective. The decisions needed to stabilise the currency union clash with democracy: in Germany many people don’t want to pay, and in the South many people don’t want to listen to what others tell them to do. Who can blame them?


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