European Update Prior to Impending German Elections


2013-07-24  By Dr. Harald Malmgren

The Euro crisis not only continues, but it is intensifying.  

The economies of the Eurozone are being sucked into deepening recession, rising unemployment, and collapse of public confidence in government.  Fiscal austerity policies imposed by the European Central Bank, the EU Commission, and the IMF are exacerbating the deterioration of the “European Project.”

National and local governments have become paralyzed, bereft of financially meaningful policy responses to counteract the downward economic spiral.  In several capitals, crumbling political coalitions have become plagued with allegations of corruption, ineptitude, and subservience to dictates of leaders of other nations and non-elected officials of the EU Commission, the ECB, and the IMF.  Popular support for greater European integration is falling.

In a world characterized by a growing array of regional political economic, and security crises, the Euro crisis is an important factor in reducing the ability and willingness of Europe to play a constructive role in dealing with crises on its borders in North Africa and the Middle East. 

The past quest for a meaningful European role in global security issues is being replaced by a more mundane quest for sales of European armaments to growing markets in other geographic areas, especially in Asia, Africa and the Middle East.

Since the world financial market crisis of 2008 and consequent global recession, the rest of the world has become accustomed to frequent meetings of Europe’s political leaders in managing one crisis after another.  Grand promises of action have frequently been followed by failure to execute, but each new meeting of leaders is somehow still expected to “fix” whatever failed after past meetings.

When three years ago European banking looked to be on the precipice of illiquidity and even insolvency, the ECB came up with a novel innovation known as “Long Term Refinancing Operations” (LTRO), allowing banks to submit securities as collateral in exchange for medium-term loans of cash.  As shortages of cash continued, the ECB permitted poorer quality collateral to be used for cash, and gradually the ECB accumulated a huge portfolio of collateral of questionable value.

When yet another crisis of financial market confidence erupted more recently, ECB President Draghi declared that the ECB “will do whatever it takes to preserve the Euro.“  These words somehow mollified profound anxieties about possible systemic failure of Europe’s banks.  He assured that “Outright Monetary Transactions” (OMT) would be provided on whatever scale might be needed, calming markets – even though OMT has not yet materialized because the ECB has been prevented from “printing money” by Germany and a handful of other cautious member governments.  As a result, OMT thus far must be interpreted as an ingenious “bluff”:  maybe the ECB will have the cards when needed, and maybe not.

Behind the heavily curtained relations among the world’s central banks, the ECB was assisted by “swap lines” provided by the US Federal Reserve, essentially exchanging dollars for Euros.

To meet dollar shortage in European business and banking transactions, these dollars provided urgently needed liquidity.  Moreover, European banks with substantial presence inside the US financial market were allowed to borrow directly from the Federal Reserve, becoming some of the largest borrowers from the Fed compared with Fed loans to US banks.  As a result, it could be said that the US Federal Reserve provided vital structural support to European banks without significant public attention to how the ECB and the banks were assisted.

In 2013 complacency seems now to have settled in as financial markets saw no alternative but to go with the continuous flow of assuring rhetoric emanating from the EU heads and their closely constrained ECB. 

Relations between European leaders have become frosty and dysfunctional as national governments struggle to keep their own voters pacified.  The President of the EU Commission seems to have lost credibility with national leaders as they sweep aside Commission proposals with obscure rhetorical reassurances of solutions promised to be in place “soon, but not yet.”

In parallel, the political and economic health of several core economies of the Eurozone is deteriorating. 

Unemployment is still growing in most of the Eurozone, with youth unemployment at or exceeding 50% in some nations, putting an entire generation’s role in society in question.

The economic and political outlook for Greece, Spain, and Portugal is increasingly uncertain.  In addition, it is becoming evident that Italy’s economy and banks will likely need some kind of bailout by the end of this calendar year.  Italian banks are not only exposed to bad credit conditions at home and deterioration of financial ties with France, German and Spain, but they are also exposed to growing risks ln nearby Central Europe, especially Slovenia, and in faraway markets like Argentina, which is hovering on another round of defaults.

It is also becoming evident that France’s budget deficit reduction plans cannot be achieved this year or next, and probably for some years after.  France is slowly sliding into a morass of recession, rising unemployment, inadequate funding to support its lavish social support system, and vulnerabilities of its highly leveraged, risky banking system which supports individuals, private businesses, and local governments.  It is realistic now to declare that France is likely to be the next Spain.

With the core economies of Spain and Italy looking likely to falter, and relations with deteriorating France fraught with growing antagonisms between Paris and Berlin, Germany may be left with no major ally in maintaining the integrity of the Eurozone.  Politically, Germany is gradually gaining dominance in political leadership of the Eurozone, with the only financial pockets deep enough to help its fellow Euro member governments.  However, the political resistance to German domination is rapidly rising in most other Euro nations.

In recent months, facing imminent national elections, Germany hardened its positions on the future of Europe, blocking virtually every new proposal for tighter economic or political integration.

German national elections in September are now only a few weeks away.   European August holidays are almost here.  Vital economic and political decisions within the governments of the other member nations of the European Union and the Eurozone are being put on hold in hopes that German elections will dramatically change the dynamics of Europe.

It seems that politicians and financial managers throughout Europe are looking for relief from Germany once its government is free of growing voter skepticism and dissent against providing further aid to Germany’s European “profligate” and lazy neighbors.

How differently will Germany behave after the elections? 

World press, media, and markets have innocently ignored the underlying legal and economic dynamics in Germany that will still stand in the way after elections are over, regardless of the composition of the new government.

The Bundesbank, Germany’s national central bank, will continue to oppose any aggressive bond purchases by the ECB.  The German Constitutional Court has already placed strictures on the freedom of action of the German Parliament to approve “transfers” of German taxpayer money to other EU nations.  Its reasoning has been that financial transfers among national governments are not permitted by present European treaties.

In its next determination expected in coming weeks or soon after the elections, the German Constitutional Court will likely circumscribe strictly the utilization of OMT by the ECB and any other form of “joint guarantee” of securities enabling provision of common Eurozone funding.

Ultimately, after the elections, the new German government will have to insist on “treaty revisions” to provide a legal basis for inter-government financial transfers of any kind among Eurozone and possibly EU members.

Agreement on treaty revisions would be politically difficult to reach among all Eurozone member governments.  Even if agreement could be reached, an accord would likely take several years to be established and then approved by all Eurozone or EU capitals.

New treaty revisions would have to permit comingling of national revenues and some greater degree of yielding of national sovereignty over fiscal policies.  One can envisage major battles between the UK and the rest of the EU over sovereignty issues, and an even greater battle between Paris and Berlin over loss of French political autonomy to its historic German rival.

In this context, OMT and other promises of aid to Eurozone governments and banks are empty promises – promises which markets seem to continue to believe in, but which have little substantive significance.

Eurozone banks are still resisting real transparency, higher capital requirements, mark to market valuations, stricter measurements of risk-weighted capital or possibly explicit leverage ratios, etc.  In spite of several “stress tests” of leading Eurozone banks, it is evident that ratios of capital to assets are woefully inadequate.

No Eurozone government wants real transparency out of fear that it will not only cause severe contraction of lending to the private sector but also severe contraction of lending to local governments throughout the Eurozone.  This is why the European governments, including the German government, are still resisting stricter capital requirements on banks that are being called for in the multilateral negotiations taking place under the so-called Basel III framework.

The US has just decided to press ahead with early implementation of much higher capital requirements on US banks, and on European banks doing business inside the US.  

This decision is aimed at dramatic reduction in the leverage of US banks.  What this means is raising much more capital, thus diluting present equity and bondholders, or shrinking lending, or some combination of both.

The leverage of US banks has already been scaled back, and is being further scaled back by implementation of the Dodd-Frank financial market reforms enacted by Congress last year.

Eurozone banks are far more leveraged than US banks.

Therefore, another imminent challenge for the Eurozone is regulatory shrinkage of many major European banks, competing for scarce capital while cutting lending to private businesses and local governments in Europe.

Thus, regardless of the German elections, the efforts of Eurozone leaders to reach agreement on a “banking union” will continue to fall short of the dreams of European elites. 

Instead, the only meaningful accord is that in future bank crises, shareholders, bondholders, and large depositors must share a large part of the costs of stabilizing or unwinding of troubled banks.  Coming onto financial markets still mired in European recession, the deleveraging and downsizing of European banks will not be painless.

For the time being, a major source of liquidity for Eurozone banks remains the liquidity provided by US money markets, shadow banking, and the Federal Reserve to their balance sheets.

If the world economy continues to weaken, and world trade fails to rebound, the Federal Reserve’s flow of liquidity for European banks and “swap lines” for European central banks will eventually come into political question inside the US.

US money market funds will soon be subject to much stricter regulatory limits.  Short-term funding of European banks and local governments through “repo” agreements will be cut as a result of likely tightening of US strictures on use and valuation of collateral.

Europe has suffered hard times since the global financial crises of 2007-08.  Even harder times lie ahead.