Yves here. It’s astonishing to see Germany take active steps to wreck the Eurozone.
By Thomas Fazi. Originally published at Social Europe
In recent weeks, Germany has put forward two proposals for the ‘future viability’ of the EMU that, if approved, would radically alter the nature of the currency union. For the worse.
The first proposal, already at the centre of high-level intergovernmental discussions, comes from the German Council of Economic Experts, the country’s most influential economic advisory group (sometimes referred to as the ‘five wise men’). It has the backing of the Bundesbank, of the German finance minister Wolfgang Schäuble and, it would appear, even of Mario Draghi.
Ostensibly aimed at ‘severing the link between banks and government’ (just like the banking union) and ‘ensuring long-term debt sustainability’, it calls for: (i) removing the exemption from risk-weighting for sovereign exposures, which essentially means that government bonds would longer be considered a risk-free asset for banks (as they are now under Basel rules), but would be ‘weighted’ according to the ‘sovereign default risk’ of the country in question (as determined by the fraud-prone rating agencies depicted in The Big Short); (ii) putting a cap on the overall risk-weighted sovereign exposure of banks; and (iii) introducing an automatic ‘sovereign insolvency mechanism’ that would essentially extend to sovereigns the bail-in rule introduced for banks by the banking union, meaning that if a country requires financial assistance from the European Stability Mechanism (ESM), for whichever reason, it will have to lengthen sovereign bond maturities (reducing the market value of those bonds and causing severe losses for all bondholders) and, if necessary, impose a nominal ‘haircut’ on private creditors.
The second proposal, initially put forward by Schäuble and fellow high-ranking member of the CDU party Karl Lamers and revived in recent weeks by the governors of the German and French central banks, Jens Weidmann (Bundesbank) and François Villeroy de Galhau (Banque de France), calls for the creation of a ‘eurozone finance ministry’, in connection with an ‘independent fiscal council’.
At first, both proposals might appear reasonable – even progressive! Isn’t an EU- or EMU-level sovereign debt restructuring mechanism and fiscal authority precisely what many progressives have been advocating for years? As always, the devil is in the detail.
As for the proposed ‘sovereign bail-in’ scheme, it’s not hard to see why it would result in the exact opposite of its stated aims. The first effect of it coming into force would be to open up huge holes in the balance sheets of the banks of the ‘riskier’ countries (at the time of writing, all periphery countries except Ireland have an S&P rating of BBB+ or less), since banks tend to hold a large percentage of their country’s public debt; in the case of a country like Italy, where the banks own around 400 billion euros of government debt and are already severely undercapitalised, the effects on the banking system would be catastrophic.
We know for fact – despite the feeble reassurances of the eurozone’s finance ministers – that the banking union’s bail-in rule – for reasons that I have explained at length here – is already causing a slow-motion bank run on periphery banks, with periphery countries experiencing massive capital flight towards core countries (almost on par with 2012 levels), as bondholders and depositors flee the banks of the weaker countries in fear of looming bail-ins, confiscations, capital controls and bank failures of the kind that we have seen in Greece and Cyprus. Extending that same rule also to sovereigns would simply mean doubling down on a measure that is already exacerbating core-periphery imbalances and increasing (rather than reducing) the risk of banking crises. The risk is not limited just to periphery countries, of course, as the recent panic over Deutsche Bank testifies.
Moreover, the proposed measure, far from ‘severing the link between banks and government’, would almost certainly ignite a new European bond crisis – of which are already witnessing the first signs – as banks rush to offload their holdings of ‘risky’ government debt in favour of ‘safer’ bonds, such as German ones (as the German Council of Economic Experts report acknowledges, ‘as a result of the risk-adjusted large exposure limit, there is more leeway for holding high-quality government bonds than with a fixed limit’). The report estimates that banks will have to divest around 600 billion euros of government debt. As Carlo Bastasin of the Brookings Institution writes:
Sovereign bonds have a unique and pivotal role for the financial systems of the euro-area. So, once sovereign bonds in some euro-area countries become more risky, the whole financial system might turn frail, affecting growth and economic stability. Ultimately, rather than exerting sound discipline on some member states, the new regime could widen bond rate differentials and make debt convergence simply unattainable, increasing the probability of a euro-area break-up.
As noted by the German economist Peter Bofinger, the only member of the German Council of Economic Experts to vote against the sovereign bail-in plan, this would almost certainly ignite a 2012-style self-fulfilling sovereign debt crisis, as periphery countries’ bond yields would quickly rise to unsustainable levels, making it increasingly hard for governments to roll over maturing debt at reasonable prices and eventually forcing them to turn to the ESM for help, which would entail even heavier losses for their banks and an even heavier dose of austerity (which is the main reason that periphery banks are in such a terrible state in the first place).
It would essentially amount to a return to the pre-2012 status quo, with governments once again subject to the supposed ‘discipline’ of the markets (what Merkel calls ‘market-conforming democracy’), as if the 2011-12 sovereign debt crisis hadn’t made clear that financial markets are just as incapable of efficiently assessing and managing the public finances of countries as they are of disciplining or correcting themselves (which, of course, is why Draghi was ultimately forced to intervene with his bond-buying program). ‘We can’t allow a regime where markets are masters of governments… It [would be] the fastest way to break up the eurozone’, says Bofinger.