The Euro-mess took another turn for the worse over the weekend following news that Standard & Poor’s has downgraded the debt of a flock of European countries, most notably France. Last night markets weakened across Asia as once again the rest of the world looked at Europe and wondered just how those people were going to get out of this debacle.
As Via Meadia readers know, while Franco-German politics are not the root cause of the eurozone’s woes, the deep division between Germany and France over the way a European monetary union should work is crippling the eurozone and has prevented a clear strategy from emerging to cope with the worsening, deepening and widening crisis.
France wants the ECB and the currency union to look like the French state writ large: a strong, centralized authority that supports the big corporations and banks at the heart of the French economy, eliminates the interest rate differential between Germany and France, and accepts external devaluation and internal inflation as reasonable ways to solve chronic budget and adjustment problems.
Germany wants a tight money policy for the eurozone, forcing reform and efficiency on “lazy” Club Med peoples through the impartial and predictable enforcement of firm and inflexible rules.
This is an old policy disagreement; what makes it important now is that overcoming the crisis in the eurozone requires Europe first to decide what kind of money it wants: a French or a German system. The danger of default, not merely in minor countries like Greece, but in large European economies like Italy and even, in a worst case scenario, France, pushes Europe toward answering the question it has long avoided: whose vision will shape Europe’s future?
The approach adopted so far is that when markets start to melt, the French and the Germans — sometimes alone, sometimes surrounded by a flock of lesser lights — meet, agonize, and emerge with a fudge. Neither France nor Germany will voluntarily surrender to the other country’s vision, but neither country wants to announce that they have failed to agree at a time of great market crisis. The result, therefore, is fudge. Fudge and more fudge.
Typically, the fudge comes in three layers. The top layer is some kind of attractive promise of a long term solution somewhere down the road. Often this involves some kind of tweak to the European Financial Stability Fund and more promises about a binding treaty at some distant point under whose provisions the Germans will finally be willing to underwrite Latin debt.
The second layer involves a response to whatever specific problem has caused the latest market meltdown. Sometimes this involves come kind of statement about Greece; sometimes it involves the bailout of a bank, the replacement of a discredited European political government with a technocratic cabinet, or a series of reassuring budget cuts and austerity pledges by whatever country is giving the markets heartburn in any given week.
The final layer is the application of soothing free central bank money to ease the financial markets where they are hurting most. It might be dollar swap facilities from the Federal Reserve; it might be pledges of more funding from the ECB to troubled European banks; it might be an interest rate cut; it might be more purchases of sovereign bonds. There are many other things it might be, but the third layer always involves threading the needle: providing enough money to allow the rickety financial system to keep operating without triggering German alarms that the Latins have gotten their hands on the combination to the vault.
Each helping of three layer fudge settles the markets for anything from a few days to a few weeks, but then the fix wears off and the markets begin to swoon. The confectioners assemble, and a new concoction appears.
Last December’s batch of fudge worked better than most, largely because there was more money in the bottom layer than usual. The ECB has been pumping liquidity into the financial system at such a rate that the prospect for a general European banking-seize up faded into the distance. Once that happened, and investors all over the world no longer feared an economic Ragnarok every day, markets rebounded very well.
But these days it is beginning to look as even this last and very generous helping of fudge will not be enough. The ratings downgrades of leading European economies, with the threat of more to come, have reminded the markets that no progress has been made on the underlying economic problems of the zone as a whole. Worse, if anything the movement is in the wrong direction: Italy and Spain aren’t so much climbing out of the pit as France is floundering its way down.
Perhaps the most direct and immediate new development is that the French ratings downgrade reduces the amount of money that is available to the EFSF just at a time when troubles in Greece, Spain and Portugal suggest that this fund will soon be heavily called upon.
Meanwhile the Greek problem, too, is getting worse rather than better. As expected, the government of that poor and distracted country has utterly failed to achieve the goals it set for itself with much fanfare late last year. As expected, both private sector creditors and international lenders like the IMF view Greece with less and less hope. As expected, the economic situation and the political climate in Greece are growing more bleak.
The German design for Europe is visibly coming apart. Italy is making it clear that the German plan will mean an Italian collapse, and that Italy will not impose unlimited sacrifices on itself in order to spare German sensibilities. The fancy new economic governance treaty that was going to be a hard-edged, tightly worded document providing the kind of economic governance that Germany saw as essential is gradually and inexorably turning into mush.
Yet Germany is not yet and perhaps will never be willing to draw what the French see as the obvious conclusion: that the only solution is that Germany must pay Europe’s debts and subject itself in future to the Gallic view of how currencies ought to be managed.
It is therefore time for more fudge. So far, the chefs have been very inventive. Each batch of fudge has been, necessarily, more elaborate and impressive than the last. But at some point, the credulous faith and short term focus that so far has ensured that markets stabilize even in the absence of a credible serious policy solution to Europe’s woes is going to begin to fail.
When that happens, we shall see whether the European chefs can make something more nourishing than candy. So far, it is not clear that they can, and as that realization spreads through the financial markets, expect some big swings and scary moves.