Expert views on whether Grexit is coming vary from “only slightly likely” to “inevitable.” The timing of Grexit among those who forecast Grexit ranges from “this weekend” to 18 months. Why so much uncertainty when the facts are straightforward? The answer lies in the inadequate response of leaders and their long-standing habit of delay and delay and delay. The root cause of the disconnect is the prolonged evolutionary nature of inching toward fiscal union that was stated in the Maastricht Treaty, with the emphasis on central authorities taking as little functionality as possible while the member states held the reins. Central authorities were always designed to take only those responsibilities that the states couldn’t manage on their own. This is very like the US Constitutional arrangement.
Moreover, and it’s an important condition of this “subsidiarity,” any give-up to a central authority has to be democratically approved. This is the basis on which Chancellor Merkel can rightfully say she cannot agree to open the German purse for Greeks to ravage unless and until the German voters approve, which of course they have not and will not. At the same time, though, the Treaty can be amended to allow greater fiscal union—it is a living document, like the Constitution. Not every change requires a legal amendment. There is some flexibility, such as when the ECB’s capital base was raised last year. It’s logical to assume the EC, Eurogroup and ECB staffers are working feverishly behind the scenes to see how far they can stretch the existing modest fiscal union, especially the European Investment Bank and ECB, to meet current needs.
Estimates of how much actual cash is needed are in short supply. It may be possible to rescue the Spanish banking system, especially if the ECB twists a few arms, but experts say bailing out Italy is beyond the capabilities of the EMU. Because the fiscal union process is inherently prolonged and contentious, responsibility falls on the ECB. Talk continues of a rate cut, which would help Spanish banks, and/or resumption of bond purchases. The most likely policy initiative would be a third LTRO; the first two tranches delivered almost €1 trillion and were deemed effective in soothing markets. LTRO is not a long-term fix, but European leaders have proven themselves incapable of long-term fixes, anyway. Besides, short-term fixes involving banking practices are outside the ken of the average voter, so escape the kind of scrutiny that more direct fiscal union actions would invite. And finally, the ECB is capable of pre-emptive action, something elected officials are loathe to embrace.
Therefore, assuming the banking crisis in Spain is about to engage in the vicious circle with bond market contagion, we need to expect action from the ECB and probably only the ECB. The ECB is fully aware that it was only good German data in Q1 that prevented the eurozone from entering a two-quarter technical recession. Markit said yesterday that the latest PMI’s are consistent with a Q2 contraction. Somewhere in a back room, ECB numbers guys are calculating the effects of recession on the banking system as well as tax collections. The problem with expecting something from the ECB this weekend, or anytime soon, is that the BBK’s Weidmann says the ECB has already reached the limit of its mandate.
As for Merkel being persuaded by Monti that Eurobonds are okay, Bloomberg reports that 15 hours after the Monti comments, Merkel’s office denied it. However, talks will resume June 13 on the Chancellor’s blueprint from the council of economic advisors that a “redemption” fund be formed, using gold reserves, to buy sovereign debt. But don’t get excited—the German government is still contemplating legalities and deep matters of subsidiarity. It is wrong to imagine the German opposition is fading, or will reverse itself, any time soon. It is not a sound basis for a lasting euro recovery.
The US basically closed its door at 2 pm today when the bond market goes home. We do not expect any big moves in either direction, nor much of a move on Monday. Actually, the US market is more willing to buy euros than the Asians or Europeans, so in its absence, it’s hard to see a euro rally on Monday—buy don’t carry a position over the long weekend, just in case.
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