The euro crisis

THE two speeches in two days by Nicolas Sarkozy and Angela Merkel reveal the many differences between them ahead of next week's European summit. I give a brief analysis in my earlier post. What follows is a more detailed exegesis (a link to Sarkozy's speech in French is here and a PDF Merkel's address in German is here):

Sarkonomics and the origin of the crisis

The French president offers a strange bit of Sarkonomics to explain that the crisis was caused by external forces – the unregulated globalisation of trade and finance – of which France is essentially a victim.

Financial globalisation established itself to compensate artificially the ravages that [trade] liberalisation without rules caused in the economies of developed countries. It was necessary so that the surplus of some could finance the deficits of others. It was necessary so that debt could compensate for the unacceptable fall in living standards of households in developed countries. It was necessary to finance a social model that was crumbling beneath deficits. It was ineluctable so that financial capital could seek elsewhere the profits that it could no longer hope to gain in developed countries. Thus was established a gigantic machine to create debt.

Mr Sarkozy says France cannot be blamed for the troubles it faces because other rich countries are in trouble too; yet he does not explain why some developed countries (Germany and several Nordic states, for example) have survived the crisis better than France despite the infernal debt machine. Later on, Mr Sarkozy says France has to cut back on state expenditure to preserve its destiny (this was tricky for him, as he had vowed three years earlier in Toulon not to conduct a policy of auterity)

Mrs Merkel, for her part, does not speak much of great uncontrollable forces unleashed by laissez-faire capitalism. Instead she emphasises the responsibility of individual states. The problem, in her view, is that countries have broken fiscal rules, and there has been nobody to enforce the limits on deficits and debt.

Early victims

There is an interesting contrast in how Mr Sarkozy and Mrs Merkel speak of the countries that have already succumbed to the markets: Greece, Ireland, Portugal, Italy and Spain. For Mr Sarkozy, their fate is a warning of what might happen if France does not act in time.

Let's take a moment to look around ourselves at the situation of other European countries that have not taken the measure of the crisis in a timely manner, that did not make the necessary efforts. They have been forced to lower salaries and pensions, and massively increase taxes.

Mr Merkel, aware of criticism that Germany is wantonly pushing vulnerable countries into recession, even depression, praises those that are undergoing the pain of adjustment:

I think we often have no idea of the contribution that people in the countries are making to ensure that the euro will be a permanent and stable currency. So I want today to express my absolute respect for these efforts. Because this is a contribution to a sustainable Europe.

She also makes a point of praising eastern European EU members outside the euro zone – the Baltic States, Romania and Bulgaria – that have also tightened their belts, sometimes brutally. Germany, moreover, does not seek to impose its will, only to promote a "stability culture".

Rushing and waiting

Both agree the euro zone and the wider European Union face their gravest crisis. Mr Sarkozy is in a hurry, not least because France's AAA-rating is in danger. Europe, he says, could be “swept away” unless it acts.

There is urgency. The world will not wait for Europe. If Europe does not change fast enough, History will be written without Her.

Mrs Merkel, though, is in no rush.

There is no possibility for a quick fix. There is not one last shot, as some say before every summit. This is not my language nor my thinking. There are no easy and fast decisions.The debt crisis is a process. It will take years.

Even senior Americans officials come away from Berlin perplexed by the way Germany seems oddly unperturbed by a crisis that is alarming the rest of the world. Perhaps Germany feels less exposed to the crisis. Or perhaps it thinks that only by dangling countries over the abyss will they understand the need to reform. In any case, Germany is reluctant to risk more of its taxpayers' money.

Discipline or solidarity?

Both Mr Sarkozy and Mrs Merkel speak of a crisis of confidence” in the markets. But they mean very different things by this phrase.

For Mrs Merkel, markets have lost confidence that the rules of the Stability and Growth Pact (which limits deficits to 3% of GDP and total debt to 60% of GDP) will be kept. Now there must be legally-enforcable rules – including legal debt brakes in each country and intrusive monitoring at the European leavel - with real sanctions for breaches.

This crisis is a chance to make a turn for the better, to repent. The lesson are quite simple: rules must be adhered to; compliance must be monitored and non-complicance should have consequences. National responsibility and European solidarity are mutually dependent.

Mrs Merkel does not speak much of “solidarity”, except to say that it must go hand in hand with discipline. She specifically rules out joint Eurobonds, of the kind being examined by the European Commission. These would breach the German constitution.

However her officials are now signalling that they may be willing to consider a partial, and probably temporary, mutualisation of debt. The best-know scheme, promoted by the Bruegel think-tank, would see joint Eurobonds issued for good debt (blue bonds) under 60% of GDP. Anything above that (red bonds) would be issued nationally and would incur higher yields. But Germany is floating the idea, inspired by a panel of wise men, of mutualising the bad debt above 60% of GDP to try to restore some order.

For Mr Sarkozy, the crisis of confidence is driven by the worries in the markets about the prospect of a succession of defaults or debt-restructurings, and the doubts about the survival of the euro. The answer is, first and foremost, cast-iron solidarity. He does not say Eurobonds, but he hints at them strongly. And he wants to stop all talk of imposing losses on private bond-holders – a prospect that many in Germany want to maintain so that markets can impose discipline on governments. The French president says:

If we want the euro to survive, we don't have any choice: we must establish solidarity without weakness against all those who doubt the viability of the euro and speculate on its break-up. It must be absolutely clear that all the countries of the euro zone will be in solidarity with each other. It must be clear that what was done for Greece, in a very particular context, will not happen again, that no state in the euro zone will be pushed into default. It must be absolutely clear that in future no saver will lose a cent in the reimbursement of a loan granted to a country of the euro zone [ie, a bond-holder]

Like Mrs Merkel, Mr Sarkozy says solidarity must go hand in hand with discipline. On this, at least, there is some agreement.

Let us examine our budgets together. Let us more rapid, automatic and severe sanctions on those that do not respect their commitments.

The EU and its treaties

All this, say both leaders, requires the treaties to be changed. For Mrs Merkel, this is a matter of completing the economic and monetary union, and establishing a “fiscal union” (though she does not define the term). For Mr Sarkozy, “Europe must be re-thought; it must be refounded”.

So far so good. But Mrs Merkel and Mr Sarkozy disagree deeply on the nature of a reformed union. Who, for intance, should be responsible for monitoring budgets and economic policies, and imposing sanctions?

Mrs Merkel is clear: independent institutions, free from political interference, are essential for credibility. Preserving the independence of, for example, the courts and the ECB, is “for the highest good of our democracy”. On the question of budgetary rules and sanctions, she says:

There must be no political leeway when it comes to determining whether the limits are violated or not. There must be real automaticity.

Mr Sarkozy sees it completely differently: the decisions must be taken by leaders. Political involvement is the essence of democratic legitimacy, in his view. This passage is telling, even though Mr Sarkozy begins by casting the argument in terms of his opposition to economic liberalism.

Europe without politics, Europe on automatic pilot that blindly applies rules of competition and free trade, is a Europe that cannot confront crises...A more democratic Europe is one where responsible politicians decide. The foundation of Europe is not the march towards more supranationalism...The crisis has pushed heads of state and government to assume growing responsibilities because, in the end, only they have the democratic legitimacy to be able to decide. Thus European integration will pass through intergovernmentalism because Europe must make strategic choices, political choices.

Intergovernmentalism may well ensure that decisions have greater legitimacy, but it also has drawbacks. National vetoes make it much harder to reach decisions and implement them, as seen throughout the debt crisis. Mr Sarkozy tries to address this by suggesting that decisions be taken by “qualified” majority (ie, a weighted majority).

There are other problems. Leaders that need each other to make political deals have too often turned a blind eye to each others' flaws, as happened with Greece. Without institutions to guard the common interest, smaller countries tend to feel bullied by bigger states: just see the growing rancour over the involvement of Merkozy in unseating George Papandreou and Silvio Berlusconi, the leaders of Greece and Italy respectively.

Europe at 17 or 27?

Mr Sarkozy has recently spoken bluntly about the need to create a core eurozone more or less separate from the ten non-euro states, including Britain (see my last post here). In his Toulon speech Mr Sarkozy toned down his latent separatism, though he still speaks of a “euro-zone government” and is filled with rancour about “social and fiscal dumping” and “disloyal competition" within the EU (ie, by low-tax Ireland and low-cost eastern European members).

Mr Merkel, by contrast, has been careful to sound inclusive. Under presure from Mr Sarkozy, she has agreed to hold more summits of the 17 member-states. But when it comes to reforming the treaties, her stated preference is to do it with all 27 members of the EU “to avoid splits within euro members and non-euro states”. She knows that treaty change at 27 is the best way – perhaps the only way - to ensure that the European Commission and the ECJ are involved.

Whether it is feasible will depend, in large part, on the price that Britain seeks to extract for its agreement to changing the EU's treaty. Though he did not express a preference, a separate new treaty at 17 is probably Mr Sarkozy's preference. This would help create a harder, more exclusive core; ensure that it it becomes as intergovernmental as possible; and exclude the more liberal British, Scandinavians and easterners. Mrs Merkel says this would be “second-best” and, even she is forced down this route, she will seek to ensure that the euro “outs” are able to join its budget strictures and remain free to join the euro in future.

The ECB's bazooka

The independence of institutions is essential for Germany, and none is more sacrosanct than the ECB. Mrs Merkel bristles at the demands, from Europe, America and elsewhere, that the ECB use its big bazooka and take decisive action to stop investors' run on sovereign debt. But the ECB's statutes prevent it from lending directly to euro-zone members. Instead, it has provided liquidity to banks – this week the ECB and other world central banks acted to reduce the cost of obtaining dollars. It has also been buying government bonds intermittently, and in a limited manner, in the secondary markets to improve “the transmsision of montary policy”. Even this has caused divisions within the ECB. In America and Britain, by contrast, the central banks have no compunction about acting as the government's lender of last resort. Mrs Merkel say:

I will make no comment on what national and European courts, and the European Central Bank, should do or not do in future. It is obviously important to point out once again: the task of the European Central Bank is different from that of the Fed in the United States of America, for example, the Bank of England. This is enshrined in the treaties. The task is to ensure monetary stability.

Mr Sarkozy, for his part, pays lip service to the independence of the central bank but is less shy about telling it to act.

There are debates on what the statutes authorise it [the ECB] to do. I don't want to enter these debates. The ECB is independent and will remain so. I am sure that, faced with the risk of deflation that threatens Europe, the central bank will act. It is up to it to decide when and with what means. That is its responsibility. None must doubt that it will assume it and, moreover, I am glad it has already started to do it.

The speech that matters

Any treaty change will take time, whether it is limited to imposing more discipline or includes a path to Eurobonds in future; whether the integration is intergovernmental or relies on supranational European institutions; whether it reopens the treaties of the 27 EU members or is done through negotiation at 17 (or even fewer).

The nature of the treaty will affect the well-being of the euro zone in decades to come, so it is worth doing right by turning the euro zone into a coherent economic unit. This is something that long-term investors care about, and giving the right signals now helps.

But what panicking investors really want to know is whether the euro will survive the coming weeks and months. Tougher fiscal rules adopted within the current treaties have so far had no effect on confidence. The impact of new governments in Greece, Italy and Spain is still uncertain. The euro zone's rescue fund, known as the European Financial Stability Facility, is inadequate. No amount of financial engineering will make it big enough to save Italy and Spain (let along France) if investors dump their bonds entirely.

For the immediate future - and possibly for as long as it takes to change the treaties - only the ECB can avert a collapse by dint of its ability to print money. Nobody should expect the ECB to declare unequivocally that it stands ready to deploy its unlimited power behind all sovereigns. But it can do more.

The word in Brussels is that Mrs Merkel is ready to let the ECB act more intensely, though she could never say so. And Mario Draghi, the ECB president, could never be seen to ask for political guidance. That said, he will probably need to have confidence that, firstly, enough discipline is being restored so the ECB will not be left holding junk bonds and that, secondly, Germany's Bundesbank will hold its tongue if he prescribes a bigger dose of unorthodox medicine.

The real question is whether European leaders will give Mr Draghi enough a wink to act. Speaking in the European Parliament on December 1^st, he sent them his own wink, implying he was ready to move if leaders adopted a new "fiscal compact". His was the speech that probably matters most, so it is worth reading carefully (full version here):

Fundamental questions are being raised and they call for an answer. At the heart of these questions are not only the credibility of governments’ policies and the actual delivery of the promised reforms, but also the overall design of our common fiscal governance.

I am confident the new surveillance framework will restore confidence over time. I am also quite sure that countries overall are on the right track. But a credible signal is needed to give ultimate assurance over the short term.

What I believe our economic and monetary union needs is a new fiscal compact – a fundamental restatement of the fiscal rules together with the mutual fiscal commitments that euro area governments have made.

Just as we effectively have a compact that describes the essence of monetary policy – an independent central bank with a single objective of maintaining price stability – so a fiscal compact would enshrine the essence of fiscal rules and the government commitments taken so far, and ensure that the latter become fully credible, individually and collectively.

We might be asked whether a new fiscal compact would be enough to stabilise markets and how a credible longer-term vision can be helpful in the short term. Our answer is that it is definitely the most important element to start restoring credibility.

Other elements might follow, but the sequencing matters. And it is first and foremost important to get a commonly shared fiscal compact right. Confidence works backwards: if there is an anchor in the long term, it is easier to maintain trust in the short term. After all, investors are themselves often taking decisions with a long time horizon, especially with regard to government bonds.

A new fiscal compact would be the most important signal from euro area governments for embarking on a path of comprehensive deepening of economic integration. It would also present a clear trajectory for the future evolution of the euro area, thus framing expectations.

On the precise legal process that brings about a move towards a genuine economic union, we should keep our options open. Far-reaching Treaty changes should not be discarded, but faster processes are also conceivable.

Whatever the approach, companies, markets and the citizens of Europe expect policy-makers to act decisively to resolve the crisis. It is time to adapt the euro area design with a set of institutions, rules and processes that is commensurate with the requirements of monetary union.