Merkel: Change European Constitution for Greater Fiscal Integration by 2013
“The government is pushing for a limited amendment to the treaty to allow greater influence over states that bust budget rules and agreed obligations on stability and consolidation,” a source told Reuters. “This should be done and dusted by the end of 2012.”
While Merkel has seemed to be more unilateralist than previous German Chancellors, she is still very much wedded to the European project. If the euro zone is to survive, as I indicated earlier this month, greater fiscal integration is the only direction that the EU can move.
If the ECB does backstop Italy credibly and fully, then yields will fall and investors will pile in again. However, this is nothing more than a temporary patch, a medium-term liquiditysolution only. Clearly, the issue for the Dutch and the Germans is that Italy would have no reason under this arrangement to make reforms or move to fiscal consolidation. They fear Italy (and Portugal and Greece) would become permanent ‘free riders’, mooching off of Germany and the Netherlands’ fiscal probity, making the euro a weak currency. The right way to deal with that fear is to choose between greater fiscal integration or breaking the eurozone up at some point in the medium-term (say 2-5 years).
My conclusion*: the ECB will eventually move to a lender of last resort role. The question is how much damage will be done before they do so.*
Europe is already in a double dip recession and the sovereign debt crisis has already moved from Greece to Portugal to Ireland to Spain and now to Italy. Belgium, with its lack of a permanent government and 100% sovereign debt to GDP is next on this list. They would be followed by France and its implicit guarantee for a poorly capitalised banking system and Austria and its implicit guarantee for a banking system highly leveraged to central and eastern European debtors. Eventually, every country will feel the impact because a fixed exchange rate system with no lender of last resort is inherently unstable unless you have fiscal integration and/or compatibility.
The ECB’s backstopping Italy and Spain for fear of German and Dutch banks’ insolvency is like the Fed’s backstopping California and New York for fear of Bank of America, Wells Fargo, Citigroup and JPMorgan Chase’s insolvency. It is not a very palatable solution longer-term. Therefore, in the medium-term, the euro area will move to tighter fiscal integration. This may or may not include Eurobonds.
However, not all members will come along for the ride. Angela Merkel, admitting that leaving the euro zone is politically and legally possible during her commentary addressing the Greek referendum in Cannes, has already broken the taboo. Now everyone knows that it is possible to default, leave the euro zone and re-gain competitiveness in a move to a devalued currency. Given the lack of economic harmonisation in the euro area, some euro members will be forced to leave and choose this path. I predict that when Europe moves to change its constitution to include greater fiscal integration, it will also include explicit mechanisms for countries to leave the euro area.
–Why Investors will buy Italian bonds after ECB monetisation
I continue to predict that the move will be toward temporary ECB intervention followed by tighter fiscal integration and explicit mechanisms for euro zone exit. Sources indicate that Germany may already be preparing for a Greek exit from the eurozone. Now we learn that the Germans may also be pushing for euro area fiscal integration and oversight as well.