The Euro Battle

By Jakob Vestergaard - 31 May 2018
The Euro Battle

This post is the first in a weekly five part series from Jakob Vestergaard exploring reforms to the EMU that the Commission is hoping that member states will commit to at the end of June.

This time last year, Emmanuel Macron took office as newly elected president of France, with an ambitious EU reform agenda. Macron went off to Berlin where Angela Merkel welcomed him and they declared their commitment to work together closely on further advancing political and economic integration in Europe. Only weeks after, the Commission released a comprehensive reflection paper on reforms on the EUs economic and monetary union (EMU). It was a genuine European spring, with renewed optimism for the EU – after several years of financial and economic crisis and ever increasing fears amongst the political elite of the rising popular support for anti-establishment parties in virtually all member states.

In less than a month, the European Council is scheduled to make binding decisions on the EMU reforms that the political establishment in Brussels has been drafting and pushing since 2012. But the conditions of possibility of a political agreement now appear anything but good. The domestic position of both Merkel and Macron is considerably weakened and they are under pressure from a small but strong alliance of Northen European countries. The market turbulence in Italy and its political crisis demonstrates, at the same time, just how necessary EMU reforms are – and how distant a goal they remain. Italy is the third largest economy of the Eurozone and – along with Germany and France – considered one of the “big three” in questions of euro governance. If the EU summit in late June ends up paralyzed by the political crisis in Italy, it will constitute a huge blow to the EMU reform process, not least with respect to the envisaged completion of the banking union.

Financial markets and nation states

A few days ago, a colleague, Benjamin Braun, tweeted an intriguing extract of a dialogue betweeen then French president, Francois Mitterand, and his Italian counterpart, prime minister Giuliano Amato, which took place more than 25 years ago. Mitterand was deeply upset by the speculative attack (in September 1992) that had very nearly brought down the French franc, an occurrence he found utterly unacceptable. ”If there wasn’t this interplay among European currencies”, said Mitterand, ”speculation wouldn’t exist”. ”There is no reason why the policy of a state should be at the mercy of volatile capital”, he continued. ”It is an intolerable immorality”.

For Mitterand, a common European currency seemed the way out of the predicament. Today, we know that the euro, in itself, was not enough. In 2011-2012, the euro came under unprecedented pressure. Yes, the EU now had the common European currency Mitterand had dreamt of, but several member states nevertheless saw their financing costs spike dramatically, to the extent that their ability to remain in the euro came in doubt. When Italy found itself engulfed in these dynamics, the survival of the euro itself was threatened. The EMU reforms pushed by the European political establishment since 2012 constitute, in essence, an effort to make the euro more resilient, much in the spirit of Mitterand’s original vision.

Although the euro is fast approaching an impressive 20 year anniversary, events in Italy over the last couple of days – and the market turbulence that has resulted – reminds us that the power of finance over the politics of European member states has in no way disappeared, as Mitterand blithely forsaw. In financial markets, the efforts of two Eurosceptic parties – the Leage and the Five Star movement – to form a government, rapidly resulted in higher financing costs for Italian sovereign debt. The spread between Italian bonds and German bunds rapidly rose to almost 2 percentage points, its highest level since 2014, and international credit rating agencies warned that a credit downgrading could be on the immediate horizon.  

On Sunday, the Italian president, Sergio Mattarella, used his constitutional right to reject the prospective list of ministers, presented to him by Guiseppe Conte, the envisaged prime minister of the new Italian government. Mattarella felt that Italy’s position in the euro, could too easily be jeopardized by Paulo Savona, the proposed minister of finance. ”The uncertainty over our position in the euro alarmed Italian and foreigh investors”, the president said to explain his decision. ”The rise in the spread increases the debt.. and foreshadow risks for families and Italian citizens”. 

After Mattarellas rejection of the list of ministers, Conte resigned his mandate to form a coalition government and the President instead appointed Carlo Cottarelli, a former official of the IMF, as leader of a new technocratic government. Despite the president’s intervention, the market turbulence continued and the spread reached almost 2,5 percentage points on Monday, with troubling (although modest) contagion to Portuguese and Spanish government bonds.

New elections in Italy appear now to be the most realistic scenario, most likely after summer. Meanwhile, many are astounded by Matteralla’s actions. Observers fear that new elections could be framed as an issue of Italy’s commitment to the euro – or as a choice between EU and democracy, even. If anti-establishment parties are further strengthened in new elections, as appears likely, and a new euro-sceptic government coalition opts for an Italian exit from the euro, the process ensuing from that would make Brexit look like a walk in the park.

For many Italian voters it is difficult to apprehend why Paolo Savona would not be considered a competent and legitimate minister of finance. Savono is a respectable economist with a long career in Italy’s banking and central banking elite, including prior employments with the Italian central bank, the Italian Ministry of Finance, as well as a stint as Minister of Industry in a previous administration. But Savona’s track record was not enough to compensate for something apparently far more serious, namely that he is a declared euro-sceptic. It was to little avail, it seemed, that Savona had issued a statement earlier on Sunday, stressing that he would be committed to “full implementation of the Maastricht and Lisbon treaties”.

Financial actors are blunt about what they see as their disciplining role in regard to the economic policies of nation states. Nicola Mai, analyst for the American finance giant, Pimco, remarked on the situation in Italy that he expected a “stand-off between Italian politicians and the markets”; markets will react, he explained, to “how confrontational the government will be with the EU”, and “as reality hits”, the promises of the new government “will have to be reined in”. It is more than a little ironic, that the main threat to the euro is the so-called disciplining of nation states by financial markets.

Serious setback for EMU reforms

The recent developments in Italy are particularly worrying because the EMU reform process was already challenged. Last year’s European spring ended sooner than most had expected. Autumn descended at surprising pace and for months now, the Commission has fought an intense battle to keep winter at bay.

The address given to the European parliament by the President of the Commission, Jean Claude Juncker, in September last year, had at first strengthened the sentiment that time was ripe for pushing through the reforms seen as necessary to bolster the resilience of the euro. In France, Macron was more than eager and in Germany, a strong Merkel looked set for reelection and more than willing to play along. Then came the results of the German election; a huge blow for Angela Merkel’s Christian Democrats as well as for the German socialdemocrats, whereas several Eurosceptic parties had spectacular electoral victories. After several months of negotiations, it was clear that Merkel could continue as chancellor of a coalition government with SPD, but it was also painstakingly clear that the Bundestag had become considerably more skeptical towards further political and economic integration in the EU. In France, even Macron, who started off with such impressive popular backing, had to realize that a year is a long time in politics. His approval ratings were consistently declining, to reach a meager 32 % of French voters in April, with almost twice as many (58 %) saying that they disapproved of his Presidency.

Further north, similar cold winds were haunting the European spring of yesteryear. In March, Dutch Prime Minister, Marc Rutte, launched a new European alliance, which a witty financial press swiftly named ‘Hoekstra and the seven dwarfs, after the Dutch finance minister, Wopke Hoekstra. In addition to the Netherlands, Ireland and the three Baltic countries, the alliance included three Nordic countries, Denmark, Finland and Sweden, and the key message was that any further European integration is inconceivable unless and until all member states have demonstrated full command and control of its public finances. ”The recipe for a larger cake is not centralised bailout funds and printing more money, but structural reforms and sound budgets”, Rutte explained.

Although member states to large extent agree on the importance of EMU reforms, observers of the process have grown increasingly worried over the course of the last few months. Long before the Italian elections, independent experts and analysts were deeply concerned. In a rare academic intervention, 14 French and German economists published a joint paper stating that – because of deep-seated political disagreements between member states – no “meaningful” progress had been made with EMU reforms since the launch of the first phases of the banking union in 2014. On this background, the 14 economists set out to reconcile the disagreements, and rearticulate an agenda for reform that they hoped could be the basis of a joint Franco-German position in pushing forward the reforms.

Both Valdis Dobrovskis, the Commissioner of Financial Stability, and Klaus Regling, the Director of the European Stability Mechanism (ESM), have warned in recent months that if member states fail to agree to significant EMU reforms at the upcoming June summit, the reform process likely will stall – and not move forward again until autumn next year, on the other side of elections to the European Parliament in late May. There would then be considerable risk that adverse events in financial markets would come sooner than the resilience boosting EMU reforms meant to mitigate their effects.

Just a few weeks ago, Vitor Constancio, the retiring vice-president of the European Central Bank (ECB), expressed his deep frustration about the lack of momentum in the EMU reforms process. In an interview with the Financial Times, Constancio worried that member states would in fact be unable to reach an agreement that would allow bank crises in the EU to become a truly joint responsibility – and that it would henceforth not be possible to put behind us the practice that such crises are, first and last, a challenge for nation states and their taxpayers to address and resolve on their own.

There is widespread agreement that the euro will only become genuinely resilient if and when member states engage fully in risk-sharing when it comes to banking and sovereign debt crises. But such risk-sharing is out of the question – says Germany, Holland and several other countries – until a satisfactory level of risk reduction has been achieved in all member states.  To cut a long story short, the EU cannot expect to move forward with the banking union, and other aspects of the EMU reforms, before member states are home safe with risk reduction.

And this was exactly the point that Vitor Constancio labored to convey in his parting shot with the Financial Times: Spain, Portugal, Greece and Ireland have all undetaken such comprehensive reforms that large deficits have been replaced with full compliance with EU rules. ”Enough risk reduction has been achieved to justify introducing common elements of risk-sharing in the banking union project”, he stressed. In Germany, Holland and other like-minded countries, few believe in this narrative – and fewer still, one suspects, after recent events in Italy.

Towards the summit

Exactly a year has passed since the Commission launched its ambitious reflection paper, and in the course of that year, the conditions of possibility for EMU reforms have deteriorated considerably. In the coming weeks, we will witness a European political drama of the highest caliber, as the finance ministers and heads of state of the EU countries strive to handle the reform plans that have circled for so long that some kind of landing can be postponed no longer.

The coming weeks will decide the fate of the EMU reforms. Although the Commission’s eagerly desired banking union is the centerpiece, it is by no means the sole act. Two other reform proposals that feature centrally in the Commission’s EMU reforms, have progressed rapidly in the course of the last year or two; the establishment of a European capital markets union and the issuance of European debt securities, the so-called sovereign bond-backed securities (SBBS). Maybe these reforms can fly – at high speed and under the radar of public, political attention – even as other parts of the reform process stall?






Next week, the blog series focuses on the banking union: what is the status, which reforms are considered necessary to complete it, and how likely are member states to reach a deal? Then follows analyses of the capital markets union and the issuance of sovereign bond-backed securities, before the final post assesses the likely outcomes of the summit, as Heads of State convene in Brussels on 28 June.

Image credit: Luigi Rosa via Flicker (CC BY-SA 2.0)

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