Some Evidence I’ve Got This Right

I think that it is unlikely that Greece will leave the euro — contrary to what seems to be the investment-banking consensus — and I think that the eventual endgame for Europe is much more likely to be close fiscal integration than a wider euro breakup. Two news stories today seem to support these views.

On Greece, the FT reports that European officials are working on an updated package for Greece that they envisage offering to Mr. Samaras if ND wins the election, but might also offer to Mr. Tsipras. The package involves further reductions in Greece’s interest payments on its bailout loans, an extended repayment schedule, and more money for investment in Greek infrastructure (partly to spruce it up for privatisation) via the European Investment Bank (and for the EU to take the first loss on loans to small businesses via this route — the EIB always invests alongside private-sector investors, something that has so far limited its ability to invest in Greece!). This seems to confirm my view about what is going on in Greece. Both sides are committed to keeping Greece in the euro, and the political noise we are seeing is the public manifestation of a negotiation over the terms. As throughout the euro crisis, many commentators have taken the line that “the EU will go no further”. This report, if correct, shows that it is already considering going further

Together with my observation on Wednesday that Mr. Tsipras wants to increase Greece’s tax take as a percentage of GDP and stabilise government spending at 44% of GDP, which from a naive perspective sounds rather moderate, and to do these things on a timescale only slightly longer than that envisaged for the present agreed fiscal contraction, today’s report suggests that both sides are prepared to move on what the market seems to be taking as entrenched positions. This is not to say that “Grexit” is impossible — it is always possible for one side in a negotiation to push the other side too far — but I think that it is hard to argue that it is the most likely outcome.

On the subject of fiscal integration, I noted in conversation with DC last week that there is a plan on the table, in Germany, to take countries’ debts above 60% of their GDP and put them in a common pool (Ambrose Evans-Pritchard has a summary in the Telegraph this week, although it does not make the structure completely clear Merkel closed the door on this option in November, but her officials are now, apparently, not ruling it out. According to the Telegraph, the SPD and Greens are in favour, and the Greens have threatened to block the fiscal treaty in the Bundesrat if the debt plan is not implemented. I have noted before that the SPD is a supporter of Eurozone bonds.

Perhaps you will think: “Ah yes, but Merkel has the support of the German people and will not accept any more responsibility for Europe.” Wrong. The Germans have refused to make open-ended commitments to fund the deficits of the European partners, but that does not mean that Germany will not accept fiscal integration in a framework that aims to prevent excessive spending by other EU countries in future. Speaking to the parliament this week, the FT reports today, Merkel said that the key to ending the crisis was the agreement of a wide range of new rules for a political union — to complete the project of European integration of which the euro was conceived as a key building block. She has observed before, correctly, that the euro was fundamentally a political project. The whole point was that political integration would naturally follow, over time, although I am not sure whether it was understood that it might have to happen under crisis conditions such as those we are presently experiencing. Merkel is committed, as the German political class has long been, to European integration. She said yesterday that Europe was in a “race with the markets” to create the necessary political union.

Incidentally, this project of political integration is a terrible idea. There is not a single European demos, and so there will not be true democracy in a European superstate. Democracy is a good idea. I am very glad that the EU-integration project has become a Eurozone-integration project — it means we will be able to keep out of it.

The ECB and What can Happen

Why are Spain’s bond yields rising? One explanation is that the ECB is not buying Spanish bonds through the SMP. Why not? Most likely because, as I have said before, the ECB has a tendency to hold off from such purchases until governments have done what it wants. What does it want at present? It may want follow-through on the Spanish bank recapitalisation, in which case it ought to start buying Spanish bonds as soon as it is agreed. However, it may — and increasingly I think this is likely — want to force Spain into a bailout because it does not trust Spain’s politicians to cut the budget deficit without strong external pressure. Also, the ECB is a European institution that is committed to European integration and that is constitutionally opposed to inflation. It is not staffed by idiots. It must know that the realistic ways out of the crisis are 1) inflation in Germany or 2) permanent fiscal union. 1) it finds extremely unpalatable, and in any case would only be a solution to this particular crisis. 2) fits with its ideological leanings and would deal with the inherent contradictions of the euro. I really think that it is far from implausible that the ECB is deliberately driving Spain into a bailout in order to increase the momentum towards fiscal union. The crisis, as I have said many times, can only get as bad as the ECB allows it to get.

What about all this talk of euro exit? To the extent that the problem is a lack of access to public markets, this can be dealt with by direct EU bailouts or by ECB purchases. To the extent that the problem is a misalignment of competitiveness within the Eurozone, it can be dealt with indefinitely through the expansion of TARGET2 assets and liabilities — which, if you consider the Eurosystem as a single central bank and assume that the euro will not break up, are just the representation of money that the central bank owes to itself. A political battle seems to have been won within the ECB to see TARGET2 in this way — the Bundesbank’s apparent efforts last year to limit the growth of its TARGET2 assets seems to have been completely overridden, which is why the system has been able to finance the massive external deficits of Spain and Italy in recent months. I am sure, however, that there is some remaining nervousness over the system, and that is another reason why the ECB will be so keen to force fiscal discipline on the periphery, in order to close the balance-of-payments deficits. Euro exit only becomes a serious issue once both the ECB and the EU are clearly prepared to allow the entire banking system of a peripheral nation to go bust. On the basis of my reading of the political situation in the first section above, and of the enormous costs this would entail for the rest of the EU, I do not think that that is at all likely.


  • US CPI fell to 1.7% YOY d.e. May. Core 2.3% YOY a.e.
  • US initial jobless claims rose to 386k, d.e. This leading indicator continues to deteriorate.
  • US current account deficit increased to -137bn, d.e., Q1. Widest since 2008.
  • Japan held rates and did not add to the BoJ asset-purchase programme.
  • Italy’s trade balance turned negative again in April, d.e.
  • UK trade balance hit its widest deficit ever in April, d.e.
  • Eurozone trade surplus increased to a fairly high level in April, b.e.

Coming Up

  • US capacity utilisation and industrial production
  • US prelim. Michigan consumer sentiment
  • China foreign direct investment
  • Greek election