Europe should be feeling quite unsettled following the European Parliament's questioning of European Central Bank (ECB) President Mario Draghi on Monday. Of the questions, there were two that strike at the core of the latest struggles within the eurozone. The first was about the veracity of recent revelations that the Italian treasury is in talks with the ECB about including bundles of nonperforming loans in its asset purchase program. Draghi responded that the ECB would not buy such assets directly but that it may accept them as collateral in exchange for funds. The second was related to a plan that originated in the German Council of Economic Experts that would involve a shakeup in the way European sovereign bonds are treated, with potentially disastrous consequences for Southern Europe. This question he deflected.
The two issues are the latest focus of a struggle that has been underway in Europe since at least the 2008 financial crisis. On one side is Northern Europe, led by Germany, which desires any further advance toward closer union to be carefully considered. Germany believes each step should be taken only after all members have already demonstrated their fiscal rectitude, largely through reducing budget deficits and debt levels. On the other side are Southern European nations, most clearly represented by Italy, which see union and the accompanying pooling of funds as a way out of their financial problems. These countries believe that with the economic might of Germany behind them, they will be safe from negative market forces.
The advantage in the great battle shifts from one side to the other. When the sovereign debt crisis struck in 2011, Southern Europe found itself on its knees, ultimately having to beg the north to be bailed out. The bailouts arrived but with stringent conditions attached. Recipients had to implement deep reforms, and all players had to agree to a Fiscal Compact — new budgetary rules designed to keep them in line. With the crisis also came the creation of what are known as banking bail-in rules, under which investors would bear the initial brunt of an ailing bank before national governments stepped in.
In this way, the north held the advantage for several years, using austerity and fiscal responsibility as its watchwords. Meanwhile, the south struggled to regain its poise. This status quo changed in 2015, when the ECB under Draghi, who is Italian, went against German wishes to undertake a quantitative easing program. (Though European civil servants are supposed to forget their nationalities when they undertake their postings, in this case it is notable that Draghi is Southern European.)
Succor for Southern Europe
Draghi's decision to begin quantitative easing essentially lifted the pressure on Southern European states to reform, since it kept the yields on their government bonds under control whether or not they were pursuing austerity. In addition, the oil price dropped dramatically — a happy confluence of events for the south since it empowered European consumers, enabling more growth in countries such as Spain and Portugal and leading to a resurgence of southern confidence. By the end of 2015, several southern countries were publicly flouting the Fiscal Compact.
But 2016 has not started so well for the south. The banking union bail-in mechanisms have now come into force, and they have brought market attention on the exorbitant levels of nonperforming loans still extant in the banking systems of countries such as Italy and Portugal. Quantitative easing may protect government bonds, but it does not protect banks' shares and bonds, and debtor countries are now once again threatened. It is this problem that the Italian treasury would like the ECB to solve by including bundles of nonperforming loans in its euro area asset purchase program.
From the Italian perspective, the inclusion would be a simple extension of the program: more ECB coverage to avert disaster. From a German perspective, it would fill the union's central financial institution with potentially toxic assets, spreading the sickness of southern irresponsibility further into the blood supply of the entire union. But Draghi has shown his willingness to oppose the Germans in the past, and now that he has directly stated that the ECB will accept Italian bank loans at least as collateral, it seems that he is ready to confront Germany again.
The German Response
Which brings us to the second issue, the one that Draghi avoided: the German riposte. Originating with the German Council of Economic Experts — the five wise men, as they are commonly called, though one is a woman — the plan was first leaked in 2015. It now apparently has the support of both the German Finance Ministry and the Bundesbank and involves taking the same bail-in thinking that has been used on eurozone banks and applying it to sovereign bonds as well. This means that, for example, should Portugal reach a point where it could not afford its debt repayments and go into default, bondholders would be the first to bear the cost before the European Stability Mechanism — which was created in response to the 2011-2012 crisis — could come in and prop up the country's finances using funds from the rest of the union.
Implementation of this plan would likely dramatically raise Southern European bond yields, since investors would be facing a great deal more risk from holding them. If implemented, the plan would probably immediately push Europe back to the panicked days of 2011-2012, when the eurozone was on the verge of a rapid unraveling. It is not in itself surprising that this idea has been proposed. What is critical, though, is the decision to leak it and to test it in the public sphere.
Euroskepticism has taken various forms across the Continent. The German form is a push for fiscal responsibility and rule enforcement to such an extent that it could break up the eurozone.
This is clearly an explosive proposition, and its emergence likely reflects two factors in play. The first is a feeling deep within the German economic establishment that the eurozone in its current state is not working for Germany. Euroskepticism has taken various forms across the Continent. The German form is a push for fiscal responsibility and rule enforcement to such an extent that it could break up the eurozone. The second factor is more tactical. Faced with the terrifying prospect of such a rule change, Southern Europe may be less willing to increase spending and debt levels.
The difficulty in picking these two factors apart — tactical versus true Euroskepticism — was demonstrated last summer in the climax of the Greek crisis, when Finance Minister Wolfgang Schaeuble (who has long suggested that a smaller northern eurozone built around Germany would be preferable to the current model) suggested a Greek "timeout" from the eurozone. Had it been carried out, the timeout would have dealt a severe blow to the eurozone's structural integrity, but the threat was enough to terrify the Greeks into signing humiliating terms with German Chancellor Angela Merkel, who arrived to negotiate the next day.
Thus, the battle continues to rage between north and south. An ultimate Italian victory would involve unlimited acquiescence from the ECB, with Italian banks and sovereign bonds all protected by European guarantees. A resounding German victory would involve stringent budgetary undertakings from all European nations, strictly enforced by a disciplinarian European institution willing to impose harsh punishments on those that break the rules. The problem, however, is that neither side can ever win, and the compromises that are struck — just as they are ultimately likely to be in these two cases — will not suit either side, leading to more extreme positions in each subsequent round of the fight.