Only Germany can save EMU as contagion turns systemic

 German Chancellor Angela Merkel warned there will be no 'spectacular step' at the EU meeting on Thursday Photo: AP

"We are heading towards fiscal union or break-up," said David Bloom, currency chief at HSBC. "Talk is no longer enough as the fire threatens to leap over the firebreak into Spain and Italy.

"What the market is worried about is Germany's long-term committment to the euro project. If we see unreserved and absolute backing from the political establishment of Germany, that will be a soothing balm."

Chancellor Angela Merkel seemed in little hurry on Tuesday to convey such a message. There will be no "spectacular step" at the Justus Lipsius building on Thursday; just a "controlled process of gradual steps and measures", she said with unflappable calm. Given the simmering wrath from top to bottom of German society, it may be impossible for her to do much more.

Jens Weidmann, the Bundesbank's president, has made her task that much harder by telling the eurosceptic Bild Zeitung that "nothing would destroy the incentives for a solid budget policy more quickly and more permanently than joint liability for national debts. European and especially German taxpayers would have to answer for the entire state debt of Greece. That would be a step toward a transfer union."

Days earlier he shot down proposals for issuance of eurobonds or use of Europe's rescue fund to buy Spanish and Italian bonds on the open market, crucial steps to prevent Italy and Spain being drawn into the maelstrom. "It has a high cost, limited use, and dangerous secondary effects," he said, departing radically from the script of the European Central Bank.

Such scathing words from the Bundesbank tie Dr Merkel's hands, just as she is tied by a Bundestag motion five weeks ago that imposed strict limits on further bailouts. Above her head hangs a Sword of Damocles, a ruling by her consitutional court in September that may curb or even block German participation in the EU's rescue machinery. The further she goes on Thursday – the further she breaches the "no bailout" clause of the Lisbon Treaty – the greater the risk of a negative ruling.

In essence, this is a soul-searching drama within Germany over its own national destiny and place in Europe, echoed in the Netherlands, Finland and even France. Europe's confusion reflects the schizophrenia of its ancient tribal nations, each faced with the fateful choice of crossing the Rubicon to an EU Treasury and joint government or letting the EU project unravel after half a century.

EU leaders would like to confine their summit to the details of debt buy-backs or "selective defaults" for Greece, or cuts in the penal rate on rescue packages, but the crisis is once again a step ahead of politicians. Fear that Italy and Spain may be tipping into double-dip recessions as global growth falters has changed the landscape, threatening the debt dynamics of both countries.

The International Monetary Fund said there is now "serious risk" of eurozone contagion with "large" potential knock-on effects worldwide. "Market participants remain unconvinced that a sustainable solution is at hand," it said.

Suki Mann from Societe Generale caught the mood in a note to clients, asking whether it is "all over". "Eurozone politicians don't – or don't want to – understand that the eurozone as we know it is on the precipice. Greece appears beyond repair, Italy is on the brink, and the chances are that the euro might be no more very soon," he said.

RBS fears that Europe is on the cusp of "system-wide convulsion" after yields on Spanish 10-year bonds reached post-EMU records of 6.34pc this week, and Italian yields topped 6pc. "We believe that Spain has entered the danger zone for yield levels," said Harvender Sian, the bank's credit strategist, who fears the "point-of-no-return" may be 6.5pc. "Given that Spain [and likely soon Italy] has entered this territory, there is a growing risk that a large systemic risk event is plausible in the near term and if not then in a matter of weeks."

The bank has called for a bail-out fund with €2 trillion of full lending power to stabilise the system, even if this risks pushing German debt levels above 110pc of GDP and causing apoplexy in the Bundestag.

The bond fund Pimco has its own idea: throwing Greece, Ireland and Portugal to the wolves, and concentrating €1 trillion in "overwhelming force" to defend Spain and Italy. That major players should utter such thoughts shows how fast events are moving.

For 18 months the EU has treated the serial crises on the EMU margins as liquidity headaches. It hoped that time would slowly lift the distressed debtors off the reefs, while the penal terms of "Ultima Ratio" attached to bailout loans would deter other EMU states from seeking help. "Shock and Awe" rhetoric would do the rest.

The strategy has failed because it did not acknowledge that the deeper crisis is a North-South structural gap that has left half the eurozone with variants of 1930s debt-deflation, a condition that cannot be solved by austerity measures or by any one country alone.

"We are approaching the endgame for this part of the European sovereign crises: the number of cans that now need kicking down the road would challenge the left foot of Lionel Messi," said Gary Jenkins from Evolution Securities. "The chances are that the EU will only take the step of fiscal union or common bond issuance at one minute to midnight on a weekend when it is clear that the system is close to collapse."

The EU has a long history of muddling through existential crises – though none quite as threatening as this – so it may find some way to fudge fiscal union with a formula that assuages German hawks and lawyers. If all else fails, it can still cajole or order the ECB to undertake mass bond purchases and usher in fiscal union by the back door.

But there is a larger question: does Germany really want to pay the costs of monetary union any longer?

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EMU policies are pushing Southern Europe into systemic political crisis

This is what happened to Britain during the ERM crisis of 1992, the trial run for the monetary union.

German reunification was an "asymmetric shock", setting off a boom that compelled the Bundesbank to tighten the screw again and again, and forcing the Bank of England to follow suit at a time when the UK housing bust was already underway.

Spain is about to relive the experience, for Germany is going through another such shock. This one is caused by surging exports to the BRICs -- machinery, luxury cars, aircraft, medical kit, and chemicals. German exports to China rose 40pc last year, and 42pc to Russia.

Oddly, perhaps, I am not seriously worried about Ireland. It has a dynamic manufacturing and export service base, and can hope to export its way back to health. The fact that Ireland has required an EU-IMF rescue should not be misread as evidence that it is in worse shape than several others. Banking busts are desperate but not serious, as the saying goes.

The less open economies of Greece, Spain, and Portugal will find it more of a struggle to recover. The IMF says Portugal’s current account deficit will still be 9.2pc of GDP this year (and 8.4pc in 2015, if it is possible to defy gravity for so long), Greece will be 7.7pc, and Spain 4.8pc.

That these deficits should be so high two or three years into a slump shows how hard it will be to turn this crisis around. Meanwhile, The Netherlands will have a surplus of 6.8pc, and Germany 5.8pc.

The structural misalignment is grotesque, like the perma-divide between Italy’s North and South but without the vast annual subsidies that stops it blowing up.

A full 140 years after the Two Sicilies were gobbled up into Cavour’s lira zone, convergence has not occurred. The Bourbons might have done better.

Already reeling, the indebted European periphery must now brace for a fresh shock as the European Central Bank tightens monetary policy to stop Germany from over-heating.

One-year Euribor rates used to price Spanish mortgages have been creeping up for months, and jumped to 1.54pc after Jean-Claude Trichet turned seriously hawkish on inflation last week. It may go much higher very fast if the ECB starts to raise rates by the middle of this year.

This will not help clear a four-year backlog of unsold homes in Spain, which is no doubt why Madrid is pushing for a capital injection of up to €80bn into the smaller banks and cajas – by partial nationalization if necessary.

The central bank said in November that the banks have €181bn (£153bn) of "potentially problematic" loans to the real estate sector, or 17pc of GDP.

Mr Trichet’s fire-breathing rhetoric can be taken as a signal that the ECB will continue to run monetary policy for German needs and tastes, refusing to accommodate a little slippage on inflation to let Club Med regain lost competitiveness without having to endure the agony of debt-deflation. Indeed, the ECB seems to have picked up some of the worst habits of its mentor.

Mr Trichet is no doubt in an impossible position because the German people gave up the D-Mark under an implicit and sacred contract that EMU should never lead to inflation in their country. Should it ever do so, acquiescence in the whole project comes into question.

Yet Mr Trichet's comments on Thursday were astonishing. He cited the ECB’s rate rise in July 2008 with approval – and as a warning -- as if this monetary Charge of the Light Brigade had been vindicated by events. Most economists viewed that decision as best forgotten.

We now know that large parts of the eurozone were already in recession by then, that the commodity spike was burning itself out, that ECB rhetoric had set off a destructive dollar rout and pushed the euro to ruinous highs of $1.60, and that the foundations of the credit system were already crumbling.

A paper by the Richmond Fed suggests that ECB’s action was a key trigger of the global crisis.

The ECB is now itching to tighten again, this time because of a temporary jump in headline inflation to 2.2pc, caused by rising oil and food prices. No matter that M3 supply growth in the eurozone is anaemic at 1.9pc.

Real M1 deposits have contracted at a rate of 2.8pc over the last six months in the quintet of Italy, Spain, Greece, Ireland and Portugal.

"This is comparable with the decline in early 2008 just ahead of the plunge into recession," said Simon Ward from Henderson Global Investors.

The ECB has passed the eurozone debt parcel back to EMU governments, deeming it the proper responsibility of fiscal authorities to sort out the mess.

So be it. Since the only government that seems to matter in our new German Europe is in Berlin, the parcel has in reality been handed to Chancellor Angela Merkel.

She has two viable options. She can choose to save monetary union, first by doubling the size of the EU bail-out fund and halve the interest rate charged so that the debt-stricken states can recover; and then by acquiescing in fiscal federalism and a pooling of debts -- what McKinsey’s chief in Germany calls a "spiral into a Transferunion" – entailing a regime of subsidies for years to come.

That is to say, Germany must be prepared to do for Southern European what it has already done for its own kin in East Germany, but on six times the scale.

Or she can pull the plug, by quietly signalling to the Verfassungsgericht that Berlin would not be too angry if the eight judges declared the EU’s rescue machinery to be unconstitutional, ending EMU as we know it.

What is clear is that status quo is ruinous. The slow suffocation of nations still under Fascist rule just one generation ago cannot end well for liberal democracy in Europe.

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