Germany got a wake up call last week when an auction of 10 year government bonds failed to get bids for 35% of the bonds offered. While German bond auction failures are not as infrequent as one might imagine – six of the last eight auctions received fewer bids than the maximum amount of bonds offered – this one, coming in the midst of the European debt crisis, was perceived to be more ominous. If the strongest economy in Europe can’t sell all of its bonds, what chance does Italy or Greece have? Some have opined that this failure means the Euro crisis has entered a new phase and that Germany itself – the one government in Europe thought capable of ending the crisis – is now at risk. It was more likely a power play by Europe’s bankers intended to send a message to Merkel and Schaeuble. And it appears the message was received.
Schaeuble has been at the forefront in Germany demanding that banks share losses in any sovereign bailouts that come via the European Stability Mechanism to be established next year (moved up from 2013). The failed German bund auction last week was the banks reply and Schaeuble almost immediately backed down. Friday, Schaeble told reporters that “(i)f we now manage to move toward a stability union, we’ll see how one might possibly adjust the treaty”. Bankers 1, Schaeuble 0. It would appear the bankers are firmly in charge of Europe now and have no intention of playing the patsy. The banks were given an incentive to buy sovereign debt under the Basel committee rules that essentially made all European sovereign debt risk free. Banks could own European sovereign debt – no matter the country of issuance – without having to reserve for potential defaults. Europe’s governments, having fixed the rules to ensure a market for the bonds to fund their welfare states, now want to renege – and the bankers are having none of it.
Don’t get me wrong, Europe’s banks were given a free ride in the run up to the Euro (remember the convergence trade?) and have no one to blame but themselves for loading up on dodgy PIIGS debt but there was an implicit guarantee in the Basel rules that Europe’s governments must now honor. It is not much different than the situation in the US with Fannie Mae and Freddie Mac whose debts are now being honored by the US government. Europe’s governments got the benefit of issuing large amounts of “risk free” debt and now the bill has come due. Germany benefited from this arrangement every bit as much as their southern neighbors by exporting to the artificially supported PIIGS. Punishing the banks for doing their bidding – no matter how satisfying that might be – would reduce the ability of all European governments – including Germany – to borrow in the future.
What is happening in Europe right now is a contest to see who pays the bill for decades of government overspending (sound familiar?). The private banks want Germany to find a way force the PIIGS to pay up or allow the ECB to enter the market in force to push up the prices of the bonds they already hold. The bankers at the ECB are resisting until they can be sure the PIIGS have budgets in place that ensure the bonds can eventually be honored. The PIIGS – and the rest of Europe’s governments for that matter – want to carry on as they always have but that ship has sailed. These profligate governments are facing a diminution of their power that will be accomplished voluntarily by reducing their citizens promised benefits or by giving up control of their budgets to the Germans through the EU. The bankers are merely forcing the issue to resolution sooner rather than later and Germany is now furiously trying to find a way to enforce EU wide fiscal discipline.
This is the logical end of the European cradle to grave welfare state. For decades, Europe’s politicians have gained power by granting ever more generous benefits to their citizens as if there was no limit to what they could extract from the private sector economy. With the introduction of the Euro, countries such as Greece, Italy, Portugal and Spain were given a one time opportunity to get their fiscal houses in order. Riding on Germany’s coat tails they should have used the intervening years of falling interest rates to reform their social safety nets to something sustainable. Instead they took the lower interest rates as a signal that they could postpone the needed reforms until…well, until now.
Whether the Euro holds together or not cannot be predicted, but Europe’s unique brand of “market socialism” has failed. The overly generous promises of generations of politicians will have to be scaled back no matter how the crisis is resolved. It may be in the form of a much weaker Euro or it may be in the form of “austerity” but the current situation is unsustainable for much longer. It appears the bankers – private and at the ECB – have the upper hand and the governments of Europe will be forced to downsize. Europe and the global economy will be better for it in the long run despite whatever short term pain is involved.
This should also serve as a warning to US politicians. We face our own unsustainable benefit programs and eventually the market will force change upon us as well. Earlier this year, Dallas Fed President Richard Fisher described QE II as a bridge to fiscal sanity. Unfortunately, our politicians chose a fiscal Chappaquiddick and it will now be at least another year before any real reform is possible – assuming our bankers don’t force the issue sooner.