The German dilemma
Since the drama of the Italian election in the spring, European politics have been remarkably quiet. This has been by design – the countries who would like Germany to provide money or ease policy to support their beleaguered economies have understood that it is very important not to scare the German voters ahead of their general election on September 22. There was a fear that “bailout fatigue” amongst Germany’s electorate might force the politicians to make promises not to provide further support to weaker economies.
In two senses, the result is not in doubt – (i) Mrs Merkel seems sure to remain as Chancellor following the election, as her party is odds on to have the largest share of the votes and (ii) in that event, she will have to lead a coalition to form a government. What is uncertain is that this coalition will either be a continuation of the current coalition (of Merkel’s centre-right Christian Democrats with the Free Democrats should they reach the 5% threshold of the total vote required to get any seats in the Bundestag), or, if they don’t, there will be a “grand” coalition with the Social Democrats, the large centre-left party.
Whatever the shape of the resulting coalition, the next German government faces a huge dilemma between its two major policy objectives. It can choose to do all that it can to keep the Euro intact, which will achieve its foreign policy objective of being at the heart of an ever-closer European Union, but at the expense of its economic policy objectives of low and stable inflation and balanced budgets. Or it can choose to insist that Europe’s economic policies reflect those of Germany and watch as the rest of Europe suffers from economic stagnation until the option of withdrawing from the Euro becomes impossible to resist for some, threatening the survival of the Euro.
To achieve both of Germany’s key policy objectives, the optimal solution is a continuation of the current German stance where they provide the minimum in bail-outs to prevent a default, in return for a commitment to continued austerity at an agreed pace. This achieves their dual goals of keeping the Eurozone together, whilst maintaining a German –style attitude to fiscal policy and thus low inflation and a sound currency. It delivers the “stability” that is so prized by German politicians. However, this is an inherently risky policy for most of the rest of Europe, delivering a graveyard type of stability. It will ensure near zero growth, high unemployment and weak banking systems across the Eurozone, for a long time to come. It is eerily similar to the policy adopted by Japan which led to two decades of stagnation.
To escape this stagnation, countries in the Eurozone have three options: (i) leave the eurozone and repay their euro-denominated debt in their new (and devalued) currency – this would dramatically improve their trade competitiveness and reduce their national debt, but badly damage their relationships with their European neighbours; (ii) persuade the ECB to engage in Quantitative Easing in an effort to create inflation, which would reduce the real value of their debts and might also encourage some growth; or (iii) construct the necessary banking, fiscal and political unions to go alongside and support the existing monetary union. At an aggregate level the economy of the Eurozone does not have great budget and trade deficits. It is only at a national level that the problems appear, which implies that a deep and real economic union between the countries can be successful.
Of these three options, the first is seen as suicidal by incumbent politicians, not only for their prospects for domestic re-election but also for their chances of any future European roles in Brussels. The second is hard to imagine, since it would require both the ECB and the Germans to support a higher inflation objective. The third is very complicated to achieve - in 2011 the German Constitutional Court pronounced that the German constitution does not permit further significant political integration without a German referendum. It would also probably require referenda in several other Eurozone states. This is though the most logical solution to the Eurozone’s problems.
The banking systems across the Eurozone remain very weak, with the OECD recently estimating that since the crisis began, Eurozone banks have reduced the size of their balance sheets by €2.8tr but have a further €3.0tr still to go, from total balance sheets of approximately €32tr. The banks, particularly in the peripheral countries are in no position to support growth by increasing their lending. The outlook for economic growth in the Eurozone is thus very restrained, meaning that unemployment will remain very high and that governments will continue to struggle to deliver deficit reductions.
The implications for investors are that Eurozone growth will be very sluggish (even though in the short term growth may be improving), and will remain so as long as Germany’s preferred policy approach continues to hold, since no further fiscal or monetary stimulus will be supplied to the eurozone economy. We remain very cautious on European equities, which do appear cheap, but that cheapness is concentrated in banking shares and in the markets of the peripheral economies whose prospects remain very challenging.