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Analysis
Key to joint action is full-scale bail-out for Madrid

Key to joint action is full-scale bail-out for Madrid

August will be a busy and possibly disagreeable month
Writing on the wall for Greece

by David Marsh, OMFIF Chairman

Mon 30 Jul 2012

As different sides in the euro crisis try to push each other into equally unpalatable action, the stage is set for some hard talking this week between Mario Draghi, the European Central Bank president, and Jens Weidmann, the head of the Bundesbank. Indicating the euro imbroglio’s huge importance for the US economy, Treasury Secretary Timothy Geithner is expected to recommend urgent rescue action from Berlin in talks today with his opposite number Wolfgang Schäuble on the north German holiday island of Sylt.

Despite this, there is a danger that financial markets may have over-reacted to Draghi’s indication last Thursday in London that the ECB is about to restart purchases of bonds of peripheral euro members through its Securities Market Programme (SMP). A correction to the equity and credit market buoyancy of the end of last week may eventually work through.

The key to joint bond-buying action by the ECB and the European EFSF rescue fund is a Spanish application for a full-scale European bailout in the next few weeks. That would be a major concession by the Spanish government, but it will be difficult to avoid if the concerted measures to help Spain previewed by European leaders in the last few days are to become reality.

The Bundesbank said on Friday it opposed the idea of fresh bond purchases. Not for the first time in its history, European leaders are trying to press the German central bank into turning a No into a Yes. Although German chancellor Angela Merkel has stepped up verbal support for ‘protecting the euro’ in recent days, that falls a long way short of ordering the supposedly-independent ECB to go out into the marketplace and buy Spanish and Italian bonds.

Weidmann and Draghi are due to talk in the next few days, ahead of the ECB council’s next meeting on 3 August where the issue of bond purchases is expected to be hotly debated but not necessarily settled.

The Bundesbank’s general irritation at Draghi’s comments, combined with the weekend publicity given to the need for clarification with Weidmann, suggests that Draghi’s statement last week was not agreed in advance with the ‘hard money’ central bank representatives on the ECB council.

The Bundesbank and ECB have been in sporadic discord over bond purchases since the SMP started in May 2010, which led to a bitter row between then-ECB president Jean-Claude Trichet and the Bundesbank chief of the time Axel Weber. Although Draghi since he took over in November has been at pains to underline his support for Bundesbank orthodoxy, the last few weeks’ trials over the euro area’s future bring the biggest test of his relationship with the newly-energised German central bank.

Weidmann’s hard line, opposing both bond purchases and a mutualisation of euro area debt, is being supported by a strong coalition of interests in Germany. Adding to the line-up of conservative economists, professors and members of Merkel’s governing party, German trade union federation (DGB) chief Michael Sommer emerged over the weekend as a strong critic of Merkel's euro rescue strategy. He claims this infringes German democratic principles and transfers ever more competence to Europe beyond the control of the German parliament. Sommer’s suggestion for strengthened powers for the European parliament would introduce further complexity into an already horribly complicated exercise.

At the same time, there are doubts whether Spain will succumb to German requests to launch a full-scale bail-out to tap Europe’s rescue funds for the Madrid government and not just the banks. Without this, the effect of the Draghi announcement is likely to be short-lived. There are four possible outcomes on the SMP issue. Three of them are relatively bad for the euro.

First, the ECB will back down and not carry out bond purchases at all. This would be disastrous for Draghi’s credibility. Probably it won’t happen.

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