Just as Italy outplayed Germany on the football field in the European championships yesterday, the consensus view today is that Italy’s Monti outplayed Germany’s Merkel, forcing her to allow direct recapitalization of Spanish and Italian banks through the bailout fund called the European Stability Mechanism (ESM). But is this really a turning point in the crisis or just another kicking of the can down the road? The markets seem to think the former, with the Dow and the Euro both up significantly. But is this really the case? The answer is no.
First of all, the ESM recapitalization scheme doesn’t solve Europe’s banking crisis, it merely postpones it. Just as the earlier ECB LTRO refinancing operations were supposed to buy three years of time for the banks to sort out their balance sheets (but the effect lasted three months), so this is really just another attempt to solve a solvency problem (your banks are full of assets that are not coming back) with a liquidity instrument (lots of cheap ESM money). In the short term that may lower sovereign bond spreads, but in the long term no amount of liquidity can solve a solvency problem.
Second, even if the banking problem were solved, the underlying competitiveness problems of almost every economy against Germany remains. German industrial exports have the lowest price elasticities in the world. In plain English, it doesn’t matter if the BMW goes up ten thousand dollars it still sells. That is not true for FIAT or Renault. Being in the same currency with Germany places the strain of adjustment on domestic wages and prices in deficit countries, hence austerity policies. But such policies are self-defeating. Denied their own currency to devalue against the Germans, the result is eternal recession in the periphery. There’s a limit to how much recession an economy can take.
So two cheers for Monti’s scheme. It buys Europe more time. But time to do what remains in doubt.