Whatever You Do, Don’t Pay Attention to the Rising Eurozone Stresses

One of the noteworthy elements of Davos, at least according to media accounts, was the cheery, self-congratulatory tone among the Davos Men, at least until the final day, when the emerging markets rout began. And why shouldn’t they be pleased? They’d come richer and more powerful out of an-economy-wrecking financial crisis, the sort of disruption that should normally have shaken up the social order and dislodged some of them from their perches. The fact that they fared so well boded well for them profiting from future upheavals, or at least surviving them intact.

One of their causes for celebration was the supposed improvement in the Eurozone, as witnessed by official results generally stopping their downward trajectory and showing enough noise around a new low base that the Panglossians have hazarded to call it a recovery. But as we have pointed out repeatedly, the fundamental policy contradictions remain unresolved. Germany wants to continue to run trade surpluses, particularly to other countries in Europe. It also wants to stop lending to them. It cannot have both. Yet it seems as unwilling to change its economic model or moderate its austerian demands of the so-called periphery countries as it was two years ago.

So while we see no overt crisis indicators (well on second thought, interbank lending rates have been elevated), political stresses seem to be rising. And it’s not clear how political conflict will play back into the economic realm, but the two have the potential to interact in nasty ways.

One negative sign is the definitive repudiation by the German High Court of the ECB rescue device called the OMT. Now on a practical level, this probably has very little near-term significance. The OMT was a clever move by Draghi to take existing powers and rebrand them to stare down on of the regular upheavals that used to plague the Eurozone. The headfake was astonishingly successful.

A German case challenging the OMT was decided by the German constitutional court last week. A very superficial reading would say the ECB won, since the German High Court referred the case to the European Court of Justice. But reading the ruling shows the reverse, that it was a blistering smackdown of the OMT. As Ambrose Evans-Pritchard wrote Friday evening:

The tough language leaves it doubtful whether the ECB’s back-stop scheme for Spanish and Italian bonds can be implemented if Europe’s debt crisis blows up again, and greatly complicates any future recourse to quantitative easing if needed to head off Japanese-style deflation.

The German constitutional court refrained from issuing a final ruling on the legality of the plan, known as Outright Monetary Transactions (OMT). It referred the case to the European Court instead, but only after having pre-judged the issue in lacerating terms that effectively bind German institutions. “The Court considers the OMT decision incompatible with primary law,” it said.

“This is a massive attack on Europe’s rescue strategy. I do not know whether the markets have understood this yet,” said Clemens Fuest, head of Germany’s ZEW Institute.

The usually-measured Wolfgang Munchau of the Financial Times was even more negative:

On Friday the German plaintiffs who brought the case were celebrating. It is not hard to see why. If you read past the first 15 pages of procedural jargon, you find the court concludes that OMT violates the German constitution. It accuses the ECB of making a power grab by extending its own mandate. It says the scheme endangers the underpinnings of the eurozone rescue programmes. Worse, it says OMT undermined deep principles of democracy. Were it to be used, it would deprive the German parliament of its fiscal sovereignty by forcing it to accept any losses the scheme generated. The ruling considers OMT to be debt monetisation, whereby a central bank prints money to finance sovereign debt. It is hard to think of any act short of a military coup that could violate so many important constitutional principles all at once.

And Munchau think the ECJ referral will only cause more mischief:

If you look back to all the previous German constitutional court cases on the euro, the answer was always a variant of “Yes, but”. This ruling was the legal equivalent of “No, no, no” – with one important addition. The court is asking the ECJ to clarify important points of European law, including whether OMT is covered by the ECB’s mandate; whether OMT needs to be capped; whether it violates the sovereignty of national parliaments; and whether it constitutes monetary financing of government debt.

Most commentators think the ECJ will side with the ECB. I am not sure. The ECJ, too, is hard to predict. It might not take the case; or it might take it and let it ferment. If the ECJ were to side with the ECB, we would end up with a “constitutional crisis”, whereby German constitutional law directly contradicts EU law. The German court left no doubt that the Bundesbank and other German institutions were bound by the constitution. They also made clear they were not letting go of this case. The ruling gives the distinct impression that the judges are referring the case not up to a higher court but down to a lower court.

Sadly, I can’t read the German press but this forceful a ruling has to strengthen the position of the Euro-opponents in Germany and they had already been gaining ground in the polls.

Stresses are emerging on other fronts. The Financial Times reports that the Eurozone’s new supranational banking regulator plans to take office, guns a blazing. If Daniel Nouy only lives up to a quarter of her talk, she’ll still make Elizabeth Warren look like a shrinking violet.* Key extracts:

The eurozone’s new chief banking regulator has warned that some of the region’s lenders have no future and should be allowed to die, heralding a far tougher approach to the supervision across the currency bloc.

In her first interview since taking charge of the euro area’s new banking overseer, the Single Supervisory Mechanism, Danièle Nouy also signalled she wants to weaken the link between governments and the bloc’s banks that lies at the core of the region’s crisis by breaking with tradition and demanding lenders hold capital against their sovereign assets…

Ms Nouy agreed with Mario Draghi, the president of the European Central Bank, that the ECB’s upcoming health check of the region’s biggest lenders would need to see some institutions fail to be credible. “We have to accept that some banks have no future,” she said, parrying speculation that a wave of consolidation could save the currency bloc’s weakest lenders. “We have to let some disappear in an orderly fashion, and not necessarily try to merge them with other institutions.”

The appointment of Ms Nouy, who joins the SSM from the helm of France’s banking supervisor, comes at a crucial time for the region’s embattled lenders. Her first task as Europe’s chief regulator is to oversee the health check, which will include an asset quality review and stress tests, before overseeing their supervision towards the end of this year….

Her readiness to countenance bank failures will trigger alarm among national politicians reluctant to see local lenders go to the wall. Italy has moved to reject the idea of setting up a “bad bank” for fear that it will focus market attention on the exposure of Italian banks to a rising level of non-performing loans and put the country’s credit rating at risk…

“Human nature being human nature, I don’t believe that the lessons are learned forever. So we have to be cautious and vigilant supervisors because, after a certain period of time, the lessons are forgotten. That’s for sure.”

While the Italians are the banks fingered as pushing back by the Financial Times, the ones who will come under even more harsh scrutiny are the German banks. As Kamal Ahmed of the Telegraph notes:

Eurozone banks are facing a new capital black hole of as much as €50bn (£42bn), according to one of the UK’s most respected financial analysts.

Davide Serra, the chief executive of Algebris, who advises the Government on banking, said that this year’s stress tests by the European Banking Authority and the European Central Bank were likely to find fresh problems in the eurozone banks.

He said that Germany had one of “the worst banking systems in the world” and that three or four regional Landesbanken were likely to be wound up. He also said banks in Portugal and Greece were likely to need more capital.

Now consider how this can play out. If the Germans get a better report card than they are believed to warrant, Nouy will be discredited and the countries whose banks get bad grades will feel even more justified in fighting the supra-regulator’s authority. And if the German banks are correctly found wanting, expect even more ire and lack of willingness among the growing ranks of the skeptics. The tensions are only likely to rise as these lingering issues can no longer be postponed. The open question is when they hit a breaking point.

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* Yours truly has not lost sight of the fact that talk is cheap and needs to be matched by deeds. However, Nouy and Draghi have painted themselves in a bit of a corner with their insistence that the stress tests will be tougher and the proof will be forcing some banks to fail.