24 October 2011

Simon Nixon: Crunch time for Franco-German relations

For the past 60 years, the European Union in its various guises has helped to ensure peace and prosperity. Central to this project has been the relationship between France and Germany.

For the past year, tensions between France and Germany have hampered a decisive response to the euro crisis. At issue is who should bear the ultimate losses should a eurozone government become insolvent. Germany believes those losses should be borne by eurozone government bondholders, bank shareholders and the citizens of the countries that ran up the debts. France argues the damage to eurozone credibility from failing to stand behind its governments and banks will ultimately cost taxpayers far more than supporting them with bailouts and liquidity facilities, including access to the unlimited firepower of the European Central Bank's balance sheet. The situation is complicated by the ECB itself, which agrees with France that sovereign defaults will trigger contagion and slump, but concurs with Germany that providing profligate governments with a blank check will fuel moral hazard.

But if this is the moment of truth for the eurozone, which will prevail: Germany or France? Both claim the moral high ground. Germany argues that socialising the costs of the crisis—whether through further bailouts, ECB liquidity support to governments and banks, or debt forgiveness—will reward irresponsible governments, creating moral hazard. Besides, European treaties forbid ECB financing of government debt and the bailing out of countries. And as the eurozone's richest member, Germany is only too aware France's approach would require German taxpayers to pickup the lion's share of the costs of the bailouts. France's approach also appears self-serving, since its banks are among the most highly leveraged and most heavily exposed to eurozone debt.

But France rightly argues the crisis has exposed severe shortcomings in the eurozone framework and that, in a highly interlinked currency union, there is no way to ring-fence the problems of one Member State without marshalling the full resources of the bloc. Simply recapitalising the banks isn't sufficient; there is no realistic amount of capital that would reassure markets the euro-zone banking system could withstand an Italian default. Only the ECB can remove the uncertainty over the eurozone's commitment to support its struggling sovereigns and banks. That may carry the risk of moral hazard, but there is nothing moral about triggering a global depression.

From the market's perspective, a French victory would clearly be the best outcome. But this seems unlikely since, even if Germany relented, the ECB doesn't want to put its balance sheet at risk. Worst would be a disorderly Greek default without a massive bank recapitalisation and increase in bailout facilities. Instead, what eurozone leaders appear to be inching toward is yet another fudge: a Greek deal that avoids default but still falls short of putting debt on a sustainable basis; a bank recapitalisation that's not sufficient to withstand multiple defaults and an expanded bailout fund that isn't big enough to restore the confidence of sovereign and bank debt markets. That would send a worrying signal that the rift between Germany and France hasn't been mended. And the longer they leave it, the wider it is sure to grow.

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