The Eurozone Sovereign Debt Crisis
 
By
Henry C.K. Liu
 
Part I: The Eurozone Sovereign Debt Crisis
Part II: The Role of the IMF/ECB/EC Troika
Part III: Supranational Globalization vs Nation State Sovereignty
 
 
Part IV: Need for an Orderly Withdrawal Mechanism from the Euro and the Eurozone
 
 
In the face of imminent breakup, eurozone and EU governments will do well for their common good to create an orderly exit mechanism for Greece and any other country in financial distress that may wish to leave the monetary union to regain sovereign authority to preserve independent, unilateral monetary operational space.
 
Hang Together or Hang Separately
 
Benjamin Franklin’s famous forewarning at the signing of the US Constitution that “We must all hang together, or surely we will all hang separately,” does not seem to apply to the situation facing the eurozone governments. There does not seem to be any compelling reason to preserve the eurozone as it is currently constituted. In fact, it seems that to save the euro as a common currency, it is necessary to restructure the eurozone to rid it of profligate sovereign member states or to adopt fiscal union that would dilute national sovereignty. Hanging together in defiance of structural centrifugal forces of economic nationalism acting on the eurozone may drag the whole zone into the abyss of bottomless sovereign debt.
 
Need for Supranational Authority
 
To keep the eurozone in good economic health, there is a need for a supranational institution with a clear mandate and authority to coordinate a zone-wide fiscal regulatory regime with two hands, one with monetary policy authority and the other with  commensurate fiscal policy authority. Yet forcing eurozone member governments to adjust their separate fiscal policies to accommodate monetary rigidity of a common currency is to ask their political leaders to commit domestic electoral suicide. Without the availability of both monetary and fiscal supranational authority, the effect of supranational policy dealing with the sovereign debt crisis caused by a common currency is merely the same as sounds of one hand clapping.
 
Pre-Arranged Exit
 
A pre-arranged exit door for voluntary withdraw for member states may provide a better chance to restore the monetary credibility and financial strength of the eurozone by ridding it of the unsustainable burden of hopeless fiscal liability of profligate member states while allowing the member states in sovereign debt and fiscal distress the monetary option of using sovereign credit denominated in their own national currencies to work out their public finance difficulties independent of the rigid centralized monetary policy of the eurozone. This is particularly true when current eurozone monetary policy appears to be designed only for the needs of the zone’s stronger economies, with such rigid unified monetary policy inevitably landing the weaker economies in unsolvable sovereign debt crises that need to be paid for with socio-politically de-stabilizing fiscal auterity down the road. Conceptually, voluntary monetary union membership is not truly voluntary without an operative mechanism for voluntary withdrawal.
 
A clear legal framework with standardized financial terms for member states wanting or needing to withdraw voluntarily from the euro as a common currency will be less disruptive to the European Union than would otherwise be with involuntary sovereign debt defaults inflicted by market forces or with the uncontrolled consequences of ad hoc expulsion of hapless member states in the midst of a severe financial crisis.
 
German and French Deliberation on Eurozong Restructuring
 
Unconfirmed reports from Brussels in early November 2011 gave hints that the leaders of Germany and France, the two biggest and strongest economies in the eurozone, had begun preliminary deliberation on a restructuring of the eurozone to create a “New Europe” of more solid credit worthiness, in view of the fact that Italy, the third largest economy in eurozone after Germany and France, and the government with the biggest sovereign debt exposure, while being too big to fail, is also too big to rescue. Should Italy default, the vulnerability of sovereign debt of Spain to market pressure would be heightened, as would those of France and even Germany.
 
Political Turmoil in Italy
 
By November 2011, Italian Prime Minister Silvio Berlusconi had lost control of the political situation at home as a result of his failing leadership in dealing effectively with relentless market pressure on Italian sovereign debt, and had to resign “voluntarily” his  prime minister position to avoid the indignity of a no confidence vote in parliament, with a consolation prize of being allowed to tender his resignation officially only after his austerity fiscal program designed to calm creditor concern was adopted by parliament. Concurrently, a new “national unity” coalition government was experiencing weeks of birth pains as the sovereign debt crisis in Italy was left to deteriorate further in the market by an open-ended political vacuum.

Equity Market Sell-Offs

Equity markets were hit with deep sell-offs in the weeks after November 16 following news from Brussels that the leaders of France and Germany were discussing the need for a formalized expulsion process for fiscally unruly member states from the eurozone, despite quick denial by French government spokesmen that such talk was mere baseless rumor.

The leaders of France and Germany were reported  as holding discussions on possible treaty changes to create tighter coordinated “economic governance” for governments whose economies use the euro, including the idea of more central surveillance of national budgets and fiscal estimates and projections, with clearer operational rules and stricter sanctions for those governments that persistently violate criteria set by the Stability and Growth Pact (SGP) in the Maastricht Treaty, namely fiscal deficit not over 3% of GDP, public debt not over 60% of GDP and inflation rate of not more than 1.5 percentage points higher than the average of the three best performing (lowest inflation) member states of the EU.
 
SGP Criteria Depress Growth

The fact is that no economy in the world today meets the SGP criteria, and should a government impose such criteria, its economy might not be better off because of the resultant anemic growth rate from the tight fiscal criteria. The Achilles’ heel of the SGP is that stability, both monetary and fiscal, in high growth situations yields wonderful economic results, but stability in anemic growth situations is hell, particularly for politicians in democratic countries whose governments are more vulnerable to short-term voter sentiment.

This is an economic truth insightfully observed by John Maynard Keynes. Whether this truth is labeled as a Keyensian Perspective or not does not distract from its validity.
 
France and Germany Debate via Public Speeches

On Thursday, December 1, 2011, days before a potential market implosion on eurozone sovereign debt when several large tranches of sovereign debt from eurozone governments would face market challenges of rolling over on their maturing sovereign debts, French President Nicolas Sarkozy used a major hour-long speech in the southern port of Toulon to sketch out the French vision of Europe’s future by setting out initiatives that appear to be at odds with Germany’s proposal for more rigorous monetary union by treaty reform to save the single currency and to restore a stronger European Union able to ward off fragmentation from its most serious economic and political crisis since its existence.
 
France Calls for Suprantionalism by Another Name

Firing off an official blast in the high-stake political debate among top EU political leaders that will decide on the fate of the euro as a common currency, Sarkozy delivered an high-profile speech calling for a new deal that would enable political leaders of the 17 eurozone member states to strike political bargains among themselves, while conceding that Europe’s sovereign debt crisis and collapsing market confidence in the common currency have left France with the realization that it must surrender some sovereignty to a new supranational supervisory regime of fiscal discipline. Along with France, all other eurozone governments would need to forfeit their constituent rights of veto in eurozone central fiscal policy-making under a new system of majority vote.
 
Sarkozy left the details of his proposal vague in his otherwise carefully crafted speech. Still, the main thrust of his proposal appears to run counter to Berlin’s call for a much more rigorous monetary union in which participating governments would surrender ultimate control of the their sovereign fiscal policy prerogative to a centralized supranational EU entity with intrusive powers of scrutiny on national fiscal conditions and enforcement of prescribed penalties for fiscal violations.
 
Denying the obvious, Sarkozy declared adamantly: “The reform of Europe is not a march towards supranationality. The integration of Europe will go the inter-governmental way because Europe needs to make [unified] strategic political choices.”
 
Germany Insists on Treaty Reform

German Chancellor Angela Merkel, before going to Paris on Monday, December 4, to try to work out details of the new eurozone treaty change with her French counterpart, would unveil her own proposals and priorities in a speech to the Bundestag in Berlin on Friday, December 2, one day after Sarkozy’s policy speech. British Prime Minister David Cameron would also to go to Paris Friday, December 2 for discussions on the crisis the French President.
 
Addressing parliament in Berlin amid warnings that time is running out for the euro, Merkel repeated her view that the eurozone should establish a fiscal union in order to safeguard the single currency, urging that the Lisbon Treaty be renegotiated to create a regime of controls and penalties which would ensure that European sovereign debt crisis will not be a recurring affair.
 
Merckel refused to be rushed into trying to resolve the crisis with temporary, expedient measures, declaring that staying power rather than speed was the answer. This position held by Germany is understandable since Germany is the only country whose economy has staying power.  Thus Merkel's declaration of the importance of staying power is a message of Germany holding all the cards in the quest for solution to the European sovereign debt crisis.
 
Merkel Rejects Proposal for Eurobonds but Shows Flexibility on ECB

Ahead of talks in Paris on Monday, December 5, 2011 with her French counterpart to work out a unified strategy before taking it to an EU summit in Brussels on Thursday, December 8, 2011, Merkel ruled out any pooling of eurozone debt in the form of Eurobonds as non-starter. She did hint some flexibility on her position on the European Central Bank. This was viewed by the market as a concession by Germany, as Merkel had been adamantly opposed to both the issuing of Eurobonds and allowing the ECB an expanded market intervention role as the eurozone’s lender of last resort.

“A discussion about Eurobonds is pointless,” Merkel declared. “Anyone who has not grasped that Eurobonds are no remedy has not understood the nature of the crisis.” To German thinking, it would be a move towards uncontrolled moral hazard for the profligate government whose lack of fiscal discipline had caused the sovereign debt crisis.
 
On the ECB issue, Merkel appeared to be less uncompromising than before. “The role of the ECB is different from that of the US Federal Reserve or the Bank of England,” she pointed out. She would leave it to the German Central Bank in Frankfurt to act as it sees fit, since a central bank is supposed to be politically independent. “I’ll not comment on what national central banks, or the European Central Bank, do or don't do,” expressing a correct political posture that would also put the burden of monetary decision on the German Central Bank where it belongs.
 
Merkel Buying Time with Demand for Long-Term Solution
 
Some in the market think that Merkel is merely buying time to institute a new longer-term euro regime with short-term action to ward off market pressure on the euro. The ECB would be encouraged to expand its bond-buying similar to the Fed’s TARP program, while the International Monetary Fund (IMF) could take a bigger role; eurozone countries could post more bilateral loans with the IMF to enlarge bailout capacities, effectively setting up a prototype European Monetary Fund.
 
Enlarging the IMF would face the question of where the new funds would come from and the question could be expected to intensify discussion on IMF reform, as the emerging economies have been demanding a bigger voice in IMF policy formulation if they are asked to increase their contribution to the IMF.
 
ECB Sets Tight Fiscal Regime as Condition for Market Intervention
 
Mario Draghi, new head of the ECB, signaled on Thursday, December 1. 2001 that once the stiffer fiscal regime was agreed, ECB could become more proactive in helping to solve the crisis. However, the condition of fiscal union is not expected to become reality anytime soon as the debate on the balance of national sovereignty and supranational authority rages on regarding federalism in the European Union.
 
Germany Warns Britain  
 
Merkel repeated her view that the Lisbon Treaty had to be re-opened for systemic reform to be possible. In a clear warning to British Prime Minister David Cameron, the German Chancellor pointed out should the 27-member EU block treaty reform, the 17-member eurozone within the EU can forge their own sub-pact within the Lisbon Treaty, which could leave Britain out of decision-making completely. The implication is that, if Cameron makes too many problems (tabling additional demands unacceptable elsewhere) eurozone leaders will sidestep the stalemate.
 
Merkel Calls for Tobin Tax and Ban on Short Selling
 
Earlier in May 2011, Merkel launched a barrage of rhetoric against financial markets, throwing Germany’s weight behind a demand for a global tax on bank transactions (known as the Tobin Tax from the days of the Asian Financial Crisis of 1997) and proposing a radical shift in the rules governing the single currency by insisting struggling eurozone countries be allowed to restructure their debt with government protection from market speculation.  The idea, when floated by Greece to Washington with German encouragement, did not receive support form President Obama.
 
Following Greece’s debt emergency and with the euro in the throes of its worst crisis of confidence, Merkel proposed a nine-point plan rewriting the euro regime to include legally enshrined budget deficit ceilings in all 16 member countries. The German demands, in a finance ministry paper, could require the EU's Lisbon Treaty to be renegotiated, presenting British Prime Minister David Cameron with a dilemma over whether this would trigger an EU referendum in Britain.
 
Markets Fell by German Response to Sovereign Debt Crisis
 
German reponse to the sovereign crisis in the eurozone and Germany’s shocking decision to impose a ban on naked shorts – a strategy designed to profit from falling markets – drove the FTSE 100 down below 5,000 for the first time since November 2010 and to its biggest two-day fall since March 2008.
 
Wall Street was also rattled after a rise in jobless claims added to the euro tension. With the blue-chip Dow Jones industrial average down almost 3% by the middle of the session. The broader S&P 500 index reached official "correction" territory as it sank 10% below its recent high point, set in late April.
 
Britain’s Financial Sector Under Pressure from German Call Regulatory Reform
 
Cameron’s coalition government feared pressure on the UK banking sector by Germany’s call for a Tobin Tax and promising to rewrite the “fundamentally flawed” system of financial regulation. The British prime minister also pledged to study the “complex issue of separating retail and investment banking” and giving regulators greater powers, as an echo of financial regulatory reform in the US.
 
Merkel, unrepentant about her controversial unilateral ban on short selling,  told a Berlin conference on market regulation that governments the world over were failing to come good on their pledges made two years earlier to strengthen regulation of financial markets.
 
In a concession to her centre-left opposition before a crucial vote in Berlin on the €750bn for the EFSF rescue funding for the fragile euro, Merkel said she would fight for a global financial transactions tax at the G20 meeting in Canada in June. German Finance Minister Schäuble argued that if the G20 effort failed there should be a European tax and if that ran into resistance – not least with the British – he would recommend it for the 16 countries of the eurozone.
 
In Brussels, Germany has consistently demanded for the eurozone heightened budgetary rigor, coupled with draconian penalties for profligate eurozone member governments, without which the euro cannot survive as a common currency. “The crisis in Greece has brutally exposed weaknesses in European monetary union,” the paper by Schäuble reads. “Monetary union is ill-equipped to deal with the extreme scenario of sovereign liquidity and solvency crises.”
 
Sarkozy Calls for “Debt Guillotine”
 
President Nicolas Sarkozy of France, in a gesture of support to Merkel, said he was looking at changing the French Constitution to introduce a “debt guillotine”, with no mention of figures or deadlines, invoking horrifying images of the French Revolution.

A coolapse of the euro will cause significant financial problems for France, having to revert back to a national currency whose value will fall even lower than what it was before the adoption of the euro. France’s debt of the €800million owed to the European Central Bank will consequently double in exchange value, and would have to be paid by Metroplitan France (l'Hexagone - as the French refer to Metroplitan France, the part of France in Europe, as opposed to l'Outre-mer, or colloquially les DOM-TOM - Overseas France, which together form what is officially called the French Repulbic of which Metropolitan France accounts for 81.8% of the territory and 95.9% of the population.).

Sarkozy, or his successor, would have to play the Tropical card: a devaluation of the CFA franc could allow France to owe to African countries of the CFA zone only half of their assets deposited at the French Treasury and to use more than 40% of African resources to keep France solvent. Sarkozy has commissioned two African heads of states, Alassane Dramane Ouattara of Cote d’Ivoire and Sassou Nguesso of Congo-Brazzaville, to prepare the West African populations to receiving the merciless blade of the debt guillotine.  

The franc CFA is the name of two currencies used in former French colonies in Africa which are guaranteed by the French treasury. They are the West Africa franc CFA and the Central African franc CFA. Although theoretically separate, the two franc CFA currencies are effectively interchangeable, currently at a fixed exchange rate to the euro: 100 franc CFA = 1 former French (nouveau) franc = 0.152449 euro; or 1 euro = 655.957 franc CFA.
 
Although Central African franc CFA and West African franc CFA have always been at parity and have therefore always had the same exchange value to other currencies, they are in principle separate currencies that could theoretically have different exchange values at any time that one of the two CFA monetary authorities, or France, so decide. Therefore West African franc CFA coins and banknotes are theoretically not accepted in countries using Central African franc CFA, and vice versa. However in practice the permanent parity of the two CFA franc currencies is widely assumed.  Franc CFA currencies are used in fourteen countries: twelve former French colonies in Africa, as well as in former Portugese colony Guinea-Bssau and in former Spanish colony Equatorial Guinea. The ISO currency codes for the Central African franc CFA is XAF and for the Wesr African franc CFA is XOF.

ISO 4217 is a standard published by the Inrernational Standards Organization (ISO) which delineates currency designators, country codes (alpha and numeric), and references to minor units in three tables: 1 - Current currency & funds code list; 2 - Current funds codes and 3 - List of codes for historical denominations of currencies & funds. The tables, history and ongoing discussion is maintained by SIX Interbank Clearing, Ltd which acts as the ISO 4217 Maintenance Agency on behalf of the International Organization for Standardization (ISO) and its Swiss member SNV (Swiss Association for Standardization).

The ISO 4217 code list is used in banking and business globally. In many countries the ISO codes for the more common currencies are so well known publicly that exchange rates published in newspapers or posted in banks  use only these to delineate the different currencies, instead of translated currency names or ambiguous currency symbols . ISO 4217 codes are used on airline tickets and international train tickets to remove any ambiguity about price.

In 1973, the ISO Technical Committee 68 decided to develop codes for the representation of currencies and funds for use in any application of trade, commerce or banking. At the 17th session (February 1978) of the related  UN/ECE Group of Experts agreed that the three-letter alphabetic codes for International Standard ISO 4217, “Codes for the representation of currencies and funds”, would be suitable for use in international trade. Over time, new currencies are created and old currencies are discontinued. Frequently, these changes are due to new governments (through war or a new constitution), treaties between countries standardizing on a currency, or revaluation of the currency due to excessive inflation. As a result, the list of codes must be updated from time to time.

Germany Calls for Allowing Governments to Default in “Managed Way”

In May 2010, Schäuble eased up on Germany’s initial proposals that debt-ridden delinquents without fiscal reform be kicked out of the common currency. Still, the German finance minister argued that countries in dire sovereign debt straits must be allowed to restructure their sovereign debt or default “in a managed way”, without  making clear whether such a country would need to quit the euro, or how contagion can been limited by a firewall.
 
Schäuble also suggest that national budgets of eurozone governments be peer-reviewed by specialists at the European Central Bank or “independent” experts to ensure budgetary rigor and adhesion to a revamped Stability and Growth Pact. In May 2010, German officials seemed not to understand that fiscal problems in many eurozone countries are not economic problems, but political problems with economic implication. Some of these changes on further surrender of sovereignty to supranational authority would need the Lisbon Treaty to be reopened, requiring the assent of all 27 members, whether in the eurozone or not.
 
Germany Insists on Log-Term Solution

Despite pressure in Washington, in London, and elsewhere for prompt spectacular action to halt a potential disaster spilling over to the US and UK, Merkel in May 2011 pleaded for time, emphasizing that a crisis which had taken years to build would require years to resolve.
 
A European diplomat was reported to have said: “We want this fixed as soon as possible. But Merkel and others say that misses the point, that these are really big issues. We’re now realistic about how long it’ll take. It will be sufficient [meantime] to muddle through.”  Muddling through was exactly the Europeans did in the 18 months since the sovereign debt crisis broke out. The US press called it “kicking the can down the road,” without a plan.
 
“Merkozy” Team not a Partnership of Equals

The “Merkozy” team is clearly not a partnership of equals, a fact clear from the separate speeches in Toulon and Berlin on the difference between the French and German views on “The Future of Europe”.
 
Charles Grant, director of the Centre for European Reform, wrote: “For the first time in the history of the EU, Germany is the unquestioned leader, and France is number two. Since the financial crisis struck in 2008, the economic inequality between France and Germany has grown.”
 
While both Germany and France agree on the need for fiscal union for the eurozone, pooling or surrendering some national sovereignty over budgets to keep debt within fiscal capacity and to punish those who violate the SGP criteria. The key difference lays the process of constitutional reform. Rewriting the Lisbon Treaty will required negotiation by all 27 EU governments and ratification by all 27 EU parliaments. Experience shows this to be time consuming, politically hazardous, diplomatically acrimonious and government positions held hostage by referendums. Germany under Merkel insists on it due to domestic political sentiments while France under Sarkozy would prefer to avoid it also for domestic political reasons.
 
There are bigger differences. Assuming Merkel prevails, who is the enforcer of fiscal union? Sarkozy wants powers to stay with national leaders. Merkel wants them vested in a "European institution". 
 
The Lesson of Thatcher’s Hostility to a Federal Europe

Lest one forget Margaret Thatcher’s famous “NO,NO,NO!” speech in the House of Commons on the European Council meeting in Rome held on October 27/28 1990 on the final stage in the European Council, her hostility to a federal Europe led to Geoffrey Howe resigning on November 1 and to his fellow federalist Michael Haseltine’s bid for the Tory leadership which brought down Thatcher on November 22, 1990.
 
Germany Calls for Using European Commission and European Court as Referees

 On Friday December 2, 2011, Merkel suggested the European Commission and the European Court of Justice referee fiscal conduct of eurozone governments, and issue automatic penalties to offenders. “You couldn't [then be able as a sovereign state] legislate your own budget. You need to seek agreement from someone else on how to spend your taxpayers' money,” commented an EU diplomat.
 
Sakozy Denies France Supports Supranationality

On Thursday, December 1, 2011, Sarkozy denied he was proposing supranational authorities, but was only stressing tightly coordinated decision-taking between governments and their leaders. Forfeiting sovereign power over France’s budget could be politically costly for Sarkozy, facing election May 2012. For both the right and the left in France, the notion is contested. Gaullists among Sarkozy’s own ranks are also against any such idea.
 
Euro Faces Critical Week

Merkel demanded more strict control over fiscal policies of eurozone member governments at the beginning of a critical week for the euro. Hopping to forestall the imminent collapse of the common currency, the German chancellor decided to give the impression of finally taking decisive action to calm the financial markets when she said it was time to stop talking about a fiscal union and start creating one.

Merkel acknowledged, however, that negotiations to secure for the 17-member eurozone greater central fiscal control could not be rushed and would involve a risky renegotiation of the Lisbon Treaty and risky ratification on the negotiated changes.
 
Still, interest rates on Italian and Spanish government borrowing fell sharply and markets rose on hopes that European politicians are finally taking the euro crisis seriously and have woken up to the potential damage that a breakup might inflict, despite the fact that the process could take years to bear fruit, and could still be torpedoed by politicians from any of the 17 eurozone countries subject to domestic political pressure on the loss of sovereignty.
 
Britain and France Gave Support to German Call for Treaty Reform

British Prime Minister David Cameron, for whom the talks over closer fiscal union threaten to be politically perilous, and concerned about the negative impact of a chaotic breakup of the euro on an already fragile UK economy hurt by uncertainty on the euro, was in Paris on Friday, December 2 for a 90-minutes working lunch at the Elysee Palace with French President Nicolas Sarkozy, before heading back to London where, appearing resigned to Merkel’s plan for treaty reform, declared he was not categorically opposed to it.  “If there is treaty change, then I will make sure that we further protect and enhance Britain’s interests,” he said. 
 
A statement No.10 Downing Street said Britain accepts that the eurozone needs a “new set of rules” and, with a treaty negotiation looking increasing imminent, Britain’s priorities in those talks would include protecting the single European market and the City of London [as an international finance center] and preventing the 17 countries in the eurozone ganging up against the interests of the 10 non-euro EU countries who are outside it.
 
France and Germany would try to draw up a more detailed blueprint at a summit on the following Monday, December 5 after Merkel presented her proposal to the Bundestag, while the US Treasury Secretary Tim Geithner is expected to stress Washington’s concern over the risk to the global economy posed by the monetary crisis when he makes his fourth visit to Europe in six months. A final battle between national sovereignty and supranationalism is on the horizon.
 
Merkel is pushing for a new enforceable European fiscal regime under which countries using the euro would ultimately need to sacrifice sovereign fiscal powers to a European supranational authority that would monitor and subsequently either endorse or veto national budgets. It would “punish” those whose debt levels are deemed to be destabilizing the euro as a common currency. She pointed again that there was no quick fix to a crisis that had taken years to develop, and stressed there was no danger for German budgetary sovereignty presumably because Germany has a good record of fiscal discipline and therefore no supranational authority would challenge German sovereignty on fiscal issues. In other words, national sovereignty is save for countries that do not violate SGP criteria.
 
Merkel Sets Eyes of Long-Term Preventive Cure

The thrust of Merkel's argument is not so much about settling the immediate sovereign debt crisis, but installing a longer-term regime to ensure such crisis can never happen again. The Lisbon Treaty would need to be revised to make that possible. But if that proved too difficult, she added in remarks that will resonate in No.10 Downing Street, the eurozone leaders could take matters into their own hands outside the EU treaty, and leave trouble makers such as Britain out of the decision-making circle.
 
EU Treaty Reform Problematic For British Political Leaders

An EU treaty negotiation would present Cameron with the perilous task of trying to prevent a rupture between his pro-European Liberal Democrat coalition partners and the increasingly impatient Eurosceptic wing of the Conservative party.
 
But some Tory Members of Parliament want to use any renegotiation to demand a wholesale repatriation of sovereign powers from the EU – a position that is unacceptable to the Liberal Democrats. Cameron’s response has been to stress his commitment to the repatriation of sovereign powers in the long term while arguing that, with the euro in crisis, now is not the time for the time for a full-scale renegotiation. The British position of short-term surrender of sovereign powers with repatriation in the long-term is based on reverse logic from that of Germany, which wants long-term surrender of sovereign powers with short-term compromise until the sovereign debt crisis is solved with long-term solutions.
 
Merkel Insists Only Long-Term Solutions Will Appease Markets

Merkel sought to turn the tide on two years of a collapsing euro by demanding a permanent fiscal union among the 17 common currency countries through a risky re-negotiation of the Lisbon Treaty.
 
Amid apocalyptic warnings that the decade-old common currency was on its last legs, with only days left, before sovereign default by Italy and Spain failing to roll over their maturing bonds, for European leaders to concoct an effective response to the sovereign debt crisis that would appease the bond markets, Merkel, however, emphasized that she would not be rushed and that there was no quick fix to a crisis that had taken years to develop.
 
In her speech to the Bundestag in Berlin on Friday December 4, Merkel said the time had come to stop talking about a fiscal union and start creating one. She is to draw up a more detailed blueprint with President Nicolas Sarkozy in Paris on Monday and deliver the new scheme to a crucial EU summit in Brussels next Thursday.
 
A Franco-German Duet

Coming a day after Sarkozy’s speech in Toulon on the future of Europe, Merkel's statement was a signal of Franco-German resolve to deal with the sovereign debt crisis after 18 months of persistent ineffectiveness. The question remains that even with a show of German leadership and French support, can the sovereign debt crisis be resolved to everybody’s satisfaction, including the voting public in different countries?
 
The key reason Germany is adamently opposed to the issuance of Eurobonds is simple – Germany will be the party paying for all the cost of the bad debts of other euro nations while other eurozone governments continue on a painless joy ride on Germany’s good credit as they have done since the introduction of the euro. Without fundamental fiscal reform, the good credit rating of Germany will be sacrificed for no good purpose, as the unconditional backing of German credit on Eurobonds would only give the profligate eurozone governments less incentive to introduce politically unpopular but operationally necessary fiscal reform.
 
Germany under Chancellor Merkel also opposes any expansion of the market interventionist role of the European Central Bank even though no other institution is available or financially qualified to save the euro from market pressure, without fundamental constitutional reform on fiscal union, because it would turn the ECB into a dope pusher instead of being a detoxification agent of ruinous debt. It appeared, however, that Merkel has been forced by internation pressure to moderate her resistance to an expanded if limited ECB role, only if just to buy time and to clear the way for national central banks in the eurozone and International Monetary Fund to intervene in bond markets to relieve the time pressure so as to provide the breathing space needed for working out a more fundamental systemic response.
 
France Protective of National Sovereignty

France is uncomfortable with the approach of formal permanent dilution of sovereign powers by a supranational institution. Loss of sovereign power is historically a long-held Gaullist phobia. Accrodingly, it is understandable that Sarkozy leans towards a less formal arrangement on a case-by-case basis on the kind of punitive sanction to be decided by heads of government in the eurozone, taking into consideration the socio-political dynamics of each nation facing imminent default, so the penalty will lead to positive policy effects rather than painful punishment on the population for no redeeming purpose.
 
Sarkozy also favors immediate measures such as the floating of Eurobonds or a proactive market intervention role for the ECB, despite Merkel’s strong opposition on both in public. On Friday, December 2, 2011, Merkel in her speech in the Bundestag acknowledged that treaty reform can pave the way towards Eurobonds issuance. She appeared to be softening her stance on the ECB’s interventionist role, not to cure the crisis but to buy time for long-term cures to take hold.
 
Market expectations ahead of the European summit schedule for Friday December 9, 2011 include visible progress on agreements on long-term reform on fiscal integration and that agreement on long-term solutions may help close gaps in short-term disagreements among EU member states.
 
Britain Will Defend its National Interests from Supranationalism

British Prime Minister David Cameron, who had a lunch meeting  with Sarkozy in Paris during the last week of November, indicated upon returning to London that he would support Merkel’s plan of treaty reform, although stressing that he would vigorously defend Britain’s national interests in any EU treaty changes.
 
Disappointed by the outcome of the EU summit meeting on Tuesday, November 29, which saw eurozone finance ministers admit to having failed to boost the EFSF bailout fund to the promised €1 trillion, markets rallied the following day when the world’s major central banks stepped in under urging from the US Federal Reserve to lower the cost of US dollar funding for banks in Europe and elsewhere to offset capital flight from the euro. The market rally carried right through to Friday, further supported by expectations of a cut in the ECB’s key policy rate on the coming Thursday and the EU summit on the coming Friday, which will hopefully deliver plans to transform the currency union into a closer fiscal union.
 
Shuttle Diplomacy and Public Dialogues

All the shuttle diplomacy and public dialogue though official speeches were designed as political theater for setting up national positions for negotiation at the EU summit the week after. The on-coming summit has been described as another of Europe’s last chance to secure the survival of the euro as a common currency, among many previous last chances warnings that had passed without a solution. France and Germany now appear united on the need to keep the euro as a common currency even by shrinking the eurozone, yet the two nations remain divided over the proper ways to achieving that objective.
 
“Together we will make proposals to guarantee Europe’s future,” said Sarkozy, ignoring that the fact that proposals by France are diametrically opposite to those by Germany. France wants the European Central Bank (ECB) to intervene in the market to stabilize the euro as a common currency of government with difference fiscal policies and conditions.  This role for the ECB has been persistently rejected by Germany.
 
In his speech in Toulon, while acknowledging the “independence” of the ECB, as a central bank, from national political pressures, something that all central banks insist on, Sarkozy also said that the ECB should act if conditions require as a matter of fulfilling its institutional mandate. “The ECB is independent and will remain so. I am convinced that facing the risk of deflation that threatens Europe, the ECB will act,” he said. “It’s up to it [ECB] to decide when and in what way.” The implication is that the ECB will act according to macro-economic conditions and not from poltical pressure. 
 
Merkel also wants to reform the treaty conditions governing the euro by rewriting the Lisbon Treaty, to be negotiated by all 27 EU member states that would also involve the European parliament and the European Commission.
 
While he did not provide details, Sarkozy emphasized the autonomy of the eurozone from the EU, suggesting that the 17 member states in the eurozone could form a separate sub-pact without reopening the Lisbon Treaty that governs the EU. Merkel in Berlin insists there should be automatic punishments for countries in violation of the treaty terms, with the European Court acting as referee. Sarkozy said only that sanctions should be “more automatic”, leaving room for member state leaders to strike deals. The use of the term “punishment” rather than “penalty” suggests that Merkel is thinking of inflicting pain on the population as an effective leverage, rather than imposing disadvantages on government to government interaction.
 
ECB Supports Eurozone Fsical Union

Mario Draghi, the new head of the ECB, supports the German view on constitutional reform while hinting that the European central bank could become more proactive in supporting the European bond market once the new regime of fiscal coordination is operational.
 
“Fundamental questions are being raised and they call for an answer,” Draghi told the European Parliament in Brussels on December 1, 2011. “A new fiscal compact” is “definitely the most important element to start restoring credibility. Other elements might follow, but the sequencing matters. It is first and foremost important to get a commonly shared fiscal compact right.” Draghi did not specify what more the ECB could do and said the central bank’s bond purchases “can only be limited.”  “Our economic and monetary union needs a new fiscal compact – a fundamental restatement of the fiscal rules together with the mutual fiscal commitments that euro area governments have made.” 
 
Coordinated Central Bank Action

 A day earlier, the ECB joined forces with the Federal Reserve to cut the cost of emergency dollar loans to banks outside the US. While the coordinated action fuelled a global stock market rally, the yield on Italy’s 10-year bond remained close to 7% as contagion spreads to the euro region’s core.
 
The euro initially fell on Draghi’s remarks before rebounding to trade at $1.3486 at 1:25 pm in Frankfurt. The Stoxx Europe 600 Index also recouped its losses.
The market viewed Draghi as trying to manage market expectations to make people understand while the ECB would not behave as the Bank of England or the Federal Reserve do, it does not mean it is unable to supportive of the market.
 
ECB Cuts Interst Rate and Faces a Classic Liquidity Trap 
 
The ECB unexpectedly cut its benchmark interest rate by a quarter point to 1.25% earlier in November, and the market expects another quarter-point reduction when policy makers meet on December 8. Draghi said the central bank’s bond purchases aim solely to ensure its rates are transmitted on markets, as the Fed normally does in it open market operation, and not to create new money or “subsidize governments” as in quantitative easing.
 
The ECB is already lending banks as much money as they ask for, in an attempt to stimulate the flow of credit to households and businesses. But Draghi pointed out: “The ECB has created an enormous amount of liquidity, and we see now that this liquidity is being redeposited with the ECB deposit facility. Which means it is not so much the amount of liquidity that is the matter, but it’s the fact that this liquidity is not actually circulating.”
 
Draghi thinks the most important thing for the ECB to do is restore the flow of credit to the economy. “We have observed serious credit tightening in the most recent period, which combined with the weakening of the business cycle doesn’t bode at all well for the months to come,” Draghi said. The head of the ECB is describing a classic Keynesain Liquidity Trap in which fear of capital losses on assets besides money creates a “liquidity trap” setting a floor under which interest rates cannot fall. While in this trap, interest rates are so low that any increase in money supply will cause bond-holders (fearing rises in interest rates and hence capital losses on their bonds) to sell their bonds to attain money (liquidity).
 
European leaders are scheduled to meet in the week December 5 to discuss the next steps in winging down a sovereign debt crisis that will soon enter a third year. Draghi’s approach is backed by German Chancellor Angela Merkel, who says politicians must drive the euro region toward a fiscal union rather than rely on the ECB’s bond purchases. “Governments must restore their credibility vis-à-vis financial markets,” Draghi said.
 
December 4, 2011