MacroScope

Franco-German motor

Today’s big setpiece is a meeting of German Chancellor Angela Merkel and French President Francois Hollande ahead of a June EU summit which is supposed to lay the path for a banking union. The traditional twin motor of Europe has sputtered – not least because the French economy is so much more sickly than Germany’s – but also because of real differences of opinion.

When the Franco-German relationship was running smoothly, the two countries’ leaders routinely met before EU summits to prepare a joint position which more often than not prevailed (much to the annoyance of some of their partners). But Merkel and Hollande have conspicuously not done so on a number of occasions since the latter took power a year ago.

Hollande wanted a banking union including a structure to wind up failing banks and common deposit guarantee. The latter is already dead in the water and Germany is wary of the liabilities the former might impose upon it. The European Central Bank may have taken euro break-up risk off the table – though its pledge to save the euro is still to be tested – but banking union is still a huge issue. Without it the seeds of a future crisis, or even a revival of this one, will have been sown.

The smart money is that the June summit is long on bank regulation, short on bloc-wide measures to deal with stricken lenders. The big question is whether progress will be easier after Germany’s September elections.

There appears to be a recognition in Germany that antipathy towards its insistence on budgetary rigour (cuts and pain) is reaching uncomfortable levels. It has approached Spain and Portugal with a plan to help get money flowing to their credit-starved companies in the hope that it will bring down sky-high unemployment and German Finance Minister Wolfgang Schaeuble warned on Tuesday that failure to win the battle against youth unemployment could tear Europe apart. He also ruled out ripping up Europe’s welfare model.

The pain in Spain – redux

Spain’s borrowing costs are likely to soar at an auction of 12- and 18-month T-bills after its 10-year yields were pushed through the totemic 6 percent level on Monday. The history of the euro zone debt crisis shows that once above 6 percent the spiral accelerates and before you know it you’re at 7 percent – the level generally seen as unsustainable for state financing.

Worryingly, Spain is dragging Italy’s yields up in its wake. But in Spain’s case, there are strong reasons for caution about imminent disaster. The government cannily used ECB-created benign market conditions in the first part of the year to shift nearly half its annual debt issuance needs already and the banks – which look like they will need recapitalization at some point – are well funded for now having also loaded up on the European Central Bank’s three-year liquidity splurge.

We also know Europe’s banks, too scared to invest elsewhere, are depositing 700-800 billion euros back at the ECB daily. If Madrid could engender a shift in confidence, some of that money could flow back into its bonds, particularly by Spanish banks.