MacroScope

The British government faces another potentially thorny day with the International Monetary Fund delivering its annual review of the UK economy. If David Cameron has a consistent policy, it’s that the only way to get Britain back on its feet is to cut spending and debt. Trouble is, we know the IMF doesn’t agree and advocates a more growth-fostering approach. Finance minister George Osborne has changed rhetorical tack in response but is walking a tightrope as a result.

This comes at a time when there are distinct signs that Cameron’s Conservative party is unraveling and not just over Europe. Unless he gets a grip soon, who knows what further concessions may be made on an EU referendum which could push Britain further towards the exit door. It remains unlikely that the coalition government will fall apart before 2015 elections, not least because the junior, pro-EU Liberal Democrat partners face electoral evisceration according to the polls. It’s even less likely that Cameron will be toppled by fractious members of his party. But it’s no longer impossible.

Britain’s LibDem deputy prime minister will take the unusual step of holding a news conference to say the coalition will hold together until 2015. Another big flashpoint looms this summer with the government’s spending review where hardline Conservatives will push for big welfare cuts and the LibDems will resist. Former foreign secretary Geoffrey Howe, the man who did more than anyone else to end Margaret Thatcher’s reign, says Cameron is losing control of his party. From the other side of the political divide, Peter Mandelson says he has to lead not follow. Hard to argue with either of them.

Monthly UK public sector debt and retail sales figures will give a snapshot of the state of the economy and minutes from the Bank of England’s last policy meeting will show if outgoing governor Mervyn King and a minority continued to press in vain for more money printing.

After a one-day EU summit in Brussels, Cameron will hold evening talks with France’s Francois Hollande. The latter has been calling for more euro zone leaders’ meeting to beef up a drive for united economic government. That would push Britain further to the margins of the EU. The pair have some hatchets to bury. France has sounded distinctly less conciliatory than Germany to Cameron’s stated intention of renegotiating Britain’s relationship with the EU, after which he is promising an in-out referendum.And Cameron’s offer to roll out the red carpet to French entrepreneurs who did not wish to pay Hollande’s 75 percent top tax rate still rankles in Paris.

Spanish Prime Minister Mariano Rajoy meets labour union and business leaders to discuss reforms to pensions and public institutions. After some fairly brutal cutting, Rajoy has grown more cautious. He is negotiating a new formula for calculating pension payoffs but is wary of going further for fear of sparking greater protest. And all the time, recession put the country’s debt targets further out of reach.

There’s still some pretty serious stuff on the table. Rajoy’s cabinet has proposed a “stability factor” for the pension system, which would periodically adjust pay-outs and retirement age based on economic performance, demographics and other factors. The government is also studying a major reform to public administrations that could mean numerous job cuts in the public sector at a time when unemployment is at 27 percent.

The EU has granted France, Spain and others more time to meet their deficit targets in an attempt to foster some growth. But it is also insistent the pace of structural reforms must be stepped up. The French parliament voted through labour reforms on Tuesday which will make hiring and firing somewhat easier. President Francois Hollande will hold a rare news conference having travelled to Brussels yesterday to declare he would use the leeway to boost competitiveness and growth. Details? There were none. The European Commission will spell out its recommendations at the end of the month.

Evidence that Europe’s austerity policies are not working was in ample supply this morning. The euro zone as a whole is now in its longest recession since the start of monetary union. France has succumbed to the region’s retrenchment. Italy’s GDP slump is now the lengthiest on record. And Greece, still in depression, shrank another 5.3 percent in the first quarter.

To understand why this is happening, Brown University professor Mark Blyth says it is necessary to forget everything you think you know about the euro zone crisis. The monetary union’s troubles are not, as often depicted, the result of runaway spending by bloated, profligate states that are finally being forced to pay the piper. Instead, argues Blyth, it is merely a sequel to the U.S. financial meltdown that started, like its American counterpart, with dangerously-indebted risk-taking on the part of a super-sized banking sector.

In a new book entitled “Austerity: The history of a dangerous idea,” Blythe writes that sovereign budgets have come under strain primarily because taxpayers of various nations have been forced to shoulder the burden of failed banking systems.

Britain’s David Cameron began the day on Monday gently slapping down two Cabinet colleagues who said if they had a vote today, they would opt to leave the EU. It was senseless, he said, to throw in the towel before he had had a chance to renegotiate Britain’s relationship with Europe. He ended it by caving into rebels in his Conservative party who are demanding legislation now to commit to an in/out referendum before the next election.

The 25 year history of the Conservatives and Europe – internecine warfare and successive election defeats as they obsessed about something which figures low on most Britons’ priority list – suggests no good can come of this and if Cameron wins the 2015 election it moves Britain incrementally closer to the EU exit door. The more immediate question is whether Cameron has lanced the boil. Again, history suggests that if you give ground to the eurosceptics they merely demand more. And what the PM’s pro-EU Liberal Democrat coalition partners make of this isn’t hard to imagine which means he might not even have the numbers to get the bill through parliament. One of the leading rebels seized on that point, saying the move could well fail.

The anti-EU fringe party UKIP, which could well not win a single seat at the next election but has seriously spooked the Conservatives with strong showings in recent local elections, must be laughing all the way to the bank. If it can remake the Conservative party in its own image, its job will be done. But just as likely is a split party. The irony of Cameron doing all this while in Washington to bang the drum for an EU/U.S. trade deal is hard to ignore. President Obama pointedly said the British premier should fix its relationship with the EU.  If Cameron believes Britain should remain part of its main trading bloc, as he says he does, he is going to have to start explaining why and that is difficult to imagine.

It seems eons since the euro zone finance ministers’ meetings which made such a hash of the Cyprus bailout but they were only two months ago. Monday’s Eurogroup will be altogether less eventful with some of the gathering probably a little jaded having spent part of their weekend at the G7 outside London where the usual differences about growth versus austerity and banking reform were aired.

No one will be sorry for a more routine meeting and there are no icebergs on the horizon but the agenda is still a full one. Featuring will be the economic situation on the basis of the Commission’s latest forecasts, the state of play in Cyprus, the decision already taken to release more bailout money to Greece, the new steps taken by Portugal to fill the gaps in its budget after the country’s top court struck some measures out, a review of European Commission reports on what is ailing Spain and Slovenia and a broad discussion about the merits of the ESM bailout being allowed to recapitalise bank retroactively from next year.

Italy offers a range of bonds at auction worth up to 8 billion euros which should be snapped up given the European Central Bank’s underwriting of the euro zone and Japanese money coursing through the financial system.

“What did he mean by that?” 19th century Austrian diplomat Metternich is said to have asked of  Talleyrand when he heard the French statesman had died. The euro zone crisis, and the response of its leaders, has often required the same question to be asked.

There were some carefully chosen words from Germany yesterday with Finance Minister Wolfgang Schaeuble saying that elements of a banking union would have to be pursued without lengthy and arduous treaty change, something he’d previously said would be necessary.

Now you could view this as a sign of softening opposition, certainly the French read it that way. However, the subtext could just as easily be that because treaty change takes too long, Berlin will pursue only those elements of banking union that don’t require it – i.e. bloc-wide regulation yes, but forget about a bank resolution mechanism let alone a joint deposit guarantee. That would be a pale imitation of what was proposed nearly a year ago and wouldn’t provide the sort of structure that would foster confidence that a future financial crisis could be contained.

European Central Bank chief Mario Draghi felt it necessary yesterday to depart from the script at a ceremony awarding an honorary degree to reiterate his message from last Thursday – that the ECB could cut interest rates again and was looking at pushing the deposit rate which it charges banks for holding their funds overnight into negative territory in an attempt to get them to lend again.

Nothing new in the message obviously but the fact he felt the need to repeat it at a forum at which nobody would expect him to could be telling. Draghi has form here. It was at a pre-Olympics conference in London last July that he delivered his “whatever it takes” to save the euro pledge that fundamentally shifted the terms of the currency bloc’s debt crisis.

That the recession-plagued euro zone economy could do with a shot in the arm is beyond question though Draghi insisted countries must not let up on their debt-cutting. Very different tone from the prime ministers of Italy and Spain who demanded action to cut unemployment though Italy’s Enrico Letta said growth could be boosted without increasing debt.

It’s European Central Bank day and we have it on very good authority that a quarter-point interest rate cut is on the cards, which will take rates to a record low 0.5 percent. A plunge in euro zone inflation to 1.2 percent, way below the target of close to but below 2 percent, has cemented the case for action.

In terms of reviving the euro zone economy this is pea shooter and elephant territory. The ECB has consistently diagnosed the key problem that already ultra-low interest rates are not transmitted to high debt corners of the euro zone, where lending rates are much higher and credit restricted. A rate cut won’t change that. It also illuminates the gulf in approach with the Bank of Japan and Federal Reserve who continue to print money at a furious rate.

The Fed said on Wednesday it would continue buying $85 billion in bonds with new money each month and added it would step up purchases if needed to protect the economy, dousing recent suggestions that the programme could be wound up in the months ahead. Nonetheless, a euro rate cut will help at the margins.

Fresh from winning a vote of confidence in parliament, new Italian Prime Minister Enrico Letta heads to Berlin to meet Angela Merkel, pledging to shift the euro zone’s focus on austerity in favour of a drive to create jobs. He may be pushing at a partially open door. Even the German economy is struggling at the moment and the top brass in Brussels have declared either that debt-cutting has reached its limits and/or that now is the time to exercise flexibility. Letta will move on from Berlin to Brussels and Paris later in the week.

France, Spain and others will next month be given more time to meet their deficit targets and Berlin does not seem to object. Don’t expect Merkel to join the anti-austerity chorus but there are some hints of a shift even in Europe’s paymaster. Yesterday, it launched a bilateral plan with Spain to boost lending to smaller companies and said it could be rolled out elsewhere too. Details were very sketchy but something may be afoot. The European Central Bank, expected to cut interest rates on Thursday, is considering something similar although that is far from a done deal.

Forgotten about Cyprus, which only last month had financial markets in a lather and threatened to reignite the euro zone debt crisis? Today, Cypriot politicians vote on the terms of the bailout offered by the euro zone. It should pass but it could be tight. No single party has a majority in the 56-member parliament, and the government is counting on support from members of its three party centre-right coalition which have 30 seats in total.

German newspaper Handelsblatt has got hold of a confidential Bundesbank report to Germany’s constitutional court, which sharply criticized the European Central Bank’s bond-buying plan. This could be very big or it could be nothing.

Bundesbank chief Jens Weidmann has made no secret of his opposition to the as yet unused programme and since the mere threat of massive ECB intervention has driven euro zone bond yields lower for months there is no urgency to put it into action. But the OMT, as it is known, is by far the single biggest reason that markets have become calmer about the euro zone, so anything that threatens it could be of huge importance.

The key point is not the Bundesbank’s stance but how the Constitutional Court responds. It is due to consider OMT in June. Through the three-year debt crisis, when Berlin has reluctantly crossed red lines it has had to get the court’s approval. So far, it has always been forthcoming, though sometimes with strings attached. But if it took the Bundesbank’s assertion that bond-buying could “compromise the independence of the central bank” at face value, it is almost certain to have a long hard look. We already know that the court is a potential stumbling block to banking union as it has ruled that any future euro mechanisms would only be in order if Germany’s maximum liability was clearly defined.