Well, it didn’t take long. You may have thought that yesterday’s comments from people allegedly close to Bundesbank President Jens Weidmann to the effect that Germany could live with the shocking inflation rate of 2-3% were in any way a sign that Germany was about to cave in on its resistance to anything that resembles high inflation. Well the front page of Bild Zeitung - the gold standard of European tabloids (pun intended) - says it all:

The “Bundesbank is going soft on the euro”, adding that:

“Over the next few years prices in Germany will rise much faster than before. Our venerable Bundesbank, the sacred guardian of price stability, will do nothing about this since it considers it to be ‘manageable’”.

And in case the 13 million or so Bild readers didn’t get the message, page 2 features a giant picture of a one billion DM banknote from the Weimar era:

An op-ed by the paper’s chief editor Nikolas Blome argues that:

“[inflation] will above all hit workers, employees and pensioners. Precisely those who kept a cool head and ploughed on through the crisis. This is unfair. It gnaws at our trust in money and our major institutions, in politics and central banks… since Germans have bitterly experienced it themselves they know that high inflation ultimately breaks down every society”. 

It wasn’t only Bild though. The man himself, Weidmann, moved swiftly to deny the reports, claiming in an interview with Süddeutsche that this was an “absurd discussion”. He clarified that keeping inflation below 2% in the eurozone as a whole meant that “in some cases” German inflation would be higher, but that “we will ensure [in the ECB’s governing council] that inflation in Germany will not run out of control. Citizens can rely on the vigilance of the Bundesbank”.

This is one national core belief you don’t mess with.

With Europe as fluid as ever, talk of some sort of EU referendum is heating up in the UK (well at least in the Westminster bubble).

The always excellent James Forsyth of the Spectator argued in the magazine yesterday that London Mayor Boris Johnson’s support for a referendum and UKIP’s rise taken together “make it highly likely that Britain will have its first vote on Europe since 1975 within the next five years.”

He also notes that,

“The popularity of Cameron’s EU veto made his circle realise how much of a political asset Euroscepticism could be, if used in the right way. There is also concern in No. 10 that if the Tories don’t offer the public a vote, Labour will.”

He goes on to say that,

“One source intimately involved in Tory electoral strategy told me recently that a referendum in the next manifesto was ‘basically a certainty’…My understanding is that, at the moment, the favoured option is to propose renegotiation, followed by a referendum on the new arrangements within 18 months. During the campaign, the Tories would argue for staying in if new terms could be agreed but leaving if the rest of Europe refused to play ball.” 

The equally excellent Paul Goodman over on Conservative Home today echoes Forsyth, listing a range of reasons why a referendum draws nearer.

And Forsyth’s colleague Alex Massie also picks up on this on the Speccie’s Coffee House blog, looking at all the complications involved in trying to square an EU renegotiation with a referendum (the “on what?” question always looms large). We’ve looked at the various options for a referendum in detail before, so this is all familiar (if you’re interested in the different options, we strongly recommend reading this piece).  Massie makes a good point though. An EU referendum is too often seen in Tory leadership ranks as being about “a matter of party morale, discipline and tactical positioning”, not getting something that actually works for the UK.

We agree. The thing is, this is far too complicated an issue to make a matter of mere party management. It will be part of the equation, of course, but making it subject to pure party politics will reduce the discussion to the usual Westminster back-and-forth on vague concepts such as “influence”, “isolation” or “sovereignty” - it will be Mandelson land.

But where Massie - and a whole range of other commentators and politicians - get it wrong is when they say that in contrast to the renegotiation option, “an in/out plebiscite at least offers a choice between easily-grasped options.”

No it doesn’t. Staying in raises a whole range of complicated questions - what does the UK do if the eurozone takes that quantum leap towards further integration? What happens if the EU merely becomes a political extension of the eurozone (which Britain can’t join)? In other words, if we want things to stay as they are, things will have to change.

And the “out” option? It sounds easy at a superficial glance, but in a serious discussion, it would raise far more questions than answers. In fact, there’s virtually no “out” option (save perhaps one) - all options to withdraw from the EU treaties (which is what ‘out’ must mean, though it is rarely defined), involves joining something else. Doing a “Norway” would be suicide for UK, i.e. accepting 2/3 of EU laws but with no say over them; a Switzerland would be slightly better but still immensely complicated. A different type of Free Trade Agreement altogether involving business paying hefty fees or facing new admin burdens on exports to the EU, which contain some imported components? A customs union a la Turkey meaning being stuffed on market access on services? Simply falling back on the WTO’s Most Favoured Nation (MFN) rules, with a range of costly barriers to trade and movement?

Answers anyone? The truth is that most of the complications that apply to renegotiation, also apply to the “out” option. The truth is that all three options: staying in on current terms, renegotiation or withdrawal from the EU treaties are massively complicated. To whet your appetite, we’re about to publish a comprehensive report looking at the different options for the UK was it to vote to decide to leave. And trust us, it’s complicated.

What we do know is that both Britain and the eurozone will simply have to move. It’s therefore right that No 10 is now considering different options.

But again, it should be for the right reasons.

Shock horror. According to Reuters Deutschland, an unnamed central banker close to Bundesbank President Jens Weidmann today said the following, in response to the wide rumours that the Bundesbank may be willing to accept higher inflation to help solve the eurozone crisis:

“By this it is meant [that with] a rate of inflation that is moderately above the target of the ECB which is just under 2 per cent…No one need be afraid of massive currency devaluation”. 

 Apparently, the belief is that the Bundesbank ‘can live with’ 2.5% or 2.6% inflation.  

This follows an interview with German Finance Minister Wolfgang Schäuble,  published by Focus over the weekend, in which he said thus:

“It is fine if German wages are currently increasing more sharply than in all other EU countries”. 

After many years of reforms, he said, Germany has done its homework and can afford higher collective wage settlements than other countries.

So is this a sign that Germany is starting to follow the advice of a whole host of Anglo-Saxon commentators who see higher inflation in Germany as vital if the euro is to survive? 

We wouldn’t bet on it. When commentators talk about higher inflation, they have something much higher than 2.5% in mind (though some commentators may not realise that themselves) - this certainly doesn’t seem high enough to encourage the re-balancing and evening-out of competitiveness which many believe the eurozone needs to survive in the long term. The media may be getting ahead of itself on this one.

The political situation in Greece following Sunday’s elections is getting even messier. Following the failure of conservative New Democracy to even begin a serious discussion about forming a government (negotiations lasted all of six hours), the Radical Left (SYRIZA) yesterday also threw in the towel. The “dream” of a leftist Coalition government had failed, said SYRIZA’s leader Alexis Tsipras, but added that his party had nonetheless forced Europe to reconsider the Greek bailout package (perhaps a bit premature). 

The buck has now been passed to socialist PASOK, the former governing party which slumped to third in the elections. PASOK leader Evangelos Venizelos said yesterday that he will ask Greek President Karolos Papoulias - who by now must be a seriously nervous man - to give him the go-ahead to start discussions with other parties in a last-ditch effort to try to form a government. If that fails, we’re definitely looking at fresh elections, probably in June. The prospects for PASOK succeeding are slim - to say the least.

So what’s going to happen? Frankly, heaven knows. As we have noted before, even fresh elections may not generate a stable government, though there’s a chance that those people who voted on smaller parties that didn’t get over the 3% threshold to enter the Greek parliament, may shift their votes to bigger parties. SYRIZA clearly remains the X-factor, and could potentially pick up more votes. The party has outlined a five point plan - including completely ripping up the bailout agreement - that is simply fundamentally incompatible with the position of the Germans and the IMF. The politics are immensely complicated, but if SYRIZA’s support is required for forming a government, then we’re basically looking at three potential outcomes:

1) SYRIZA and Germany/IMF stick to their guns, the bailout cash is frozen, Greece defaults and almost certainly leaves the euro
2) SYRIZA caves and Greece is given the next tranche of bailout cash and the charade continues for a bit longer
3) Germany/IMF cave, the bailout terms are revised and Greece is given the cash

Perhaps a path between the second and third options would be possible too - and given the stakes, not unlikely. In any case, it ain’t lookin’ good.

The Queen delivered her “Queen’s Speech” earlier today - which, for non-UK readers, isn’t her speech at all but rather the government’s, setting out its agenda for the forthcoming year (a rather odd ceremony but good opportunity to see Ken Clarke in a wig if nothing else).

For those interested in the ever-so-opaque EU dimension, the Queen said in passing:

“My Government will seek the approval of Parliament relating to the agreed financial stability mechanism within the euro area.”

And

 ”My Government will seek the approval of Parliament on the anticipated accession of Croatia to the European Union.”

The latter won’t be much of an issue - most MPs will play along as further enlargement rightly enjoys buy-in across the political spectrum.

The former is a different story. This relates to the EU treaty change dating back to December 2010, when the Germans managed to get agreement for tweaking the Lisbon’s Treaty Article 136 to allow the eurozone’s permanent bailout fund, the ESM, to be put on a more legally sound footing (at least that’s how Berlin sees it). This treaty change has now finally come up for UK ratification in Parliament. Before carrying on, just to clarify, this is not the EU treaty change that Cameron vetoed in December 2011, and which gave rise to the separate Fiscal Treaty.

The December 2010 agreement didn’t cause a whole lot of fuss at the time, and MPs gave their preliminary approval. Back then, Cameron had far greater control over both events and his own backbenchers. And the UK media was still waking up to the massive - and ongoing - continental political shift unleashed by the euro crisis.

2012 is a different matter altogether.

The ESM won’t actually impact on the UK itself, so the ‘referendum lock’ wouldn’t kick in. However, the treaty change that Cameron vetoed back in December wouldn’t actually have had a direct impact on the UK either - that veto was about getting guarantees that UK interests were protected as the eurozone integrates further, and the rules of the game are effectively changed.

Exactly the same logic could apply to the Treaty change to put the ESM on legal footing. Like the Fiscal Treaty, the ESM will lead to greater integration in the eurozone (indeed, the two go together - see here), so Tory MPs could use the same line of reasoning they did leading up to the December summit in calling for the UK to block the measure, in return for EU concessions. Remember, an EU treaty change is not a change at all until it has been ratified by all member states.

Will they? So far, there are no signs that this issue is fully on MPs’ radar and the UK government prays it will stay that way. But a lot of things to look out for:

• The UK government is likely to sell the measure as a guarantee that it will never again be forced to indirectly contribute to eurozone bailout funds - a few papers have already run with that story. At the same December summit, Britain won a political declaration and an EU decision that the article that forced it to contribute to the EU-wide bailout funds, the EFSM, won’t be used again (Article 122 - for background, see here and here). However, the legal status of this guarantee is uncertain. It is not part of the treaty change itself, and MPs may argue that a guarantee that isn’t anchored in the Treaties could well prove ineffective. After all, the UK has received guarantees before which proved to be pretty worthless (clue: Charter of Fundamental Rights, Working Time Directive). If MPs wake up to the legal ambiguity underpinning the ‘guarantee’ they may ask for something firmer in return for ratifying the treaty change.

• The timing of the ratification will be crucial, i.e. if it coincides with some cataclysmic event or political row in Europe (there will be a few to choose from), it would make life potentially much more difficult for the UK government. The ratification certainly won’t happen before the summer’ that’s for sure. 

• Under the current agreement between eurozone leaders, the ESM is supposed to be up and running by 1 July (in parallel with the temporary bailout fund, the EFSF). This is important, because without the ESM in force, the lending capacity of the euro bailout funds will be a lot lower than markets are expecting, meaning more market nervousness, in particular as Spain is struggling.  

• To make matters even more complicated, the treaty change itself isn’t actually what’s needed to approve the ESM in eurozone countries - for that, eurozone leaders have agreed a separate ‘ESM treaty’ which is now going through national parliaments in the eurozone. As you’d expect, this is by no means plain sailing as the treaty - for obvious reasons related to taxpayers’ cash - is subject to controversy in Germany and the Netherlands, which are still to ratify it. All 17 eurozone countries need to approve the ESM treaty before it can become operational and lend money to countries and banks. 

• And this is where things get rather bizarre.  Even if all euro countries manage to ratify the ESM treaty, the Germans originally said that they absolutely need the separate EU Treaty change for the ESM to be fully legal. However, since the UK won’t have ratified the EU treaty changes by 1 July, the ESM will be up and running before the ‘vital’ Treaty change designed to make the whole construction legal is actually ratified in national parliaments. In other words, expect another batch of court cases to soon land in the in-tray of the German Constitutional Court in Karlsruhe.

Pretty messy - but then again, we’re talking eurozone politics and EU ‘law’. That one short line in the Queen’s Speech hides so many complications…

Italian daily La Repubblica had an interesting story over the weekend. Apparently, Italian Prime Minister Mario Monti and his team are trying to win support for watering down the EU’s deficit and debt rules.

Italy is suggesting that ‘virtuous investments’ (i.e. public spending aimed at boosting ‘growth’) should not be counted when calculating a country’s deficit and debt under the EU’s budget rules (3% deficit, 60% debt-to-GDP ratio). The same exception should be applied to the re-payment of money currently owed by the various public administrations to private firms - some €70 billion in Italy’s case.  

The always well-informed Marco Zatterin - Brussels correspondent for La Stampa - writes on his blog that Italian Europe Minister Enzo Moavero Milanesi has already been talking to EU Commissioners for Internal Market (Michel Barnier), the Budget (Janusz Lewandowski), and Industry (Antonio Tajani, Italy’s man in the Commission) over the past few days. EU Economics and Monetary Affairs Commissioner Olli Rehn is reportedly willing to consider the proposal. The Monti government hopes that EU leaders will discuss the proposal at the European Council at the end of June.

These exceptions, Italy’s reasoning goes, would make the fiscal treaty “more sustainable” once it comes into effect. But is this really a good idea? As we pointed out before (see here and here), the fiscal treaty already has some serious credibility issues and has already been watered down.

Allowing for some debt to be swept under the carpet doesn’t exactly inspire confidence. Do people remember how we got here in the first place?

Meanwhile, mayoral elections took place in Italy over the weekend (we understand if you didn’t notice given everything else that was going on during the eurozone’s ‘SuperSunday‘). Still, a couple of interesting facts are worth flagging up:

• Candidates from Silvio Berlusconi’s People of Freedom party did not make it to the second round in any of the bigger cities where elections took place (Genoa, Palermo, Parma and others). Following the results, the party’s Secretary General, Angelino Alfano, said that backing for Monti’s government continues, but no more ‘mini-summits’ with the centre and centre-left leaders supporting Italy’s technocratic cabinet in parliament will be held from now on. This could have an impact on Monti’s ability to push through his reform agenda, especially since he has no electoral mandate to fall back on when things get tough;
• Lega Nord, Berlusconi’s former ally, also did quite badly in the wake of the scandals that forced its leader Umberto Bossi to step down last month. Lega Nord managed to keep Verona, but lost several towns traditionally considered strongholds in the Lombardy region;
• Turnout was about 67% - almost 7% lower than in the previous local elections;
• The Movimento Cinque Stelle (Five Star Movement), led by Italian stand-up comedian Beppe Grillo (in the picture) came out as the real winner. Its candidates achieved double-digit percentages in a couple of important cities (including Genoa, Beppe Grillo’s home town, and Parma, where the Five Star Movement’s candidate Federico Pizzarotti made it to the final run-off, with 19.5% of votes). A political maverick, Grillo has been campaigning for the need to clean up Italian politics, for instance by barring convicted people from running for the Italian parliament. Most interestingly, he has recently been claiming that Italy should drop the euro (but remain in the EU) and refuse to pay back at least part of its public debt. 

The general elections will be a different ballgame altogether, but it’s interesting how the Italians, too, are now looking for something different.

Another day, another U-turn in the eurozone – although this time it may mark the Spanish government’s acceptance of the huge problems in the country’s banking system.

The Spanish government announced on Monday that it will be injecting Bankia, the country’s third largest bank, with up to €10bn in capital, using the state-backed FROB bank restructuring fund, despite previously dismissing the possibility of doing so. Given the timing of the announcement – on the same day that Greece went through political upheaval – one can’t help but think that the Spanish government harboured some hope that the declaration might fly under the radar.

Given the size of Bankia and the implications of the bail-out such hopes were deeply misplaced. Bankia has one of the largest exposures to the country’s bust real estate and construction sector at €38bn, of which €18bn is considered problematic. It was also the poster child for what now looks to be the laudable but ultimately doomed structural reform of Spanish banks which took place last year. It is the largest of the consolidated ‘cajas’ (Spanish regional banks) and the problems on its balance sheet highlight how little the banking consolidation solved.

Taxpayer-backed bank bailouts are never ideal but if Spain chooses to go down this road, getting the correct mix of support and strong conditions is vital.

The most likely form of any future intervention is the widely mooted ‘bad bank’ plan. A plan to remove the huge amount of risky assets lurking on bank balance sheets sounds great in theory but it is never that simple.

The first question, as always, is where will the money come from? Currently Spanish banks have €54bn in provisions against €136bn in doubtful loans. The latter number looks set to increase as conditions worsen, particularly with much larger falls in real estate prices expected – we predict that provisions will need to be at least doubled, while the corresponding capital need to underpin a ‘bad bank’ would be large. Bankia is likely to be only the tip of the iceberg both in terms of problems in Spanish banks and the use of public funds.

Securing private funding will be near impossible, leaving two sources of public funds: the Spanish FROB bank restructuring fund and the EFSF/ESM eurozone bailout funds. The FROB in theory has a lending capacity of €99bn, but most of the cash must be raised by issuing debt, with only €18bn directly guaranteed by the state. There are rightly questions over whether the fund could borrow cheaply if it backed a bad bank, potentially leaving the majority of the gap to be filled by eurozone bailout funds.

Given the growing political opposition to both the bailouts themselves and the austerity conditions which they come with, such a large transfer of European funds could be political dynamite in Europe.

The main concern is the huge moral hazard associated with bailing out banks – this was a trend which many in Europe hoped had been bucked, opening it up again would do significant damage to credibility in the eurozone. The aim is ultimately to encourage banks to start lending and aiding economic growth again but this is notoriously difficult – who’s to say they won’t continue hoarding funds over wider fears of a eurozone break-up. The most important part of the process will be an honest external valuation of these doubtful loans, something which Spain and the eurozone have shied away from before.

Any funds must therefore come with clear conditions. The key element to enforcing these will be allowing some banks to fail or be wound down, if too large a percentage of their assets need to be shifted to the bad bank. In the end, many of these banks have unworkable balance sheets in the aftermath of the housing bust. This will be the clearest signal to show that public funds are not being used to solely prop up banks, that only viable businesses will survive and that the Spanish government is committed to reform.

In many ways the use of public funds to help Bankia could be a turning point for the crisis in Spain. The good news is that the Spanish government finally accepts the need to tackle the wider problems with its banks, presenting an opportunity to flush out the sector once and for all. On the other hand, it significantly increases the likelihood of taxpayer-backed Spanish and eurozone funds being used to bail out banks once again. What’s clear is that, until the problems are fully addressed, the Spanish banking sector malaise will still threaten to engulf the whole economy and potentially drive the country into a full bail-out programme.

Secretary-General Ban Ki-moon congratulates François Hollande for his victory in the second round of the French presidential elections, which took place on Sunday, according to Mr. Ban’s spokesperson.

At least seven people are reported to have died recently while sailing from Libya to Malta, bringing the number of reported or confirmed dead among people attempting to reach Europe from the North African nation to 81 this year, the United Nations refugee agency said today.

We’re back after the unfortunately timed (for those with an interest in EU politics and the eurozone crisis) bank holiday, following a weekend in which French and Greek voters were able to have their say on their governments’ handling of the crisis, which as we’ve covered in our daily press summary, was unequivocally negative. Given the position that Germany will adopt will be the single most important factor in determining the future of the eurozone, we thought it would be worth taking a closer look at the reaction in the German press to the weekend’s results.

Starting off with Bild, Germany (and Europe’s most widely-read paper), the paper’s Greece correspondent Paul Ronzheimer argues that:

 â€œIn a democracy, each voter has the right to decide freely. And no one wants to deny the Greeks this right. But a free choice can have consequences… About two-thirds of Greeks want to stay in the eurozone. But at the same time, they chose to vote for radical parties that reject all that is required for this membership: savings and reforms. Germany and the EU desperately need a Plan B: How can the eurozone best continue on without Greece?”

Moving onto FAZ, we have economics editor Holger Steltzner, a well established austerity hawk arguing in a piece entitled “Merkel fights alone” that:

“How do you deal with a country that firstly swindled access to the euro, then plunged the EU into an existential crisis, and then cast two-thirds of votes for radical parties that deny austerity?” 

 On Hollande, Steltzner is slightly more restrained, if still pessimistic:

“Merkel takes the debt brake seriously, Hollande does not want to submit to any rule to curb the deficit. When Merkel speaks of growth, she means structural reforms to loosen restraints on the labour or manufacturing markets. About the beneficial effects of competition (the fruits of which the German economy is currently reaping) Hollande speaks barely a word.” 

This gloomy take is also shared by the Die Welt’s foreign affairs editor Clemens Wergin who argues the election results are triumph of denial over reality, and the embodiment of “old Europe”:

“Greek and French voters have rebelled against what they perceive as German savings and reform diktats. This is however unfair when measured against the significant risks and liabilities which Germany has taken on in order to save the EU’s problem countries from bankruptcy. Likewise Germany’s fiscal capacity is significantly overestimated by those who think that Berlin should commit even more money towards Europe-wide stimulus programmes.”

Wergin continues by saying:

“While Italian PM Mario Monti is trying to implement real reforms and in the longer term adopt German-style austerity politics, it seems Hollande does not realise the enormous need for reforms that the eurozone’s problem countries are procrastinating over… Europe could cope with an irresponsible Greece committing suicide in the eurozone. Some would even welcome it. However a France that loses the confidence of financial markets would be the worst case scenario for the euro - and for Europe.”

However others strike a slightly more optimistic tone, with Die Zeit’s Gerd Appenzeller arguing that:

“In Greece, as in France, the desire is now for more growth in lieu of cuts, regardless of where the credit comes from… Francois Hollande will, nevertheless, be committed to European integration and Franco-German strength, like all other French presidents before him. In spite of this, he is not likely to make concessions with the fiscal compact and austerity plans. Indeed, Greece poses even more of a problem with its intentions to discontinue further cuts which would mean that it could be imminently bankrupt. This would ultimately endanger Greece more than the rest of Europe.” 

 Meanwhile, Handelsbaltt’s EU correspondent Ruth Berschens argues that:

“If the second largest EU state were to veer from the path of savings and reform, then the monetary union would come into its heaviest existential crisis yet. However, it does not appear that Hollande would so lightly put the euro, the most important legacy of his political mentor François Mitterrand, at risk.”

All in all then the Germans are not hitting the panic button just yet, although arguably many are clearly worried that Merkel risks becoming politically “isolated”, a concept we think is far too simplistic in the context of European politics (see here and here for examples). However, it is certain that following the French and Greek results, the road ahead for the eurozone rescue is looking more bumpy than only a few days ago.