Remember the Icelandic financial crisis? The times when the same media, which have now heavily criticised the temporary imposition of capital controls in Cyprus, applauded Britain for using its ant-terror laws to freeze Icelandic bank accounts? In the wake of Iceland’s economic and financial meltdown, voters in Iceland had ushered in a centre-left government with a mandate to clean up the mess and to turn to the EU to firmly anchor Iceland in Europe. With the centre-left having done its unpopular duty and the economy rebounding, voters now went back to where they had been before. The centre-right squarely won the Icelandic elections. One of the election promises is to stop the negotiations with Brussels about joining the EU. For Europe, this won’t make much of a difference. For Iceland, let’s hope that the brave small island will never be in a position again where it could need the protective umbrella of Brussels against the whims of individual European countries. If Iceland had been an EU member when its crisis broke, it would have been much more difficult for other members to apply such unusual and unfair treatment to Iceland. But forsaking that extra legal protection is now the Vikings’ choice.
Judging by various media and research reports over the last few weeks, many observers seem to believe that the German line on austerity has hardened over the last month or two. In our view, this is wrong. Instead, Berlin has cautiously made its stance a little more flexible.
Of course, German rightly insists that crisis countries must meet the conditions to be eligible for support. Berlin refutes all public demands that the Eurozone must change tack in any major way. And on Cyprus, Germany indeed took a tough line. Without alleged “Russian money launderers” taking a major hit, the German Bundestag would not have approved any support package for the small island with its oversized financial sector.
But as often in life, we should look beyond the obvious headlines. Step by step, Brussels is granting one Eurozone country after the other more time to meet fiscal targets. We have heard hardly any serious protest from Berlin against that. The maturity of support loans for Portugal and Ireland have been extended by seven years. Even in Greece, the troika is taking a less controversial approach, emphasising more the huge progress which Athens has made and scaling down its demands for immediate action on those few policy issues where Greece is behind (although the Greek parliament will have to approve some action now before the next two tranches of €2.8bn and €6.6bn can be released). German is quietly encouraging French president Hollande to go for more serious labour market reforms, suggesting that such reforms matter more than simple austerity.
All in all, Berlin seems to acknowledge that the euro periphery (but not France) has made serious progress. In response, the German emphasis is shifting a bit away from short-term austerity to longer-term structural reforms. Ahead of the German election on 22 September, Berlin has a prime interest in (i) visible progress in the Eurozone and (ii) the absence of dramatic tensions. The result seems to be an approach that is pragmatic and flexible without changing the overall direction by much. It certainly is not a harder line.
Europe works in its own weird ways, but it works. For the last four months, we had identified Italian politics as the single biggest risk to our call that the euro crisis will continue to fade. This risk has now receded further. Eight weeks after its inconclusive election, Italy got a new government on Sunday. The process was noisy und the Italian uncertainty contributed to a temporary setback for the euro economy. But the end result could be fairly positive.
Ahead of the election, the general assumption was that Italy would be governed by the centre-left headed by dour party apparatchik Bersani. He would have safeguarded the Monti achievements but not done much else. Instead, Italy now has Monti without Monti, namely a broad coalition of all those political forces which had backed Monti until last December. The new PM Letta has a much more centrist background than Bersani. Chances are that this new government could get a few useful things done.
With its 3% deficit-to-GDP ratio despite a deep recession in 2012, Italy does not need and will not get any further austerity. With less political uncertainty, the economy can spring back to life later this year. Of course, Letta faces serious challenges, for instance how to deal with the Berlusconi demand of repaying Monti’s unpopular €8bn real estate tax. But under the stern guidance of super-president Napolitano, chances are that Letta will get around this hurdle as well.