Brinkmanship, reform pressure and the endgame

Marco Annunziata 25 November 2011



A sovereign bond auction failed in a Eurozone country, and the central bank took 40% of the offered bonds on its books (€2.4 billion). That country was Germany. The instinctive temptation is to shout ‘gotcha!’

  • Aren’t these the guys who oppose using the ECB lender of last resort for government bonds?
  • And now they rely on the Bundesbank, their own central bank, as a LOLR when it is their government bonds that go unsold?

Tempting as it is, it would be unfair. The Bundesbank buys and sells bonds to manage liquidity and interest rates. This time it ended up buying a lot more than usual, but it is neither committed nor obligated to buying unlimited amounts of government bonds.

Symbolism matters: Betting on EZ breakup

Nonetheless, the symbolic and substantial implications of what happened should not be underestimated. The failure of Germany’s bond auction might be an aberration due to specific temporary factors. In normal times it would not have made headlines. But coming in the midst of contagion to ‘core’ countries like France and Austria and coming on the heels of euro depreciation, the bond-sale failure matters.

  • Market dynamics suggest that investors are gradually ratcheting up the probability that the Eurozone might disintegrate.
  • Seen in this light, the bond-auction failure is a powerful reminder that a Eurozone blow-up would be devastating for Germany.
  • It also reminds us that avoiding such a blow-up, decisive central bank action will also be necessary.

The doomsayers have been repeating for a while that the Eurozone’s day of reckoning is at hand. They have no shortage of arguments: spreads are extremely wide, contagion is in full swing, banks are under increasing pressure, Germany steadfastly refuses the idea of common Eurobonds, and the ECB steadfastly refuses to buy large amounts of sovereign debt.

To top it all off, policymakers’ belated efforts to restore confidence in Europe’s banks seem to be back-firing, scaring banks away from sovereign bond exposure and raising the risk that deleveraging might cripple credit growth (Baldwin 2011). It is not surprising that more and more investors are stepping away to watch the Eurozone developments from a safer distance.

Accounts of the Eurozone’s death are greatly exaggerated

However, it is too early to mourn the euro. In fact the doomsayers are strangely reluctant to draw the logical, disastrous – and global – implications in their economic forecasts or investment decisions. Eurozone stock markets are substantially above their September levels.

  • I have been sharply critical of the Eurozone’s response to the crisis from the very beginning (see my recent book, Annunziata 2011 for the original sins and persistent denials which have brought the single currency area to a full-fledged existential crisis).

But it would be unwise to ignore the magnitude and significance of the changes now taking place in the Eurozone.

  • Governments in Greece and Italy have been replaced in the space of a week because they were unable to guarantee the rapid implementation of economic reforms.
  • Italy has accepted IMF and EU monitoring of reforms including deep liberalisation measures that had so far seemed out of reach, notably on labour legislation.
  • Spain, Ireland, Portugal and Greece are undertaking ambitious fiscal and structural adjustment measures—in Ireland these are already paying off in terms of economic performance and credibility.
  • Eurozone governments have agreed to enshrine balanced budget rules in their national legislations.

All this is impressive; all of it started since early October – much of it after the 27 October 2011 package of reforms was agreed by EZ leaders.

Too little, too late?

Once it is forced to choose between acting as a lender of last resort to governments or allowing the Eurozone to disintegrate, the ECB will bite the bullet and commit to buy as much sovereign debt as necessary. And at that point, I believe it will have the open blessing of Germany, without which the ECB’s move would be neither credible nor sustainable.

Before taking that step however, Germany and the ECB will force as much progress as possible in terms of fiscal and structural reforms at the national level, and institutional reforms at the EU level to make macro policy discipline enforceable and sustainable.

Market discipline is still the most powerful weapon they can wield to force these changes – and it is a very dangerous weapon because they can control it only up to a point. In Italy, high bond yields strengthen the hand of new Prime Minister Monti as he presents ambitious reforms to Parliament.

What will the endgame look like?

In Europe, widening contagion strengthens countries’ incentives to give up policy sovereignty in exchange for mutual insurance in the form of Eurobonds. Ideally, limits to national policy sovereignty would be enshrined in Treaty changes. That would take time, but in the interim the pragmatic proposals put forward by the European Commission would constitute a very significant step towards stronger fiscal integration.


This brinkmanship game is not for the faint of heart. Eventually the solution will have to encompass greater ECB purchases, Eurobonds, Eurozone rule changes, and stronger reforms at the national level. In short, it will require a quantum leap towards fiscal and political union.

Waiting till the very last moment before deploying the safety net raises the risk that the situation might spin out of control. Greater mutual support implies a sharing of risks and of costs – including borrowing costs. It must go together with a sharing of decision-making power. The trick is how to accelerate the latter so that the former can be launched quickly enough.


Annunziata, Marco (2011), The Economics of the Financial Crisis: Lessons and New Threats London: Palgrave MacMillan.

Baldwin, Richard (2011), “EZ rescue or recession: Fallout of the October 2011 package”,, 28 October.



Topics:  EU institutions Financial markets

Tags:  EZ crisis, ECB bond purchases

Chief Economist and Executive Director of Global Market Insight, General Electric Co.


CEPR Policy Research