The news flow out of Europe has slowed down lately, but that doesn’t mean the financial system has been mended.Indeed, things just appear to be getting worse for the periphery as investors flock towards the relative safe havens of Germany, France, and Belgium.
Borrowing costs in those three countries have hit record lows as the price of borrowing marches steadily higher in Italy and Spain. Yields on these bonds are not far from the 7 per cent benchmark on 10-year borrowing after which Ireland, Portugal, and Greece all needed a bailout.
This divergence in yields on bonds is completely counter-productive for Europe. Political pressure against inflationary, pro-European reforms in “core Europe”—where bond yields are falling—remains strong, and the torrent of money flowing into those economies is reinforcing rather than inducing change.
Sony Kapoor, the Managing Director of think tank Re-Define Europe, explains in a recent column:
As things stand now, market panic about Italy & Spain, drives investors, wealth and talent towards Germany reinforcing the already massive divide between Spain, which is facing record high levels of unemployment and Germany which faces record low unemployment. For now, the crisis feels abstract in Germany & the flight to safety simply reinforces the perspective that many Germans hold that they are doing something right and if markets are panicking about Italy it can be resolved if only the Italians did more of what the Germans do.
This means that Germany has the ability to help the crisis countries in the Eurozone, but the dumbbell effect reduces its willingness to do so. Inevitably, Germany cannot stay immune as more of its neighbours get caught up in the crisis and its economy starts to bleed. But even as that happens the dumbbell effect may remain in play as Germany is likely to become the one eyed in the land of the blind and its relative safety that is a driving force for the effect.
Until Germany et. al. truly begin to feel the effects of the crisis, Chancellor Angela Merkel and her supporters will have little desire to pursue inflationary policies and cede sovereignty towards a central Europe. We really haven’t seen this yet.
Moreover, each measure that falls short of truly restoring faith in the peripheral Italy and Spain bolsters the drive to invest in safer European havens and also the medium-term financial stability of core European economies. Take the most recent Spanish bailout—the fact that Spanish banks won’t collapse has not reassured investors that the Spanish government will not need a bailout. However, it has calmed investors worried about trouble in the entire European banking system, meaning that Deutsche Bank and Societe Generale—which are probably highly exposed to Italian and Spanish banks—can borrow at cheaper rates.
The continued divergence between Spain/Italy and Germany/France/core Europe is the best reason the European crisis will continue to drag on. Until Germany can no longer avoid the effects of the crisis, its leaders will still lack the political will to move towards the United States of Europe.