GSAM warns against premature joy if leaders agree at summit

Goldman Sachs Asset Management’s chairman has one word of advice for investors preparing champagne if Thursday’s meeting of EU leaders brings agreement on restructuring the bloc’s founding pillars: ‘Don’t’.

Or at least ‘not yet’, to paraphrase Jim O’Neill (pictured).

Yes, a positive result at the Brussels meeting would go some way to help the bloc resolve its problems, he says.

(A positive result would be, broadly speaking, agreement to change EMU treaties to include closer oversight and control of member states’ budgets.)

This could produce a “new stronger, more disciplined EMU”, in O’Neill’s words.

Or in the words of Germany’s chancellor Angela Merkel to the Bundestag last week, a “closer fiscal union”.

Today, she and her French counterpart Nicolas Sarkozy also said they had aligned themselves in supporting automatic penalties for countries violating agreed deficit rules, and in countries adopting constitutional limits on their debt.

Sarkozy said they planned to reach consensus on required changes by March.
After meeting Merkel in Paris today, he said: We don’t have time — we are conscious of the gravity of the situation.”

But even agreement on matters like this would not go all the way to solving the eurozone’s problems, O’Neill adds.

“Deep underlying issues still remain. In particular, how can all these 17 countries stay in a permanent monetary union with no source of competitive improvement through currency adjustments? Countries would have to undertake much more forceful supply-side reforms and, controversially perhaps, Germany and the other stronger northern members provide some kind of transfers.

“Otherwise, it will be tough to see the EMU survive. Germany and other stronger northern members might have to deliberately seek slightly higher inflation than the others, even within the ECB’s 2%-or-less inflation mandate, in order to make such a long term transition less difficult.”

O’Neill also notes, although Germany, France and Italy are in broad agreement on changes needed, some important differences remain between them.

Germany wants a new authority to have budgetary oversight with automatic clear sanctions, he says. France, on the other hand, “appears to still have a more nuanced position on some key aspects. In particular, France seeks a deal that will only require support from the 17 member Euro Area countries and one that Brussels won’t be the main arbiter of active decisions”.

A further problem that could arise, even if in-principle agreement comes from Thursday’s meeting, is the “major challenge” of changing treaties. This requires ratification from all 27 EMU members, and “particularly skillful Brussels footwork”.

O’Neill says: “This creates significant additional challenges, especially involving the UK. In order for the summit to claim success, there will have to be some commitment to an eventual treaty change, even if it might take considerable time. If all key participants sign up for this goal, then the meeting will be a success and the markets will cheer it in the days afterwards.”

The result of the meeting failing is unclear, however rumours circulated today of eurozone members preparing plans for just such an outcome – Germany printing Deutschmarks, and various member states designing responses to various ‘what-if’ scenarios.

“For those that are capable of figuring out the immense politics, brink theory and policy reaction functions, there are big investment consequences,” O’Neill says.

In his view, the EMU could not exist without Italy, but Italy cannot survive with 10-year bond yields above 7%.

Before all this, though, O’Neill suggests watching the ECB meeting, due to take place before the summit. Don’t expect ECB head Mario Draghi and his colleagues to reveal all their hopes and expectations.

But do expect a rate cut, some extension of liquidity support, and for the bank’s leaders to “give a flavour of what they expect and hope for”.

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