While the issue of Greece continues to occupy the attention of the currency markets, it has in effect become a sideshow. The real conflict in Europe is now between Italy and Germany as the argument over the course of the monetary unionâ€™s policy going forward has taken a decidedly nasty turn for the worse. In todayâ€™s La Repubblica, the newspaperâ€™s star columnist Massiomo Giannini wonders if Bundesbank President Jans Weidmann is guilty of â€œseditionâ€ for openly opposing the ECBâ€™ s plan to cap periphery borrowing rates by setting a trading band around the credit spreads in the region.
This is not the first time that Italian media has used such incendiary language to voice its disapproval of German policies. In an infamous cover a few weekly ago Il Giornale put Angela Merkelâ€™s picture along with the heading of â€œFourth Reich.â€ Such sharp rhetoric is a testament to the level animosity between the two countries as Germany continues to insist on further austerity measures, while Italy which is already mired in a deep recession is seeking action from ECB to lower its borrowing costs which are more than 300 basis points above that of Germany.
As many analysts have pointed out Italy runs a primary budget surplus meaning that, excluding debt interest payments, its income is greater than their spending. However, escalating debt service costs along with steepening recession have put an enormous strain on Italian budget finances which threaten to price the country out of the sovereign debt markets if its interest costs continue to rise.
This is why the conflict between Italy and Germany on the future of european monetary policy is the seminal issue facing the euro as we approach the fall quarter. If European policymakers are unable or unwilling to enact policies that would ease the debt service costs for the periphery economies in the region than some market pundits have speculated that Italy could well consider spinning out of the euro fracturing the currency union.
Ms. Merkel is well aware of the risks and has apparently sided with Mr. Draghi in his plan to ease the credit spreads in the region. However, she faces stiff opposition at home and must walk a fine line between proper economic policy and pragmatic political action. As markets return to full strength in September after the last of summer holidays the resolution of this key conflict will determine euroâ€™s direction for the near term.