Posts Tagged Eurozone

The Greek debacle

Posted by George Irvin in EU on February 13, 2012

Does the Greek Parliament’s latest vote in favour of further cuts—despite the 40 deputies who defied the whips and were forced to resign—mean that the Greek crisis is resolved?  Of course it doesn’t.  For one thing, the troika (ECB, IMF and EU) will not approve the €130bn ‘bailout package’ next Wednesday unless Antonis Samaras, leader of the New Democrats, agrees to sign. Samaras has made it clear he will not do so until after the April elections because he knows that if he signs now, his party is toast.

For another, even with Parliamentary endorsement of nearly €4bn in cuts for 2012, it is hard to see how the government of Mr Papademos—or whoever succeeds him after the elections—can deliver. And of course, there must be a serious question about whether Ms Merkel and her Eurozone (EZ)  allies want Greece to stay in the euro. As the Dutch PM, Marc Rutte, is reported to have said last week, the EZ is now strong enough to weather Greece’s departure—eurospeak for ‘get out’.

Recall what the troika is demanding for 2012 alone:

  • a 22 per cent cut in the monthly minimum wage to €586;
  • layoffs for 15,000 of civil servants;
  • an end to dozens of job guarantee provisions;
  • a 20 per cent cut in its government work force by 2015;
  • spending cuts of more than €3 billion;
  • further cuts to retiree pension benefits.

These demands come as the country faces its fifth consecutive year of recession, and recent OECD figures showing GDP to have fallen by nearly 15% since January 2009 with unemployment standing at 18.7%. As Helena Smith reports in The Guardian, ‘Greece can’t take any more’. Even with the latest cuts and bailout, it is optimistic to forecast that the country’s debt/GDP ratio will be 120% in 2020. According to the FT’s Wolfgang Münchau: “[a] 120% debt-to-GDP ratio by 2020?  That’s 9 years of strikes in Greece,” and that is not sustainable.

Is Greece’s problem high labour costs?  Nouriel Roubini’s influential think-tank RGE estimates that as far as labour costs are concerned, the view that Greek wages rose too much during the good years is pure myth. In fact, over the period 2005/08, Greek wages rose less quickly than the average for the EZ.

Further cuts mean further recession, and it should be perfectly obvious by now that Greece cannot pay down its sovereign debt as long as the economy is shrinking. As I (and many others) have explained elsewhere, the debt/GDP ratio can only fall where the rate of interest on the debt is less than the rate of GDP growth. Just as Osborne’s cuts are jeopardising the future of the UK economy, so Merkel’s cuts are sinking a (far weaker) Greece.

Unlike some of my colleagues on the left, I have always been pro-euro. But the suffering imposed on Greece now makes me ashamed of being European.

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Europe’s debt trap

Posted by George Irvin in EU on January 14, 2012

Europe is obsessed with the growing stock of public sector debt; fiscal austerity has become the watchword of our time. Little does it seem to matter that fiscal austerity means reducing aggregate demand, thus leading to economic stagnation and recession throughout the EU as all the main forecasts are now suggesting.1 Even the credit rating agencies are worried, as S&P’s downgrading of France and eight other countries shows. Whether it’s Angela Merkel or David Cameron speaking, public debt is denounced as deplorable, and all are told to get used to hard times. As Larry Elliot puts it: “The notion that economic pain is the only route to pleasure was once the preserve of the British public school-educated elite, now it’s European economic policy”.2

In Britain, immediately after the general election, the Tory-led coalition decreed that in light of the large government current deficit, harsh cuts were necessary to win the confidence of the financial markets. But although the current deficit was high, the stock of debt (typically measured by the debt/GDP ratio) was relatively low and of long maturity, the real interest rate on debt was zero (and at times negative) and, crucially, Britain had its own Central Bank and could devalue. As Harriet Harman argued in June 2010, Osborne’s cuts were ideologically motivated. The aim was to shrink the public sector, and the LibDems—fearing a new general election—chose to go along with the policy.

In the Eurozone (EZ), where a balance of payments crisis at the periphery has turned into a sovereign debt crisis, the German public has been sold the idea that if only all EZ countries could be like Germany and adhere to strict fiscal discipline, all would be well. The ultra-orthodox Stability and Growth Pact (SGP) has now been repackaged under the heading of ‘economic governance’ under which Germany and its allies will vet members’ fiscal policies and impose punitive fines on those failing to observe the deflationary budget rules to be adopted. Never mind the fact that indebtedness in countries like Spain and Ireland was mainly private, or that the draconian fiscal measures imposed on Greece have, far from reducing public indebtedness, increased it.

Is debt always a bad thing? In the private sector, obviously not since corporations regularly borrow money for expenditure they don’t want to meet out of retained earnings, while most households aim to hold long-term mortgages. Public debt instruments like gilts in the UK or bunds in Germany are much sought after by the private sector, mainly because such instruments are thought to act as an excellent hedge against risk. Remember, too, that when a pension fund buys a government bond, it is held as an asset which produces a future cash stream which benefits the private sector. So ‘public debt’ is not a burden passed on from one generation to the next. The stock of public debt is only a problem when its servicing (ie, payment of interest) is unaffordable; ie, in times of recession when growth is zero or negative and/or interest rates demanded by the financial market are soaring.

The question is when is debt sustainable? Sustainability means keeping the ratio of debt to GDP stable in the longer term. If GDP at the start of the year is €1,000bn and the government’s total stock of debt is €600bn, then the debt ratio is 60%; the fiscal deficit is the extra borrowing that the government makes in a year – so it adds to the stock of debt.3 But although the stock of debt may be rising, as long as GDP is rising proportionately, the debt/GDP ratio can be kept constant or may even be falling.

Consider the following example. Suppose the real rate of interest on debt is 2% (say 5% nominal but with inflation at 3%, so 5 – 3 = 2). That means government must pay €12bn per annum of interest in real terms. But as long as real GDP, too, is rising—say at 2% per year—there’s no problem since real GDP at the year’s end will be €1020bn. Even if the government were to pay none of the interest, the end-of-year debt/GDP ratio would be 612/1020 or 60%; ie, the debt ratio remains unchanged. By contrast, if real GDP growth is zero, the ratio would be 612/1000 = 61.2; ie, the debt ratio rises only slightly.  The rule is that as long as the real economy is growing by at least as much as the real rate of interest on debt, the debt/GDP ratio doesn’t rise. Moreover, this holds true irrespective of whether the debt ratio is 60% or 600%.

But there’s a catch. In a modern economy, the public sector accounts for about half the economy. If a country panics about its debt ratio and cuts back sharply on public sector spending, this reduces aggregate demand and may lead to stagnation or even recession. When a country stops growing, financial markets decide that its debt ratio may rise and so become more cautious about lending and demand a higher bond yield (ie, interest rate). The gloomy prophecy of growing public indebtedness becomes self-fulfilling.

This is exactly the sort of ‘debt trap’ which faces much of the EU and other rich countries. The way out cannot be greater austerity. What works for a single household or firm doesn’t work for the economy as a whole. A household can tighten its belt by spending less, saving more, and thus ‘balancing the books’, but an economy cannot. If everybody saves more, national income falls. Of course, Germany and some Nordic countries can balance the government books because an export surplus offsets domestic private saving. But the Club-Med countries cannot match them. When no EZ country can devalue, to ask each EZ country to balance the books by running an export surplus is empirically and logically impossible. Even if all could devalue, what would follow is 1930s-style competitive devaluation.

The way out of the ‘debt trap’ is the same as the way out of recession: if the private sector won’t invest, the public sector must become investor of the last resort. It doesn’t matter whether new investment is financed by more government borrowing, quantitative easing or redistribution (some combination of the three would be optimal). What matters is growth.

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[1] See Joe Weisenthal http://articles.businessinsider.com/2011-11-10/markets/30380618_1_fiscal-consolidation-economic-growth-slow-growth

2 See Larry Elliott, http://www.guardian.co.uk/business/economics-blog/2012/jan/08/eurozone-crisis-angela-merkel-whip-hand?

3 See Paul Segal http://www.guardian.co.uk/commentisfree/2010/sep/03/government-debt-growth-unemployment

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Europe’s new credit crunch

Posted by George Irvin in EU on October 7, 2011

As the Euro Area (EA) dithers about bailing out Greece in the short term and continues to argue about how to expand the European Financial Stability Facility (EFSF), the sovereign debt crisis is turning into a full-blown banking crisis. Shares in Dexia, the Franco-Belgian banking group, are down 72% on their 52-week high—closely followed by other pillars of western finance such as Bank of America (-66%),  RBS (-57%) and Deutsche Bank (-50%). [1]  In effect, financial markets have seen the wiring on the wall and have been pulling out of bank shares—both banks that hold euro sovereign debt assets and those that hold shares in other banks that do. This means that the asset side of banks’ balance sheets are contracting and that insolvency looms.

True, the gloom lightened briefly when both Angela Merkel and EU President J-M Barroso announced they favoured a pan-European recapitalisation programme—causing EU bank shares to rally for a time. Governments are trying to pour cash into the banks—in the UK, Mervin King has announced an extra £75bn of quantitative easing (QE), allegedly to help industry get more and cheaper credit, but in reality to ward off a new credit crunch along the lines of what happened after Lehman’s collapsed in 2008. In his words, we face the ‘worst financial crisis ever’.

However, the recapitalisation of Europe’s banks faces a serious credibility gap. First, Dexia was one of the banks to pass the European Banking Authority’s (EBA) ‘stress tests’ with flying colours. Secondly, one result of these tests was a serious underestimation of the degree of recapitalisation required.  In consequence, a new round of tests will be required adding further to delays. Perhaps more importantly, there is growing pressure from investors to make banks ‘mark to market’; ie, report the current market value of their assets. Adoption of such a rule combined with current market volatility would doubtless lead to a large number of banks failing the stress tests.

And of course, the prospect of a Greek default looms larger by the day. The problem is not so much that a Greek default is unaffordable; doubtless, were the country to default on its own, it would take some banks down—starting with its own banks. The real danger is that of contagion. We know that Spain and Italy are ‘too big to fail’, and the markets have already begun to mark down commercial banks with exposure to them, not just in Spain and Italy but in France and even the UK. Whatever one may think about financial markets, their analysts are not fools; what they are telling us is that a Greek default will trigger widespread contagion.

Meanwhile, EA Parliaments dither about just how the EFSF’s limited capital can be stretched to meet the bill. Since the €440bn available cannot be miraculously turned into the €2tn required for ‘shock and awe’ to be sure of succeeding, the latest twist involves turning the EFSF from a lending institution into a insurance company, in effect selling credit default swaps (CDSs) to those most in need of insurance. These would be structured into equity, mezzanine and senior layers just like their Wall Street cousins, thus enabling €440bn to be hugely leveraged.

But as more than one commentator has pointed out, there are several problems here. First, one is using over-leveraged instruments to deal with the problem of over-leverage. Second, there is no ‘lender of the last resort’—if the scheme goes wrong, governments cannot bailout the losers since it is governments who hold the equity tranches. In principle, the ECB could perform this role—but the Germans are resolute in their opposition to the ECB acting as a Central Bank for governments. [2]  For that matter, tiny Slovakia is threatening to upset the EFSF applecart unless collateral is provided for its pledged assistance.

An obvious way out of this nightmare would be to forgive Greece at least half its debt (which the markets believe is in any case unpayable) while further reducing the interest on its loan, lengthening its debt maturity profile and aiding the country to become more competitive. Cynics might say this has been obvious from the start, and that it is now too late. If a European financial crisis does not happen next week, it will occur as part of a disorderly default in December when the pain finally becomes too much for Greeks to bear. It is then that we shall all feel the pain of a full-blown financial crisis, most probably followed by more years of economic recession.

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[1] See D Blanchflower ‘As bankshares tumble ..’ New Statesman, 10 Oct  2011.

[2] See http://on.ft.com/qi7ZIw

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An endgame for the eurozone

Posted by George Irvin in EU on June 16, 2011

Despite Wimbledon week, the main centre court contest that many economists are watching is that between the German government and the ECB. An abbreviated summary of the action so far is as follows. The German Finance Minister, Herr Schäuble, initially appeared to gain the advantage by admitting that the Greek situation is so perilous that they should be allowed in effect to default—the phrase he used was ‘voluntary restructuring’. Monsieur Trichet then fought back hard arguing that a Greek default would be catastrophic and implying that eurozone governments (not the ECB) should continue lending. The ECB even threatened to stop accepting Greek Eurobonds as collateral for its continued lending to the Greek central bank, a move that would effectively pull the plug on the Greek banking system. Who will prevail?

On the face of it, Herr Schäuble has a strong case, albeit rendered more palatable to his critics by such sweeteners as having Greece sell off public assets, voluntarily ‘reprofile’ its sovereign debt and so forth. The real case for default, though, is that the retrenchment medicine is not working and risks killing the patient. Instead of extracting a vengeful levy entirely from ordinary Greeks, German and French banks should be made to pay their fair share—a ‘haircut’ variously estimated as between 35% and 70% of the bonds they hold. Indeed, given the dramatic turn of events in Athens in recent days, default now looks almost certain.

But here is the rub. A default—however sugar-coated—is still a default. The ECB argument is that if Greece is allowed to do so, other highly indebted members will follow suit and, as contagion spreads, the markets will cease buying members’ sovereign debt altogether. The ECB would be left to bail out not just the small peripheral economies, but probably Spain and Italy too. That would spell the end of the euro. That is partly why Jean-Claude Trichet will be replaced in October by another tough conservative, Italy’s Mario Draghi who famously prefaced an interview with the Financial Times by the phrase “The euro is not in question.”[1]

On the face of it, then, the first set of the match will almost certainly end in a nail-biting tie break. But whoever wins, the match will be far from over. To borrow Wolfgang Münchau’s phrase, the existing union is too weak to function properly, but too strong to blow up.[2] Assuming the eurozone does not blow up, how might it be strengthened?

The central pillar of a new economic architecture for the eurozone would be the creation of a Treasury Secretary with a secretariat; ie, an embryonic Eurozone Treasury (Ministry of Finance). Indeed, the idea was floated earlier in June by Monsieur Trichet himself who added that such a Ministry would also carry out “all the typical responsibilities of the executive branches as regards the union’s integrated financial sector, so as to accompany the full integration of financial services, and third, the representation of the union confederation in international financial institutions.”.[3] The key points to retain are, first, that such a Ministry would have real power (ie, it could override national bickering in the Council); and secondly, that the Eurozone would have a single banking system.

Another pillar would be fiscal-financial. Like its US counterpart, a Eurozone Treasury would need to be able to emit E-bonds jointly guaranteed by all members. Not only would this enable the eurozone to supersede the now-discredited system of relying on national Eurobonds, it would greatly strengthen the euro as a reserve currency since euro-assets would be far more desirable (and available) to hold. Additionally, a Euro-Treasury might start by improved ‘co-ordination’ of member-states’ fiscal policy, but it would soon need to raise significant amounts of revenue. A useful mechanism would be to follow up on a suggestion by Spain a decade ago that a tax on member-states (ie, a share of their VAT receipts) be levied progressively in proportion to their per capita income.

The third pillar would be political. The eurozone cannot survive unless its citizens benefit from its existence. And here is where serious political courage is needed—the courage to set up a Eurozone unemployment benefit scheme, and/or for that matter, a Eurozone pension scheme. Initially such schemes would complement the national schemes already in place, but as they grew in size, they would come to play the same macroeconomic stabilisation and redistributive functions as the US Treasury.

How do these proposals relate to the current contest between the Germans and the ECB? The answer is straightforward. Although the Greeks, the Irish and other countries at risk will doubtless be offered further loans, at the end of the day what we are witnessing is a slow-motion default. Why? Because ‘internal devaluation’ and the fiscal straightjacket imposed upon the weakest members means they can never repay. Ultimately, Germany, France et al will have to bail out their own banks. If slow-motion default leads to another major financial crisis, we shall all pay.

In truth, Eurozone member-states already live in a ‘transfer union’, and the sooner members realise it and adopt a common macro-economic framework, the better. The practical details may take a long time, but one thing is certain: the gruelling match on centre-court is far from over.

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[1] See ‘Interview with Mario Draghi: Action on the addicts’ http://www.ft.com/cms/s/0/af24be36-03ca-11e0-8c3f-00144feabdc0.html#ixzz1PAShPhkq

[2] See Wolfgang Münchau ‘Ingredients of a European political union’ Financial Times, June 5 2011.

[3] See http://www.bloomberg.com/news/2011-06-02/trichet-proposes-euro-area-finance-ministry-to-coordinate-fiscal-policies.html

 

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The Eurozone is already a transfer union

Posted by George Irvin in EU on June 1, 2011

Five years ago I wrote a book supporting the euro, but saying inter alia that Eurozone governance was fatally flawed and that a European Treasury was needed.[1] Although not taken very seriously at the time, this view has today gained wide currency. Like it or not, a US-style Treasury is needed to guarantee states’ financial system and to effect fiscal transfers within the Eurozone. Yes, the Eurozone is a ‘transfer union’ and the sooner the rich countries face up to this reality the better. The alternative could be collapse of the euro, followed by financial chaos.

Intra Euro debt: Claims between national central banks (£bn)


 

 

 

 

 

 

 

source: M Wolf, ‘Intolerable choices for the Eurozone’ FT, 31 May 2011.

In a series of excellent pieces in the Financial Times, Martin Wolf has spelled out a compelling case for fundamental reform.[2] The eurozone, Wolf reminds us, started life as a reincarnation of the gold standard. Eurozone member states were meant to finance a trade deficit by borrowing abroad; ie, by emitting their own central bank bonds. If markets were unwilling to buy these, a member-state would have no option but to find the money internally by means of a squeezing labour costs, or what is euphemistically termed ‘internal devaluation’.

There are two problems here. One is that squeezing wages may have an unacceptably high political cost. While it is true that cutting aggregate demand sufficiently will balance the books at some (very much) lower level of national income, the patient may stop breathing as a result. (For example, Ireland has now experienced four years of recession and the young are emigrating in droves.)

The second problem is the banking system. Since private credit died up after 2008, the ECB (and the Bundesbank) have acted de facto as the Eurozone’s lender of the last resort, both in buying the sovereign debt of the periphery’s Central Banks and helping Europe’s large private banks to do so. Indeed, the accompanying figure illustrates the unnerving symmetry between Germany’s position as chief central bank creditor and the growing indebtedness of the Eurozone periphery—unnerving because the Germans are indirectly financing the periphery through the banking system rather than through explicit fiscal transfers. Although this has helped peripheral states to weather the storm, what happens if peripheral countries default?

Many commentators (including myself) believe that some form of default is now inevitable[3]—but default could have dire consequences too. The insolvency of periphery governments would almost certainly threaten the solvency of debtor country central banks, leading to large losses for creditor country central banks (eg, Germany), which national taxpayers would need to shoulder. Doubtless this is a major reason for Signor Smaghi’s implacable opposition to default. And in the absence of support from the ECB and other creditor central banks, the threat of default by Greece or Ireland would hasten contagion and paralysis. Banks would not want to rink continued lending to any potential defaulter, credit would seize up and, ultimately, the existing financial transfer mechanism would collapse.

The options for the eurozone are narrowing. Either default will result in weaker countries leaving the eurozone—a lengthening list as contagion and financial collapse spreads—or the eurozone must undergo radical reform. This means tearing up the current system under which Greece and its banking system depend on selling sovereign bonds to the market and establishing in its place a Eurozone Treasury which would, like its US counterpart, guarantee the integrity of the Eurozone’s financial system as a whole. Needless to say, other key reforms would be necessary (true e-bonds, smaller trade imbalances) which I shall not dwell on here.

All this boils down to a single basic point: Europe already has a central bank ‘transfer union’, but it is under growing threat. Either Europeans bite the bullet and accept the need for true fiscal union and economic governance, or they can stand aside and watch the Eurozone disintegrate. Just as in the case of climate change, it’s too late to think that we can merely wish for the best and ‘muddle through’.

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1 See George Irvin, Regaining Europe; an economic agenda for the 21st century, London: Federal Trust, 2007.

2 See http://www.ft.com/cms/s/0/1a61825a-8bb7-11e0-a725-00144feab49a.html#axzz1O2IdJ0I6; also see http://on.ft.com/lCP0jT

3 See http://ftalphaville.ft.com/blog/2011/05/10/564346/roubinis-guide-to-a-greek-debt-restructuring/.

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The big bailout scam

Posted by George Irvin in EU on April 11, 2011

Suppose that my rich neighbour down the road mortgaged his mansion up to the hilt to bet on the horses, ran up millions in debt and asked me, an ordinary punter, to pay off his debts plus interest. Suppose that foolishly I accepted, and while I struggled to pay it off while barely able to feed my family and pay off the mortgage, my super-rich neighbour acquired an even bigger mansion. To make matters worse, he used all sorts of clever dodges in the Caymans to pay negligible taxes, while if I failed to pay mine I knew I’d be sent to prison.

It may sound like total madness, but that’s pretty well what’s happening to a growing number of Europeans (including Brits) today.

How did we get here? In Britain, the 2008 credit crunch produced a massive recession which played havoc with government finances. In Ireland the government took over the entire debt of its banking system, while in Greece, the rich paid minimal taxes and successive governments, unwilling to challenge them, indulged in creative accounting.  That’s somewhat simplified, but it’s the essence of the story.

Everywhere in Europe, voters are being told that decent pensions and universal welfare provision are no longer affordable and that we must all tighten our belts. Governments can no longer borrow because the credit rating agencies might downgrade their bonds. First it was Greece and Ireland, today it is Portugal, and tomorrow perhaps Spain, then Italy, and then … who knows?

But ordinary punters are starting to wake up. Instead of enduring years of economic depression, the Greeks and the Irish will probably have to default, as will the Portuguese if their economy reacts the same way to belt-tightening.[1]   And what if Spain has to be bailed out, still less defaults? That would spell a major hit for banks in Germany, France, the UK (and elsewhere), all of which could easily add up to another major financial crisis.

Are we really so vulnerable? The answer is indeed yes—-because so little has been done to address the underlying causes of the 2008 crisis.

While the recent Basle Three agreement requires banks to carry a slightly higher cash cushion, nothing has been done to re-establish the division between investment banking and commercial high-street banking, a division which disappeared with the repeal in the US of Glass–Steagall in 1999. Except for a temporary ban on naked short sales in Germany, the derivatives trade remains mainly unregulated.[2]  Credit default swaps (a form of insurance on risky financial products) are still sold over-the-counter rather than through an official market, the US President having failed to follow up his 2009 promise to re-regulate these.[3]

Meanwhile, the trillions poured into the big banks since 2008, instead of going to cash-starved small business or being used to build infrastructure and to create jobs, have largely helped fuel a new stock market bubble.[4] The extraordinary rise in the value of companies such as Facebook and Zynga provides a worrying parallel with the dotcom bubble of 2000.

Tax dodging is now a major growth industry—witness the latest GE scandal. As for making the bankers pay by introducing some form of Tobin tax, there’s been much talk but little action.

Perhaps most galling of all is the injustice of using Keynesian economics to justify the need for state intervention in banking bailouts while claiming today that the profligate state caused the problem, as politicians now argue in London, Brussels and Frankfurt.[5] How long will sensible people go on accepting this nonsense before venting their anger on our ruling classes?[6]

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(An earlier version of this piece first appeared at http://www.social-europe.eu/2011/04/the-big-bailout-scam)

1 http://www.bbc.co.uk/news/business-12864413

2 http://online.wsj.com/article/SB10001424052748703957904575252611852571860.html

3 http://www.cnbc.com/id/30731157/Regulating_Wild_West_CDS_Market

4 http://www.marketoracle.co.uk/Article19523.html

5 See Ha-Joon Chang, ‘The revival—and the retreat—of the state?’ Red Pepper, Apr/May 2011.

6 http://www.france24.com/en/20110312-300000-protest-job-insecurity-portugal

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Another banking crisis for Europe?

Posted by George Irvin in EU on January 26, 2011

We tend to forget that sovereign debts crises and banking crises are merely two sides of the same coin. At the end of 2009, for example, consolidated claims of French and German banks on the four most vulnerable members of the Eurozone were 16 per cent and 15 per cent of their GDP, respectively. For European banks, as a group, the claims were 14 per cent of GDP.

In the words of Martin Wolf, ‘any serious likelihood of restructuring would risk creating sovereign runs by creditors and, at worst, another leg of the global financial crisis.[1]

Since 2008, the main difficulties for financial institutions have been in the UK, Germany, the Benelux countries and Ireland.  Although the exact nature of each institution’s problems varied, broadly the difficult was a shortage of liquidity in the banking system. The Irish problem of extending a blanket government  guarantee for a mountain of private bank debt is well known. In Germany and The Netherlands, names like Hypo and Fortis spring to mind. But what of all that shaky sovereign debt held by EU banks? As the ECB rcently warned, Eurozone banks will face refinancing needs of €1000bn over the next two years.[2]

To understand this problem, have a look at a new piece by Professor Mark Blyth of Brown University in the US. Speaking of the European crisis, Blyth says:

What was a crisis of banking became, in short order, a crisis of state-spending via a massive taxpayer put, and with sovereign bondholders’ interests being held sacrosanct while their investments were diluted (if not polluted), the taxpayer had to shoulder the costs twice: once through lost output and new debt issuance; and then twice through the austerity packages held necessary to placate the sovereign bondholders.[3]

Blyth goes on to point out that too little attention has been paid to the role of Europe’s banks, who in the past two years were happily dumping northern states’ sovereign bonds for high-yield Club Med bonds. But private actors will want to hedge their positions, buying equities, real estate and the like. A problem arises when these markets go south, leaving banks holding risky bonds with little cover. Their only option is to ‘dump good to cover bad’—but if all players do so together, the strategy yields perverse results. If I know you’ll dump Greece, I’ll dump Ireland, and you’ll then dump Spain to stay ahead of me, so I’ll dump Italy and so on.

With everyone trying to go liquid, liquidity suddenly becomes nearly impossible to achieve. As Blyth says, you can keep passing the ‘put’ around, but there comes a time when somebody has to pay up. The taxpayer cannot pay forever (because he or she is or soon will be on the dole), and the EFSF is just a special purpose vehicle with little cash and much rhetoric about which bondholders have grown deeply cynical.

There’s a limit … and it’s called Spain. Spain’s government and private bonds are held by banks all over Europe. Spain is ‘too big to save’. Blyth concludes that the Germans know this—their theatrical rhetoric is merely designed to postpone the mother of all bank runs.

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1 See http://www.ft.com/cms/s/0/0c382c9c-0237-11e0a40-00144feabdc0.html #axzz1C2vbemOj

2 See http://www.ft.com/cms/s/0/6dba1338-03ac-11e0-9636-00144feabdc0.html #axzz17y7ZYFDz

3 See http://crookedtimber.org/2011/01/18/the-end-game-for-the-euro-german-rules-and-bondholder-revolts/

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Could the euro disappear?

Posted by George Irvin in EU on December 1, 2010

Let me make it clear that I strongly support the euro; I’m a Brit who believes in European integration and who has little time for Euro-sceptics. But I can also see the writing on the wall. The euro—and with it the whole EU integration project—is in grave danger. It is entirely possible that in five years’ time, travelling from Paris to Berlin and thence to Madrid or Rome will entail queuing to change money and struggling through customs posts once again.

Why should the euro be in danger? After all, the Eurozone taken together is in quite good shape, considering the fact that we’ve been though the worst recession since the 1930s. The 16 euro-states’ budget deficit in 2010 as a percentage of GDP is 6.9% (versus 10.2% for the USA); the ratio of public debt to GDP is 84%, far lower than the US figure of 94%.[1] So what’s the problem?

The problem is the peculiar architecture of economic governance. Since tax receipts fall and spending rises in a recession, government deficits necessarily swell and must be financed by borrowing. Because the Eurozone has no federal treasury and cannot emit federal bonds, smaller member states whose domestic bond markets are too narrow must go to the international market to sell their own Eurobonds.

In normal times, member-states’ government bonds are considered a safe bet by the market. But as past financial crises show clearly, bond markets tend to be driven by the herd instinct; ie, once the rumour circulates that one country’s bonds are at risk, everyone joins in. This is commonly known as ‘contagion’, and there’s lots of it about today. Witness the fact that not just Greece, Ireland, Portugal and Spain are under threat, but in the past week Belgium and Italy have been added to the list.

The joint European/IMF bailout plan agreed earlier this year provided some €750bn (€860bn if Greece is included) in potential relief to afflicted countries—with plenty of nasty strings attached, one must add. The plan covers the period 2010-14, but the combined borrowing requirement over 2011-14 of Italy, Spain, Portugal, Greece and Ireland totals nearly €650bn and is growing. Add to this Belgium’s public debt of about €350bn, and the total is €1tr, far larger than the bailout package. The size of the package is unlikely to increase because of political resistance and possible required changes to the Lisbon treaty; per contra, what is likely to increase is the troubled states’ borrowing requirements. The financial markets have already done their sums, the main reason they are betting against the longer-term success of the rescue.

What are the options? First, Chancellor Merkel and President Sarkozy recently agreed on a sovereign debt default mechanism for troubled Eurozone countries thus forcing bondholders to share the bailout pain. Doubtless such a scheme will appeal to taxpayers and sacked public-sector workers alike, but as Paul De Grauwe has noted forcefully, legitimating sovereign debt restructuring makes speculative runs more likely, not less so; ie, the new mechanism increases potential turbulence.[2]

Of course, it is not just the troubled states that are being rescued; it is the major banks holding troubled Eurobonds that are in danger. Everybody knows—except apparently the German electorate—that when Germany ‘bails out’ Greece, the main beneficiaries are German banks (just as the main beneficiary of the recent UK ‘bailout’ for Ireland will be RBS). As ever, these are deemed to be ‘too big to fail’. To ensure their solvency, the European Central Bank (ECB) has been lending them money at a typical rate of 1 percent, money which is then on-lent to Greece or whomever in the form of bond purchases yielding 5 percent or more.

The problem here (quite apart from the big commercial banks making huge profits) is that the resources of the ECB are finite. It simply cannot conjure up another trillion euros if required. Of course it could do so by engaging in Quantitative Easing (QE)—a form of monetisation—but politicians think this will lead to inflation.

And here lies another trap. Although core inflation in the Eurozone remains very low, once energy and food are added back into the measure the rate goes up. In the next few years, food and energy inflation (both largely imported) are likely to accelerate. And if the ECB prints money, politicians—most of whom still believe in the simple ‘quantity theory of money’—will take the blame.

Finally, there is the fundamentalist solution preached by the deficit hawks: make all the ClubMed countries (including those not bordering the Mediterranean) cut their spending and balance their budgets! But there are two problems here. First, budget balancing might be feasible for one country when the world economy is buoyant, but in a world where the OECD economies are stagnating, asking many countries to balance their budget is not feasible. As a recent IMF study shows, ‘expansionary fiscal contraction’ is not the answer.[3]

So what is the answer? The answer is twofold: first, the ECB, not member states, should be able to issue Eurobonds, an idea which has recently gained limited traction. Secondly and more important, in the long term there must be a Eurozone Federal Treasury, akin to the US Federal Treasury. As the President of the ECB, Jean-Claude Trichet, said in the summer “Nous sommes une fédération monetaire. Nous avons maintenant besoin l’équivalent d’une fédération budgetaire” (Le Monde, June 1st).[4] He repeated this warning to a European Parliamentary Committee on 30 November.

To date, Europe’s political class has been unwilling to listen. They argue, inter alia, that Germany’ constitutional court would never cede fiscal sovereignty. Indeed, the tradeoff between monetary and fiscal sovereignty was at the heart of the Maastricht Compromise of 1992. It is most certainly not in Germany’s interest to allow the euro to flounder. Let’s hope Europhiles wake up before it’s too late.

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[1] See FT Alphaville 23 Nov 2010; http://optionalpha.com/european-national-debt-2010-as-a-percentage-of-gdp-9001.html
[2] See P De Grauwe ‘A mechanism of self-destruction in the Eurozone’ 9 November 21010; http://www.ceps.eu/book/mechanism-self-destruction-eurozone
[3] See http://www.social-europe.eu/2010/11/expansionary-fiscal-contraction-and-the-emperor%E2%80%99s-clothes/
[4] See G. Montani, ‘European Economic Governance and fiscal sovereignty’; http://www.thenewfederalist.eu/European-Economic-Government-and-Fiscal-Sovereignty

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Why Club-Med cuts won’t work

Posted by George Irvin in EU on October 4, 2010

It is conventionally assumed that the Eurozone crisis arose because Club-Med governments have been too profligate. If only they had been as cautious as northern European countries, the argument runs, they would have retained their export competitiveness. A recent carefully researched paper, popularly known as the RMF Report and compiled by academics at the University of London, SOAS, shows this view to be entirely without foundation. [1]

Inter alia, the Report investigates the relationship between Club-Med current account (external) deficits, government deficits and the countries’ total stock of debt. Club-Med governments have not been wildly profligate: Greece, Spain and Portugal all have government deficits lower than the UK, and with the exception of Greece, their net public debt-GDP ratios are running at 60% or less.

The key point, however, is that much of Club-Med debt is held by the private sector: nearly 90% of all debt in Spain, 85% in Portugal and over 50% in Greece. Moreover, less than half of all Spanish debt has been contracted abroad (in contrast to Portugal and Spain where the overseas proportion is much higher). Secondly, a far higher proportion of private debt is relatively short-term, meaning it will need to be refinanced sooner than much of the public debt.

In Spain, private profligacy has mainly to do with a sharp rise in private investment resulting from the housing boom. In Portugal and Greece, by contrast, private investment growth was much less important; in essence, private savings have contracted to finance rising consumer demand. Nor is there anything surprising in these patterns—until 2008, the UK experienced both a private housing boom and a private savings collapse to sustain consumer demand.

All-round austerity starting with government deficit reduction has become the official answer to the problems of the Eurozone. But as the case of Ireland demonstrates, severe cuts reduce aggregate demand and induce further economic contraction, thus lowering government revenue faster than expenditure.

The main argument used by Eurozone deficit hawks—since devaluation is no longer possible—is that public cuts will restore the competitiveness of Club-Med countries. Once again, the problem is that where everyone practices fiscal retrenchment, aggregate demand throughout the Eurozone contracts. Because so much of the Eurozone’s trade takes place within it (ie, is ‘intra-trade’), what may benefit one country taken singly cannot benefit all simultaneously. Competitive wage-cutting has much the same effect as beggar-thy-neighbour devaluation did in the 1930s. And with the poor performance of the US economy increasing competitive pressures in the rest of the world, Club-Med countries cannot easily increase net exports outside the Eurozone.

In effect, we face three possible Eurozone scenarios.[2] The first is a decade of very low growth and high unemployment all ‘round. The danger is that in a decade’s time, Europeans will be so thoroughly disillusioned with the European project that it will fall apart politically.

The second scenario is default—whether partial or full. A partial default or debt restructuring exercise will, minimally, involve losses for creditor banks in Germany and France and necessitate further bailouts. Maximally, debtor-led full default would lead some Club-Med countries to leave the Eurozone, entailing the possible demise of the single currency. Alternatively, growing German resistance to ‘bailouts’ and a serious falling out with Paris over its export-led growth model might lead Germany to quit the euro and revert to its beloved DM.

The third scenario is fundamental reform of the Eurozone: the establishment of a genuine European Treasury with a substantial budget and fiscal powers and reform of the ECB, starting with the emission of federal Eurobonds. It is becoming increasingly clear that if the euro is to be saved, this is the path Europeans will need to adopt. By contrast, universal fiscal retrenchment enforced by levying fines on ‘profligate countries’ fails to address the real issues. But will European political leaders listen?

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[1] See Lapavitsas, C et al (2010) ‘The Eurozone between austerity and default’, RMF, University of London, SOAS <http://www.researchonmoneyandfinance.org/media/reports/RMF-Eurozone-Austerity-and-Default.pdf>

[2] See http://www.skidelskyr.com/site/article/europes-debt-crisis-and-implications-for-policy/

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The Eurozone and the USA

Posted by George Irvin in EU on July 15, 2010

I’ve had a number of posts on my blog about my piece on Merkelomics. I shall ignore the one which says ‘all debt is bad’: has the person in question has ever had a mortgage?

Let me take the more serious point made by one commentator (Commentator ‘A’) who clearly wants to Eurozone to succeed—a sentiment I share fully. ‘A’ says: ‘I believe the fault in your analysis is that you don’t see the Eurozone as a national economy in the making. If you were, you would’ve realised that it doesn’t matter whether Eurozone exports originate in Germany or some other Eurozone country.’

My reply? I do indeed wish that the Eurozone were a national economy in the making and that I could praise the Germans for their export-led growth model. That German industry is admirably efficient I have no doubt (far more so than the UK). But perhaps I can best explain the case for Eurozone reform in the following manner. Below is a short ‘thought experiment’.

Let us assume—you can tell I’m an economist—that the contemporary USA were like the Eurozone, that there was little labour mobility, no Federal Treasury, that Congress was weak and that power lay almost entirely with the individual states (as indeed it did in the late 18th century). Let us further assume that because there was no Treasury but only a Central Bank, there was no federal borrowing and that individual states had to finance themselves through taxation and state bond issues.

In such a world, the ‘rating agencies’ would look at the trade statistics of the various US states. Suppose that most US state-level trade was with other states (which it is) and that Michigan and Ohio (which produced mainly manufactures) had enormous trade surpluses while the relatively poor states of Louisiana and Mississippi (which produced mainly fish) ran persistent trade deficits. (Remember, this story is allegorical.)

Ohio and Louisiana might initially both have AAA+ ratings, but because Louisiana was dirt poor and suddenly was struck by a hurricane causing coastal devastation, its economy became a basket case and its tax receipts collapsed. In consequence, the rating agencies downgraded Louisiana’s dollar bonds, making it nearly impossible for the state to borrow. Nor could Louisiana export its way out of trouble because, as part of the dollar zone, it could not devalue. Drastic cuts (internal depreciation) would make it even poorer and more likely to default.

So Louisiana—-together with Alabama and Mississippi— needed help from richer states like Ohio and Michigan. But Ohio, Michigan and various other ‘northern states’ were not without internal problems, and their citizens were reluctant to help the ‘lazy and feckless southerners’. Nor would they let the Central Bank buy the bonds issued by these poorer states … until a major crisis occurred.

I leave the reader to finish the story. Needless to say, the crucial point is that the USA is not in the above situation because it has the economic institutions necessary for operating a federal economy.

At least the USA had Alexander Hamilton and James Madison to shape its structure—today, Europe has Angela Merkel and Nicolas Sarkozy. I’m not optimistic.

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