Posts Tagged Germany

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 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 logic of Merkelomics

Posted by George Irvin in EU on July 14, 2010

Last year, in defiance of all macroeconomic reasoning, Germany’s ‘grand coalition’ government (CDU/SDP) enshrined a budget balancing law in the Federal Constitution requiring the Federal budget to balance annually from 2016. Angela Merkel, currently in coalition with the centre-right FDP, trumpets the virtues of Schwabian thrift and apparently wants the whole Eurozone to follow Germany in adopting the same type of ‘debt brake’ economics. The rules of the SPG are to be tightened, probably involving new sanctions on members who violate the 60% public debt-to-GDP ratio such as imposing cash penalties and/or possibly withdrawing their voting rights. But Mrs Merkel apparently wants to go further, expelling deficit members altogether.

By contrast, most professional economists believe that deficit spending during and after recession is a good thing, and that government’s budget should only ‘balance’ over the 7-8 year business cycle at best. Why then does Germany reject this view? Can it be that by balancing the budget annually, Germany will have abolished the business cycle forever? Dream on!

Some put Germany’s debt-obsession down to the folk memory of the disastrous inflation of 1922-23. But that was nearly a century ago, when Germany was saddled with reparations from the Versailles Treaty which could only be met by printing money. Besides, debt finance is not inflationary; public borrowing financed by the non-bank public increases both public liabilities and private assets, so overall, the country’s books remain balanced.

Others point to the political fallout from the Greek sovereign debt crisis; unless Germany reduces its debt /GDP ratio from 75 to 60% as Maastricht requires, Germany’s credit rating risks being downgraded, they argue. This argument totally ignores that Germany is running an export surplus, that most of its debt is domestically held, that demand for German bunds has grown and that debt insurance rates for bunds have been rock steady.

Still others—in Germany, typically politicians and the Springer-dominated popular press—point to a rising national debt burden, an ageing population and the likelihood of higher interest rates (and thus high debt servicing costs). But the debt is rising because the deficit has grown faster than GDP—true by definition in a recession. And as Paul Krugman has noted, even allowing for higher future German debt servicing costs, the annual interest charge on debt would be less than 1% of GDP. Moreover, since the debt is mostly domestically contracted, servicing debt is simply a public-private transfer: a positive earnings stream for German bondholders.

In truth, there is overwhelming evidence for the twin propositions that (a) growth reduces the budget deficit; and (b) during and after a recession, deficit spending provides part of the necessary stimulus to reawaken growth.  Just as these propositions were true in during the Great Depression, they held true in Europe’s 30 year post-war wirtschaftswunder, in the US under Clinton in the 1990s and again since the 2008 credit crunch and accompanying stimulus packages (not to be confused with bank bailouts).

The IMF, in its July revision of its own April 2010 growth projections, shows that countries which applied a stimulus are doing better in growth terms than those that did not. It has raised its growth projections for countries that applied a vigorous stimulus package (eg, US, Japan) and its lowered growth projections for those where the stimulus was small or negligible (eg, UK, Germany).

If there is any discernible logic to Germany’s position, it emerges using the simple ‘savings’ balance model taught in Economics 101. Assuming no change in the private sector’s savings surplus (eg, steady wage repression), reduced public spending by adopting a balanced budget must lead by definition to a larger current account surplus—if it does not, national income must fall. Suddenly, the ‘debt brake law’ seems to make sense. The object of the exercise in the long term is to boost Germany’s export-led growth model, not just outside the Eurozone but within it where 2/3rds of its exports go.

The German-based correspondent of the Financial Times, Wolfgang Muenchau, has summed up the situation admirably. Balancing the budget forever by entrenching it in the Constitution will either plunge Germany into the vicious circle of falling tax revenue, expenditure cutting and negative growth, resulting in the eventual collapse of the Eurozone. Or else it will bring a virtuous circle of export-led growth, reinforcing Germany’s trade dominance of the Eurozone. The latter option may seem preferable. But in reality, because not all Eurozone countries can run a surplus with each other (one country’s exports are another’s imports), the latter option is equally unpalatable and will result in failure of the euro by a different route.

So there’s an underlying logic for the Eurozone in Merkelomics after all: heads you lose—tails you lose again!

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