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Monday, December 26, 2011

Italy Braces Itself For The Full Monti

To take the second question first, one of the reasons that many are confident Italy will make it on through with the debt challenge is the country's recent record in controlling the deficit. According to OECD data, while Italy ran a cyclically adjusted primary deficit every year between 1970 and 1991, it ran a cyclically adjusted primary surplus every year since 1992. That is to say, before allowing for interest payments Italy has not been running a deficit for many years now, and it is simply the burden of servicing the accumulated debt which is causing the country to spend more than it receives in revenue. As many of those who are in the "optimistic" camp on the question of the country's ultimate solvency eagerly point out, Italy’s cyclically adjusted primary balance as a proportion of GDP has remained in a better shape than those of the largest developed countries as well as those of European peripheral and core countries since the onset of the crisis. It is only the legacy of the past which acts like a dead weight pulling the country down, but what a legacy this is, and especially as yields on Italian debt have steadily risen.

Poised On A Knife-edge

But given everything it is clear that Italian debt, and with it the future of the Euro, now sits poised on a knife edge, as is illustrated in the chart below (which comes from Barclay's Capital). If you take a neutral scenario where Italy has a balanced budget and a sum total of zero nominal GDP growth (ie growth+inflation = 0) debt stays put at 120% of GDP out to infinity.

But then imagine the average finance cost of Italian debt rises, and stays high. In this case  the only way to compensate  is by running a larger primary surplus (ie more spending cuts, or revenue increases to compensate for the extra interest cost). The net effect of this would either be to generate deflation or a more sustained economic contraction, in which case debt to GDP would start to rise indefinitely. Think of it like this, either prices fall by one percent and GDP (via exports) rises by 0.5% (for example), in which case nominal GDP falls 0.5% a year (the Japan type case), or prices rise by 0.5%, exports lose more competitiveness, and so growth falls by 1%. I mean, this example is only illustrative, but it is meant to give some sort of feel for what "knife edge dynamics" really mean.

In fact, before the recent surge in the spread, average interest costs on Italian debt had been falling in recent years, but now they are evidently rising again. It is very important here to remember that  yields in bond auctions only affect new emissions of debt (and changes in the secondary market only really affect banks, and sovereigns through possible needs to recapitalise banks). So it is a question of years before the higher levels "lock in" - the average maturity on Italian debt, for example, is around 7.2 years, and indeed since governments finance at fixed and not floating rates (not at a certain % above 3 month Euribor, for example), debt costs are at much at risk from increases in ECB base rates as they are from the actual spread with German bonds. Any substantial increase in interest costs naturally makes selling debt more expensive. Fortunately for peripheral sovereigns, the likelihood of ECB rate rises in the foreseeable future is near to null.

No Way Back Home

But again, let's do another thought experiment. Imagine I am right, and  Italian debt is on a knife edge path, and suppose the average interest rate on the whole debt creeps up by 1 percentage point. With debt at 120% of GDP, then the primary surplus to cover the added interest costs and maintain a balanced budget would be 1.2% of GDP. But suppose, for the sake of argument, that increasing the primary surplus by 1.2% pushes Italian debt to gdp up to 125% (via a combination of either deflation or economic contraction), then the next year the primary surplus would need to be up by an additional 0.05%, helping force debt to GDP up even further and so on and so forth. This is why people call this the debt snowball. The point is, whichever way you turn, you seem to find the exit door locked.

Coming back to the details of the present situation, the Italian government has committed itself to a consolidation program worth €74bn over the next two years amounting to roughly 3.7% of GDP. This is designed to bring the budget into balance (or the deficit to zero) by the end of 2013. On quite conservative assumptions, just to tread water, and maintain the debt level where it will be in 2013 (which will be more than 120% of GDP due to the recession), Italy will need a primary surplus of 2.3% of GDP.

But then we need to think about the recently undertaken commitment to reduce the debt (the last EU summit). The exact numbers have yet to be agreed for the new pact, but it looks like a cyclical maximum of 0.5%, and (even more importantly) a commitment to reduce outstanding debt over 60% of GDP by 5% a year. This, in Italy's case will mean the country is going to need (from 2014 onwards) a primary balance of something like 5.5% of GDP (depending on the evolution of interest costs) over the rest of this decade. Which means the Italian economy is going to face an even more restrictive fiscal environment.

Now, those who argue the Italian crisis will have a happy outcome point to history, and argue that Italy was able to achieve a primary surplus of around 5% on average during the years 1995-1998, so why shouldn't the country be able to do this again? The main counter argument would be that that was then, and this is now. That is to say, these were the years of Italian "coupling" with monetary union, sizable privatisation programmes, falling (not rising) interest rates, and basically Italian trend growth had not fallen as far as it has now.

Moreover, the external environment in Europe will not exactly be conducive to boosting exports. Even core Euro Area countries are commited  to undertaking additional fiscal consolidation beyond what is currently envisaged in order to comply with the new debt rule. Taking 2014 as the starting point, debt to GDP for the Euro Area as whole might be something like 90%. Hence the 1/20th rule would imply that on aggregate the Euro Area will need to reduce its debt ratio by around 1.5 percentage points per year. If this agreement is complied with the adjustment will almost certainly imply a net fiscal drag on growth in the years following 2013. Of course, if it is not complied with then it will almost certainly be "bye bye Euro" (assuming the common currency still exists that far up the road).

It's All About Structural Reforms, Or Is It?

So basically, what the whole argument about whether or not Italy can make a final burst and reach the finishing line is all about structural reforms, and whether the country can get enough growth (quickly enough) to turn the "knife edge trap" around. Personally I am extremely doubtful that it can, which is why I placed so much emphasis on the growth performance in the first section. The turnaround needed here is massive. It is a 30 year decline we are talking about, and I doubt short of outright default and substantial devaluation we have historical examples of anyone doing this. The adjustment made in Germany between 1999 and 2005 was much smaller in comparison.

One of the proposals is to introduce labour market reforms to increase participation rates, but in fact the Italian labour force grew substantially between 2004 and 2008 (due to large scale immigration), with employment being up by over a million (or around 5%, see chart above), yet the increase in output was ridiculously small. On the other hand we know the Italian working age population is contracting (and the average age rising), while the elderly dependent population is increasing rapidly. Conventional economic models tend to be silent on this issue, but common sense should tell us that this is going to take its toll on growth - a factor the "structural reform answers all our problems people" don't seem to have given enough thought to.

The Monti government needed  just five weeks in office to push through an additional 30 billion-euro emergency budget package, but how long will he need to get GDP growth back up above 1% annually? And how much time does he have? Investors initially cut him some slack, but judging by the reaction to the final approval of the package by the Senate - the yield on Italy’s 10- year benchmark bond was pushed up by 12 basis points to 6.91%, dangerously close to the key 7% level (although still somewhat below the Euro era record hit on November 9, just before Monti took charge). 7% is  widely considered to be critical if sustained for any great length of time, partly due to the cost of debt servicing but also because of the level of dependence of Italian banks on the ECB that it would produce.

Till The Dowgrades Fall

So the "Full Monti" effect now seems to have  been priced in, while investors nervously wait to see what the real plan for Spain and Italy actually is.

The first quarter of 2012 looks to be critical for Italian debt, with about one third of the total Euro Area debt maturing being Italian. Indeed the battle starts this week with the Treasury having to sell an assortment of T-bills and 2 year and 10 year bonds. In addition the Italian government is now increasingly guaranteeing bonds issued by Italian banks to be used as collateral at the ECB  - with about 40 billion euros being issued last week according to some estimates. So effectively Italy is now more or less guaranteeing the banking system with the likely outcome that ratings agencies will be even harder on the sovereign rating.

Not that the outlook was exactly bright on that front anyway. Understandably, Italy was among the 15 Euro Area countries Standard & Poor’s placed on review for a possible downgrade on December 5. This follows an earlier downgrade to a single A by the agency in September. In addition, Spain and Italy were both warned by Fitch (which cut Italy's rating to A+ on October 8) on December 15 to brace for a further debt downgrade after concluding that a "comprehensive solution to the eurozone crisis is both technically and politically beyond reach". And to complete the set, Moody's, which cut the country to A2 on October 4, maintained a negative outlook, signifying that a further dowgrade in the coming months was highly probable  The bottom line is that Italy is both too big to fail and too big to be bailed out, which is why it is still hanging dangerously in limbo-land. Since, as I argue in this article, some sort of restructuring or other is well nigh inevitable in the Italian case, the sooner Europe's leaders work up a credible plan on how to achieve this, the better. Otherwise it will not only be Italy's citizens who are subjected to the Full Monti, Europe's leaders may also find themselves with their credibility stripped naked.

This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".

Monday, December 19, 2011

Is Finland Really A Closet Member Of The Eurozone Periphery?

At a time when many eyes look hopefully towards the ECB for the kind of action which may prove to be the salvation of the much beleaguered Eurozone other, more critical, ones are casting themselves back over the recent track record of the institution itself, and asking what, if any, responsibility the Frankfurt-based bankers have for having allowed Euro Area government finances to fall into the sorry state they are now in.

Lessons From Japan?

No idle question, since it harks back to the time when a good deal of attention was focused on the Bank of Japan, and how much responsibility policymakers there had for the deflation trap into which the country's economy eventually fell. Now according to a very influential paper published by the Board of Governors of the US Federal Reserve System back in 2002 (Preventing Deflation: Lessons from Japan’s Experience in the 1990s, by Alan Ahearne and colleagues) the most important concern raised by Japanese policy during the country's first "lost decade" was not that policymakers did not predict the oncoming deflationary slump –that in itself was not especially surprising, after all, neither did the majority of analysts and forecasters – but that they did not take out sufficient insurance against downside risks through a continuous precautionary loosening of monetary policy. Simulations carried out at the time using the FRB/Global model lead the authors to the conclusion that, had the BOJ lowered short-term interest rates by a further 200 basis points at any point between 1991 and early-1995, at least the first bout of deflation could have been avoided. (On the other hand the model indicated that loosening after the second quarter of 1995 would have been too late to avoid deflation, as by that time inflation had already fallen below zero.)

Well, that was 2002, and who else apart from myself and a few other policy wonks with good memories now remembers the once renowned Ahearne et al paper? The Japan lesson was "learnt", and then conveniently forgotten it seems. Now, of course, the Euro Area is not actually caught in Japan style deflation, but this isn't over yet, and we don't know how the story is going to end. What we do know is that the region is once more falling back into recession, while the economy has been submitted to a triphasic cocktail of fiscal austerity, monetary tightening and regulatory pressure for bank recapitalisation. And, of course, with a massive public and private overhang, a credit crunch that is tightening by the day and a backdrop of rapidly ageing populations, the deficiency in domestic demand the region is suffering from looks even more visible to the naked eye than that famous hole which appeared in the side of the Titanic must have been after its unfortunate contact with the iceberg. Which is only another way of saying that the deflation risk is a real and ever present one, and a bit of downside insurance would have been a good thing. Prescient even.

Using The Ejector Seat Without A Parachute

Just to ask the question whether policymakers got their "mix" right here seems like some kind of sick joke in bad taste. Virtually no insurance was taken out against possible downside risks to the price level (inflation was consistently seen as being a much more pressing problem), even if (going by the PMI output prices, see chart below) price pressures seem to have been on a downward path since early 2011. In any event, what inflation there was in the Eurozone was mainly the by-product of imported commodity prices or the knock-on impact of VAT increases, and in no case could it be seen as the result of domestic demand "overheating" which is really what monetary policy is equipped to deal with.

So the much discussed ECB "exit strategy" seems to have been applied far too early and far too systematically. In both the case of extraordinary liquidity measures, and in the case of interest rate policy, Mario Draghi has had to put the motor into reverse gear, and emphatically so. Not that this outcome was that hard to see at the time, as I explained in a post on the CNBC blog back in March (Chronicle of a Policy Error Foretold).

Crunch, Crunch, Something Funny Is Going On Here!

The parallel with Japan in fact extends beyond simple interest rate policy. Issues associated with the capitalisation of the banking system also have a certain parallel, as can be seen in the chart below (which comes from a Richard Koo presentation). Fiscal and monetary measures taken following the outbreak of the crisis worked initially, but since the core of the problem was not addressed keeping all the zombie loans going soon gave the banks funding problems which lead to a second credit crunch.

The interesting point here is that this process seems to be now being repeated in the Eurozone, as a second credit crunch firmly starts to set in. If you look at the chart below (which comes from a report by Unicredit), then you will see that the credit standards applied by banks (as extrapolated from the ECB monthly survey) have been tightening for some months now (and are obviously continuing to do so, hence the recent batch of liquidity measures. As Marco Valli (who wrote the Unicredit report) also points out, these lending conditions move in tandem with the PMIs (red line) which means that as the banks steadily close the lending spigot activity in the real economy slows correspondingly.

Spread Them Wide

So obviously the ECB has been doing quite a bit wrong since the time of those wonderful "how we saved the world from disaster" speeches, leading to an evident waning of confidence in the institution. How much waning? Well that is currently the source of some debate. One line of reasoning, perhaps best personified by nobel economist Paul Krugman, has been arguing that the key turning point in the whole Euro debt crisis came last March, with the ECB decision to raise interest rates. His evidence, echoing that offered by Rebecca Wilder, comes from an examination of the divergence between the Finnish and Swedish 10 year bond yields, which started to drift apart around April.

As Krugman says: "What happened then? Ah, yes — the ECB started raising rates. And.....that’s precisely when euro bond spreads began their upward march, culminating in the current crisis".

This idea that it has been ECB policy rate decisions which lie to some extent behind the growing financial turmoil which surrounds the Euro is really quite widespread. FT Alphaville's Izabella Kaminska, for example, runs a similar argument vis-a-vis French spread problems and the ECB's second rate hike in July. As she says "it’s clear that something influential happened in July. Something which not only destabilised the balancing system but tipped France, in particular, into the red. Could it have been the ECB’s July 7 rate hike to 1.5 per cent?"

Dutch Disease

While I fully agree with both authors that the application of the ECB crisis exit strategy has done a lot to undermine confidence in the idea that policymakers at the bank were really on top of the problems, I am not that convinced that it has been this strategy in particular which has fueled the ongoing crisis (heaven forbid, there are really no shortage of candidates here). One of the reasons I am not convinced by the Krugman case is that the Finnish spread itself has been detaching from other core Euro Area spreads, and this is a little difficult to explain simply by referring to ECB policy decisions.

If we look at the chart below, which was prepared by Marcel Bross at Commerzbank, we can see that the Finnish 10 year spread with the Dutch 10 year bond has been widening since early summer. (The black line shows the spread between the Finnish 10 year bond yield (RFGB) and the Dutch one (DSL) - the yellow lines shows the 5 year spread, which has performed rather differently).

Whatever Happened To My Current Account Surplus?

Now rather than the Swedish yield (Sweden remember is not in the Euro, and thus benefits from safe haven status, in that people can buy Swedish government bonds as a hedge against Euro Area break up), what is more interesting is to examine why Finnish yields might have been rising in relation to Dutch (and, of course, German ones). Does anyone have an explanation for this? I think I might have one. The principal exhibit is this.

The point is that Finland has steadily moved from having a goods trade surplus to having a deficit, and the situation has been deteriorating continuously since the start of the global crisis. Even the much renowned current account surplus has been steadily disappearing in recent years.

What Goes Down Doesn't Necessarily Come Back Up Again

The interesting point is that while exports fell sharply (as they did in say Germany) during the recession, they didn't recover again afterwards.

In part this could be a question of the product mix they were relying on (and difficulties in the land of Nokia), but having said that we couldn't be facing another one of those good old Euro periphery competitiveness issues, could we?

Strange how as the Finnish real effective exchange rate has drifted away from the German one, and now the Finnish 10 year bond yield is doing the very same thing. I wonder if there is a connection?

In fact Finland up to the onset of the crisis had a pretty competitive export driven economy. Then came the great recession, and peak to trough Finnish GDP was down by almost 10%. However, even after the onset of the recovery Finnish GDP was still nearly 3% below the pre-crisis high at the end of Q3 2011, and now, evidently, as recession starts to fall over Europe output is falling back again.

Growth in Finland resumed in Q1 2010, but the economy has already started to show signs of slowing again, with annual growth falling from 5.4% in Q4 2010 to 2.7% in Q3 2011.

We Couldn't Have Another One Of Those Credit Driven Housing And Consumer Booms On Our Hands, Could We?

Another part of the picture is the way in which - in contrast to exports - household consumption recovered quite strongly in Finland. Not only did consumption recover, but at the end of Q2 it was 1.5% above the pre crisis high.

So the question is why did this happen? In some ways Finland could be thought of as the good student, steadily correcting one of those horrid imbalances which so worry everyone. But how did it do this? Well ECB interest rates and a house price boom certainly form part of the picture. The low interest rate environment generated in the wake of the global financial crisis has meant that those developed economies which did not experience a major housing boom-bust during the first decade of this century and still have housing market momentum have been running an elevated risk of experiencing one.

In particular the situation in three Scandinavian countries – Norway, Sweden and Finland – has attracted a lot of attention. In each case there was a minor house price correction around the time of Lehman Brothers, following which prices continued on their earlier upward path. And the comparison between the way industrial output failed to recover, while construction output really took off is another warning signal.

Finnish house prices have effectively been rising in real terms since the slump of the early 1990s. They fell back slightly during the crisis, but supported by ultra low interest rates from the ECB – some 95% of Finnish mortgage loans are variable - they soon resumed their upward path. In fact Finland is one of the few examples of a Eurozone country where the monetary stimulus may have actually worked. Let's just hope they won't live to regret it.

Anyway, one day or another some sort of correction was inevitable, as even the most reluctant of students among us must surely now have learnt that property prices do not continue to rise forever. To my eyes it seems that that fated day may finally have arrived in Finland in June this year.

Confidence data certainly reinforce this impression.

Don't Worry, Be Happy!

But why worry, since as I said above, surely this is all part of that very much needed Euro Area rebalancing process? Finland has been running a property boom, but the population is not heavily indebted. Private sector debt is not especially high by some Southern European standards, and government debt is still low (and indeed under 60% of GDP), while the fiscal deficit has not breached the EU 3% limit.


So things are not too bad, unless.... unless you take seriously my ageing populations, export dependency hypothesis, in which case the recent loss of competitiveness is about to pose serious problems. The country is now the fifth oldest on the planet – after Japan, Germany, Italy and Austria – with a median age of 42.5.

This level of ageing is normally associated with low or volatile growth (think Germany and Japan), heavy export dependence, or both. The country has an ageing and declining workforce, and this, as the EU Commission noted in its most recent country forecast looks set to further take its toll on competitiveness and growth.

"The Finnish labour market is confronted with a notable demographic shock. Due to the retirement of a large baby-boom generation, the working-age population is projected to decline by over 5% of the current labour force by the end of the decade...(hence).... taking account of the weakening of the growth potential of the Finnish economy due to its declining working-age population, the recovery will be more subdued than in previous recovery cycles...."

Conclusion: the country's debt dynamics are far from unsustainable at this point, but given the weakening in the country's export performance and the steady unwinding of the housing boom we can now anticipate I would expect growth to be weaker than either the EU or the IMF are currently anticipating, and pressure on the country to increase fiscal spending to maintain expectations to rise, with the implication that pressure on the Finnish spread over 10 year German bunds will continue, as the country risks drifting off from being part of the core towards the growing periphery, at least in the eyes of investors. So finally, coming back to the ECB and movements in the policy rate, it could well be the case that perceptions about rising future interest rates played their part in encouraging individuals not to leverage their balance sheets further thus weakening the housing boom, but my feeling is that in the Finnish case the catalyst for the coming property implosion may not have been the recent 50 bps interest rate rises from the ECB, but rather the ongoing impact of the sovereign debt crisis on confidence, subsequently reinforced by the inbound shock from the recessionary wave now steadily sweeping Europe.

Saturday, December 10, 2011

A Deep Seated Hostility Towards European Construction?

The British decision to veto the proposed new EU treaty is not surprisingly provoking an avalanche of commentary this weekend. Among journalists, at least, there seems to be a consensus that David Cameron committed some kind of major diplomatic blunder.

Possibly this is so, but given the difficulties presented by having to take this agreement forward outside the formal structure of the EU, it is hard to not reach the conclusion that both Angela Merkel and Nicolas Sarkozy have been guilty if not of a similar blunder, then at least a major error of judgement. On the other hand the issues involved in the proposed new arrangements are highly complex and in some senses ground breaking, so it is indeed suprprising that so many (and so diverse) countries were able to reach such rapid agreement on the need for and the broad outlines of a new agreement.  While Angela Merkel was probably worried before the meeting that too few countries would sign up (there was talk of only a hard core of countries proceeding), now she is surely concerned by the fact that so many have. In many ways the biggest weakness of her debt brake proposal is that it has become "too successful" to be fully credible.

A Continent Which Has Isolated Itself  From The British Isles?

That British "separatism" has again raised its ugly head should not be surprising, since this issue has a long history  (as I was only too clearly reminded yesterday when the local TV news here in Catalonia ran footage of General de Gaulle warning that allowing the UK to enter the common market would be a major strategic mistake and a significant setback for the European construction process), but the water in which all this discourse flows is now so mirky that it is hard to separate what is really relevant to the point at issue, and what isn't.

In fact France, Germany and the UK  should have reached agreement before the summit even started, and the agreement should have been restricted to measures which were considered necessary to resolving the Euro debt crisis, including the rules and institutions which are lacking.  Maybe it is a pity that these three countries have to have such a decisive role in European decision making, but for better or worse that is the way it is.

Now the UK has exercised its veto, and we have a legal mess. According to Peter Spiegel writing in the Financial Times,  Britain’s rejection of treaty changes means that the other 26 EU members will now have to jerry-rig an intergovernmental system without the automatic right to use the EU’s institutions, leaving decisions taken vulnerable to continuing legal challenge. As a result financial market participants will have one more reason to doubt the new fiscal pact’s viability and credibility.

"The arcane issue of whether a group of countries acting outside the EU’s treaties can use the European Commission, with its surveillance and enforcement powers, and the European Court of Justice, has been pushed to the forefront of the eurozone debt crisis. Britain, which refused to sign up to a treaty, but does not wish to see itself sidelined altogether, insists that its 26 EU partners must do without the European institutions".

If the European Union's institutional maze was already proving hard for investors and external policy makers to follow, this latest twist in events will hardly make it easier for them.

This is an outcome that should have been avoided at all costs, and indeed I think the most intelligent thing the three of them could do now would be to meet again and find a solution to the real problem at hand before the euro finally blows itself apart, with highly undesireable consequences for all of us.

People say that the EU was created to ensure there were no more wars in Europe but personally I think a West European centred WWIII was never a very likely eventuality. In any event the EU could have been set up with a much more limited objective, namely to end periodic outbreaks of tribalism and jingoisim. This is the real European curse, and this is what we are now facing in one country after another, as - with the local national press in the vanguard - each blames the other for causing the crisis, or for not reaching the much needed agreement to end it. The sad reality is that Europe's leaders fiddle even as Rome is about to burn.

Save The Euro!

The nub of the question is the Euro, and setting up some form of workable common governance for those countries who belong to the monetary union. In this sense an agreement between the 17 countries who share the common currency would have made perfect sense, and in is not clear to me at least why the UK (or countries like Bulgaria and Romania for that matter) would need to be party to this kind of agreement. But, it seems, representatives of the EU Commission and the German and French governments have been so concerned to identifty saving the Euro with the idea of saving Europe that this important point of detail seems to have gotten buried well down in the pile of paperwork.

Countries like the UK, Sweden and Denmark do not use the Euro since they decided not to do so. Countries like Latvia and Lithuania do not use it since they were not allowed to, and the EU even refused a 2008 request from the IMF to allow Latvia to devalue and enter the currency area at a moment when that country was indeed in a situation of most urgent need.

What the latest tiff underlines more than anything else is the way we are lacking a coherent and consistent account of what the relationship between the EU and the Euro is, and this is not something which has only been discovered yesterday. Maybe the seeds of what happened last Friday are the result of having the Euro regulations form part of the EU Treaty itself, rather than being an agreement between a more limited group of countries in the manner that is now being proposed. Again, if the Euro was to form one of the indispensible parts of the EU Treaty, in many ways it didn't make sense to allow the East European members to join until the had fulfilled the Maastricht criteria for Euro membership.

Viewed in this light, last Friday's events were always a problem which was waiting to happen.

It may well be that the Euro was created as a stepping stone towards a form of political union that not all member countries wanted, but now we are apparently seeing a sort of fait accompli shotgun wedding, since without such an enhanced union, not only may the currency itslef fall apart, but entire global financial system, and everything we know and love seems likely to be carried away with it. I'm not sure whether or not this constitutes moral hazard, but it sure as hell constitutes a pretty potent form of moral blackmail.

Fiscal Pact or Fiscal Union?

Then again, what Europe's leaders were talking about last Friday was  not just any old kind of political union. Despite all the talk about creating the groundwork for fiscal union (it will be remembered that one of the commonly cited differences between the dollar and the euro as common currencies is that all states in the American Union are backed by the US Treasury, while the world still waits to learn who - or what - is backing the individual states in the European one).  What we we are being offered is not a common treasury of the kind which would convince markets that there was something solid standing behind the currency, but rather what Wolfgang Munchau recently referred to as "another one of those Silly growth and Stability Pacts".

 "Contrary to what is being reported, Ms Merkel is not proposing a fiscal union. She is proposing an austerity club, a stability pact on steroids. The goal is to enforce life-long austerity, with balanced budget rules enshrined in every national constitution. She also proposes automatic sanctions with a judicially administered regime of compliance".

Doing The Berlin Brake Dance

What Wolfgang is getting at here is that the core of the proposed EU agreement is the introduction of the so called "balanced budget amendment" as a binding principle across all the eventual signitaries. Naturally Germany already has this amendment in place. According to Wikipedia: "In 2009 Germany's constitution was amended to introduce the Schuldenbremse ("debt brake"), a balanced budget provision. This will apply to both the federal government and the Länder (states). From 2016 onwards the federal government will be forbidden to run a deficit of more than 0.35% of GDP. From 2020, the states will not be permitted to run any deficit at all. The Basic Law permits an exception to be made for emergencies such as a natural disaster or severe economic crisis".

This is the role model for the kind of constitutional amendment other states will now be expected to introduce - as the Economist wryly notes perhaps Schuldenbremse will one day form part of the French and Italian languages in the same way “kindergarten” has become part of the English one.

The 0.35% deficit permitted is in fact a form of what is termed "structural deficit", that is to say there is a formula according to which it can be averaged out over the economic cycle, although even after allowing for this the deficit number is not going to be that high, and  in any event at no point should the deficit exceed 3% of GDP.

More important even than this deficit restriction, however, is the so called debt brake principle, which implies countries must steadily reduce their debt to 60% of GDP over a specified time period. If, as may be anticipated, growth and inflation in the Euro Area is going to be  low, then effectively countries will not be running deficits at all, but rather surpluses, depending on how much over 60% they will be when the present crisis comes to an end, and what the time scale for reduction eventually is. As far as I can see the current proposal for the new pact coming from the finance ministers (Ecofin) is that from 2013 countries reduce the part of the debt which is over 60% of GDP by 1/20 per annum.

At the end of the day one thing is clear, and this has not been emphasised enough in the press reporting of the summit, this is the end of Keynesian demand management as a policy tool as it has been practised in Europe since the end of WWII. That is to say, while it is be one thing to argue that simply creating more debt through fiscal policy may not be the most appropriate way to solve a crisis which has been caused by excessive indebtedness, it is going a bridge further to suggest that counter cyclical fiscal policy should not be practised. Germany's leaders have, it seems, crossed that bridge. Naturally not all German economists agree. As the Economist reports Peter Bofinger, one of five economic “wise men” who advise the German government, is one of them. On a normal Keynesian view, the balanced budget ammendment could choke-off economic recoveries - some would argue Germany's commitment to this principle at this point is an example of this issue. Having a structural component in the target target allows deficits to rise slightly when output falls below trend with the additional deficit being offset by surpluses during upswings. But, as Bofinger argues, this “assumes textbook-like economic cycles,” and garden variety recession. In the real world cycles and crises vary. An externally induced recession followed by a weak recovery can excessively reduce potential growth, while the balanced budget restriction would restrict the deficit spending needed to stimulate demand.

Given the magnitude of these issues, it is surprising how little debate the proposal is generating, and of course it is hard not to be struck by how quickly people who obviously would not have understood what was really involved were to arrive in Brussels and offer to sign on the ditted line without too much attention to the small print. The exact detailing of the amendment varies - in Spain for example the limit is 0.4% of GDP for the deficit, and the limit is operationalised in 2020. In addition the Spanish wording is also interestingly different from the German version, since it stipulates that the limit can only be exceeded in the event of "natural disaster, economic recession or other extraordinary circumstances". This substitutes the wording "economic recession" for the German "severe economic crisis" variant, which really rather than concealing any sinister intention suggests to me more than anything that the Spanish parliament didn't understand what they were voting for, since the idea is (as I say) for structural deficit over the cycle, and "cycle" obviously includes recession, so a mere recession cannot be an exception, though what counts as "severe" in the German case doubtless awaits interpreting in the courts.

Here Comes My Nineteenth Nervous Brake-down

Once more the Economist gets the basic point:

"Germany has yet to put its debt brake to the test. The federal government made things easier for itself by a generous calculation of last year’s structural deficit, which is to be cut in equal annual steps to reach the 2016 target. Flush with cash, thanks to a strong economy, it has found room for giveaways to voters without falling foul of the brake. Civil servants will get a bigger Christmas bonus next year, for example. For the Länder, the 2020 deadline seems a long way off: 13 of them budgeted for increases in structural deficits this year, laments a study by RWI Essen, a research institute. A “stability council”, composed of federal and state ministers, has little power to sanction prodigals. Apparently, it is as toothless as the enforcers of European financial discipline".

There is an imbalance in voting intentions between countries. Angela Merkel is marking out a very long term agenda:"This is a breakthrough to a union of stability," Reuters cite her as saying. "We will use the crisis as a chance for a new beginning." It is hard to see why countries like Romania and Bulgaria with a very poor institutional record are in such a hurry to sign up to this without a lot more reflection. The use of the word "stability" is very important. Merkel is prioritising sustainability and stability in the longer run over short term growth. This is very consistent with a whole German view of things and completely in harmony with the ecological strain of thought in the modern German world view. I have a lot of respect for this (even where I disagree), and especially for the fact that someone in Europe is trying to think in the longer term. But I cannot help feeling many of the people and countries voting for the new agreement were only thinking about their financing needs in the short term, and were not fully cognisant of the fact that they were voting for a new beginining, a new type of Europe, where living standards may be lower, but the debt dynamics will be more stable. Personally I can only make sense of this in terms of Europe's current demographics, and the challenge that is represented by maintaining health and pension systems in the face of low growth and ageing and declining workforces.

Each Unhappy Family Is Unhappy In Its Own Way

Hence perhaps the most worrying thing about last weeks agreement to agree was that each and every one of the 26 countries concerned has stated that "I will stop beating my wife, I promise I will, and soon", but understands what this means in their own special way. Despite the fact that Germany has been quite clear, for example, the much respected Mario Monti is sure that Euro Bonds are almost within reach.

"Italian Prime Minister Mario Monti said Germany and other countries will eventually be convinced that commonly issued euro zone bonds are a useful way of tackling the region's debt crisis. "I believe we have enough arguments to convince the Germans," Monti told Euronews in a television interview". He also is still pushing to have the funding capacity of the EFSF increased, again as if the German parliament had not voted to put a ceiling on the level of its exposure. "Monti said he regretted that European leaders had not agreed to increase the European bailout fund (EFSF) by more than 500 billion euros ($668.25 billion) at last week's meeting in Brussels. A more substantial firewall would have been a better guarantee against market tensions, he said, adding this had been blocked by several European countries that "have a very limited view of what is the common interest".
The worrying thing is not only that Mario Monti believes this but, more importantly, that this is probably what he is telling the Italian electorate, leaving them with a very limited understanding of the kind of sacrifices they are actually going to be ask to accept. Last week's round of 2012 austerity measures will be as nothing when compared with those that would really be required to get Italian debt back down to 60% of GDP.

Thus many of those who were eagerly struggling to be first to sign on the dotted line last Friday didn't get the gist of the point of what they were signing up to, and the agreement will only really be adding to credibility once it is tried and tested. In the meantime everyone is simply following the lead given by Mario Monti, and assuming that what is actually going on isn't the death of Keynes, but the birth of German funded Eurobonds.

Land Ahoy!

But, having said all this, let's go back to where we started, to the isolation of the UK within the European Union. Could it be, as Philip Stevens suggests in an opinion piece in the Financial Times, that the UK is on its way out of the EU? As he says, it all depends on which end of the telescope you look down. Viewed from one one end, Mr Cameron’s veto was the moment Britain signalled the beginning of a long goodbye to Europe; looked at through the other it was Europe bidding its farewell to Britain. But are we sure, even Stephens has his doubts:
"It is important to insert a caveat here. The presumption of everyone in the room in Brussels was that the eurozone countries will indeed succeed in saving the single currency and build alongside it a more integrated political union. That enterprise could yet fail. Some will say after the limited progress made at the summit on rescue plan, the odds have now stacked against the euro. If it were to fall apart, so too would all other ambitions among the 17 eurogroup members".
So advertently or inadvertently David Cameron now has a Euro put. If the Euro survives his fate is sealed, in the most negative of senses, yet if it fails, then not only will he have been proved right, he may also find himself having to assume the mantle of leadership (backbench eurosceptics and all) and instill in a European Union in complete disorder the kind of Dunkirk Spirit for which the islands from which he hails have made themselves famous. And while we are on the question of survival, perhaps it would be to the point to close with John Authers assesment of the state of play in the argument.
Amid all the heated speculation about the European Union summit’s impact on Europe’s economic future and Britain’s role in it, traders are asking a more mundane question: “Has it done enough to get us through to Christmas?” Their answer: probably not. The muted market moves on Friday may be misleading. The euro rose against the dollar – but this may have been driven by banks repatriating assets. European bank shares, while above their lows, trade at half their book value, implying grave fears that some of their assets will be written down. The yield on Italy’s 10-year government bond fell 30 basis points during the day to 6.32 per cent – but this is still higher than at any point in the eurozone’s history until a month ago. The risk remains that the market will test Mr Draghi’s resolve by attacking a peripheral country’s debt in the two weeks before Christmas – particularly if a rating agency provides an excuse.
Amen to that! This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".

Sunday, November 27, 2011

Last Days Of Pompeii?

This week we got what seemed to be some good news in the ongoing Euro debt crisis. Bond spreads in many of the countries on Europe's periphery tightened vis-their German equivalents. Unfortunately we also got some bad news to go with it (no silver lining these days without the accompanying black cloud it seems): the tighter spreads were the result of a weakening of German bunds (or a rise in their yields) following what many considered to be a failed bond auction.

What is becoming clearer to almost everyone is that this is now no longer simply a Euro periphery sovereign debt crisis. It has become a full blown crisis of confidence in the Euro itself.

But just in case anyone was in any doubt, this week Deutsche Bank Chief Economist Thomas Mayer said as much on Bloomberg TV. Naturally he is far from the first to make this point - Commission President José Barroso and European Council President Herman Von Rompuy have been stressing the point for some time now - but it is an interesting reflection of how widely this opinion is now spreading.

One of the reasons for the recent rise in tone and in the level of concern is that it is clear contagion is now spreading far from the periphery. Belgium and French bonds have come under increasing presssure. And, of course, that famous German bond auction seems to suggest that even German yields are not immune to contamination. Actually, one unsuccesful German bond auction doesn't make a season of them, and Germany is well able to finance itself, but obviously markets are now drawing the conclusion that if Germany isn't willing or able to cut loose from the sinking economies on the periphery, then the German economy will eventually be dragged down with them, which means that German bunds are no longer seen as a surrogate Deutsche Mark, but rather as the backstop for all the unfunded periphery losses which might show up  on the EU desk.

The frontier between core and periphery is becoming increasingly blurred, with Belgian borrowing costs hitting a Euro era high of 5.8% last Friday.

Of course, this weekend there has been a huge rush to agree a budget and put together a government, but after seven months of dawdling as if the large sovereign debt the country is labouring under wasn't a problem all these last minute efforts somehow fail to convince. Really it is the whole European model of nation states and national identities which lie behind  the common currency that often lie at the heart of the problem. If countries like Belgium lack a national consensus, while others like Italy and Spain have minorities (who pay more than there numerical share) who are not really convinced they want to be in the country, then how can a fiscal union which would be based on some countries permanently paying (the so called transfer union) while others continually receive hope to hold itself together politically?

Then the possibility of joint and several responsibilities between an ever diminishing number of "core" core countries is simply leading to impossible pressures on the sovereign debt of the countries concerned. We have seen the first jitters in the direction of German debt this week, but France is a much clearer example as the exposure of the French banking system to Italy (400 billion euros worth, including public and private sector debt, according to BIS data) is leading to impossible pressure accumulating over the French rating, something which makes activating the EFSF as initially intended look increasingly difficult.

And contagion from the crisis is now heading East. Austria is worried about its triple A, and is imposing new restriction on CEE funding by Austrian Banks. Naturally, as Fitch suggest, this is likely to extend the credit crunch out to the East.

Hungary is the obvious "missing link" here.

But Romania is evidently not far behind, and President Traian Basescu is definitely  not amused.

Of course the problem is not just a European one. Japan has a massive sovereign debt problem too.

In fact, far from having the "V shaped" recovery from the Tsunami some (not me) were predicting the short term outlook for the economy seems pretty dire. Policymakers in Japan still attempt to pin the problems down to confidence issues stemming from the Euro debt crisis and the high value of the yen, but surely what has been happening in Japan over the last 20 years has something more than local interest, since it was a harbinger of things to come elsewhere.

The Present Crisis Is  Generalised One, Effectively Facing All Developed Economies

In the first place there is the problem of debt (whether public or private).

Secondly there is the problem of population ageing. The figures below show the transformation in Italy's population pyramid between 1970 and 2030. In many ways Italy's demography was at the most favourable point for economic growth (supply side) around 1990 (third figure top row) since the proportion of the total population in the working age group was at near its maximum, and the median age of the workforce was still relatively low. The point to get is that it isn't simply the level of debt that is the problem, it is the level of debt in the context of  the implicit liabilities (in terms of health and pensions) which such population ageing represents, and the reduced growth outlook that having declining and ageing populations represents. Europe's leaders are essentially in denial on the extent of this problem, and are putting all their eggs in the "structural reforms to raise trend growth" basket.

The third factor which has decisively changed things to the disadvantage of the ageing and endebted developed economies has been the rise of the new emerging economies. This has changed the perception of risk, against developed economies and in favour of emerging ones. It is unlikely that this trend will be reversed. So we have economies with excessive debt plus implicit liabilities who are going to be challenged to sustain growth rates similar in magnitude to those we have observed in the recent past, and it is this which makes the level of accumulated debt unustainable and which makes it possible to speak of a developed world generalised debt crisis.

But, despite this, those countries in the Euro area have a special problem. The common currency was created with a deficient institutional structure, which creates confusion over who is responsible for what. Viewed from outside the EU it almost seems as if you need a PhD in European studies to follow what is going on. In an era where the best policy if you have a financial product to take to market is "keep it simple" this hardly would seem to be a good idea.   

Cutting through all the foam and wrapping here, the key question is who is going to sign the cheques and who is going to pay? José Barroso and Herman Van Rompuy may make very nice photo images in Washington, but what exactly does there bank balance look like? So the key question market participants want to know, as President Barack Obama asked in Canberra recently, is who (or what) really stands behind the Euro. The answer so far has simply been a deafening silence.

So what are the institutional solutions that are being toyed around with? The basic point to get is that this is all about money, who is to provide it, and who will take any losses there may be in the longer term. Basically there are three lines of attack on the table.

a) The ECB
b) The EFSF
c) Eurobands

In fact the solution Europe's leaders are likely to come up with involves some variant of all of these. As I suggested in my last piece, the ECB is desparate to go so far and no further. This is understandable given that no central bank likes the idea of finding itself having to show losses.  Just how far the bank is prepared to go in order to avoid this is made plain from the rumour circulating this weekend that the IMF was readying up 600 billion Euros to lend to Italy. Just where the IMF was going to find the money was not explained by most of the sources, but thanks to a speedy translation from Edward Harrison at Credit Writedowns, we discover that it was another one of those cockamany schemes whereby the ECB would actually lend the money, but the IMF would guarantee all the risk. Which simply begs the question; is there no one in Europe willing and able to guarantee the risk? And if not, why not? A stunning silence from Berlin.

Under the circumstances it is hardly suprising that the IMF rapidly denied the report. It looks to me like someone, somewhere (someone with responsibilities for funding the IMF perhaps?) put their foot down, and firmly.

Nonetheless it is quite likely that the ECB would be involved in some way, shape or form in any final attempt to rescue the Euro, possibly via some kind of security markets programme, and keeping the banking system supplied with liquidity.

Which brings us to the EFSF, and here we do have some news. According to a report from Reuters, the documentation is all ready and prepared for the EU Finance Ministers meeting tomorrow on formulas for leveraging the EFSF.

The formula being used for leveraging makes the current proposal look very similar to original Alianz Insurance proposal.  The documents seen by Reuters specify that the EFSF could offer partial protection to investors buying a country's bonds at a primary auction of around 20-30 percent of the principal amount of the bond, depending on market circumstances.The protection certificate would be detachable from the bond and could be traded separately, but the investor would have to hold bonds of the country before cashing it in. The certificate could be paid if the bond issuer triggers a credit event under the full definition of the International Swaps and Derivatives Association, but, of course, in the wake of the Greek private sector involvement swap investors are now nervous that any future restructuring of Eurozone bonds might be carried out in such a way as to not trigger an ISDA event, so it is not really clear how valuable this insurance actually is, or how it will be perceived by investors. 

But this isn't the sum total of the problems faced by the EFSF approach, since according to CEO Klaus Regling, the original levaraging objective is now no longer attainable, due to the loss of market confidence. And with Italy alone rumoured to be looking for something like 600 billion Euros, the doable quantities from the EFSF now fall far short of what will be needed.

Which brings us back to Eurobonds, which must be the last ditch recourse of someone or other. Markets certainly pricked up their ears last week when Angela Merkel issued those famous "now for now" words, but since that time we have simply had confusion. Actually the latest proposal on the bonds have come from the commission rather than the Paris-Berlin axis.

Most observers have reached the conclusion that such bonds will at some point form part of Eurozone policy, but how, and when? The problem is that Angela Merkel is widely perceived as holding back in order to put pressure on recalcitrant periphery governments to bring their deficits into line. But you can only take brinksmanship so far before you risk having things blow up in your face, a point which is very well illustrated by the dilemmas facing Mario Monti's new government. The problem is the timescale of debt reduction is one thing, and that of market confidence another.

Germany is insisting that any advance towards Eurobonds is dependent on moves to what Angela Merkel calls a fiscal union. But by this she doesn't mean the type of common treasury they have in the US, where stronger states help the weaker ones, what she means is common fiscal discipline, with powers from the centre to enforce.

The only thing that can be said with any certainty about this situation is that it is very confused. One leaked proposal follows after another, while representatives of the EU Commission in Brussels can barely conceal their frustration with the "go it alone" approach being promoted in Paris and Berlin. Matters reached a head today with an article in the German newspaper Die Welt (allegedly based on a leak) asserting that Germany was preparing to issue "top tier" Eurobonds with a select group of other triple A countries.

This could be read as a first step to a two tier Euro, which would at least be a step towards something. But it is too early to answer the question of whether it is, or whether it isn't.

Readying Up For The Transition

In the meantime market participants are walking with their feet. Both banks and ratings agencies are sounding their loudest warnings yet that the euro area risks unraveling unless those responsible for decision taking intensify their efforts to stop the rot.

Just this morning I got a research report from Mehernosh Engineerand Gregory Venizelos of the PNB Paribas European Credit Research team.in which they argue that capital flight is already effectively taking place.

On the other hand Citi's European Research Team are on "deposit watch", and claim to see signs of deposit outflows from periphery to "core", not retail deposits but corporate ones.

Meanwhile over at Nomura they are already speculating on how assets will be denominated after break up:

and giving advice to clients on the legal ins and outs of asset redenomination. Closing time in the gardens of the west anyone?

In this environment, it is hardly surprising that Wolfgang Munchau was his usual cheerful self in the FT this morning.

While perennial optimist Paul Krugman puts the situation really quite succinctly on his blog.

Incidentally, if you can't read any of the inserts, try clicking over them to get a magnified version.