Economics 16/05/2010: EU on the brink

Before I begin the post on Euro, let me bring you a piece of really good news I've learned about last night. Although it has been publicly released few weeks ago, I learned about this just last night. Ireland is ranked third in the world as a centre for research in immunology (details here). Interestingly, I was informed by an anonymous source close working in scientific R&D field that the DofF is putting loads of pressure on science funding organizations to provide 'commercial return'-linked 'Irish drugs' products backed by the above-mentioned research. In immunology, like in any other field linked to phrama or biopharma, it takes around 15 years on average and scores of millions of euros in funding before a drug can brought to the market. We are just at the beginning of what is now internationally recognized to be successful undertaking in immunology research. Sometimes, DofF needs to wait patiently for a payoff! Let's hope they do.


Ambrose Evans-Pritchard, in today's piece (link here) has a superb analysis as to why Euro is in the end game, with pat not an option for its fierce opponents. And, incidentally, why it's the markets that are getting things right in nailing Euro zone. Let me quote few passages (as usual, comments are mine):

"Geneva professor Charles Wyplosz said EU leaders made the error of overselling up their shock and awe package [€750 billion rescue package issued two weeks ago] before establishing any political mechanism to mobilise such sums. The fund is an empty shell, he wrote at Vox EU. Worse still, crucial principles have been sacrificed for the sake of unconvincing announcements."

Bingo: Wyplosz is 100% correct, as I wrote here, the package is a bizarre amalgamation of impossible, improbable and outright reckless:

• It contains guarantees that cannot be backed by resources
• It shoves more debt onto the shoulders of already insolvent sovereigns
• It turns Germany - a solvent nation - into an implicitly (as long as guarantees remain implicit) insolvent nation
• It contains no real mechanism for imposing any sort of discipline on Eurozone sovereigns who might continue engaging into reckless deficit financing
• It demolishes any credibility built up by the ECB over the last decade and with it tears the fabric of the Euro
• It represents a massive cost imposition on Eurozone's economies

"Brussels was unwise to talk of smashing the wolf pack speculators and defeat the worldwide organised attack on the Eurozone. As Napoleon said, if you set out to take Vienna, take Vienna. Besides, the language of the EU priesthood ex-ECB board member Tomasso Padoa-Schioppa talks of the advancing battalions of the anti-euro army frightens Chinese and Mid-East investors needed to soak up EU debt. These metaphors are a mental flight from the issue at hand, which is that vast imbalances masked by EMU, indeed made possible only by EMU have been decorked by the Greek crisis and now pose a danger to the entire world."

Bingo again! Since the foundation of the EU in its modern incarnation - in other words since the mid 1990s, Brussels did nothing in terms of economic policies other than issue lofty plans and guidance documents - which promptly went nowhere real, and blame 'others' for its own troubles. At times, this reminded me of the good old Sovietskies whose entire edifice of the state was supported - from the early 1970s through the late 1980s - solely by the threat of 'others' coming to take over the Motherland.

"One can only guess what Mr Trichet meant when he said we are living through the most difficult situation since the Second World War, and perhaps the First. ...was Mr Trichet alluding to something else after witnessing the Brussels tantrum by President Nicolas Sarkozy? According to El Pais, Mr Sarkozy threatened to pull France out of the euro and break the Franco-German axis at the heart of the EU project unless Germany capitulated. To utter such threats is to bring them about. You cannot treat Germany in that fashion."

And herein is where the trouble's brewing. One thing for people to say Germany should exit the troubled Euro to save itself. Another thing for the country like France, which never really bothered to comply with the budgetary restrictions of the Maastricht Criteria or SGP to threaten to pull out, leaving Germany to pick up the pieces...

"The German nation is moving on. I was struck by a piece in the Frankfurter Allgemeine proposing a new hard currency made up of Germany, Austria, Benelux, Finland, the Czech Republic, and Poland, but without France. The piece entitled The Alternative says deflation policies may push Greece to the brink of civil war and concludes that Europe would better off if it abandoned the attempt to hold together two incompatible halves. It can be done, the piece says."

So the rationale for a German exit is there. As it has been since the first day of the Euro creation and the massive pan-European euphoria (or call it chauvinism) that engendered the idea (no matter how absurd) that EU can absorb the entire Continent into its folds and stretch into Asia via 'acquisition' of Turkey, plus the grand delusion of the Euro becoming the reserve currency of the world. Only now, this rationale has real feet - the markets gave them these by exposing the weakness behind Europe's great experiment. The markets did exactly that with the USSR in the 1980s, with Asia in the second half of the 1990s, Russia in 1998, New York in the 1970s, Orange County in the 1990s, Latina America in the 1980s and then in 2002-2003. They will, once the European day-dreams are fully dealt with, do the same to China's economy on state steroids. After all, this is what the markets are designed to do - expose lies and support the true value.

But, says Evans-Pritchard, "What makes this crisis so dangerous is not just that Europe's banks are still reeling, with wafer-thin capital ratios. The new twist is that markets are no longer sure whether sovereign states are strong enough to shoulder rescue costs. The IMF warned in last weeks Fiscal Monitor that the tail risk of a widespread loss of confidence in fiscal solvency could no longer be ignored. By 2015 public debt will be 250pc in Japan, 125pc in Italy, 110pc in the US, 95pc in France, and 91pc in the UK."

Do I need to remind you what it will be like in Ireland? Check out here. And that's with only direct cost of Nama factored in. 122% of the national income by 2015! And our Minister for Finance dares to call us turning the corner.

Evans-Pritchard is right in his analysis of 'solutions' to the Euro crisis: "There is a way out of this crisis, but it is not the policy of wage deflation imposed on Ireland, Greece, Portugal, and Spain, with Italy now also mulling an austerity package. This can only lead to a debt-deflation spiral. ...The only viable policies short of breaking up EMU or imposing capital controls is to offset fiscal cuts with monetary stimulus for as long it takes. Will it happen, given the conflicting ideologies of Germany and Club Med? Probably not. The ECB denies that it is engaged in Fed-style quantitative easing, vowing to sterilise its bond purchases euro for euro. If they mean it, they must doom southern Europe to depression. No democracy will immolate itself on the altar of monetary union for long."

Note to all folks eagerly rubbing their hands in hope of getting their hands on Government 'stimulus' to offset deflationary effects of austerity in Ireland: Evans-Pritchard is talking about Euroarea-wide massive emission of liquidity. I called for that months ago in the Indo and in Mail articles. And on this blog as well. Back then, before the current sovereign bonds crisis hit, I thought an issuance of €1 trillion directly to citizens of Europe would do the trick. Now, we are more in the need of issuing €3 trillion. This should be split as follows:

• €2 trillion issued directly to each adult and child inhabiting Europe (EU27) and
• €1 trillion issued to the EU16 sovereigns on the basis of each sovereign share of the total Euroarea population.

Wait another month, and we'll need €4 trillion...

Of course, there's always an option of Germany leaving the Euro and setting up a separate, credible currency. It's the lower cost solution, for it requires no replay of the same crisis 10 years from now - which is, of course, an inevitability given the nature of the Euro area. No matter whether fiscally integrated or not.

Economics 24/01/2010: A Mexican stand-off: Eurozone v Greeks

It is nice to note that the theme picked up by the post below has been followed upon by the continued media debate today:

According Der Spiegel today: the European Commission warned that the euro area’s chances of survival would depend on adjusting the internal imbalances. DG Ecfin apparently claims in a new paper that internal imbalances would weaken confidence in the euro and endanger the cohesion of the monetary union. Rising deficits and weakening competitiveness in several countries, notably Ireland, Spain and Greece are singled out by the Commissions as the main causes of the pressure on the euro. DG Ecfin, allegedly says the necessary adjustment in the deficit countries will require wage moderation to address rising unemployment in the above countries.

And another one from today: here.

So what is going on with Greece? Not much, it appears. Just like Ireland did before it, Greece decided to throw some smoke around its fiscal debacle with promises of reaching the 3% SGP limit by 2012 (Ireland is now saying it will be 2014, although ESRI’s presentation last Monday was clearly showing they expect deficit to be well above 3% level then).

And like Ireland, Greece has elected to cut some easy expenditure targets – capital investment and irregular payments and some social services. Ireland has gone slightly further by imposing a modest cut on wages and passing a gratuitous tax on pensions in the public sector. Of course, wage cuts were far from what was necessary, while the pensions tax was not even enough to cover the expected future increases in pensions liabilities that will arise due to, frankly Marcian in its surreality, practice of indexing future public sector pensions to wage rises in the sector.

And so, like Ireland, Greece has not been reckoning with the reality of its deficits. Unlike Ireland, however, it was not able so far to fool the markets, and it was unable to raise taxes. And unlike Ireland, Greece was a serial offender on the front of deficits (see charts) in recent years, during the boom. Note, this, of course, does not reflect the fact that Greek’s deficit accounts for their banks supports measures (negligible), while ours does not (massive).
And this means, everyone is still wondering – what is going to happen with Greece?

Last week several significant statements were made on the subject. First, Handelsblatt reported that "the EU has put the thumb-screws to the Greeks", noting that "under massive European pressure the Greek government has agreed to have its state finances cleaned up faster than initially planned". Greece has now pledged to reduce its budget deficit from around 12.7% in 2009 to under 3% of GDP by the end of 2012.

Handelsblatt information de facto denied by senior EU figures. In an interview with Il Sole 24 Ore, ECB Executive Board Member Juergen Stark said that the EU would not help bail out Greece, arguing: "Greece is in dire straits: not only has the deficit reached very high levels, but the country has also witnessed a serious loss of competitiveness [haven’t Ireland?]. Such problems are not due to the global crisis, since they are substantially homemade. …Rules... are unequivocal: being part of the Monetary Union doesn't guarantee any right to claim for financial support by other member states."

Of course, if pressure was applied on Greece [per Handelblatt], there must have been some sort of a threat. What can such a threat be?

Could the EU officials told Greek Government ‘Shape up or you are out of the Eurozone’? Nope – no such possibility even in theory.

Could they have told the Greeks ‘If you don’t resolve the problems with you deficit optics, we can’t give you a bailout’? Oh, yes, that could have happened. In fact, the threat of ‘no EU goodies, unless…’ threat is just what EU has used before on other countries –Switzerland and Norway (access to EU markets), and Ireland and Denmark (access to ‘influence’ within the EU).

So let us take it as a possibility, no mat6ter how remote, that the EU folks told the Greeks to get working on some sort of a face-saving formula to allow for their rescue by the EU/ECB.

Last Friday Wall Street Journal reported that the EU Commission spokeswoman outright denied such a rescue plan being worked on, saying she wasn't aware of any financial bailout packages being arranged. But then, in an interview to Die Welt Chief Economist of Deutsche Bank Thomas Mayer (a man whose statements are not to be taken lightly) said: "The situation [in Greece] is more serious than it has ever been since the introduction of the euro. The trouble in Greece plays a key role for future development... If the Greece situation is handled badly, the Euro-zone could break down, or suffer major inflation. Neither the European Central Bank nor the Commission nor any other EU body can force Greece to implement necessary reforms in exchange for help."

What does he mean ‘no body in the EU can force Greece’? He means here not the political infeasibility of the EU actually slapping on the conditions on Greece to implement austerity measures in exchange for funding. That can be done. What cannot be achieved is the enforcement of such conditions.

The problem is really simple and, thus, grave.
The EU can give Greece a loan – via ECB, say, for 10 years at 2-3% per annum, in the amount of 30% of its debt. That would be fine. It will not solve Greece’s problem, but it will alleviate pressures on deficit side, as country interest bill will fall substantially, allowing it some room to reduce structural side of deficit more gradually. But the EU will have to impose severe restrictions on Greek fiscal policy in order to discourage other potential would-be-defaulters today and in the future. They would have to require, as a condition of the loan, a constraint on Greek deficits going forward so severe that other PIGIES (note the renaming of the club – Austria is out, Estonia is in) don’t dare roll their massive deficits into debt into perpetuity in hope of a similar rescue.

That won’t work – the Greeks will take the money and will do nothing to adhere to the conditions, for there is no claw back in such a rescue.

Alternatively, the EU might commit ECB to finance existent Greek debt on an annual basis. This will allow some policing mechanism, in theory. If Greeks default on their deficit obligations, they get no interest repayment by ECB in that year. Sounds fine in theory but what happens if the Greeks for political reasons default on their side of the bargain?

If ECB enforces the agreement and stop repayment of interest, we are back to square one, where Greece is once again insolvent and its insolvency threatens the Euro existence. Who’s holding the trump card here? Why, of course – the Greeks. And, should the ECB play chicken with Greeks on that front, the cost of financing Greek bonds will rise stratospherically, and that will, of course, hit the ECB as the payee of their interest bill.

Thus, in effect, we are now in a Mexican standoff. The Greeks are dancing around the issue and promising to do something about it. The EU is brandishing threats and tough diplomacy. And the problem is still there.

Martin Wolf of Financial Times: "the crisis in the eurozone's periphery is not an accident: it is inherent in the system. …When the eurozone was created, a huge literature emerged on whether it was an optimal currency union. We know now it was not. We are about to find out whether this matters."

Indeed, we are about to find out… hold on to your socks, folks.