2/7/2012: 16 issues with ESM 'deal'

This is the second post for this blog on the latest Euro area ‘deal’ struck early morning last Friday – the ‘deal’ that is thin on details (see statement here http://trueeconomics.blogspot.ie/2012/06/2962012-deal-preliminary-reaction.html) and even thinner on actual commitments (as in ‘new commitments’ not ‘repeated old commitments’).

(1) The core ‘commitment’ in the deal is the possibility that – once “effective single supervisory mechanism is established” (which may or may not take long – depending on whether the already existent EBA structure can be seen as ‘effective’ and whether it can be enhanced with real supervisory powers to oversee EA17 states, who are yet to agree such enhancements and such oversight) “the ESM could, following a regular decision, have the possibility to recapitalize banks directly” (so on top of establishing a common supervisory structure and endowing it with sufficient powers, the member states are yet to endow ESM with ‘regular decision’ powers to recap banks).

Assuming that such possibility is indeed delivered upon, this would allow banks recapitalizations via ESM instead of directly via sovereign funds and thus will – for accounting purposes – prevent banking debt being counted directly as Government debt. This is the positive and it is a significant positive, for Europe.

However, it has limitations, although it also delivers some potential positives. A mixed bag overall for Europe.

(2) Irish experience shows that – with Nama debt not officially counted as Exchequer debt, while Promissory Notes to IBRC and interest on them is counted as such. Both are fully backed by Government and both have economic implications, but only one (Promo Notes) has implication for sovereign finances. In other words, removing for accounting purposes debt off Government balancesheet does not remove the costs and burdens of this debt off the balancesheet of the economy as a whole. What this means is that the ‘deal’ does not share responsibility for debt across the Euro zone, as long as there remain Government guarantees. Instead it spreads debt into the economy (as banking system will still have to repay them), putting taxpayers into the second line of fire.

Incidentally, Nama – that vehicle which absorbed some of the banks bailouts – is highly unlikely to be featured in any potential/theoretical/rumoured/alleged retroactive restructuring of the banks-related sovereign debt.

This also means that the deal does not fully break the link of contagion from banks bad debts to Government balancesheet, but makes this link more opaque.

(3) There is no retrospection in the deal, although the Irish Government claims there is. We hope there can be such retrospection, but it is difficult to see how that can be delivered given that

a) Retrospection would open ESM to some €200 billion worth already committed Governments’ funds from the peripheral and other states (including Germany), effectively erasing 40% of ESM capacity before it gets to lend to any new states (e.g. Italy and Spain).

b) Retrospection in any case would not apply to non-debt funds committed by the Irish state (some €21 billion in NPRF cash paid in already).

c) Retrospection could challenge some of the requirements for conditionality (as it cannot be covered by any new conditions) and any potential requirements for collateralization (see below).

The Irish Government is so convinced that retrospective deal is possible, it has set the target of 17% of GDP for debt writedown (see: http://www.irishtimes.com/newspaper/breaking/2012/0702/breaking4.html) which will require a restructuring of €34 billion and if achieved will be a significant help to the Exchequer, although doubtful in value to the economy at large.

(4) The deal clearly states that the banks bailouts will be subject to the "appropriate conditionality, including compliance with state aid rules, which should be institution-specific, sector-specific or economy-wide and would be formalized in a Memorandum of Understanding." In other words, the conditions will not be universal for all states, but will be granular – specific to individual environments. Render onto… comes to mind, and the Caesar – Italy, Spain, any other large member state, is not the same as Ireland, Cyprus, Portugal, Greece et al.

(5) The ESM itself is, at this stage, still not set up and, more importantly, has not raised any funds. When operational it will have capacity to raise €500bn which is highly unlikely to be sufficient to cover sovereigns’ own needs, let alone underwrite any significant banks bailouts. If current EFSF participants were allowed to roll into ESM their banks’ exposures along with Spain, the ESM will have to allocate some €200 billion or so of funds to existent programmes, leaving €300 billion or so to fund other banks bailouts that might arise and fund Exchequers’ needs outside banks bailouts. Thus, ESM will be faced with a dilemma – either it acts as a somewhat credible banks bailout fund or a somewhat credible support for Government bonds. So far, under any of the existent proposals, it cannot do both. Were such proposals to be put in place in the future (e.g. leveraging via ‘banking license’ etc – explicitly excluded from the ‘deal’), the ESM will have to balloon well past €1 trillion mark.

Absent such proposals for ESM structure, the ‘deal’ says that ESM will be allowed to directly intervene in the markets to purchase Government debt. This is not new – in fact it was always supposed to do so.

(6) ESM structure remains unchanged under the deal, so the fund will go to the funding markets with a backing of collective guarantees of the member states. The internal backing of credit flows within ESM is that of the guarantees by the borrowing states to the fund – same as in the EFSF – except absent subordination. This can mean two things:

a) ESM will have to pay more for borrowing in the markets, and

b) ESM might face severe difficulties, similar to those experienced by the EFSF, in raising funds.

The things are getting so tight with the ESM (even before it is launched) that within the ESM set-up, the combined "guarantees" by the peripheral states borrowers from the EFSF/ESM plus Italy to ESM creditors are proportionately in excess of the guarantee provided by Germany.

However, on the positive side here, removal of subordination clause from ESM lending affirms to private lenders to national Governments the equal treatment of their bonds with supra-national ESM debt. In the long run, therefore, this should reduce risk premia for those member states still capable of tapping the private markets for debt. Thus, making things harder for ESM might make things easier for Germany & Co.

(7) ESM structure of guarantees is itself a troubling scheme. When Spain receives the bailout funding, its share of ESM funding and guarantees will be reallocated to other member states. Germany’s share will move from 29% to 33%, Italy’s share from 19% to 22%, France’s from 22% to 25% and so on. Two weaker Euro area states – Italy and Belgium – will become larger guarantors of ESM. And France, which wants effectively to expand ESM and to grow the overall euro area debt pile to finance own agenda. More fun? Unwilling participants to the scheme – Finland, Austria, the Netherlands – all are getting more ‘voting’ power in the ESM too. Which, of course, should make the whole ESM proposition even more risky in the eyes of external investors.

(8) ESM structure under the ‘deal’ is reinforced by the compulsion of the borrower state to comply with strict and specific conditions. To maintain credibility, therefore, ESM will require these conditions to be at least as stringent as those imposed under the EFSF (Troika) deals. The problem, alas, is that no country, save Ireland, to-date has been able to comply with the previous conditions and the entire mess we are in today was triggered (not caused) by Greece and Spain refusing to comply with these conditions.

This means that either ESM will have to offer its own funders much lesser security (higher risk of borrowers from ESM not being able to deliver internal adjustment programmes necessary for repayment of ESM funds) or it will have to avoid buying Spanish and Greek debts. Alternatively, the ESM lending will have to come with even stricter conditions to compensate for the lack of subordination, which is clearly unviable in current political environment.

(9) To secure ESM funding, the member state applying for the funds will be required to sign an agreed Memorandum of Understanding (as with Troika) which then will have to be approved by other member states. In the past, Finland, the Netherlands, Austria and Slovakia, not to mention Germany, have opposed to some conditions that would have allowed easier access to ESM funds. Specifically, some countries on the list have demanded use of collateral to secure lending even with assumed (under previous ESM plans) and actual (under EFSF) super-seniority conditions. What these and other countries might demand from the ESM funding recipient state is, thus, completely unclear and uncertain. The same applies to ESM lending to the banks, with an added caveat – conditions for banks will have to be even more strict.

We are now, therefore, facing a possibility that the collateral for loans debate can be reignited.

(10) Pretty much everyone agrees that the only lasting resolution to the crisis will have to arrive via ECB. Yet, to-date, ECB has been reluctant to engage even with the crisis spinning out of control. If the latest agreement de facto injects more funds in support of the banking and sovereign balancesheets, the current deal can actually result in even lower willingness of ECB to engage. In other words, the ECB might play a wait-and-see game, allowing the ESM to become fully engaged and only thereafter, assuming the crisis remains acute, stepping in. In other words, instead of deploying monetary policy upfront, we might see Euro area first increase its overall level of indebtedness via ESM and only after that move for the aggressive deployment of the monetary policy. As we know, this has happened in Japan and it has shown the weakness of the monetary policy at the time of elevated debt crisis.

(11) On a positive side, we must recognize that the deal explicitly recognized two things:

a) Germany no longer holds total power over the Euro area decisions,

b) A Euro area state should not be forced to accept bankruptcy level debts in order to underwrite banking system solvency (although there is yet to be a realisation on the side of same happening to the economy)

(12) Also on a positive side, it appears that likely outcome of common supervision regime will include deposits guarantee and banks insolvency resolution regime. Both are net positives and both are consistent with my long-held views on what should be done to repair Euro area banking system. Alas, the resolution regime will have to come ex post already adopted measures, so it is unlikely to make material difference to the banking system we currently have.

(13) A unified banking supervision itself might be a tight spot. Suppose it is set up. And suppose it is functional. In this case, any Euro area banking regulator will be faced with a problem – banks under his/her supervision holding massive and increasing exposures to the sovereign debt of their own governments, some of which are in ESM. There is a clear-cut case here to be made that this situation cannot be sustained. However, should the Euro area regulator move to curtail, say Italian or Spanish banks buying more of their Governments debts, there will be effectively an end to these countries participation in the funding markets and a larger call on ESM. Alternatively, should the regulator ignore the problem of accumulating risks, the regulatory system itself can be undermined.

(14) The deal – and especially the path that it took to arrive at – is the example of European policy brinkmanship, not cooperation. All accounts show that the meeting was broken by Mario Monti with support of Rajoy and that Hollande provided back up. There is absolutely no argument to make that any other member state was explicitly on their side, although most likely Ireland and Portugal were only happy to ride on the coattails of the opposition. Either way, the whole process of deriving the deal was not a cooperative solution, but a stand-off. This is not a break from the established pattern of past summits. But equally ominously, the latest success of brinkmanship is underpinned not by the change in the Euro area leaders’ positions, but by changes in the electoral landscape in Europe, with opposition to the status quo growing on the side of the ‘rebels’ in Greece (Syriza), Italy (Five Star), France (recent lections shift toward more extreme parties support), Finland (the True Finns), Germany and so on.

(15) In the end, ESM will not resolve the problem of too much debt accumulated on the shoulders of European sovereigns and dysfunctional banking system. The economies involved – Spain, Ireland, Greece, Portugal, Cyprus, and potentially Italy – are simply incapable of repaying these debts (please, do consider that even under the rosy Irish Government scenarios – the best performer in the group – Government debt reductions envisioned post 2014 are minor and mostly driven by economic growth, not repayment of actual debts). With this, the ESM can become a perpetual lender, with the requirement to continue raising funds well past the envisioned 10-15 years period. Any cyclical recession before then or after will derail repayments and the ESM debt will have to simply rise, risking a debt spiral that we are experiencing today replaying at some point in the future. Not a pretty thought and certainly a risk that the ‘game changer’ of the ‘deal’ might end up being the ‘end-game’ losing move.

(16) The deal does provide some room for ECB to claim that now there is a realistic progression toward more centralized oversight over banking sector and thus it can engage more actively in monetary easing. The signal to watch for is the ECB 1% repo rate, which can be lowered, implicitly signalling ECB willingness to long-term tolerate inflation over 2%. Thereafter, 4% inflation becomes feasible and ECB can start priming the pump. In turn, devaluation of the euro will compensate German economy by boosting exports and will put even more pressure on internal devaluations in peripheral states (imports costs up, exports largely non-existent to benefit from cheaper euro, etc).

Today’s PMI figures showing broad euro zone-wide and sharp contraction in activity in June should make the ECB move this Thursday a ‘no-brainer’.

29/6/2012: The 'deal' - preliminary reaction

Overnight statement from the EA [emphasis mine]:

"We affirm that it is imperative to break the vicious circle between banks and sovereigns. The Commission will present Proposals on the basis of Article 127(6) for a single supervisory mechanism shortly. We ask the Council to consider these Proposals as a matter of urgency by the end of 2012. When an effective single supervisory mechanism is established, involving the ECB, for banks in the euro area the ESM could, following a regular decision, have the possibility to recapitalize banks directly. This would rely on appropriate conditionality, including compliance with state aid rules, which should be institution- specific, sector-specific or economy-wide and would be formalised in a Memorandum of Understanding. 

The Eurogroup will examine the situation of the Irish financial sector with the view of further improving the sustainability of the well-performing adjustment programme. Similar cases will be treated equally.

We urge the rapid conclusion of the Memorandum of Understanding attached to the financial support to Spain for recapitalisation of its banking sector. We reaffirm that the financial assistance will be provided by the EFSF until the ESM becomes available, and that it will then be transferred to the ESM, without gaining seniority status.


We affirm our strong commitment to do what is necessary to ensure the financial stability of the euro area, in particular by using the existing EFSF/ESM instruments in a flexible and efficient manner in order to stabilise markets for Member States respecting their Country Specific Recommendations and their other commitments including their respective timelines, under the European Semester, the Stability and Growth Pact and the Macroeconomic Imbalances Procedure. These conditions should be reflected in a Memorandum of Understanding. We welcome that the ECB has agreed to serve as an agent to EFSF/ESM in conducting market operations in an effective and efficient manner.
We task the Eurogroup to implement these decisions by 9 July 2012."

I note that there is NO retrospection in the above - a negative for Ireland. So far we have a statement from some Irish Government members not present at the summit who claim there is retrospective applicability, but as far as I am aware, this is NOT confirmed in any documentary evidence.

I also note that transfers to ESM from EFSF will be carried out "without gaining seniority status" de jure, although it will most likely still be de facto super-senior debt - a positive for Ireland.

It is worth noting furthermore that countries entering ESM without first obtaining funding via EFSF might be able to avoid facing a Troika-imposed set of conditionalities, but will be required to comply only with the internal EU rules (see here). This, however, does not seem to apply to countries like Ireland who will enter ESM from EFSF and, potentially (based on reading of the official statement) to countries that have obtained funding not solely for the purpose of recapitalizing their banks 9again, precluding Ireland from softening of conditionalities).

Per Enda Kenny (via RTE):

• Ireland's government debt (not only banks-related) will be 're-engineered' in other words - it will be restructured (effectively a soft default). "Mr Kenny said the new deal means Ireland's overall debt burden, including the bank debt, can be re-engineered in a way which will give Ireland equal treatment to Spain and any other countries which avail of the new system."

• "where funding is made available through the EFSF it will later be transferred to the ESM" so it is now the Government position that we will have a second bailout. 

So the Irish Government is de facto 'defaulting' and welcomes this. And it is going into the second bailout despite repeated claims that it will be funding itself via markets post 2013. And it welcomes this too. Reverse gear has not been used as much for some time on Merrion St.


I have consistently called both events as inevitable for Ireland. Hence, in my view, the 'deal' is a net positive. However, we cannot tell how positive it is yet.

One area of concern will be the treatment of the banks debt under ESM - with respect to seniority and any attached Government guarantees. In particular, in my view, if ESM were to assume directly unsecured banks debt, even with an attached explicit sovereign guarantee, such debt will have to adversely impact ESM cost of funding.

The biggest issue with the above statement is that it will NOT reduce overall economic debt carried by the EU states, including Ireland. The potential reduction in the cost of financing this debt is good news. The fact that this economy (not banks or some rich uncle in America) - aka us - are still on the hook for debts of insolvent banks remains.

Ditto for Euro area as a whole. You might call it 'Government Debt related to the banks', you might call it 'quasi-Government Debt related to the banks' or 'Non-Government Debt guaranteed by the Government to the super-senior lender related to the banks' or indeed a 'Pink Teddy Bear that stinks up the room' - the debt is... err... still there and there will be more of it post this 'deal'.

Update 1: some interesting thoughts - it appears from the EU statement that any euro area member state in compliance with fiscal constraints can apply for ESM funding of the banking sector measures. Now, if - as the Irish Government are claiming - such funding can be applicable to restructuring past sovereign exposures to banking sector, then:

• As Belgium is already starting to signal, it can be applied  to €4 billion spent on Dexia Banque Belgique plus €54 in guarantees extended to the bank (link covering more current exposures potential), plus €6 billion in Franco-Belgian assistance the bank received back in 2008 (link).
• Germany's €150 billion 'rescues' of Hypo and other banks via FMS (link here)
• Austria - same Hypo (link here) but peanuts so far
• Dutch Government pumped some €32 billion into its banks (link)
• and so on...

Now, give it a thought - ESM is supposed to run at €500 billion absorbing existent EFSF up to €700 billion. So even if Spain just caps EFSF and it transfers to ESM, we have - before Italy comes waltzing in - ESM full capacity potential left after the banks bailouts are retrospected into it - of what? Some €200 billion max?.. or absent EFSF - at the announced running volume - nil.


This sort of suggests there is serious problem with an idea of allowing retrospective roll-backs of banks-related debt and measures to ESM...




Update 2: It appears that Enda Kenny's alleged contribution to the summit ('winning the deal for Ireland') is not a part of the record of the summit, at least as far as I can see (one example - here).


Update 3: H/T to Brian Lucey: this is just in - Germany apparently/allegedly wants ESM bank aid to be tied to acceptance of the Financial Transactions Tax. I suppose compliance with a harmonized corporate tax will be the condition too. In the end, the 'Enda deal' might just become a seismic event... So the logic of FTT link is therefore, in Irish context will be:
Step 1: EA leaders use Irish taxpayers to rescue own speculators and banks from Anglo/INBS etc default on bonds.
Step 2: EA leaders use FTT to demolish jobs in Dublin IFSC, so they can finance their 'growth package'?
The sort of the 'deal' we've been waiting for from our 'European partners'?

Update 4:  Citing Spiegel source, Global Macro Monitor blog states [emphasis is mine]: "What happens to the countries that have already received money from the temporary rescue fund, the EFSF? Officials in Brussels said that the new decision did not change anything about the programs for Greece, Portugal and Ireland. All the agreed goals will continue to apply and be monitored by the troika. But those countries might also start clamoring for the terms of their deals to be relaxed. The summit’s decision gives the Greek government in particular more ammunition for renegotiating the terms of its bailout, a step that new Greek Prime Minister Antonis Samaras has already said he wants to take."

15/6/2012: Some probabilities for post-Greek elections outcomes

Some probabilistic evaluations of post-Greek elections scenarios and longer range scenarios for the euro area:

In considering the possible scenarios for Ireland’s position for post-Greek elections period, one must have an explicit understanding of the current conditions and the likelihood of the euro area survival into the future.

Short-term scenarios:

In my opinion, there is currently a 60% chance that Greece will remain within the euro area post elections, but will exit the common currency within 3 years.  Under this scenario, the ECB – either via ESM or directly – will have to provide support for an EU-wide system of banking deposits guarantees, and new writedowns of Greek debt, as well as full support package for Spain’s exchequer and banks. Ireland, in such a case, can, in the short term, benefit from some debt restructuring. Part of the package that will allow euro area to survive intact for longer than 6-12 months will involve increased transfer of structural funds to stimulate capital investment in the periphery, including Ireland.

On the other side of the spectrum, there is a 40% probability that Greece exits the euro area within 12 months either in a unilateral, unsupported and highly disorderly fashion (20%) or via facilitated exit programme supported by the euro area (20%). In the latter case, Ireland’s chances to achieve significant writedown of our debts will be severely restricted and our longer term membership within the euro area will be put in question. In the former case, post-Greek exit, the euro area will require very similar restructuring of debts and real economy transfers as in the first option above. Here, there is an equal chance that the EU will fail to put forward reasonable measures for preventing contagion from the disorderly Greek default to other countries, including Ireland, which would constitute the worst outcome for all member states involved.

Longer-term scenarios: 

In terms of longer horizon – beyond 3 years, the scenarios hinge on no disorderly default by Greece in short term, thus focusing on 80% probability segment of the above short term scenarios.

With probability of ca 30%, the coordinated response via ECB/ESM to the immediate crisis will require creation of a functional fiscal union. The union will have to address a number of structural bottlenecks. Fiscal discipline will have to be addressed via enforcement of the Fiscal Compact – a highly imperfect set of metrics, with doubtful enforceability. Secondly, the union will have to address the problem of competitiveness in euro area economies, most notably all peripheral GIIPS, plus Belgium, the Netherlands (household debt), France. As mentioned in the short-term scenario 1 above, growth must be decoupled from debt overhang and this will require simultaneous restructuring of real economic debt (corporate, household and government), operational system of banks insolvencies, and investment transfers to the peripheral states. The reason for the probability of this option being set conservatively at 30% is that I see no immediate capacity within euro area to enact such sweeping legislative and economic transformations. Much discussed Eurobonds will not deliver on this, as euro area’s capacity to issue such will not, in my view, exceed new financing capability in excess of 10% of euro area GDP.

The second longer-term scenario involves a 60% probability of the euro area breakup over 2-5 years. This can take the form of a break up into broadly-speaking two types of post-Euro arrangements.

The first break up arrangement will see emergence of the strong euro, with Germany at its core. Currently, such a union can include Finland, Benelux, Austria, and possibly France, Slovakia, and Slovenia. The remaining member states are most likely going to see re-introduction of national currencies. Alternatively, we might see reintroduction of 17 old currencies. Italy is a big unknown in the case of its membership in the strong euro.

In my view, once the process of currency unwinding begins, it will be difficult to contain centrifugal forces and the so-called ‘weak’ euro is unlikely to stick. Most likely combination of the ‘strong’ euro membership will have Germany, Benelux, Finland and Austria bound together.

Lastly, there is a small (10 percent) chance that the EU will be able to continue muddling through the current path of partial solutions and time-buying. External conditions must be extremely favourable to allow the euro area to continue in its current composition and this is now unlikely.

12/6/2012: Show Some Will, Will Ya?

From EuroIntelligence.com today [emphasis mine]: 

"Christine Lagarde told CNN (via a report in El Pais) that she agreed with George Soros’ assessment that the EU had about three months to save the euro. She added that this was not a precise date, but what mattered at this stage is the demonstration of a clear political will to solve the crisis."

Quick note to Ms Lagarde & Mr Soros: at certain point in any crisis, demonstration of a will to solve it becomes insufficient to dealing with the crisis. That point 

1. Arrives once actual resolution becomes requisite due to the conditions of the crisis becoming immediately unsustainable (6.5% yields on Spanish & 6.1% yields on Italian 10 year bonds would qualify), and
2. Usually arises due to continued postponement of the said resolution.

In brief - Christine Lagarde might be right on timing (3 months, but with a margin of error both ways), but she is wrong on the required course of the action. Showing will is no longer an option. Deploying solutions is now the only immediately necessary step the EU can take.

11/6/2012: ESM / EFSF : building a bypass to nowhere

A quick one. Why ESM+EFSF lending capacity can't take Spain 3-years of funding (if Exchequer funds are drawn)? Here's a chart from Bridgewater:

Estimates for banking sector needs of Spain alone are running on average around €250 billion, with some sovereign supports, this rises to €370-470 billion. This will more than top the €700 billion hypothetical capacity of EFSF/ESM funding. With full 3 years Exchequer supports, the above mid range estimate can rise to ca €550 billion. That scenario (rather benign, given the markets conditions) will leave EFSF/ESM with ca €150 billion of funds (assuming Cyprus and Ireland do not dip into the funds this year or next) and that is nopt enough to fund Italian deficits and debt redemptions for even 1 years.

As the song goes: So long and thanks for all the fish...

24/1/2012: Europe's Latest Non-Leadership on ESM/EFSF

Another heated non-debate is sweeping Europe. In the latest round of bizarre, outright Kafkaesque rhetorical contortions, European leaders are now engaged in a heated discussion on the 'enlargement' of ESM. Alas, the whole thing is clearly heading for the same outcome as Europe's previous rounds of 'solutions'. Here's why.

Recently, as reported in German press (here) Angela Merkel started to yield on the idea that the 'permanent' ESM fund should be increased from €500 billion to closer to €1 trillion by, among other things, allowing for concurrent running of existent €250 billion EFSF facility and the setting up of the new ESM.

Sadly, this 'solution' is really a complete red herring, despite all the hopes the EU is pinning onto it. In fact, it so much of a fake, the markets are simply likely to laugh their way through it.

The EFSF is designed to run out of time in the end of 2013. ESM is designed to start the earliest in mid-2012. Which means that even in theory, combined ESM/EFSF can last not much longer than 12 months. In practice, however, even this is not going to happen.

Firstly, EFSF is becoming increasingly funded through short term debt issuance and this means that as we hit 2013, the rate of EFSF paper maturing is going to accelerate. To roll this into longer-dated paper will require more than just re-writing the statutes of the EFSF. It will require EFSF raising funding at the same time as ESM is raising funding. The likelihood of this being a successful market funding strategy is zero.

Secondly, ESM capital basis of (meagre) €80 billion is not going to be fully invested on the initiation of the fund. Which means ESM even in theory is not going to come out on day 1 and borrow full €500 billion capacity. In practice, it can't be expected to raise even 1/4 of that in the first year of operations.

Which means that even running concurrently, EFSF+ESM duo will not constitute a fund with anything close to €750 billion capacity. And this means that European leadership is clearly in line for winning the Global Non-Leadership Prize again this year. IMF, insisting on the concurrent running of EFSF/ESM as well, is going to be a runner up.

13/12/2011: European Summit and Markets Efficiency

One thing that clearly must be disheartening for the perfect markets efficiency theory buffs (supposedly there are loads of them around, judging by the arguments from the 'State Knows Best' camp, though I personally know not a single one who thinks that markets are perfectly efficient) is the speed with which the markets produced an assessment of the Euro zone's latest 'Grand Plan'.

Frankly speaking, the ink was still drying on the last week's summit paper pads and it was already clear that the new 'Solution' is not a solution at all and that the Euro zone crisis is not about to be repaired by vacuous promises of the serial sinners not to sin in the future.

This blog highlighted back on the 10th of December (here) the simple fact that Euro zone is highly unlikely to deliver on its newly re-set old SGP criteria targets, no matter what enforcement (short of Panzer divisions) Merkozy deploy. And in a comment to Portuguese L'Expresso (see excerpts here and full text here) and elsewhere I have said that instead of resolving the debt crisis, European leaders decided to create a political crisis.

Many other observers had a similar assessment of the latest Euro Land Fiasco pantomime that was the Summit. And yet, despite the factual nature of analysis provided, I was immediately attacked as a token Euro skeptic and an Anglophile.

Now, more confirmation - this time from the EU Commission itself (presumably this too has evolved into a Euro skeptic and an Anglophile institution overnight) - that the propposed Merkozy Pact is (1) extra-judicial and (2) largely irrelevant to the problem at hand. Today's Frankfurter Allgemeine reports that the new Pact will be - per EU Commission opinion - part of an inter-governmental treaty, which is subordinate - in international law - to any European treaty. This, in turn, means that a country in breach of the 'quasi-automatic fiscal rules - 3%-0.5%-60% formula - can simply claim adherence to existent weaker rules established under the fully functioning European treaties. This, in turn, will mean that there can be no application of the new Pact rules.

Thus, the new Merkozy Pact is subordinated to the weaker fiscal rules under the SGP and any extra-SGP enforcement of these rules is subordinated to the SGP procedures. Can anyone explain how, say Italy, can be compelled to implement the new Pact, then?

Meanwhile, of the other 'agreements' reached at the Summit, the EFSF agreement represents the weakening, not the strengthening of the previous Euro area position. In fact, post Summit, the EFSF is about to lose its AAA status (as France is preparing to lose its own AAA rating). S&P has the EFSF AAA-backers on negative watch and under a review, Moody announced yesterday that it will be reviewing AAA ratings across the Euro zone and Fitch labeled the Summit a failure. And amidst all of this EFSF is going to remain about 1/3 of the size required to start making a dent in the Euro zone problems. That, of course, assuming it can get up to that level - a big question, given pending downgrade and previous difficulties with raising funds.

The third pillar of the Euro zone 'strategy' for dealing with the crisis - the permanent ESM - also emerged from the summit in the shape of a party balloon with a hole in its side. Rapid deflation of the ESM hopes means that even with 'leverage' option, the ESM will not be able to underwrite liquidity to Italy and GIP, let alone Spain & Belgium. Furthermore, there is a question yet to be asked of the European leaders. Fancying ESM at €500 billion might be a wonderful exercise in fictional narrative, but where on earth will they get these funds from?

The fourth pillar of the 'strategy' was the IMF merry-go-round loans carrusel. Now, recall that brilliant scheme. The IMF has strict (kind of strict - see here) rules on volumes of lending it can carry out. But Euro zone problems are so vast, the IMF limits represent a huge constraint on the funding it can provide to the common currency debt junkies. So the EU came up with an 'Cunning Plan'. The EU will lend IMF €200 billion (which EU doesn't really have) and the IMF can then re-lend EU between €800 billion (under old rules on IMF lending) or up to €2 trillion (under that new 'leverage scheme'). Note: IMF doesn't really have this sort of money either.

So a junkie will borrow somewhere some cash, lend it to his dealer-supplier, who will then issue junkie a credit line several times greater than the loan, so the junkie can have access to few more years of quick fixes. Lovely. When you think of it, the irony of the EU passing a new 'Discipline Pact' with one stroke of pen, while leveraging everything it got and even leveraging the IMF to get itself more debt with the next stroke of pen takes some beating in the land of absurdity.

But fear not. The IMF is not likely to engage in this sort of financial engineering. Not because its new leader, Christine Lagarde - who comes from the European tradition of creating massive fudge out of monetary and fiscal policies - objects to it. It is unlikely to do so because its other funders - the US and Japan and BRICs etc are saying 'No way, man' to the Euro zone's plans. The US expressed serious concerns that Euro zone's plan will lead to US losses on IMF funds, while Japan's Fin Min Jun Asumi said that Europe must create a functional firewall first, before any IMF involvement can be approved. He also stated Japan's support for US position.

And so we have it. Post-Summit:

• There is no effective new 'Treaty' or enforceable new rules
• There is no enhanced EFSF and the old one is about to lose all its firepower
• There is no feasible ESM
• There is no Euro-leveraging of the IMF

Oh, and the ECB is becoming increasingly non-cooperative too.

And amidst all of this, the newsflow gets only worse and worse for Europe's battered economies. Greece is now projecting GDP decline of 6% in 2011 and 3% in 2012. The new deficit projections for 2011 are at 9% of GDP or €2.6 billion worse than the annual budgetary forecast of 8.5% deficit. Ditto for Belgium, where 2011 deficit is heading for 4.2% of GDP - 0.6 percentage points above the budgetary target (€2.2 billion shortfall). And, of course, there is that post-boy of austerity - aka Ireland - where Government tax revenues are collapsing as data through November shows (see details here).

So reality bites, folks. Markets are clearly not perfectly efficient. But once they discover the truth about the Euro Summit, fireworks will begin.

2/12/2011: Euro crisis: wrong medicine for a misdiagnosed patient

There's been much talk about the fiscal union and ECB money printing as the two exercises that can resolve the euro area crises. The problem is that all the well-wishers who find solace in these ideas are missing the very iceberg that is about to sink the  Eurotanic.
 (image courtesy of the ZeroHedge.com):

Let's start from the top. Euro area's problem is a simple one:

• There is too much debt - public and private - as detailed here, and
• There is too little growth - including potential growth - as detailed here.

Oh, and in case you think that discipline is a cure to debt, here's the austerity-impacted expected Government debt changes in 2010-2013, courtesy of the OECD:

In other words, it's not the lack of monetary easing or fiscal discipline, stupid. It's the lack of dynamism in European economy.

Let me explain this in the context of Euro area policies proposals.

• The EU, including member states Governments, believes that causality of the crisis follows as: Loss of market confidence leads to increased funding cost of debt, which in turn causes debt to become unsustainable, which in turn leads to the need for austerity and thus reduces growth rates in the Euro area economies.
• My view is that low growth historically combined with high expectations in terms of social benefits have resulted over the decades in a build up of debt, which was not sustainable even absent the economic recession. Economic recession caused the tipping point in debt sustainability beyond which markets lost confidence in European fundamentals both within the crisis environment, but also, crucially, beyond cyclical recession. My data on structural deficits (linked above) proves the last point.

So while Europe believes that its core malaise is lack of confidence from the markets, I believe that Europe's real disease is lack of growth and resulting high debt levels. Confidence is but a symptom of the disease. 

You can police fiscal neighborhood as much as you want (and some policing is desperately needed), but you can't turn European economy from growth slum to growth engine by doing so. You can also let ECB buy all of the debt of the Euro area members, but short of the ECB then burning the Government bonds on a massively inflationary pyre, you can't do away with the debt overhang. Neither the Euro-bonds (opposed by Germany) nor warehousing these debts on the ECB balance sheet (opposed by Germany & the ECB) will do the trick. Only long-term growth can. And in that department, Europe has no track record to stand on.

Take Italy as an example. Charts below illustrate the country plight today and into 2016. I use two projections scenarios - the mid-range one is from the IMF WEO for September 2011, the adverse one is incorporating OECD forecasts of November 2011, plus the cost of funding Italian debt increasing by 100bps on the current average (quite benign assumption, given that it has increased, per latest auctions by ca 300bps plus).

As chart below shows, Italy is facing a gargantuan-sized funding problem in 2012-2016. Note that the time horizon chosen for the assessment of fiscal sustainability is significant here. You can take two assumptions - the implicit assumption behind the Euro area policy approach that the entire problem of 'lack of markets confidence' in the peripheral states can be resolved fully by 2013, allowing the peripheral countries access to funding markets at costs close to those before the crisis some time around 2013-2014. Or you can make the assumption I am more comfortable with that such access to funding markets for PIIGS is structurally restricted by their debt levels and growth fundamentals. In which case, that date of regaining reasonable access to the funding is pushed well past 2015-2016.

Government deficits form a significant part of the above debt problem in Italy (see below), but what is more important is that even with rosy austerity=success model deployed by the IMF, the rate of decline in Italian public debt envisioned in 2013-2016 is abysmally small (again, see chart below). This rate of decline is driven not by the lack of austerity (deficits are relatively benign), but by the lack of economic growth that deflates debt/GDP and deficit/GDP ratios and contributed to nominal reductions in both debt and deficits.

But the proverbial rabbit hole goes deeper, in the case of Italy. IMF projections - made before September 2011 - were based on rather robust euro area-wide growth of the first quarter of 2011. Since then two things have happened: 

1. There is a massive slowdown in growth in Italy and across the euro area (see here), and
2. Cost of funding Italian debt has risen dramatically (see the second chart below).

These two factors, imperfectly reflected in the forecasts yield my estimation for Italian fiscal sustainability parameters under the 'adverse' scenario.

The above shows why, in the case of Italy, none of the solutions to the crisis presented to-date will work. Alas, pretty much the same applies to all other peripheral countries, including Ireland.

Which means that the latest round of euro area policies activism from Merkozy is simply equivalent to administering wrong medicine in greater doses to the misdiagnosed patient. What can possibly go wrong here?