26/8/2012: The way of Berlin in Greek drama

"Those whom the gods wich to destroy, they first make mad" is a proverb that is commonly, but possibly mistakenly, attributed to Euripides, who was, by all official accounts, a Greek, to the bone. In modern parlance - a European, more than that, an ancestor to those we now call citizens of a member state of the euro area, and Schengen, the arrangements that distinguish them as being the members of the European Core. That, and, ... oh one of the three fathers of Greek - Athenian - tragedy.

But enough with history. Whether Euripides authored the above statement or not, it pretty certainly came from Greece. Sophocles uses a similar phrase in Antigone, which pre-dates Euripides' plays.

The latest revival of the rather dated by now idea of granting the European Court of Justice (ECJ) the powers to "monitor the budgets of the member states and punish those that run up a deficit" (reported here) is the case proving the above conjecture.

The extension of such powers would make the ECJ the only court system with the power to oversee and directly influence the fiscal policy of the sovereign states. It will also be the only power that will be allowed to impose sanctions on sovereign states. Even the IMF has no power of similar nature vis-a-vis the states.

But there is more to the above equation. The ECJ is a court, here to decide on the matters relating to the law. Giving it any power resting outside its remit both undermines the system of checks and balances that normally constitute the foundation of any state, and, as the result undermines the legitimacy of the court itself. Blending of the boundaries between the executive (fiscal authority), the legislature (power to budget), and the judiciary delegitimizes all three.

And exactly the same, in my view, applies to the fiscal supervision and oversight powers to be vested with the ECB per another recent plan. No Central Bank in the advanced world has such powers of control over the fiscal policies of the state. You can call it a 'Dictator Draghi' case, but humor aside, the remit creep infecting Europe today is worrisome.

The euro area lead states - Germany in particular - are now locked in a frantic drive to build up institutional solutions to the problem created by the poor design of the common currency union over fifteen years ago. These solutions are not only unlikely to work, but the method of arriving at them is now risking to undermine the still-functional institutions of the European Union as a whole.

Irony has it, we have to turn to Greeks to spot the trend in gods work.

6/2/2012: Fiscal Compact Treaty - Sunday Times 05/02/2012

This is an unedited version of my Sunday Times article from February 5, 2012.

In medical analogy terms, this week’s Fiscal Pact signed by the 25 EU Member States, is equivalent to a misdiagnosed patient (the euro area economy) receiving a potent cocktail of misprescribed medicines.

In other words, the Fiscal Pact is neither a necessary, nor a sufficient solution to the ongoing crisis of the euro area insolvency. Moreover, it saddles the euro area with a choice of only two equally unpalatable alternatives. The first choice is compliance with the Pact that will lead to a situation whereby a one-policy-fits-all monetary framework will be coupled with an equally mismatched one-policy-fits-all fiscal framework. The second choice is business as usual, with continued reckless borrowing, internal and external imbalances and ever deepening links between the sovereign finances, the ECB and the banking sector balancesheets. In other words, there is a choice of either pushing Euro area down the deflationary, stagnation-inducing deleveraging spiral, or leaving it in the current modus operandi of reckless borrowing.

Both alternatives are internecine for Ireland, and both increase the probability of an eventual collapse of the euro over the next 5-10 years.

Suppose the EU member states, opt for the first alternative. As a whole, to comply with the Pact parameters, the Euro area economy will have to shrink by some €535-540 billion every year between now and 2020 – an equivalent of reducing euro area growth by a massive 3.9% annually. Just for the purpose of comparison, during the 2009 recession, Euro area experienced a real decline of overall income of 4.25%.

Ireland will be one of the worst impacted economies in the group courtesy of our excessively high structural deficits, debt to GDP ratio and cyclical deficits. In 2012, Ireland is forecast to post a structural deficit in excess of 5.5% of potential GDP – the highest structural deficit in the entire Euro area. To cut our structural deficit to 0.5% will require reducing annual aggregate demand in the economy by some  €7-8 billion in today’s terms. Debt reductions over the period envisioned within the pact will take an additional €12 billion annually. For an economy with huge private sector debt overhang, paying some 12% of its GDP annually to adhere to the Fiscal Pact is a hefty bill on top of the already massive interest bill on public debt.

Ireland’s fiscal performance under the Fiscal pact constraints, 2012

Sources: author estimates based on the combination of data from the Department of Finance, Budget 2012, IMF World Economic Outlook database, and author own forecasts

Crucially, the idea of the Fiscal Pact as a tool for resolving the structural crisis faced by the Euro area is equivalent to doing more of the same and expecting a different outcome.

The crisis arose because the Euro area combined vastly heterogeneous and complex economies under a one-policy-fits-all monetary umbrella. This has meant that no matter what policy the ECB pursued, interest rates and money supply will never be in synch with all economies within the Euro. The modern economic theory suggests that fiscal transfers can act as automatic stabilizers, correcting for monetary policy disequilibrium.

In European case, this theory is a pipe dream. Firstly, fiscal transfers cannot happen with the same timing as monetary policy changes, especially given the bureaucratic nature of the EU and its institutions’ detachment from the member states’ realities. Take one example – Ireland and other euro areas have been experiencing severe unemployment problems since 2009. Yet, only this week did the EU wake up to the problem and thus far, there are no tangible plans for dealing with it. Automatic stabilizer of fiscal policy will never be timely and responsive enough to undo damages caused by the unsuitable monetary policy. Secondly, fiscal transfers are an imperfect substitute for private sector adjustments to dislocations that monetary policy generates. No need to go beyond the current crisis to see this with aggressive monetary policy interventions since 2008 yielding not an ounce of real economic impact on the ground. Which means that the theoretical stabilizers are not really that effective in stabilizing the economic disruptions caused by monetary policy misfiring. Lastly, neither the current Pact, nor any other institutional arrangements within the Union provide for any automatic fiscal transfers.

Yet, when it comes to the penalties that apply to member states breaching the Pact conditions the new agreement are automatic and very tangible. This imbalance – with the Pact being all stick and no carrot – risks destabilizing economic systems struggling with shocks.

Take for example a country like Ireland. Suppose ECB policy in the future leads to high interest rates – a scenario consistent with the current monetary policy developments. This would imply that our terms of trade will deteriorate, reducing our exports and driving our economy into an external deficit. Simultaneously, slowdown in the economy will put pressures on our fiscal balance. This deterioration will not be consistent with a cyclical recession, implying that we are likely to simultaneously breach the twin deficits targets under the Fiscal Pact, triggering automatic penalties. Economy brought to its knees by the monetary policy mismatch will be forced to pay additional price through fiscal penalties.

In other words, the Pact is now attempting to create another policy system that will risk further detaching fiscal policies within the Euro area from the monetary policy.

When it comes to dealing with the current crisis, the new Pact contains no tools for achieving structural reforms required to arrive at sustainable public finances. Paying down the debts and cutting back deficits requires simultaneously running surpluses on the Exchequer side and the current account side. In other words, both external and internal surpluses must be achieved simultaneously. As international research shows, the likelihood of any state moving from long-term external imbalances to a sustainable current account surplus is extremely low.

Matters are worse when it comes to both fiscal and external balances. My own research based on the Euro area data shows that during 1990-2008, only two euro countries – Finland and Malta – have complied with the Fiscal pact criteria more than 50% of the time. The rest of the member states, including Germany and France, have run sustained deficits more than 60% of the time. Once a euro state found itself stuck in twin current and fiscal deficits in one decade (the 1990s), transitioning to a twin current account and fiscal surplus in the next decade (the 2000s) was virtually impossible. For example of all states in EA17 who were in current account deficit throughout the 1990s, only 2 have managed to achieve current account surpluses during the following decade. Only one country that experienced fiscal deficits in the 1990s has managed to generate fiscal surpluses over the following decade. No country has been successful in restoring fiscal and external balances after a decade of twin deficits.

The Fiscal Pact implies even less flexibility in adopting structural reforms necessary to achieve an already highly unlikely economic transition to the long-term sustainability path for many euro area states, including Ireland.

Consider for example two economies currently in a crisis – Ireland and Portugal. Portugal requires severe and substantial cuts in all public spending and then deep reforms in the private sectors of its economy. The country does not need a debt restructuring, but it needs huge capital injections to put it onto the path of capital investment convergence with the euro area average.

In contrast, Ireland needs restructuring of the private sector debts, deep reforms on the current expenditure side of the Irish exchequer, and more gradual reforms in the private sectors. Ireland has a functional exports generating economy, it has achieved current account surpluses on external side and balance on its Government spending side in the past. During the adjustment, Ireland needs structural reductions in the current spending best timed to start concurrently with the pick up in private sector jobs creation to offset adverse effects of these reforms on the most vulnerable – the unemployed. Ireland also needs to boost its after tax returns to human capital in the medium term – something that Portugal has no need for at this point in time.

There is nothing within the Pact that would facilitate either Portuguese or Irish economic stabilization and recovery. Neither will the Pact improve the chances of Spain, Belgium and Italy ever reaching real growth paths that imply sustainability of fiscal and external balances. In short, the Pact our Government so eagerly subscribed to is at the very best a continuation of the status quo. At its worst, Ireland and other member states of the Euro are now participants to a fiscal suicide pact, having previously signed up to a monetary straightjacket as well.

Box-out:

Last two weeks marked two significant milestones on Ireland’s economic performance front. Despite the adverse newsflow on the real economy side, Irish bond yields for 5 year bonds have dipped below 6% mark last week for the first time since the beginning of the crisis. This week, spreads on the 5 year Credit Default Swaps (the cost of insuring Irish bonds) also fell below 6% mark. For the first time since the crisis began our implied cumulative probability of default (CPD) – the probability that the Irish Government will default on its debt at some point over the next 5 years has touched 40%, down from over 46% at the end of 2011. Although the CPD is a mechanical function of CDS yields and not a statistical estimate of the true risk of the Government default, the CPD is an important metric for the markets. The significant decline in our CDS spreads this week, was prompted by the Irish banks buying into longer maturity bonds in the recent NTMA-led bond swap, plus the overall improving sentiment for sovereign debt in the euro area markets. The later itself was driven by the artificial forces, such as the ECB extending €497 billion to the banks in 3 year money. Nonetheless, our bond yields and CDS spreads declines are starting to show some improvement in overall markets risk-pricing for the Irish Government debt – a much needed stabilization and a moment of respite from the relentless crisis dynamics of the recent past.

Economics 22/7/10: EU stress tests - what do they tell us, really?

The EU stress tests of the banks confirm the worst fears of all analysts – including myself. The tests were simply a PR exercise, so poorly conducted that no one can have any credibility in their outcomes. Worse than that, the whole circus:

• The difficulty with which the EU member states appeared to be willing to release information about the tests;
• The way in which information is being released (via a drip feed – bit by bit over time, with massive leaks beforehand);
• The struggle through which member states have gone in order to even agree to carry out the tests in the first place;
• The rhetoric from the EU regulators assigning an almost heroic quality to its efforts to test the banks in the face of a clear shambolic nature of the whole exercise.
  

All of these things provide for a strong suspicion that the EU will not be able to undertake robust regulation and monitoring of the euro zone banking system in the future, plus a clear cut realization that the entire idea of the euro member states coming together to police their own fiscal behaviour will be even less honest, transparent or robust. In other words, how can we expect the EU to act as a functional policeman of its members fiscal policies if:

1. It failed to do so over years past, even armed with already robust and automatic regime of the Stability & Growth Pact, and
2. It failed to properly stress test its own banks?
   

In the nutshell: German banks, including Landesbanken, have already privately leaked the ‘news’ that they all had passed the test. Ditto for banks in France, Ireland and Italy. Only one German bank – already failed HRE – has failed the test from among 91 institutions.

In the case of AIB – the sick puppy was ‘passed’ by allowing to include into regulators’ calculations the €7.4 billion the bank plans to raise by the end of 2010. Good intentions count for hard evidence, then, per EU regulators. And Bank of Ireland passed - along with all the rest of the PIIGS banks is by the test excluding any possibility of twin shocks - simultaneous continued deterioration in quality of loans and a sovereign debt crisis. Now, in all likelihood, if the sovereign debt crisis continues to rage, does anyone in their right mind thinks that housing and other asset markets in the likes of Ireland and Spain are going to improve to alleviate the loans book pressures?

Farcical!

What the 91 tested banks did ‘pass’ was not a stress test, but a joke, concocted either by those with no understanding of banking (Eurocrats?) or created specifically with an ex ante intent of passing them all. The French and Greek banks privately said that the haircut applied to their holdings of Greek government debt were about 23%. Markets are factoring in 50-70% haircuts, so the EU stress test was less than half as severe as what is being priced already. Worse than that – the sovereign debt haircuts were applied only to bonds held in banks’ trading books. That accounts for just 10% of all Greek bonds held by the euro area banks, as 90% of Greek sovereign debt has been already moved to ‘held to maturity’ parts of banks assets portoflia, not reflected on trading books.

In other words, when it comes to Greek sovereign debt exposure, the EU tests were capturing no more than 5% of the total risk of such exposure for the banks. Like a doctor, looking at the brain activity chart of the patient and saying: ‘Look, there’s no activity at all. But 95% of all other vital signs are performing just fine. Indeed, no worries old man, the patient is still looking 95% alive then…’

And there's more. Per media reports, a memo from Germany's Financial regulator BaFin earlier this year said the real concern should be contagion from "collective difficulties" across the PIIGS, not an isolated default of Greece.

All of this did not prevent Irish stockbrokers from issuing upbeat reports about 'the good news' for BofI and AIB. What good news? The shares in two banks rallied today because someone, somewhere, allegedly decided that if Greece softly defaults, Irish banks will survive? Did that someone actually paused for a second to think, before placing a 'buy' order if Irish banks can survive their own home-made disasters? Or whether they can survive a meltdown of Greek debt default as priced by the markets? Or whether they can survive both happening at the same time?

Irish analysts, who issue these forecasts should be required to read Taleb's 'Fooled by randomness', though one wonders if they will understand much of what Taleb is saying for years now. Investors who chose to belive that AIB and BofI passing of the 'test' this week is some sort of a 'good news' are simply fooling themselves by ignoring a simple fact of life - misdiagnosing a patient with heart attack as being free of an Avian flu is not going to improving the patient's chances of survival. It actually reduces them.

Shamed by this absolutely incompetent, if not outright markets manipulating ‘testing’, you’d think the EU leaders would step back and start an earnest conversation between themselves as to what has gone wrong here. Nope. They are hell bent on creating more Napoleonic sounding, but utterly unrealistic and even disastrously risky plans. This time around – for fiscal harmonization. France and Germany – the two countries that have been clearly at odds with each other in responses to the current crisis have decided that a bout of amicable activism is long overdue. So behold the latest Franco-German alliance on a list of fiscal policy co-ordination proposals.

Per reports in today’s media: a French cabinet meeting took place with German presence, during which Sarkozy called for a complete harmonisation of European tax systems. ‘He did whaaat?!’ I hear you cry… yeah, he did call for that which was explicitly denied by him and the entire EU leadership core as ever having a chance of happening in the run up to the Lisbon II referendum in Ireland.

Now, don’t take me wrong here – this is not a voluntary call for individual states cooperative action – it is a call for an EU-wide ‘reform’. And if you don’t think so, the same meeting called, once again, for member states with excessive deficits to be punished by withdrawal of voting rights in the Council of Ministers, plus a fine and the compulsory imposition of an interest-bearing deposit for member states.

Eurointelligence blog has put it succinctly: “In other words, France and Germany [have called] to continue the same dysfunction regime, except that they strengthen those parts that have prove the most dysfunctional.”

Let me be a tad controversial here - wasn't all of this predicted to happen by Declan Ganley, Anthony Coughlan, Mary Ellen Synon and others who argue in favour of democratic reforms in the EU? Weren't they 'refuted' on exactly these predictions by the entire 'establishment' in Brussels and the all-knowing dons of the Upper Merrion Street? You don't have to agree with their points of view. You might as well agree that the idea of fiscal harmonization is a great thing. But what cannot be denied is that:

1. Any policies absent meaningful ability to honestly, transparently and effectively enforce them (and EU has shown none of these in its stress tests of the banks - the easiest area to deliver them in current political and economic environment) is destined to be nothing more than a bullying pit for some states to arbitrarily control others; and
2. Given grave doubts about EU's capabilities to provide for (a), the automatic default option of any new policies should be to scale opportunism and adopt pragmatic, cautious, incremental reforms approach - when in doubt, measure and caution must be the prevalent guide.
   

After all, if I were a person with the power to shape EU principles, I would adopt the milenia-old medical code of ethics, that is based on the fundamental axiom of morality: Primum non nocere, or First, do no harm.

Then again, adopting such a principle would have meant not conducting these 'stress tests'.