This is an unedited version of my Sunday Times article for December 18, 2011.
Last week’s EU Summit was billed as offering long-term solutions to the
fiscal stability in the euro area and setting out the tools for dealing with
the immediate threats. Just a week after the summit, however, the euro zone
finds itself in the midst of an ever-deepening crisis once again.
This, of course, is a logical conclusion to the meeting that not only
failed to present any new measures, but went on to undermine credibility of the
previously deployed solutions, such as the EFSF, the ESM, Private Sector
Involvement in bondholders haircuts in Greece, the expanded IMF engagement in
lending to the euro zone member states, and the ECB deployment of aggressive
quantitative easing programmes.
Let’s take a look at the hard numbers that emerged from the summit.
Post-July 2011 plan was to enhance EFSF lending capacity to €1.5-2
trillion either by raising new funding or by running €500 billion EFSF
concurrently with €1 trillion ESM. Post-December summit we have: no increase in
EFSF, no concurrent schemes and a vague promise of a €1 trillion target for
ESM. This means that the effective lending capacity of the long-term funds in
euro zone will be less than one half of what was expected.
That, of course, assumes that EFSF and ESM will carry on borrowing under
AAA rating status and that funding markets will be receptive to new issuance of
debt. The former is now jeopardized, courtesy of the summit failure, leading to
France downgrade. The latter has been under severe questions for weeks now,
since the EFSF failed to raise €3 billion in the last auction earlier this
month. In fact, things are now so desperate, that this week EFSF was forced to
issue 91 days bills. A fund that is lending under 7.5-10 year mandate now runs
short term funding schemes that imply a massive maturity mismatch risk.
In order to by-pass ECB’s statutory restriction on financing the member
states, for months prior to the December summit, EU leaders were voicing the
idea of lending funds to the IMF so that the IMF can re-lend these same funds,
leveraged ca 4-5 times back to the euro member states. This too now appears
completely out of reach. Following the summit, the US, Canada and Japan stated
unequivocally that they will not support targeted funding by the IMF. In
addition, Russia, Brazil, China and India have in the past said no to matching
euro area loans, meaning that the scheme cannot come into existence as a
general fund allocation. Of course, in all the excitement surrounding the
Summit, everyone forgot to ask a simple question – where will the EU governments
find the said €200 billion if they can’t raise the money to fund the EFSF?
Private sector participation in Greece – the cornerstone of the July and
October 2011 summits – was also put to gather dust this week. Firstly, the
European Banking Authority clearly stated that efforts to-date to agree such
‘voluntary’ participation have come short of the required target of 90% of
foreign bond holders. Secondly, in the 5th review of Greece’s
progress under the lending programmes, the IMF team in Athens concluded that:
“There are yet significant risks ahead for the [Greek] authorities’ program,
including …the possible failure to agree with creditors on a PSI deal, leading
to a non-voluntary outcome.” And furthermore, despite having engaged in
planning PSI operations since June 2011, after six months of haggling and
planning by the EU, “… the specific details of the operation remain to be
finalized …” The sums involved are hardly insignificant. October 26 summit – up
to 1/4 of the entire EFSF once banks recapitalization measures are included.
Absent full implementation of PSI, Greece will be insolvent vis-à-vis IMF,
triggering a mother of all defaults.
Last, but not least, the hopes of the ECB riding into the battle with
direct quantitative easing were cindered by Frankfurt. Following the summit,
ECB decision makers were quick to state that direct assistance to the member
states and expanded bonds purchases were not consistent with the ECB statutes
and strategy. Of course, no open market operations – no matter how large –
could have been sufficient to deal with the crisis. To-date, ECB balancesheet
of loans to sovereigns (via direct purchases of Government bonds) and euro area
banks has swollen dangerously close to €1 trillion. And, yet, this had
virtually no real long-term effect on the crisis dynamics.
Adding insult to the already grave injuries, the Summit precipitated two
new crises in Europe – a political one and an economic one. The former is
manifested in the legal problems surrounding formulation, passing and
enforcement of the new Fiscal Pact. But these are legal and political problems
so let us focus on the economic ones.
Even for the deficit hawk like myself, the Fiscal Pact is equivalent to
an economic suicide. The Pact formula of 3%-0.5%-60% is a combination of the
already failed Stability and Growth Pact targets enriched with the lethally
obscure and totally unattainable 0.5% structural deficit limit.
Between 1990 and 2008 – in other words, before the crisis hit – Ireland
was able to satisfy the 0.5% structural deficit target only once in very 10
years, same as Belgium, Germany and the Netherlands. Austria, France, Greece,
Italy, Portugal and Spain never once satisfied this criterion. Two best
performers in the euro area – Malta and Finland have met the target in 6 out of
the 19 pre-crisis years. In terms of 0.5% structural deficit rule, all member
states, except Germany will require further austerity measures.
For Ireland, a longer-term expected slowdown in growth over the next 10
years compared to previous two decades will mean that it will be even harder to
stick to the target for the structural deficit, as we see reduction in the
potential growth rates going forward.
Ireland fared much better as far as the 3% standard deficit goes,
satisfying the criteria in all but 1 year. The same does not hold for other
euro area states. France has failed to meet the target in more than 5 out of 10
years, as did Spain; Italy in more than 7 in each 10 years; Portugal and
Germany more than 4; Greece – never once. And looking forward, under rather
rosy IMF September 2011 projections for 2012-2013, Belgium, Cyprus, France,
Greece, Ireland, Slovenia and Spain will require even more austerity than
already planned to comply with 3% deficit rule.
For Ireland, complying with the 3% rule will require the deepest
additional adjustments in the euro area, while complying with the 0.5%
structural deficit rule will need second largest adjustment. In fact, this
week, Sen. Sean Barrett, a TCD economist proposed a bill that aims to bring
about a more open and transparent approach to the public finances and stresses
the overall significance of the structural deficits rules for Ireland.
Messrs Kenny and Noonan have signed off on the deal that will be the
costliest to Ireland of all other states, disastrous to our economy in its
current condition and, given the legal issues surrounding its enforceability
for countries not in debt to the Troika, also pretty much useless for the EU at
large.
The second point of weakness in the Irish Government position with
respect to the new Pact relates to the implicit Government support for the
Financial Services Transactions Tax (FSTT). Empirical evidence firmly shows
that Tobin-styled taxes in financial services, when effective in reducing the
speed and volume of transactions, have to be prohibitively high, impacting more
adversely secondary financial services centres, like Dublin IFSC and benefiting
offshore locations and jurisdictions that fall outside the new tax net. In
summary, Tobin tax can lead to less transparency, more tax evasion and lower
economic growth across the EU. James Tobin himself argued against the blanket
introduction of his ideas in later years.
By agreeing to the new Pact without as much as voicing a threat of the
veto over the FSTT, the Irish Government has signed a long term death warrant
to Dublin's competitiveness in front-office international financial services -
the highest value added segment of the sector and one of the best performing
areas of Irish economy in recent years, including during this crisis.
On the net, as the direct result of the Summit failures, the probability
of the Euro zone exits for Greece, Portugal, Ireland and Belgium has risen. At
the same time, the sustainability of public finances in Italy, Spain and France
is now in doubt as Fiscal Pact is likely to result in a reduction in the
potential growth rates for Span and France and no increase in future growth for
Italy. Likewise, the probability of Irish fiscal adjustment path must be
questioned, especially since the Pact will depress our longer term growth
rates, that are already, barring the Pact introduction, less than spectacular.
It is thus, that the Government deficit of leadership has finally
contributed to a bitter failure at the EU policy level. Contagion has spread
from all matters economics and financial to the heart of politics in Europe.
Box-out:
Breaking up the doom-and-gloom newsflow that dominates our everyday
reality, last month’s high level Irish delegation trade visit to Russia, headed
by Tanaiste Eamon Gillmore, yielded some encouraging progress on the
longer-term bilateral trade and investment policies development front. Since 1976,
Irish and Russian authorities have been in somewhat infrequent and irregular
dialogues on these issues under the umbrella of the Joint Economic Council.
Last month, for the first time ever both sides agreed to set up sector-specific
working groups with regular reporting and strict annual targets for
deliverables. Given that Irish exports to Russia are set to grow 40% plus this
year, having 52% in 2010, while Irish trade surplus with Russia is about to
expand by 150% in the last 2 years, this is a truly welcomed development. In
2010, Irish trade surplus with Russia was €465 million ahead of that with
China, €352 million ahead of trade balance with India and €119 million greater
than the trade surplus with Brazil.
Yep, pretty dramatic. The above is in billions of euros. Let's look at the historical series and decomposition by IFSC and non-IFSC:
