6/9/16: The Pain in Spain: Growth vs Structural Deficits

FocusEconomics have published an interesting research note on Spanish economy. 

The country has been muddling through 

1. An ongoing political crisis - with already two elections failing to produce a Government and the latest failed efforts at forming one last week suggesting there is a third round of voting ahead - and 
2. The long-running fiscal crisis - with the EU Commission initiating series of warnings about Spain's failure to comply with the Fiscal Compact criteria and warning that the country is falling behind on deficit targets

Yet, despite these apparent macro risks, the economy of Spain has been expanding for some time now at the rates that are ahead of its other EURO 4 peers (Germany, France and Italy). 

In a guest post below, FocusEconomics shared their research with Trueeconomics readers:

The Pain in Spain: Robust GDP growth cannot mask the persistent structural deficit

Spain’s robust GDP growth despite the ongoing political impasse has made the headlines time and time again. The panel of 35 analysts we surveyed for this month’s Consensus Forecast expect GDP to expand 2.8% in 2016, one of the fastest rates in the Eurozone this year, before decelerating to 2.1% in 2017. 

And yet both Spain’s Independent Authority for Fiscal Responsibility (Airef) and the European Commission have warned in recent months that Spain is relying too heavily on GDP growth to reduce its deficit while neglecting much-needed progress with structural reforms to reduce its sizeable structural deficit (the part of the overall deficit which is adjusted for temporary measures and cyclical variations). This leaves it vulnerable to its deficit increasing in the future should economic conditions become unfavorable again. 

According to the Airef, without further reforms, a structural deficit of approximately 2.5% will still persist in Spain in 2018. 

Meanwhile, the European Commission predicted in its updated spring forecast that the structural deficit will reach 3.2% that year—well beyond the new 2.1% revised structural deficit target for 2018 (as part of an overall 2.2% deficit target) that it recently announced in July. Spain’s general government deficit is the sum of the deficits of the central government, the regional governments, the local authorities and the social security system, and most of the overshoot is expected to come from the underperformance of the regional governments and social security. Spain has gradually been reducing its overall general government deficit in recent years, albeit not at the speed stipulated by the European Commission, but it is the persistence of the structural part of the deficit that is the main cause for concern.

After deciding last month to waive the budgetary fine on Spain for missing its targets, the European Commission set a new series of targets up until 2018 in order finally to bring Spain’s overall deficit below the long-targeted 3% that year. In 2016 it expects Spain to meet an overall general government deficit target of 4.6%, not more than 3.1% of which is expected to be a structural deficit. This is in line with the European Commission’s updated spring forecast for the country, since it has decided not to impose additional adjustment requirements on Spain this year (attributing this in part to the fact that lower-than-expected inflation, which is out of the government’s control, has hindered deficit reduction efforts this year). In 2017 and 2018, however, the Spanish government will have to implement structural reforms to make savings equivalent to 0.5% of GDP each year to bring its structural deficit down to 2.6% in 2017 (as part of an overall deficit target of 3.1% that year) and 2.1% in 2018 (as part of an overall deficit target of 2.2%). Achieving this will require a strong government able to press ahead with a reform program—something which currently looks rather a panacea. Spain’s ongoing failure to form a new government since the first inconclusive elections in December last year may not have impacted the current resilience of its GDP growth, but it certainly puts its fiscal compliance in jeopardy and prolongs the structural problems of its economy.

The agenda ahead is tight. Under the Spanish Constitution, 1 October is the deadline for the government to present its proposed 2017 budget to the Spanish Parliament. And under the EU’s rules, the European Commission must receive the budget (which must, of course, indicate how Spain will meet the required 2017 targets) by 15 October, or Spain faces a fine. Spain is still struggling to form a government after two elections in the last nine months and looks highly unlikely to have a new government in place by October that is able to push through a budget with the requisite reforms. Mariano Rajoy, who heads the current caretaker Popular Party (PP) government and is seeking to be sworn in as prime minister again, failed to garner sufficient support at both his first investiture attempt on 31 August (for which he would have needed an absolute majority in his favor) and his second attempt on 2 September (at which a simple majority would have sufficed). He might have another attempt at being appointed after the regional elections in the Basque Country and Galicia at the end of September if by chance the circumstances look more favorable by then, but otherwise Spain will probably be going to the polls again on 25 December, in what would be an unprecedented event. Even if a new government is formed by some miracle, it looks highly likely to be a weak one that might not manage to last long, let alone implement a convincing reform program.

Click on the image to enlarge

A closer look at the political turmoil

Spanish parties are simply not used to formal coalition politics at central government level, and don’t seem to be willing to adapt to the times in a hurry. Since 1982, either one or other of the two main parties, the conservative PP and the Socialist Party (PSOE), had always managed to form either a majority government or alternatively a strong minority government, in the latter case achieving working majorities by striking mutually beneficial deals with regionally-based nationalist parties—especially in the Basque Country and Catalonia—to secure their support in the Spanish Parliament (a classic case of “I’ll scratch your back if you scratch mine”). Neither party was prepared for two quite successful newcomers—the populist left-wing Podemos (“We Can”) and the centre-right Citizens party (C’s)—coming along to break up their longstanding dominance, at the same time as the pro-independence wave in Catalonia makes reviving the traditional mutual support arrangements with the Catalan nationalist parties impossible. 

The re-run elections held on 26 June have so far simply resulted in another stalemate. The PP won again and this time managed to increase its seats from 123 to 137, but it still fell far short of an absolute majority of seats (176) in Spain’s Parliament. The only plausible option for Rajoy in the circumstances is to form a minority government, since both the PSOE and C’s ruled out the possibility Rajoy had initially advocated of a “grand coalition” comprising the PP, the PSOE and potentially C’s too—an option which market participants had considered the most likely to deliver the structural reforms Spain needs, but which would not have provided the “government of change” that so many Spanish citizens voting for new parties seek. Rajoy had managed to reach an agreement with C’s (32 seats) for it to support his investiture attempts on 31 August and 2 September, as well as the commitment of the one MP from the Canary Coalition (CC) to do the same, but he failed to secure the 11 abstentions he would also have needed to be voted in on the second attempt with a simple majority. This would have required some of the PP’s arch rival the PSOE to abstain, and PSOE leader Pedro Sánchez remains absolutely adamant that his party will continue to vote against Rajoy instead. Sánchez is in a weak position since the PSOE declined at the re-run elections and is under pressure from Unidos Podemos (an electoral coalition between Podemos, the United Left party and some other smaller left-wing forces), so he is not in a strong position to try and form a government himself, but he does not want to lose yet more voters to Unidos Podemos by being seen to allow or to prop up a conservative government either. It looks like only an internal crisis within the PSOE could possibly change the circumstances.

There is an outside chance that Rajoy could attempt an investiture vote again after the Basque regional elections on 25 September, if it looks like he might be more likely to get the Basque Nationalist Party (PNV)—which has 5 seats in the Spanish Parliament—on board then, to continue to boost his numbers and up the pressure on the PSOE to deliver the final few abstentions. The only plausible circumstance in which the PP might stand any chance of getting the PNV on side is if, after the Basque regional elections, the PNV itself finds it needs the PP’s support to be able to govern in the Basque region. This is not totally beyond the realm of possibility, since the PNV is likely to win the Basque elections with a minority of votes and could struggle to form a working majority, especially if its traditional ally, the Basque Socialist party (PSE)—the Basque federation of the PSOE—declines as expected amid the rise of Podemos, which could potentially build alliances with other left-wing forces including the Basque anticapitalist and secessionist EH Bildu coalition of parties. Podemos is proving particularly attractive in the Basque Country (and Catalonia too) given that it is the first Spanish party to support the idea of self-determination for Spain’s constituent territories. Indeed, the PNV itself, a traditionally centre-right party which is struggling to attract the younger generations of Basque voters, is far from immune to the risk of losing some of its voters to the populist party: at the Spanish general election re-run in June, it was significant that Unidos Podemos beat the PNV not only in terms of votes but also seats in the PNV’s traditional Basque stronghold of the province of Vizcaya (one of the three provinces making up the Basque region). In these changing circumstances, the PNV could possibly end up needing the support of the PP in the Basque Parliament in order to govern, which would inevitably require it to return the favour in the Spanish Parliament, but this is only one of various possible outcomes at this stage and the PNV certainly looks highly unlikely to contemplate this option as anything but a very last resort.  

Summing up

Overall, the political impasse thus looks set to continue for the foreseeable future—though if we’re looking for silver linings, at least Spain’s nearly nine-month hiatus is still nowhere near Belgium’s 2011 record of 19 months without a government. Spain faces unprecedented challenges as it undergoes a fundamental political transformation stemming from the widespread disillusionment with existing political institutions and actors and the emergence of new players, not to mention the territorial crisis due to the Catalan challenge to the integrity of the Spanish state. While Spain’s GDP growth has remained remarkably resilient in recent quarters, there is no room for complacency. The country’s persistent structural deficit—which cannot be effectively addressed during the current political deadlock—still renders its economy particularly vulnerable to future changes in economic climate and puts the country on a collision path with Brussels over the required fiscal consolidation trajectory. 

Author: Caroline Gray, Senior Economics Editor, FocusEconomics

25/5/16: IMF's Epic Flip Flopping on Greece

IMF published the full Transcript of a Conference Call on Greece from Wednesday, May 25, 2016 (see: http://www.imf.org/external/np/tr/2016/tr052516.htm). And it is simply bizarre.

Let me quote here from the transcript (quotes in black italics) against quotes from the Eurogroup statement last night (available here: Eurogroup statement link) marked with blue text in italics. Emphasis in bold is mine

“On debt, I certainly think that we have made progress, Europe is making progress. Debt relief is firmly on the agenda now. Our European partners and all the other stakeholders all now recognize that Greece debt is unsustainable, is highly unsustainable, they accept that debt relief is needed.”

Do they? Let’s take a look at the Eurogroup official statement:

Is debt relief firmly on the agenda and does Eurogroup 'accept that debt relief is needed'? "The Eurogroup agrees to assess debt sustainability" Note: the Eurogroup did not agree to deliver debt relief, but simply to assess it. Which might put debt relief on the agenda, but it is hardly a meaningful commitment, as similar promises were made before, not only for Greece, but also for other peripheral states.

Does Eurogroup "recognize that Greece debt is unsustainable, is highly unsustainable"? No. There is no mentioning of words 'unsustainable' or 'highly unsustainable' in the Eurogroup document. None. Nada. Instead, here is what the Eurogroup says about the extent of Greek debt sustainability: "The Eurogroup recognises that over the exceptionally long time horizon of assessing debt sustainability there can be no forecasts, only assumptions, given the sizable degree of uncertainty over macroeconomic developments." Does this sound to you like the Eurogroup recognized 'highly unsustainable' nature of Greek debt? Not to me...

Furthermore, relating to debt relief measures, the Eurogroup notes: “For the medium term, the Eurogroup expects to implement a possible second set of measures following the successful implementation of the ESM programme. These measures will be implemented if an update of the debt sustainability analysis produced by the institutions at the end of the programme shows they are needed to meet the agreed GFN benchmark, subject to a positive assessment from the institutions and the Eurogroup on programme implementation.” Again, there is no admission by the Eurogroup of unsustainable nature of Greek debt, and in fact there is a statement that only 'if' debt is deemed to be unsustainable at the medium-term future, then debt relief measures can be contemplated as possible. This neither amounts to (1) statement that does not agree with the IMF assertion that the Eurogroup realizes unsustainable nature of Greek debt burden; and (2) statement that does not agree with the IMF assertion that the Eurogroup put debt relief 'firmly on the table'.

More per IMF: Eurogroup “…accept the methodology that should be used to calibrate the necessary debt relief. They accept the objectives in terms of the gross financing need in the near term and in the long run. They even accept the time periods, a very long time period, over which this debt has to be met through 2060. And I think they are also beginning to accept more realism in the assumption.”

Again, do they? Let’s go back to the Eurogroup statement: “The Eurogroup recognises that over the exceptionally long time horizon of assessing debt sustainability there can be no forecasts, only assumptions, given the sizable degree of uncertainty over macroeconomic developments.” Have the Eurogroup accepted IMF’s assumptions? No. It simply said that things might change and if they do, well, then we’ll get back to you.

Things get worse from there on.

IMF: “We have not changed our view on how the outlook for debt is looking. We have not gone back. We want to assure you that we will not want big primary surpluses.” This statement, of course, refers to the IMF stating (see here) that Greek primary surpluses of 3.5% assumed under the DSA for Bailout 3.0 were unrealistic. And yet, quoting the Eurogroup document: the new agreement “provides further reassurances that Greece will meet the primary surplus targets of the ESM programme (3.5% of GDP in the medium-term), without prejudice to the obligations of Greece under the SGP and the Fiscal Compact.”  So, IMF says it did not surrender on 3.5% primary surplus for Greece being unrealistic, yet Eurogroup says 3.5% target is here to stay. Who’s spinning what?

IMF: “...I cannot see us facing this on a primary surplus that is above 1.5 [ percent of GDP]. I know it's just not credible in our view. And you will see that there is nothing in the European statement anymore that says 3.5 should be used for the DSA. So there, too, Europe is moving.” As I just quoted from the eurogroup statement clearly saying 3.5% surplus is staying.

IMF is again tangled up in long tales of courage played against short strides to surrender. PR balancing, face-savings, twisting, turning, obscuring… you name it, the IMF got it going here.

24/5/16: Greek Crisis: Old Can, Old Foot, New Flight

So Eurogroup has hammered out yet another 'breakthrough deal' with Greece, not even 12 months after the previous 'breakthrough deal' was hammered out in August 2015. And there are no modalities to discuss at this stage, but here's what we know:

1. IMF is on board. Tsipras lost the insane target of getting rid of the Fund; and Europe gained an insane stamp of approval that Greece remains within the IMF programme. Why is this important for Europe? Because everyone - from the Greeks to the Eurocrats to the insane asylum patients - knows that Greece is insolvent and that any deal absent massive upfront commitments to debt writedowns is not sustainable. However, if the IMF joins the group of the reality deniers, then at least pro forma there is a claim of sustainability to be had. Europe is not about achieving real solutions. It is about propping up the PR facade.
2. With the IMF on board we can assume one of two things: either the deal is more realistic and closer to being in tune with Greek needs (see modalities here: http://trueeconomics.blogspot.com/2016/05/23516-debt-greek-sustainability-and.html) or IMF once again aligned itself with the EU as a face-saving exercise. The Fund, like Brussels, has a strong incentive to extend and pretend the Greek problem: if the Fund walks away from the new 'breakthrough deal', it will validate the argument that IMF lending to Greece was a major error. The proverbial egg hits the IMF's face. If the Fund were to stay in the deal, even if the EU does not deliver on any of its promises on debt relief, the IMF will retain a right to say: "Look, we warned everyone. EU promised, but did not deliver. So Greek failure is not our fault." To figure out which happened, we will need to see deal modalities.
3. What we do know is that Greece will be able to meet its scheduled repayments to EFSF and ECB and the IMF this year, thanks to the 'breakthrough'. In other words, Greece will be given already promised loans (Bailout 3.0 agreed in 2015) so it can pay back previous extended loans (Bailouts 1.0 & 2.0). There are no 'new funds' - just new credit card to repay previous credit card. Worse, Greece will be given the money in tranches, so as to ensure that Tsipras does not decide to use 'new-old' credit on things like hospitals supplies. 
4. Greece is to get some debt reprofiling before 2018 - one can only speculate what this means, but Eurogroup pressie suggested that it will be in the form of changing debt maturities. There are two big peaks of redemptions coming in 2017-2019, which can be smoothed out by loading some of that debt into 2020 and 2021. See chart below. Tricky bit is the Treasury notes which come due within the year window of maturity and will cause some hardship in smoothing other debts maturities. However, this measure is unlikely to be of significant benefit in terms of overall debt sustainability. Again, as I note here: http://trueeconomics.blogspot.com/2016/05/23516-debt-greek-sustainability-and.html Greece requires tens of billions in writeoffs (and that is in NPV terms).
5. All potentially significant measures on debt relief are delayed until post-2018 to appease Germany and a number of other member states. Which means one simple thing: by mid-2018 we will be in yet another Greek crisis. And by the end of 2018, no one in Europe will give a diddly squat about Greece, its debt and the sustainability of that debt because, or so the hope goes, general recovery from the acute crisis will be over by then and Europeans will slip back into the slumber of 1.5 percent growth with 1.2 percent inflation and 8-9 percent unemployment, where everyone is happy and Greece is, predictably, boringly and expectedly bankrupt.

Source: http://graphics.wsj.com/greece-debt-timeline/

Funny thing: Greece is currently illiquid, the financing deal is expected to be 'more than' EUR10 billion. Greek debt maturity from June 1 through December 31 is around EUR17.8 billion. Spot the problem? How much more than EUR10 billion it will be? Ugh?..So technically, Greece got money to cover money it got before and it is not enough to cover all the money it got before, so it looks like Greece is out of money already, after getting money.

As usual, we have can, foot, kick... the thing flies. And as always, not far enough. Pre-book your seats for the next Greek Crisis, coming up around 2018, if not before.

Or more accurately, the dead-beaten can sort of flies. 

Remember IMF saying 3.5% surplus was fiction for Greece? Well, here's the EU statement: "Greece will meet the primary surplus targets of the ESM programme (3.5% of GDP in the medium-term), without prejudice to the obligations of Greece under the SGP and the Fiscal Compact." No,  I have no idea how exactly it is that the IMF agreed to that.

And if you thought I was kidding that Greece was getting money solely to repay debts due, I was not: "The second tranche under the ESM programme amounting to EUR 10.3 bn will be disbursed to Greece in several disbursements, starting with a first disbursement in June (EUR 7.5 bn) to cover debt servicing needs and to allow a clearance of an initial part of arrears as a means to support the real economy." So no money for hospitals, folks. Bugger off to the corner and sit there.

And guess what: there won't be any money coming up for the 'real economy' as: "The subsequent disbursements to be used for arrears clearance and further debt servicing needs will be made after the summer." This is from the official Eurogroup statement.

Here's what the IMF got: "The Eurogroup agrees to assess debt sustainability with reference to the following benchmark for gross financing needs (GFN): under the baseline scenario, GFN should remain below 15% of GDP during the post programme period for the medium term, and below 20% of GDP thereafter." So the framework changed, and a target got more realistic, but... there is still no real commitment - just a promise to assess debt sustainability at some point in time. Whenever it comes. In whatever shape it may be.

Short term measures, as noted above, are barely a nod to the need for debt writedowns: "Smoothening the EFSF repayment profile under the current weighted average maturity: Use EFSF/ESM diversified funding strategy to reduce interest rate risk without incurring any additional costs for former programme countries; Waiver of the step-up interest rate margin related to the debt buy-back tranche of the 2nd Greek programme for the year 2017". So no, there is no real debt relief. Just limited re-loading of debt and slight re-pricing to reflect current funding conditions. 

Medium term measures are also not quite impressive and amount to more of the same short term measures being continued, conditionally, and 'possible' - stress that word 'possible', for they might turn out to be impossible too.

Yep. Can + foot + some air... ah, good thing Europe is so consistent... 

26/1/15: If not Liquidity, then Debt: ECB's QE competitive limping

I have written before, in the context of QE announcement by the ECB last week (see here: http://trueeconomics.blogspot.ie/2015/01/2312015-liquidity-fix-for-euro-what-for.html) that the real problem with the euro area monetary and economic aggregates has nothing to do with liquidity supply (the favourite excuse for doing all sorts of things that the ECB keeps throwing around), but rather with the debt overhang.

In plain, simple terms, there is too much debt on the books. Too much Government debt, too much private debt. The ECB cannot even begin directly addressing the unspoken crisis of the private debt. But it is certainly trying to 'extend-and-pretend' public and private debt away. This is what the fabled EUR1.14 trillion (or so) QE announcement is about: take debt surplus off the markets so more debt can be issued. More debt to add to already too much debt, therefore, is the only solution the ECB can devise.

While EUR1.14 trillion might sound impressive, in reality, once we abstract away from the fake problem of liquidity, is nothing to brag about. Take a look at the following chart:

Forget the question in red, for the moment, and take in the numbers. Remember that 60% debt/GDP ratio is the long-term 'sustainability' target set by the Fiscal Compact - in other words, the long-term debt overhang, in EU-own terminology, is the bit of debt above that bound. By latest IMF stats, there is, roughly EUR3.5 trillion of debt overhang across the euro area 18, just for Government debt alone. You can safely raise that figure by a factor of 3 to take into the account private sector debts.

Which puts the ECB QE into perspective: at the very best, when fully deployed, it will cover just 1/3rd of the public debt overhang alone (actually it won't do anything of the sorts, as it includes private and public debt purchases). Across the entire euro area economy (public and private debt combined) we are talking about the 'big bazooka' that aims to repackage and extend-and-pretend about 10-11% of the total debt overhang. Not write this off, not cancel, not burn... but shove into different holding cell and pretend it's gone, eased, resolved.

This realisation should thus bring us around to that red triangle and the existential question: What for? Between end of 2007 and start of 2015, the euro area has managed to hike its debt pile by some EUR3 trillion, after we control for GDP effects. Given that this debt expansion did not produce any real growth anywhere, one might ask a simple question: why would ECB QE produce the effect that is any different?

The answer, on a post card, to the EU Commission, please.

10/8/2014: Can EU Rely on Large Primary Surpluses to Solve its Debt Problem?

Another paper relating to debt corrections/deflations, this time covering the euro area case. "A Surplus of Ambition: Can Europe Rely on Large Primary Surpluses to Solve its Debt Problem?" (NBER Working Paper No. w20316) by Barry Eichengreen and Ugo Panizza tackle the hope that current account (external balances) surpluses can rescue Europe from debt overhangs.

Note: I covered a recent study published by NBER on the effectiveness of inflation in deflating public debts here: http://trueeconomics.blogspot.it/2014/08/1082014-inflating-away-public-debt-not.html.

Eichengreen and Panizza set out their case by pointing to the expectations and forecasts underpinning the thesis that current account surpluses can be persistent and large enough to deflate Europe's debts. "IMF forecasts and the EU’s Fiscal Compact foresee Europe’s heavily indebted countries running primary budget surpluses of as much as 5 percent of GDP for as long as 10 years in order to maintain debt sustainability and bring their debt/GDP ratios down to the Compact’s 60 percent target." More specifically: "The IMF, in its Fiscal Monitor (2013), sketches a scenario in which the obligations of heavily indebted European sovereigns first stabilize and then fall to the 60 percent level targeted by the EU’s Fiscal Compact by 2030. It makes assumptions regarding interest rates, growth rates and related variables and computes the cyclically adjusted primary budget surplus (the surplus exclusive of interest payments) consistent with this scenario. The heavier the debt, the higher the interest rate and the slower the growth rate, the larger is the requisite surplus. The average primary surplus in the decade 2020-2030 is calculated as

• 5.6 percent for Ireland, 
• 6.6 percent for Italy, 
• 5.9 percent for Portugal, 
• 4.0 percent for Spain, and 
• (wait for it…) 7.2 percent for Greece."

It is worth noting that Current Account Surpluses strategy for dealing with public debt overhang in Ireland has been aggressively promoted by the likes of the Bruegel Institute.

These are ridiculous levels of target current account surpluses. And Eichengreen and Panizza go all empirical on showing why.

"There are  both political and economic reasons for questioning whether they are plausible. As any resident of California can tell you, when tax revenues rise, legislators and their  constituents apply pressure to spend them." No need to go to California, just look at what the Irish Government is about to start doing in Budget 2015: buying up blocks of votes by fattening up public wages and spending. Ditto in Greece: "In 2014 Greece, when years of deficits and fiscal austerity, enjoyed its first primary surpluses; the government came under pressure to disburse a “social dividend” of €525 million to 500,000 low-income households ... Budgeting, as is well known, creates a common pool problem, and the larger the  surplus, the deeper and more tempting is the pool. Only countries with strong political and budgetary institutions may be able to mitigate this problem (de Haan, Jong-A-Pin and Mierau 2013)."

More significantly, Eichengreen and Panizza show that "primary surpluses this large and persistent are rare. In an extensive sample of high- and middle-income countries there are just 3 (non-overlapping) episodes where countries ran primary surpluses of at least 5 per cent of GDP for 10 years." These countries are: Singapore (clearly not a comparable case to Euro area countries), Ireland in the 1990s and New Zealand in the 1990s as well.

"Analyzing a less restrictive definition of persistent surplus episodes (primary surpluses averaging at least 3 percent of GDP for 5 years), we find that surplus episodes are more likely when growth is strong, when the current account of the balance of payments is in surplus (savings rates are high), when the debt-to-GDP ratio is high (heightening the urgency of fiscal adjustment), and when the governing party controls all houses of parliament or congress (its bargaining position is strong). Left wing governments, strikingly, are more likely to run large, persistent primary surpluses. In advanced countries, proportional representation electoral systems that give rise to encompassing coalitions are associated with surplus episodes. The point estimates do not provide much encouragement for the view that a country like Italy will be able to run a primary budget surplus as large and persistent as officially projected."

Good luck spotting such governance institutions in the euro area 'periphery' nowadays. "Researchers at the Kiel Institute (2014) conclude that “assessment of historical developments in numerous countries leads to the conclusion that it is extremely difficult for a country to prevent its debt from increasing when the necessary primary surplus ratio reaches a critical level of more than 5 percent.”"

Eichengreen and Panizza take a sample of 54 emerging and advanced economies over the period 1974-2013. They show that "primary surpluses as large as 5 percent of GDP for as long as a decade are rare; there are just 3 such non-overlapping episodes  in the sample. These cases are special; they are economically and politically idiosyncratic in the sense that their incidence is not explicable by the usual economic and political correlates. Close examination of the three cases suggests that their experience does not scale."

As mentioned above, one case is Ireland, starting from 1991. "Ireland’s experience in the 1990s is widely pointed to by observers who insist  that Eurozone countries can escape their debt dilemma by running large, persistent primary surpluses. Ireland’s move to large primary surpluses was taken in response to an incipient debt crisis: after a period of deficits as high as 8 per cent of GDP, general government debt as a share of GDP reached 110 per cent in 1987. A new government then slashed public spending by 7 per cent of GDP, abolishing some long-standing government agencies, and offered a one-time tax amnesty to delinquents. The result was faster economic growth that then led to self-reinforcing favorable debt dynamics, as revenue growth accelerated and the debt-to-GDP ratio declined even more rapidly with the accelerating growth of its denominator. This is a classic case pointed to by those who believe in the existence of expansionary fiscal consolidations (Giavazzi and Pagano 1990). But it is important, equally, to emphasize that Ireland’s success in running large primary surpluses was supported by special circumstances. The country was able to devalue its currency – an option that is not available to individual Eurozone countries – enabling it sustain growth in the face of large public-spending cuts by crowding in exports. As a small economy, Ireland was in a favorable position to negotiate a national pact (known as the Program for National Recovery) that created confidence that the burden of fiscal austerity would be widely and fairly shared, a perception that helped those surpluses to be sustained. (Indeed, it is striking that every exception considered in this section is a small open economy.) Global growth was strong in the decade of the
1990s (the role of this facilitating condition is emphasized by Hagemann 2013). Ireland, like Belgium, was under special pressure to reduce its debt-to-GDP ratio in order to meet the Maastricht criteria and qualify for monetary union in 1999. Finally, the country’s multinational-friendly tax regime encouraged foreign corporations to book their profits in Ireland, which augmented revenues."

The point of this is that "Whether other Eurozone countries – and, indeed, Ireland itself – will be able to pursue a similar strategy in the future is dubious. Thus, while Irish experience has some general lessons for other countries, it also points to special circumstances that are likely to prevent its experience from being generalized."

Another country was New Zealand, starting with 1994. "New Zealand experienced chronic instability in the first half of the 1980s; the budget deficit was 9 percent of GDP in 1984, while the debt ratio was high and rising. Somewhat in the manner of Singapore, the country’s small size and highly open economy heightened the perceived urgency of correcting the resulting problems. New Zealand therefore adopted far-reaching and, in some sense, unprecedented institutional reforms. At the aggregate level, the Fiscal Responsibility Act of 1994 limited the scope for off-budget spending and creative accounting. It required the government to provide Parliament with a statement of its long-term fiscal objectives, a forecast of budget outcomes, and a statement of fiscal intentions explaining whether its budget forecasts were consistent with its budget objectives. It required prompt release of aggregate financial statements and regular auditing, using internationally accepted accounting practices. At the level of individual departments, the government set up a management framework that imposed strong separation between the role of ministers (political appointees who specified departmental objectives) and departmental CEOs (civil servants with leeway to choose tactics appropriate for delivering outputs). This separation was sustained by separating governmental departments into narrowly focused policy ministries and service-delivery agencies, and by adopting procedures that emphasized transparency, employing private-sector financial reporting and accounting rules, and by imposing accountability on technocratic decision makers (Mulgan 2004). As a result of these initiatives, New Zealand was able to cut public spending by more than 7 per cent of GDP. Revenues were augmented by privatization receipts, as political opposition to privatization of public services was successfully overcome. The cost of delivering remaining public services was limited by comprehensive deregulation
that subjected public providers to private competition. The upshot was more than a decade of 4+% primary surpluses, allowing the country to halve its debt ratio from 71 per cent of GDP in 1995 to 30 per cent in 2010."

Agin, problem is, New Zealand-style reforms might not be applicable to euro area countries. Even with this, "it is worth observing that it took full ten years from the implementation of the first reforms, in 1984, to the emergence of 4+% budget surpluses in New Zealand a decade later."


Key conclusion of the study is that "On balance, this analysis does not leave us optimistic that Europe’s crisis countries will be able to run primary budget surpluses as large and persistent as officially projected." Which leaves us with the menu of options that is highly unpleasant. If current account surpluses approach to debt-deflation fails, and if inflation is not a solution (as noted here: http://trueeconomics.blogspot.it/2014/08/1082014-inflating-away-public-debt-not.html) then we are left with the old favourites: debt forgiveness (not likely within the euro area), foreign aid (impossible within the euro area on any appreciable scale), or debt restructuring (already done several times and more forthcoming - just watch Irish Government 'early repayment' of IMF loans).

22/7/2014: Remember that Fiscal Compact? Well, Don't Remind Europe...

Remember the Fiscal Compact? Yes, the one where debt/GDP ratio should be at 60% and the countries with ratios in excess of 60% must take 1/20th of the excess in adjustment down in debt per annum? So a country with 130% debt/GDP ratio is committed to an annual reduction of (130-60)/20=3.5% of GDP in year 1 and so on...

Oh, yes, the Fiscal Compact underpins the macroeconomic stability in the Euro area, making the euro as a currency 'sustainable'…

Oh yes, and the latest figures from the Eurostat on Government debt show that…

1. 18 out of EU28 countries have seen increases in Government debt/GDP ratios in Q1 2014 compared to Q1 2013.
2. 9 countries have posted increases in excess of 5% of GDP.
3. Year on year: the highest increases in the ratio were recorded in Cyprus (+24.6 pp), Slovenia (+23.9 pp), Greece (+13.5 pp) and Croatia (+9.9 pp), while the largest decreases were recorded in Poland (-7.7 pp), Germany (-3.2 pp), the Czech Republic (-2.2 pp), Latvia (-1.4 pp) and Belgium (-0.9 pp).
4. 15 EU28 countries had Government debt/GDP ratio in excess of 60%
5. EA18 Government debt in Q1 2013 stood at EUR8.793 trillion or 92.5% of GDP. In Q1 2014 this was EUR9.056 trillion or 93.9% of GDP. That is excluding intergovernmental debt. Adding this, Q1 2013 debt/GDP ratio was 94.6% and this rose to 96.3% in Q1 2014.

Good to see the Fiscal Compact holding so much better than the Maastricht Criteria.

So in the Age of European Austerity, savage cuts to public spending are resulting in rising debt at a rate of 1.7 percentage points of GDP per annum. One might wonder, were it not for the savage Austerity, where the debt levels might have been?

Full Eurostat release here: http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-22072014-AP/EN/2-22072014-AP-EN.PDF

28/6/2014: Public Debt: It Really Is the Case of Beggar Thy Children…

In a new paper, researchers from Germany use "controlled laboratory experiment with and without overlapping generations to study the emergence of public debt."

The set up of the experiment is simple: "Public debt is chosen by popular vote, pays for public goods, and is repaid with general taxes."

The end result is asymmetric:

• "With a single generation, public debt is accumulated prudently, never leading to over-indebtedness." In other words, if your generation is the one responsible for repaying debt, spending is prudent and debt accumulation is ex ante bounded by expected income.
• However, "with multiple generations, public debt is accumulated rapidly as soon as the burden of debt and the risk of over-indebtedness can be shifted to future generations."

Crucially, "debt ceiling mechanisms do not mitigate the debt problem. With overlapping generations, political debt cycles emerge, oscillating with the age of the majority of voters." In other words, the idea that debt can be controlled by explicit limits is useless. So much is clear from the US debt ceiling system performance, as well as from the EU SGP experiences. And as much will be confirmed by the Fiscal Compact rules application in due time. Worse, absent levels constraints we are left with the Keynesian proviso that simply says: Be nice. Save when you can, send when you need. Oops... if the stick does not work, any hope the carrot will? I don't think so...

The paper was written by Fochmann, Martin and Sadrieh, Abdolkarim and Weimann, Joachim, and is titled "Understanding the Emergence of Public Debt" (May 24, 2014, CESifo Working Paper Series No. 4820. http://ssrn.com/abstract=2458325).

16/1/2014: Some thoughts on Ireland's Rankings in the Index of Economic Freedom

Here are my thoughts on the Heritage 2014 Index of Economic Freedom scoring for Ireland (covered here: http://trueeconomics.blogspot.ie/2014/01/1612014-2014-index-of-economic-freedom.html) :

First off: the positive is that Ireland's score is rising (the ranking improvement is a major positive, but I have some reservations about that, voiced below). Another positive is that the improvements are occasionally structural although predominantly they risk being cyclical:

• Government spending gains are, in my view, largely cyclical (driven by tax extraction measures and capital spending cuts, plus banks measures tapering of) with some structural changes (some of tax systems put in place are sustainability enhancing, such as property tax).
• Fiscal policy gains are largely symbolic and driven by the EU-wide changes (6-pack, 2-pack and Fiscal Compact, etc).
• Labour markets improvements, especially some activation measures deployed are structurally sustainable and often positive. Unfortunately, their impact today runs against high unemployment and low jobs creation. In other words, we are pursuing right reforms at the wrong time. Aside from these, there is preciously little change in the structure of the labour markets. Competitiveness gains, stripping out the effects of sectoral composition, are flattening out, albeit these are still significant compared to pre-crisis.
• Trade freedom improvement is puzzling. There has been no major improvement in the EU treaties or bilateral trade agreements. Aside from this, there has been little change to the regulatory systems and costs involved in exporting from and importing into Ireland. On financial services side, there has been an increase in regulatory barriers to transactions, including compliance tightening, enhanced reporting requirements and higher costs.

Now on to unpleasant bits. The report on Ireland is raising some questions:

1) Debt restructuring is cited in relation to the February 2013 swap of the IBRC Promissory notes for senior sovereign bonds. It is alleged that this resulted in a significant reduction in debt levels. In my opinion, the swap did not deliver significant material alteration to the total debt. Instead it achieved markedly improved maturity profile of debt, and reduced front-end cash flow requirements relating to the original promissory notes. The swap was a net positive, but of modest impact when it comes to debt levels.

2) On property rights: since May 2011 the Irish Government is engaged in expropriation of private pension funds via a levy on capital component of the funds and this levy was increased in the Budget 2014. Further, Irish Government forced (since 2010 and ongoing under the IBRC shutdown proceedings) sales of distressed assets to the State agency, NAMA. This can be treated as a de facto (de jury bit remains to be tested in the courts) expropriation of a large number of private assets, especially where such assets included at-the-time fully performing loans.

4) Top income tax rate is 41%, but it applies to earnings above a very low threshold. Heritage analysis also excludes the USC and PRSI both of which are taxes on individual income. The analysis ignores the differences in taxation of the self-employed and PAYE incomes. Counting all income tax measures, upper marginal tax rate on income in Ireland stands at above 50%. In the case of businesses, the report does not cite rates - a major component of tax costs. The report quotes tax receipts as a share of Gross Domestic Income, which really means GDP. However, stripping out transfer pricing and tax transfers by the multinationals (which are not fully captured by the tax base) Irish Government tax burden is significantly above 27.6% of our economy.

5) The report cites prices as being 'generally set by market forces'. However, many goods and services traded in Ireland's domestic economy are either directly priced by the state regulators, disproportionately impacted by state taxes, levies and duties and/or are set by state oligopolies. These include energy prices, prices relating to all forms of public transport and even some private transport, majority of health services, pharmaceuticals, education, alcohol, tobacco, fuel, social protection, etc. They also include many professional services costs set under the power of professional bodies that are granted market power by the state. Whilst private sectors are in a deflationary environment, state-controlled prices are up double digits over the course of the crisis.

6) Irish lending and investment climate is assessed as unchanged year on year. Credit supply in Ireland is continuing to contract, especially to indigenous firms, while domestic investment in new enterprises is now nearly fully state-captured via state-controlled or regulated funding schemes. Meanwhile, the banking sector saw no meaningful reforms other than continued shift toward a duopoly model. Competition in banking sector is collapsing and this is an ongoing development. Irish banks are becoming  more domestic, cross-border financing is becoming less available.

7) The report cites 'public debt' at 117% of GDP. Assuming this covers General Government Debt the actual figure is at 124.1% of GDP per latest official estimate for 2013. Public debt traditionally includes liabilities of the local authorities and state bodies, which pushes the above figure well ahead of the reported percentage. Once again, given that a meaningful comparative for Irish economy is not GDP, but some metric closer to GNP, even 124.1% figure is a massive underestimate of the true extent of the 'public' debt overhang.

Conclusion: In my opinion, the above caveats do not necessarily imply that Ireland's position in the IEF deteriorated significantly year on year in 2013. However, they do pose some questions about the improvement recorded in the overall ranking for Ireland compared to 2013.

11/1/2014: Don't mention the 'D' word in the Eurozone, yet...

Bloomberg this week published a note analysing the GDP performance of the euro area countries during the Great Depression and the Great Recession: http://www.bloomberg.com/news/2014-01-06/europe-s-prospects-looked-better-in-1930s.html. The unpleasant assessment largely draws on the voxeu. org note here: http://www.voxeu.org/article/eurozone-if-only-it-were-1930s.

Perhaps the most important (forward-looking) statement is that in the current environment "complying with the EU's debt-sustainability rules will entail severe and indefinite budget stringency, clouding the prospects for growth still further". This references the EU Fiscal Compact and 2+6 Packs legislation.

And on a related note, something I am covering in the forthcoming Sunday Times column tomorrow (italics in the text are mine and bold emphasis added):

"What are the fiscal lessons? First, avoid deflation ... at all costs. ... Beyond that, the options in theory would seem to be financial repression, debt forgiveness, debt restructuring and outright default. Financial repression, the time-honored remedy, would seem to be out of bounds... and EU governments aren't yet ready to contemplate the alternatives [debt forgiveness, restructuring and defaults]. At some point, they will have to. In the 1930s, the situation didn't look so hopeless."

But why would the default word creep into the above equation?

Update: and another economist calling for debt restructuring/default denouement: http://www.voxeu.org/article/why-fiscal-sustainability-matters#.UtJWBR7i-nh.gmail
I know, I know - everything has been fixed now, so no need to panic...

27/10/2013: Financial Repression, Economic Suppression & Budget 2014

This is an unedited version of my Sunday Times article for October 20, 2013.


With fanfare of media appearances and fireworks of Dail statements, Budget 2014 was pushed off the dry dock and into the turbulent waters of reality. Full of political sparkle on the outside, overloaded with hidden taxes and charges and yet-to-be-fully-detailed painful cuts on the inside, it sailed off into the future. It will take at least 9-12 months from now to see what adjustments will have to be made in 2015 to compensate for the 'savings' on cuts delivered this week. It will take us longer to find out if the Budget 2014 will have a positive or negative effect on our ability to fund our deficits in the markets.

Yet, one thing is beyond the doubt: Budget 2014 was a significant gamble by the Government that could have done better by avoiding taking any gambles at all. Minister Noonan has decided to buy some political capital in the Budget. This capital came in the form of reduced rate of overall budgetary adjustment, compensated for by the hope-based increases in public sector efficiencies, plus some symbolic handouts to middle class families. Majority, such as the free GP visits for children under the age of 5, were poorly targeted and economically inefficient – extending scarce resources not to where they are needed most (such as, for example, long-term care provision or means-tested provision of health services) but to where political expediency leads. Many fail the core Budget objectives of making our fiscal policies more robust to adverse shocks that may occur in the near-term future.

In the end, Budget 2014 delivered virtually no real departures from the past Budgets. Predictably, there were no 'new' taxes. Instead the Budget put forward a list of new 'revenue raising measures'. The State will claw out of the banks EUR150 million in levies. Given that our banking sector is being reduced to a Three Pillars oligopoly, the levies will come straight from charging customers more for the same services. Pensions funds levy - a form of expropriation of private property - is to raise additional EUR135 million. This is a tax on present income, and in the case of pensions funds levy a tax on current wealth, plus a tax on future incomes foregone due to reduced levels of pensions funds. EUR140 million will be pumped out of the banks’ customers by taxing interest on savings. All in – financial sector will take a hit of EUR425 million on a full year basis, reducing its ability to lend, invest in the economy and to deal with mortgages distress. The measures will also weaken the quality of Irish banks' deposits base by reducing incentives to save. Carmen Reinhart and Kenneth Rogoff aptly termed such measures ‘financial repression’. De facto, we are bailing in ordinary banks customers and savers to pay for the past sins of the banks. Cyprus redux, anyone?

Cuts side of the Budget was also predictable. At the aggregate level, departmental expenditure as the share of GDP continues to run above 1990-2007 average. Instead of real cost reductions in Health we got some EUR250-300 million worth of new charges to be levied on services to insurance holders. And reduced insurance deductibility on the revenues side should do even more to reduce insurance coverage in the market. Net effect will most likely be falling transfers from private patients to public services, and higher demand for public health.

From businesses perspective, whatever the State added on one side of the budgetary equation, the state took out on the other. Thus, for all incentives for construction and building trade, overall capital spending by the Government in 2014 is projected to fall by some EUR100 million. As we stand, in 2013, capital spending by the Government barely covers amortization and depreciation of the total stock of public capital. Next year, things are going to get worse.

Much of the business stimulus schemes are geared toward supports for the property markets, including the incentives for foreign investors to put money into Irish REITs. Aside from the property-related measures, other business stimulus polices are either extensions of the already existent ones or more promise of doing something in the future. One example is the issue of Trade Finance supports. We are now five years into talking about the need to help smaller exporters with the cost of and access to trade insurance and credit.  Still, there is no tangible delivery on this.


However, the real question, left unanswered by Budget 2014 is: what's next for Ireland? The Government is rhetorically focused on our 'exit' from the Troika-led funding programme. This objective is a policy epicycle designed to ease public attention off the realities of bad domestic governance during the crisis. Exit from the bailout, financially, fiscally and economically, means a public recognition that Ireland has run out of funds we can borrow from the IMF and the EU. It also puts forward a commitment that, unlike Greece, we will not be asking for another bailout. Being not Greece does not make us Iceland, however, since Iceland repaid its bailout loans. In contrast, we will be carrying our debts to Troika for years to come.

The Government is promising that once we exit the bailout, we will regain our control over fiscal policies. This is a gross over-exaggeration. Having ratified the Fiscal Compact, Ireland is now subjected to heavy EU oversight as long as our fiscal performance falls short of the targets set in the treaty. It will be long time before we meet all of the conditions.

The scrutiny of our targets will increase, while our performance will remain under serious pressures arising from the crisis. Most recent IMF forecasts assume full EUR5.6 billion adjustments taken over 2014-2015 period, and economic growth averaging over 2.1 percent per annum (almost 6 times the average growth in 2012-2013 period). These forecasts imply that in 2014-2015 Ireland will still face the third highest cumulative deficits in the euro area ‘periphery’. And the debt levels of Irish state are set to continue rising. In 2013, the Department of Finance projects the level of Irish Government debt to be at EUR205.9 billion. By 2018 this is projected to rise to EUR211.6 billion.

And here's another kicker. The Fiscal Compact sets the target for long-term structural deficits (in other words deficits that would prevail were the economy running at its long run sustainable growth potential) at 0.5 percent of GDP. IMF projections out through 2018 put Irish structural deficits declining from 5.1 percent of potential GDP in 2013 to 2.0 percent in 2018. In other words, in 2018 Ireland is expected to be the worst performing 'peripheral' state in terms of structural deficits and operate well outside the criteria set in the Fiscal Compact.

Worse, comes December 15, we will lose a strong supporter of our efforts to restructure legacy banking debts and the only member of the Troika that promotes structurally more important economic and markets reforms.

On foot of our weak fiscal position, the politicisation of the Irish economy is already building up, driven primarily by our European partners and – until December 15 – resisted by the IMF.

The pressure is rising on Ireland's corporate taxation regime. The Government admitted as much by promising to close the loophole that allows some MNCs to nearly completely avoid paying Irish corporate taxes.

The pressure is also growing on blocking Ireland’s chances to restructure legacy banks debts. Germany, the ECB and the Eurogroup are angling to block Ireland's potential access to the European funds set up to deal with the future banking crises.

We are going into 2014 self-funding mode with all the costs of the bailout in place, including the Dvoika (Troika less one) oversight and substantial deficit and debt overhangs. It now appears that there will be no credit line to cover any increases in the cost of borrowing that might arise in the future. There will be no precautionary fund to cushion against any risk to market demand for Irish Government bonds. There will be no system in place to deal with any future banking problems or with the legacy debts should such arise. The ECB, the IMF and our forecasters are all warning us that we still face potentially significant downside risks to growth and banks stability. The IMF has been for months raising the issues of the SMEs insolvencies and poor quality of banks capital.

In other words, we are boxing ourselves into a high-risk game with little to show for this in terms of a positive return from our 'exit' from the bailout.

History suggests that prudence, not pride should be our guide. Back in 2010 we pre-borrowed aggressively in the markets prior to the state finances collapsing under the poorly structured banks bailouts. Now, we are gunning for the 'exit' without having secured any support from our 'partners' once again. The hope is that this time it will be different: the markets will lend us at decreasing costs, while growth lifts the entire domestic economy out of stagnation. This might not be an equivalent of playing Russian roulette, but it is certainly a game of chance with high stakes on the losses side and little tabled on the potential winnings side.

Box-out:
The latest OECD research on basic skills across the advanced economies puts to a serious test our claims to having a highly educated workforce. Ireland ranked eighth in terms of the proportion of younger adults with tertiary education. In terms of problem solving proficiency, both our college graduates and adults with only secondary education rank below their respective OECD averages. In problem solving in a technology-rich environment – a proxy for skills related to internationally-traded services, the sole driver of our economy today – Ireland ranks 18th in the OECD. Our younger workers score below their OECD peers in basic literacy and in numeracy. When it comes to introduction of new processes and technologies in the workplace Ireland is ranked between such premier divisions of the global innovation league as Cyprus and Belgium. Given our poor performance in digital economy-specific skills, exposed in October 2012 report by the OECD and covered in these pages before, it is high time for us to get serious about reforming our education and training systems.

19/6/2013: European Federalism and EMU Experience

There is a number of flaws in the euro area design that were exposed by the current crisis. Perhaps the most fundamental is the flaw relating to the system complete incapacity to generate critical capacity. Despite the crisis continuing for the 7th year in a row, the EU and the euro area as its core sub-set remains unable to ask the key question of viability of the social, political and economic project based on the premise that ever-increasing levels of policies and institutions integration, harmonisation and coordination is a feasible and a desired direction to pursue.

Let's start from the top.

Firstly, it is now pretty much an accepted wisdom that in shaping the EMU, European leaders have failed to see even the basic implications of deep integration. The implications missed were not just monetary or economic. Current crisis has shown deep divisions within the euro area on matters such as inflationary preferences, expectations formation mechanisms, conditionality evaluations and fiscal transfers, all cutting across social and cultural division lines, rather than purely economic ones. This failure has led to the design flaws that are principles-based and, as such, cannot be corrected by managerialist solutions. They require structural change - a matter of concern for Europe, so far incapable of following through with even managerialist changes, such as adherence to well-specified Maastricht Criteria targets at the times of aplenty or expression of any solidarity at the times of constraints. There is little hope the EU can deliver on much less defined, broader and, at the same time, culturally and socially more challenging reforms and changes required to move the euro project forward, away from the danger zone.

Secondly, it is also pretty clear that the EU institutions are incapable of learning from the mistakes of their leaders and from the signals transmitted from the nation states and the electorates. Instead of making an effort to understand the underlying causes for a rushed, poorly planned and poorly executed monetary policy harmonisation, the EU leaders are now jumping head-in into attempting to cure the sever hangover from the common currency creation by doing more of the same - embracing the idea of banking and financial services integration (the Banking Union - EBU) and political consolidation (the Political Union - EPU).

A combination of the two directions will, under these conditions, risk leading Europe toward a repeat of the EMU fiasco on a much grander scale - a failure of all three 'unions' - the EMU, the EBU and the EPU. History can repeat itself, having shown its hand today as a structural crisis in one area of the system, with a replay of the crisis across the entire system.

There are number of reasons for this conjecture.

The EU's latest drives - across political and banking dimensions - into deeper integration are lacking the deep foundations on both, the demand and supply sides of their respective equations. In this, they are  exactly mirroring the EMU creation that too faced the original minor crisis in the 1990s only to be pushed through in the noughties.

In case of the EPU, the lack of these foundations is even more fundamental than in the case of EMU or EBU. EPU has no political legitimacy and is losing any potential future legitimacy on a daily basis. EU institutions and even the core ideas of the later-stages EU (EMU, Fiscal Compact, 6+2 Pack packages of legislation etc) are deep under water when it comes to popular mandates. All Eurobarometer surveys show rising dissatisfaction across the EU with the European institutions, including the common currency. The two words 'democratic deficit' that were present in the European politics prior to the crisis are now, probabilistically-speaking, dominate the popular and national discourse about Europe in every country of the Union, including the new Accession states. A popular mandate in Iceland has led to cancellation of the EU Accession talks this month.

Only doctrinaire Europhiles, and even then, predominantly within smaller countries' national elites, as exemplified by some members of Ireland's ruling coalition, today deny the presence of this deficit at the fundamental level across all European institutions.

There is also a major problem of Europe's 'capability deficit'. Brussels - full of (mostly) men in suits with offices to go to after lunch is hardly a source for inspiration or for leadership. And absent inspiration, perspiration does not work all too well. The entire European project lacks vitality, and thus - viability. There is no enthusiasm, no ideal, no dream. These were exhausted at the stages in the project history when 'peace between France and Germany' had meaningful referential counter-point (it no longer has, as no one sane enough would conjecture that absent the EU, Alsace will be once again dug into an anti-tank trenches giant washing board) or when the EU (brilliantly and correctly) was expanding the liberty of trade and freedom of movement across its internal borders. Absent purpose, leadership is wanting too. The void is filled with simulacra of bureaucrateese: the alphabet soup of 'programmes' such as ESM, EFSF, EFS, OMT, EBU, and so on, all the way until ordinary European gets lost in the world of corridors, meeting rooms, windowless conference venues, meaningless letters and mumbo-jumbo of various white papers, etc.

To confront these deficits, the EU is creating even more bureacrateese - papers, positions, plenaries, meetings, councils, pacts, compacts, conferences, agendas.

Amidst this, Europe still lacks a single face capable of holding its own in front of the electorate. Lacks, that is, on the 'federalist' or pro-EU side. There are rhetorically competent MEPs on the opposition side of the chamber, but there is not a single appointed or elected leader of the 'official' Europe capable of not putting to sleep at least half of his/her audience.

Europe has 4 'Presidents' today: President [of the Commission] Mr Jose Manuel Barroso, President [of the Council] Herman von Rompuy, President [of the Parliament] Martin Shulz, President [of the Eurogroup] Jeroen Dijsselbloem. Absent the latter one, not a single one have been known for talking straight on any hard issues. Including the latter one, none inspire many to anything akin the commitments and sacrifices required to achieve meaningful federalisation of the EU. All, with no exception, got their EU positions bypassing direct election by the voters of Europe. Power and responsibilities of each are directly proportional to the distance by which they are removed from the European electorate. When these levels of confusion and power politics dispersion are not enough, there's always a fifth President lurking around: the Head of the Presidency State. In Henry Kissinger's terminology, the question is not 'Who do you call when you want to speak to Europe?' can now be replaced by 'Who do you not call?' Latest G8 summit photos stood as a great exemplification of the problem: there amidst leaders of 8 nations stood three 'leaders' of Europe, not because they had anything to say, but because they had to be there to upstage one another.

The five-headed 'leadership' beast is now on a quest to 'increase democratic mandate' of the EU Commission. To do so, it is proposed that the blocks of parties shall be formed in the EU Parliament to 'nominate' the next Commission and its President. In other words, the EU leadership sees 'renewal' and 'democratic participation' as a function of optics. Dominant blocks of largely sclerotic national-level parties will be dominating the EU legislature and executive to simply replicate the stasis that has captured national political platforms of the main EU states: Germany, France, Italy and Spain. Effective opposition will remain impossible, just as it remains today, but the fig leaf of 'more direct' ('slightly less-managed') democracy will act to cover this up from, hopefully, oblivious or satisfied electorates.

Thus, by design from above (not by will from below), the EU is supposed to move toward a two-party system, replicative of the traditional core parties of the national politics: the centre-left with a clientilist base in unions, state employees and 'social pillars' - the 'social democratic centre'; and the centre-right with a clientilist base of 'employers confederations' and state managers - the 'populist & conservative movements'.

The dynamism of such a system will be equivalent to the excitement of a turtles race on sticky putty. Or differently, a two-party system will do for the political leadership what the Euro did for the monetary policy - put a straightjacket of superficial conformity onto the society that for centuries was based on differentiation-driven boundaries and nation states.

Both demographic and socio-economic changes from the 1945 through today, in Europe as elsewhere, have meant emergence of more diversity and differentiation in markets for everything, starting with simple products, such as diapers to complex services, such as healthcare. To assume that politics and ideologies can remain in the stasis of the two, adjoining at the centre and even overlapping, sets of ideals and policies is about as naive and counterproductive as it was to assume that Greece and Finland, or Latvia and Portugal, can be brought into single currency within a span of one/two decades.

There are three key ingredients that are required to sustain two-party system: 1) stability of ideological preferences (informed by popular objectives for policy), 2) allegiance to the single unifying institution of the state overriding local/national/ethnic or even more atomistic allegiances and interests, and 3) organic evolution of the two-party system (usually out of the bifurcating economic power balance, such as land-owners vs capital owners, workers vs capital owners etc).

Modern world, especially the world of Europe, does not support either one of these preconditions. Current conflicts and, thus, incentives lines are drawn across generations; skills groups; risk-taking capabilities and preferences of populations; national and even sub-national distinctions; ethnic, historical and cultural differences and grievances; external threats that range across a very wide spectrum from immigration from the South to hegemonic threat from the East, to cultural threat from the West, and so on. Two ideologies can never capture this diversity, let alone provide a sufficient basis for forming participatory democratic institutions. Look no further than internal nation states' dynamics in the UK (Scotland, Norther Ireland, Wales), Italy (North, South, East), Spain (Centre, North-East, North-West), Belgium, and recall the fate of Czechoslovakia, Yugoslavia. Look at the emergence of challengers to the two-party systems in all European states - never quite capable of displacing one of the parties of the 'old' system, but always present, reflective of the ongoing process of atomisation, or rather customisation of politics.

At the same time, with hundreds of millions spent on propagandising the concept of European citizenship, Europeans remain in deep allegiance to their nation-states, and in many Federal states - to their local 'tribes'. In fact, the EU has been recognising this and reinforcing the locally-anchored distinctions. Culturally, everyday life matters more to the majority of Europeans today that the 'geopolitical' aspirations of Brussels. And culturally, we are living in an increasingly 'goo-cal' world, where trade delivers to us goods and services from all over the world, but we identify ourselves on the basis of goods and services that are local in origin.

In the countries, where two-party system seemingly is stable - e.g. the US and the UK - underneath the surface, the fact that the two-party system fails to capture sufficient percentage of population in an ever-increasingly individualised world is also evident. It is expressed in the stalemate produced by the system where mainstream parties are captive to small minorities of activists and are often torn internally by sub-groups and sub-interests.

Lastly, the two-party system of ideological debate has been shown inadequate in the face of the current crisis.

Looking forward, this failure is extremely significant. In order to work, compared to today's EU, the EPU must be either comprehensive or devolved. On the latter, see below. The former requires significant transfer of power and power base to the EU, implying ca 20% of GDP-sized Federal Government, dominant power of taxation, harmonisation of core public services, such as health, social security, pensions, education. The member states will be allowed some 'gold-plating' of the Federally-set standards, but the standards will have to be set nonetheless. The reason for this is that in a real Federal Union, there will be a functional Transfer Union and that implies standardisation of services funded by transfers. A two-party system will never be able to break away from the sub-national political bases sufficiently enough to deliver such homogenisation.


If European federalism is to evolve, it will have to evolve on the basis of accommodating more diversity, not by homogenising the system by reducing differentiation and fragmentation of the political institutions. It will have to adopt market-like features where turnover of ideas is fast, deployment of solutions (goods and services) is rapid and never permanent, and the system thrives on diversity. This is the exact opposite of the harmonisation and consolidation implicit in traditional federalism, but is rather more consistent with Swiss federalism. The key to this form of federalism is that it severely limits the central powers of taxation and redistribution of resources and vests powers of policy origination, design and implementation in local hands. It also acts to encourage policy heterogeneity - an added bonus in the world of uncertainty, as it allows for creation of policy hedges: a shock impacting different systems differently necessarily shows both the pitfalls and the strengths of various institutions and regulations. In other words, Europe needs less of European centralisation and more of European diversity.

Before this can be delivered, however, Europe needs to systemically dismantle or reduce those institutions that act as an impediment to bottom-up governance - the institutions of centralisation of power.

The first for a review should be the strictest of them all - the euro. Here, the required change will see assisted exits from the euro of non-core states, leaving behind only those countries for which monetary harmonisation makes sense. Most likely these are Germany, Finland, Czech, Austria, and possibly Belgium and the Netherlands. Other countries can revert to their own currencies and/or run open currency system with euro remaining one of the legal tenders in their economies. Belgium and Luxembourg can run in a union with France, if so desired.

The second candidate for restructuring will be the EU Commission. The President of the Commission should be elected on the basis of direct vote with state-based 'electoral' voting system similar to that of the US, to alleviate extremes of population-weighted distribution of votes. The President then can appoint her/his own Commission on the basis of: (1) each member state must be represented in the Commission, (2) Commission candidates can be nominated by member states, the EU Parliament and the President, (3) each member is confirmed independently by the EU Parliament and the Senate.

The third candidate for reform is the EU legislature. The European Parliament should be augmented by the independent, separately elected Senate, based on member states' representation principle and vested with the powers similar to that of the US Senate. The Senate should be directly elected and it should replace the current Council. To strengthen direct links between nation states and the Senate, the formal leaders of the nation states (e.g Italian and Irish presidents) should serve as senators representing their states.

The fourth candidate for reform should be the system of European checks and balances. This should, among others, include a Constitutional ceiling on taxation and redistribution powers.


There are other reforms that will be required. This is hardly a place to attempt to narrate them all. However, the key principle is that the EU needs a drastic reconstruction of its upper levels of legislative and executive powers. And the key question that is yet to be asked and debated (a necessary pre-condition to deriving any solutions) is whether the proposed EPU (and to a less important extent, the proposed EBU) stand a chance of working out any better than the failing EMU?

6/5/2013: Self-contradictions & EU Commission

Trapped in their own failures, EU 'leaders' are no longer simply contradicting each other - they are now contradicting themselves. And, I must add, via ever more apparent and bizarre statements.
Behold the latest instalment of absurdity from one of the multiple EU 'Presidents': the man in charge of the EU economic policies and performance, European Commission chief Jose Manuel Barroso. As reported in the EUObserver (http://euobserver.com/economic/120040), Mr Barroso stated that "What is happening in France and Portugal is not Merkel's or Germany's fault … The crisis and their problems are not a result of German policy or the fault of the EU. It is the result of excessive spending, lack of competitiveness and irresponsible trading in the financial markets."
Thus,

1. Loose monetary policy by the ECB that was custom-tailored to suit German needs during 2002-2007 period had nothing to do with the crisis in the peripheral states, despite the fact that it triggered vast inflows of capital from Germany (and other core states) into the euro area periphery, inflating assets bubbles left, right and centre, and leading to unsustainable debt accumulation in these economies.
2. ECB (heavily influenced by German ethos and political economy) and EU Commission and regulatory bodies' insistence on treating all sovereign bonds issued by the euro area states as risk-free assets on banks balance sheets (the main trigger for Cypriot crisis and the reason for massive transfers of banking sector costs onto taxpayers in Ireland and other member states) had nothing to do with Berlin or with Berlin's insistence on closing its eyes on what was happening in regulation / enforcement EU-wide.
3. Berlin's inability to reign in German (among other) banks' gross misplacing of risks in interbank lending to other euro area banks had nothing to do with the crisis.
4. Berlin's insistence, repeated parrot-like by Mr Barroso and his colleagues in the Commission, that the whole crisis can be addressed via fiscal adjustments (recall, that was the position the EU Commission occupied for the last 6 years) and current account rebalancing has nothing to do with mis-shaped economic policy responses across the EU since 2008 crisis onset.
5. Berlin's 'guidance' toward internecine and economically illiterate Fiscal Compact, eagerly endorsed by Mr Barroso and his colleagues in recent past, has nothing to do with the failure of Europe to respond to the crisis.
6. Berlin's opposition to the half-baked EU ideas about stimulating growth in euro periphery that shut the door on any real stimulus has nothing to do with the crisis.
7. Berlin's opposition to increasing domestic demand and abandoning contractionary pursuit of current account surpluses, also noted by Mr Barroso's Commission in the past, had nothing to do with the crisis duration or depth.

Mr Barroso also claimed that Chancellor Merkel is "one of the only [leaders], if not the only leader at the European level who best understands what is going on."

Really? Suppose so. In this case, Mr Barroso has either no clue what is going on, or simply doesn't care to be consistent with his own exhortations of the recent past, because he openly and directly contradicted Ms Merkel couple of weeks ago by claiming that 'austerity was overdone' and had "reached its limits."

Irony has reached so far in Mr. Barroso's waltzing across the ideological & economic policy landscape that according to the EU's 'President', Ms Merkel's brilliance also encompasses the fact she is presiding over German economy currently sliding toward a recession. IMF analysis shows real GDP growth in Germany will fall from 4.024% and 3.096% in 2010 and 2011 to 0.865% and 0.613% in 2012 and 2013. This might be better-than-average record for the euro area, but it is hardly an achievement worth praising.

Someone should point to Mr Barroso that eating one's cake (taking a populist position against austerity, and thus Ms Merkel) and having it (taking an appeasing position toward the major architect of all economic policy blunders so far deployed in Europe since the onset of the crisis) is just something that doesn't happen outside the make-belief world of Brussels.

25/4/2013: IMF's 'End of Austerity' Napkin Sketch Is Soggy Wet

IMF catches up with 'End Austerity' bandwagon and overtakes the EU 'policymakers' in providing a general blueprint. From today's comments by IMF First Deputy Managing Director David Lipton (emphasis is mine):

"...Europe needs to act on several fronts. Countries will need to have clear and specific commitments to medium-term fiscal consolidation, with the appropriate pace to be evaluated on a case-by-case basis. Careful consideration should also be given to the composition of fiscal measures. The European Central Bank (ECB) should maintain its very accommodative stance, he said, but noted that eliminating financial fragmentation – whereby households and companies in some countries face clogged credit channels and lending rates well above those in the core – will probably require the ECB to implement some “additional unconventional measures.”

So the Fiscal Compact of 'One Policy Target & Timeframe Fit All' is out of the window then? If timeframe (pace) were to be set on a case-by-case basis, there is hardly any real discipline left. Here's why. Suppose Italy takes slower path to deflating debt levels to the target of 60% than that mandated by the Fiscal Compact (FC) (5% adjustment per annum). France, then, can demand either a slower pace for its drawdown of debt or it can opt to demand slower reductions in deficits. Which means Spain will also have its list of requests ready, all in breach of the FC.

"As we see it, countries that can afford to support the economy need to do so—but in ways that encourage the private sector to invest and boost demand..."

Ok, but what does it mean? AAA countries borrowing to stimulate? Suppose they succeed. What happens to growth rates and income levels in Euro area? Right - divergence will be amplified and with it, mismatch of monetary and FX policies too. 

Per paying attention to the composition of fiscal measures: it is a fine objective. Except in the case of European leaders, this means, usually, hiking taxes even more instead of cutting spending. IMF knows that this is counterproductive, but whilst correctly arguing that policies should be reflective of heterogeneity between member states' economies, IMF is incorrectly ignoring the political reality of Europe, where more spending = good, lower taxes = bad.

More: "Another country responsibility is better structural policies. Countries should press on to tackle long-standing rigidities in order to raise medium-term growth prospects. Southern Europe, and even some of the core, needs to increase its competitiveness in the tradeable goods sector, especially through labor and product market reforms. So far, much of the reduction in current account deficits has come because demand is sluggish.  For a stronger, sustained improvement -- enough to boost exports that will create jobs for the unemployed -- countries need a broader and more durable improvement in competitiveness, based on structural reform. In Northern Europe, even where national competitiveness is not the issue, reforms could help generate a more vibrant services sector."

Again, usual tool kit deployed by the IMF: structural reforms are needed (no real innovation as to what these might be) and exports must be increased (who will be buying these exports in the world where every country is being told by the IMF to increase its exports?).

I wonder why would Mr Lipton label ECB current stance as being accommodative. ECB interest rate is above G7 average and ECB's 'panacea' of OMT is yet to make any real purchases. ECB has attempted to sterilise all past 'accommodative' interventions and is now pleased with winding up LTROs. In brief, setting aside war-time rhetoric from the ECB, Frankfurt is accommodating very little.

One has to agree with the need to eliminate financial fragmentation, but IMF is fully aware that European system will have to continue deleveraging. There is too much debt in the pipeline to de-clog it by simply pushing through more credit at lower cost.

"...the Single Supervisory Mechanism [is] “a key step” and ...the IMF supports a market-based bail-in approach as being considered in the European Union Directive on Bank Recovery and Resolution, which would require banks to hold a minimum amount of securities with features that permit them to be written-off or converted to equity if capital buffers fall too low..."

So getting Cyprused is  the future for Europe, then.

Mr Lipton is dead on right, saying that "In our preoccupation with sovereign debt, we tend to overlook the huge overhang of private debt in some countries that could be a deadweight on demand and bank balance sheets for a long time. We’ve already seen the hit that households have taken in the periphery economies because of the sharp correction in home prices (e.g. Ireland). This could only worsen without renewed growth (e.g. Spain, Belgium and the Netherlands)." And more: "On the corporate side, we know how much the level of debt has increased over the past decade, particularly in the periphery. We elaborated on this development in our recent Global Financial Stability Report.  ...Measured on a debt-to-equity basis, a portion of Italy's corporate sector is rising into stressed levels. In the event of a prolonged stagnation, corporate profits would slacken further, putting pressure on companies to deleverage and increasing the risk of debt distress. Corporates are not being helped by bank retrenchment back into home markets. This is most pronounced from the periphery; French and German banks reduced their exposures to these markets by some 30-40 percent between mid 2011 and the third quarter of last year."

Conclusion (relevant to 'being Cyprused' above): "None of this bodes well for banks in a stagnation scenario. They are already weak. But higher levels of corporate and household defaults and credit losses would threaten a second round of bank balance sheet deterioration."

Net result: IMF has no new ideas on what to do if 'austerity' path were to be altered. There's a good reason as to why they don't - borrowing cash to burn it on Government spending (traditional European way) is out of question, given the risk of raising costs of borrowing, slow growth and higher interest bills that await. And using monetary policy to full extent is infeasible because IMF has no hope for ECB in its current state.

'Austerity' might be overdone, but 'Not Austerity' is unlikely to be any different...