25/2/2013: When 8 out of 10 economists agree?

Eurointelligence today published a neat summary of some of the prominent economists' opinions about the Euro area macroeconomic policies:


"Motivated by the recent controversy between Olli Rehn and economic analysists critical of austerity (including from the IMF), El Pais garners the opinions of 10 prominent economists on whether the European Commission is to blame for Europe's poor economic prospects. ... Some quotes:

• Paul de Grauwe says: "the EU authorities are responsible for the recession … the Eurozone's macroeconomic policy is a disaster"
• James Galbraith says: "the Commission's leadership seems to work in an alternate reality, indifferent to the consequences of its policies"
• Luis Garicano says: "Brussels is incomprehensibly dogmatic [and] neglects the probability of a serious accident"
• José Manuel González-Páramo says: "in a way we're all responsible for the recession … The Commission's proposals are advanced and forward-looking"
• Paul Krugman blogged "these people have done terrible damage and stll have the power to continue"
• Desmond Lachman says: "The Commission was very slow to draw the conclusion that the IMF did: excessive austerity with the Euro as straitjacket is counterproductive"
• Jonathan Portes says: "The optimistic conclusion is that [Rehn] is admitting the justifications for austerity are crumbling"
• Dani Rodrik says: "The Commission has been fooling itself with the illusion that the structural reforms it spouses can stimulate the economy in the middle of an activity plunge made worse by austerity measures"
• Guntram Wolff says: "Considering all the constraints the Commission is subject to, it's adopted generally adequate policies, trying to strike a balance between fiscal consolidation and supporting the economy"
• Charles Wyplosz says: "The Commission makes politically correct forecasts knowing full well they will have to appear surprised when they are not fulfilled."

Paul Krugman also labeled Olli Rehn “the face of denialism”. According to Kurgman, the recent declines in sovereign spreads was due to the LTRO and OMT, and "while unit labour costs have converged a little, they have only converged by a fraction of what needs to be done".

Kevin O’Rourke via the Irish economy blog: “You might have thought that the disastrous but wholly unsurprising eurozone GDP numbers indicate that the bloc is in a bad way, and will continue to be so until the current macroeconomic policy mix is jettisoned. Happily, Olli “Don’t mention the multiplier” Rehn has good news for us: The current situation can be summarised like this: we have disappointing hard data from the end of last year, some more encouraging soft data in the recent past and growing investor confidence in the future. Thank goodness for that.”

I find it very interesting that virtually not a single of the above quotes, save for Krugman's passing reference to labor costs, distinguishes between the necessary structural reforms and pure, brutish, line-across-the-sky cuts that have been adopted by the EU. And even Krugman's references is hardly sufficient - labor costs in and by themselves are not and should not be the target for structural reforms. Instead, market structure, institutional competitiveness, cartel-like structure of some protected sectors, legal systems, moral hazard and other aspects of the crisis should be.

Oh, and lets face it - the drive toward 'austerity' is not only the job of the EU Commission, but also of the EU Parliamentarians (link here), plus all the nation states that adopted the Fiscal Compact.

Olli is nothing more than a mouthpiece for the consensus policies that are continuing to transfer economic crisis burden from the elites to the real economy.

23/1/2013: IMF WEO Update: Euro Area snapshot

In the previous post (link here) I have looked at the headline numbers from the IMF revision to their World Economic Outlook. Now, a quick summary for the Euro area:


"The euro area continues to pose a large downside risk to the global outlook. In particular, risks of prolonged stagnation in the euro area as a whole will rise if the momentum for reform is not maintained. Adjustment efforts in the periphery countries need to be sustained and must be supported by the center, including through full deployment of European firewalls, utilization of the
flexibility offered by the Fiscal Compact, and further steps toward full banking union and greater fiscal integration."

To summarise the forecasts and their revisions:

The above clearly show that the euro area remains the weak point for global growth and that this picture is likely to continue in 2013 and 2014. More importantly, the revisions since October 2012 show that the IMF pessimism about the euro area growth prospects is getting deeper, compared to other economies.

Time stamp

4/12/2012: Irish Exchequer Returns Jan-Nov 2012

So 2013 Budget will be expected to deliver 'cuts' and 'revenue measures' to bring fiscal stance €3.5 billion closer (or so the claim goes) to the balance. Which prompted the Eamon Gilmore to utter this:
"It is the budget that is going to get us to 85% of the adjustment that has to be made, and will therefore put the end in sight for these types of measures and these types of budgets".

Right. €3.5 billion will be added to the annual coffers on expectation side comes tomorrow. €3 billion will be subtracted on actual side comes March 2013 for the ritual burning of the promo notes repayments, and IL&P - the insolvent zombie bank owned by the state - will repay €2.45 billion worth of bonds using Government money comes second week of January. I guess, something is in sight, while something is a certainty-equivalent. €3.5 billion 'adjustments' vs €5.5 billion bonfire.

Six years into this shambolic 'austerity heroism' and we are, where we are:

1. On expectations forward, the Government will still have fiscal deficit of 7.5% of GDP in the end of 2013, should Gilmore's 'end in sight' hopes materialise. That is set off against pre-banks measures deficit of 7.3% in 2008. In fact, the 'end' will not be in sight even into 2017, when the IMF forecasts Irish Government deficit to be -1.8% - well within the EU 3% bounds, but still consistent with Government overspending compared to revenues.
2. Overall Government balance ex-banks supports in Ireland in 2012 will stand around 8.3% of GDP. In 2013 it is expected to hit 7.5% of GDP. The peak of insolvency was 11.5% of GDP in 2009, which means that by 2013 end we have closed 4 percentage points of GDP in fiscal deficits out of 8.5 percentage points adjustment required for 2009-2015 period. In Mr Gilmore's terms, we would have traveled not 85% of the road, but 47% of the road.

But wait, there's more. Here's a snapshot of the latest Exchequer returns for January-November 2012:

• Government tax revenue has fell 0.5% below the target with the shortfall of €171 million and although tax revenues were €1.96 billion ahead of same period (January-November) 2011, stripping out reclassifications of USC and the delayed tax receipts from 2011 carried over to 2012, this year tax receipts are running up 4.5% year on year.
• Keep in mind that target refers not to the Budget 2012 targets, but to revised targets of April 2012. 
• Meanwhile, Net Voted Government Expenditure came in at 0.6% above target. 
• So in a sum, on annualized basis, expenditure running 1.03% ahead of projections and revenue is running 0.86% below target. All of the sudden, the case of 'best boy in class' starts to look silly.

Things are even worse when you look at the expenditure side closer.

• Total Net Voted Expenditure came in at €40,635 million in 11 months through November 2012, which is €26 million above last year's, and  is 0.6% ahead of target set out in April. In other words, Ireland's heroic efforts to contain runaway public sector costs have yielded savings of €26 million in 11 months through November 2012.
• All of the net savings relative to target came in from the Capital side of expenditure, which is 20.5% below t2011 levels(-€629 million). Now, full year target savings on capital side are €562 million, which means that capital spending cuts have already overcompensated the expenditure cuts by €67 million. 
• On current expenditure side things are much worse. Relative to target, current spending is running at +1.7% (excess of €654 million). It was supposed to run at -1.6% reduction compared to 2011 for the full year 2012, but is currently running at +1.6% compared to Jan-Nov 2011. The swing is over €1.2 billion of overspend.
• Recall that in 2011 Irish Government expropriated €470 million worth of pensions funds through the 0.6% pensions levy in order to fund its glamorous Jobs Initiative. It now has cut €629 million from capital spending budget or €405 million more than it planned. In effect, thus, the entire pensions grab went to fund not Jobs Initiative, but current spending by the state.
• The savage austerity this Government allegedly unleashed saved on the net €26 million in 11 months. Pathetic does not even begin to describe this policy of destroying the future of the economy to achieve effectively absolutely nothing in terms of structural adjustments.
• The overspend took place, predictably, and at least to some extent justifiably by Health and Social Welfare. However, two other departments have posted excess spending compared to the target: Public Expenditure & Shambles-- err Reforms -- posted excess spending overall, while Transport, Tourism and Sport has managed to overspend on the current spending side of things.

On the balance side of things, stripping out banks measures and capital cuts, but retaining reclassifications of revenues and carry-over of revenues from 2011 into 2012, overall current account balance deficit was €9.626 billion in 2012, contrasted by the deficit of €9.712 billion in 2011. This suggests that the Government has managed to reduce the deficit on current account side by €86 million,

Laughable as this sounds, stripping out carry over revenues from 2011, the deficit on current side of the Exchequer finances was €9.45 billion in 2011 and that rose to €9.97 billion in 2012. Which means that the actual current account deficit is not falling, but rising.

Now, let's control for banks measures:

• In 2011 Irish state spent €2.3 billion bailing out IL&P, plus €3.085bn repaying promo notes for IBRC and €5.268bn on banks recaps. Total banks contribution to the deficit was thus €10.653 billion, This implies that overall general government deficit ex-banks was €10.716 billion in 2011.
• In 2012 we spent €1.3 billion propping up again IL&P (this time - its remnants) which implies ex-banks measures deficit of €11.668bn
• Wait a second, you shall shout at this point in time - 2012 ex-banks deficit is actually worse, not better than 2011 one. And you shall be right. There are some small items around, like our propping up Quinn Insurance fallout cost us €449.8mln in 2012 and only €280mln in 2011. We also paid €509.5 million (that's right - almost the amount the Government hopes to raise from the Property Tax in 2013) on buying shares in ESM - the fund that we were supposedly desperately needed access to during the Government campaign for Fiscal Compact Referendum, but nowadays no longer will require, since we are 'regaining access to the markets'. We also received €1.018 billion worth of cash from our sale of Bank of Ireland shares in 2011 that we did not repeat on receipts side in 2012. And more... but in the end, when all reckoned and counted for, there is effectively no real deficit reduction. Nothing dramatic happened, folks. The austerity fairy flew by and left not a trace, but few sparkles in the sky.
• Aside note - pittance, but hurtful. In 2012 Department for Finance estimates total Irish contributions to the EU Budget will run at €1.39 billion gross. For 2013 the estimate is €1.444 billion. That is a rise of €59 million. Put this into perspective - currently, the Government has run away from its previous commitment to provide ringfenced beds for acute care patients at risk of infections, e.g. those suffering from Cystic Fibrosis. I bet €59 million EU is insisting this insolvent Government must wrestle out of the economy to pay Brussels would go some way fixing the issue.

In the mean time, our interest payments on debt have been steadily accelerating. In January-November 2011 our debt servicing cost us €3.866 billion. This year over the same period of time we spent €5.659 billion plus change on same. Uplift of 46.4% in one year alone.

So here you have it, folks. This Government has an option: bring Irish debt into ESM, for which we paid the entrance fees, and avail of cheap rates. Go into the markets and raise the cost of funding our overall debt even higher - from €6.17bn annual running cost in 2012 to what? Oh, dofF projects 2013 cost to be €8.11 billion - a swing of additional €1.94 billion. So over two years 2012 and 2013, Irish debt servicing costs would have risen by €3.89 billion swallowing more than 1/2 of all fiscal 'adjustments' to be delivered over the same two years.

At this stage, there is really no longer any point of going on. No matter what this Government says tomorrow, no matter what Mr Gilmore can see in his hazed existence on his Ministerial cloud cuckoo, real figures show that Europe's 'best boy in class' is slipping into economic coma. 

16/8/2012: Financial Repression - Round 2

Financial repression continues to gain speed in Ireland: link here.

Basic idea: having raided actual pensions funds, the Irish Government is to issue special annuities (priced accordingly to reflect State's 'grudging acceptance' for now of the pensions tax break) for insurance and pensions providers.

The good part of the idea is, as Fitch points in the note, added funding stream for the Government.

The bad parts are, as Fitch does not bother to note:

• Deleveraging economy means that funds will be taken out of the already diminished private investment stream, should the annuities be successful in raising such funds;
• Risks of claims exposure to Ireland for Ireland-based providers will now be amplified by more assets tied to Ireland (de-diversification);
• The new funding is debt, priced more expensively than what we can avail of from the Troika programme and subsequently from the ESM (at least access to and the cheapness of the ESM funds was the Government-own rationale for convincing the voters to back the Fiscal Compact earlier this year - something that the rating agencies have confirmed, as I recall);
• The new funding is still debt, which means that the new 'source' is not going to help restoring Irish public finances to sustainability path;
• Payments on these annuities will be subject to the same seepage out to imports (consumption of recipient households) as any other income and thus will have lower impact on our GDP, and an even worse impact on our GNP, than were the annuities structured using foreign governments' bonds;
• Share of the Irish state liabilities held by domestic investors will rise, which automatically implies riskier profile for both: Exchequer future funding and pensions;
• The latter (pensions funding risk profile deterioration) will also induce higher expected value of future unfunded liabilities (basically, as risk of pensions funding rises, probability of claims on state in the future to fund public pensions rises as well), and so on.

But, hey, why would the Irish State bother with any of these concerns when they've found another quick fix to €3-5 billion of our cash?

And on a more macro level, financial repression is back on the EU agenda too. The latest spike in French rhetoric about the need for 'own-funding' of the EU operations (link here) is just that, have no doubt. The idea is to give EU some central taxation powers so, as claim goes, it reduces the 'burden' on national governments. So far so good? Not exactly. Neither the French, nor any other Government in Europe at this stage is planning to 'rebate' (or reduce) internal tax burdens to compensate for EU new tax burden. In other words, the Governments ill simply pocket the 'savings'. Which, to put it simply, means the new 'powers' will simply be new taxes for the already heavily over-taxed and recession-weakened economies of Europe.

All in the name of deleveraging the State at the expense of the real economy. And that is exactly what the financial repression is all about.

Updated: And just in case we need more 'creative' thinking, here's an example of financial suppression: It turns out Nama (Irish State Bad Bank - don't argue that SPV thingy, please) should use public purse to suppress normal price discovery processes in Irish property markets. Right... you really can't make this up. Irish elites are now so desperate for relevance, they are fishing that Confidence Genie anytime anyone is feigning some attention to what they have to say.

23/6/2012: Sunday Times 10/6/2012

This is an unedited version of my Sunday Times article from June 10, 2012.

Last week, the Irish voters approved the new Euro area Fiscal Compact in a referendum. This week, the Exchequer results coupled with Manufacturing and Services sectors Purchasing Manager Indices have largely confirmed that the ongoing fiscal consolidation has forced the economy into to stall. Irish economy’s gross national product shrunk by over 24% on the pre-crisis levels and unemployment now at 14.8%. The most recent data on manufacturing activity shows a small uptick in volumes of production offset by significant declines in values, with profit margins continuing to shrink. Deflation at the factory gates is continuing to coincide with elevated inflation in input prices. In Services – accounting for 48 percent of our private sector activity – both activity and profitability have tanked in May. The Exchequer performance tracking budgetary targets is fully attributable to declines in capital investment and massive taxation hikes, with current cumulative net voted expenditure up 3.3% year on year in May.

On the domestic front, the hope for any deal on bank debts assumed by the Irish taxpayers, one of the core reasons to vote Yes advocated by the Government in the Referendum, has been dented both by the German officials and by the ECB. Furthermore, on the domestic front, the newsflow has firmly shifted onto highlighting the gargantuan task relating to cutting our deficits in 2013-2015 and the problem of future funding for Ireland.

Per April 2012 Stability Programme Update, Ireland’s fiscal consolidation path will require additional cuts of €5.55 billion over the next three years and tax increases of at least €3.05 billion. Combined, this implies an annual loss of €4,757 per each currently employed worker, equivalent to almost seven weeks of average earnings. This comes on top of €24.5 billion of consolidations delivered from the beginning of the crisis through this year. The total bill for fiscal and banking mess, excluding accumulated debt, to be footed by the working Ireland will be somewhere in the region of €18,309 per annum in lost income.

This has more than a tangential relation to the Government’s main headache – weaselling out of the rhetorical corner they put themselves into when they solemnly promised Ireland’s ‘return to the markets’ in 2013 as the sole indicator for our ‘regained economic sovereignty’.

Even assuming the Exchequer performance remains on-target (a tall assumption, given the headwinds of economic slowdown and lack of real internal reforms), Ireland will need to raise some €36 billion over 2013 and 2014 to finance its 2014-2015 bonds rollovers and day-to-day spending. In January 2014 alone, the state will have to write a cheque for €8.3 billion worth of maturing bonds. The rest of 2014 will require another €7.2 billion of financing. Of €36.5 billion total, €19.3 billion will go to fund re-financing of maturing government bonds and notes, plus €6.9 billion redemptions to Troika. Rest will go to fund government deficits.

At this stage, there is not a snowball’s chance in hell this level of funding can be secured from the markets, given the losses in economy’s capacity to pay for the Government debts. Which means Ireland will require a second bailout. And herein lies the second dilemma for the Government. Having secured the Yes vote in the Referendum of the back of scaring the electorate with a prospect of Ireland being left out in the cold without access to the ESM, the Government is now facing a rather real risk that the ESM might not be there to draw upon. In fact, the entire Euro project is now facing the end game, which will either end in a complete surrender of Ireland’s economic and political sovereignty, or in an unhappy collapse of the common currency.

The average cumulative probability of default for the euro area, ex-Greece, has moved from 24% in April to 27.5% by the end of this week. For the peripheral states, again ex-Greece, average cumulative probability of default has risen from 45% to 52%.

Euro peripherals, ex-Greece: 5-year Credit Default Swaps (CDS) and cumulative probability of default (CPD), April 1-June 1

Source: CMA and author own calculations

These realities are now playing out not only in Ireland and Portugal, but also in Spain and Cyprus.

Spain has been at the doorsteps of the Intensive Care Unit of the euro area for some years now. Yet, nothing is being done to foster either the resolution of its banking crisis, nor to alleviate the immense pressures of it jaw-dropping 24.3% official unemployment rate. Deleveraging of the banks overloaded with bad loans has been repeatedly pushed into the indefinite future, while losses continue to accumulate due to on-going collapse of its property markets. At this stage, it is apparent to everyone save the Eurocrats and the ECB, that Spain, just as Greece, Ireland and Portugal, needs not loans from the EFSF/ESM funds, but a direct write-off of some of its debts.

Spain’s problems are immense. On the upper side of estimated demand for European funds, UBS forecasts the need for €370-450 billion to sustain Spanish banking sector and underwrite sovereign financing and bonds roll-overs. Mid-point of the various estimates is within the range of my own forecast that Spanish bailout will require €200-250 billion in funds, a move that would increase country debt/GDP ratio to 109.9% in 2014 from current forecast of 87.4%, were it to be financed out of public debt, as was done in Ireland or via ESM.

Overall, based on CDS-implied cumulative probabilities of default, expected losses on sovereign bonds of the entire EA17 ex-Greece amount to over €800 billion, or well in excess of 160% of the ESM initial lending capacity.

Europe is facing three coincident crises that are identical to those faced by Ireland and reinforce each other: fiscal imbalances, growth collapse, and a banking sector crisis.

Logic demands that Europe first breaks the contagion cycle that is seeing banking sector deleveraging exerting severe pressures and costs onto the real economy. Such a break can be created only by establishing a fully funded and credible EU-wide deposits insurance scheme, plus imposing an EU-wide system of banks debts drawdowns and debt-for-equity swaps, including resolution of liabilities held against national central banks and the ECB.

Alongside the above two measures, the EU must put forward a credible Marshall Plan Fund, to the tune of €1.75-2 trillion capacity spread over 7-10 years, with 2013 allocation of at least €500 billion. This can only be funded by the newly created money, not loans. The Fund should disburse direct monetary aid to finance private sector deleveraging in Spain, Ireland and to a smaller extent, Portugal. It should also provide structural investment funds to Greece, Italy and Spain, as well as to a much lesser extent Ireland and Portugal.

The funds cannot be allocated on the basis of debt issuance – neither in the form of national debts, nor in the form of euro bonds or ESM borrowings. Using debt financing to deal with the current crises is likely to push euro area’s expected 2013 debt to GDP ratio from 91% as projected by the IMF currently, to 115% - well above the sustainability threshold.

The euro area Marshall Plan funding will require severe conditionalities linked to long-term structural reforms. Such reforms should not be focused on delivering policies harmonization, but on addressing countries-specific bottlenecks. In the case of Ireland, the conditionalities should relate to reforming fiscal policy formation and public sector operational and strategic capabilities. Instead of quick-fix cuts and tax increases, the economy must be rebalanced to provide more growth in the private sectors, improved competitiveness in provision of core public services and systemic rebalancing of the overall economy away from dependency on MNCs for investment and exports.

Chart: Euro Area: debt crisis still raging

Source: IMF WEO, April 2012 and author own calculations

The core problem with Europe today is structural policies psychosis that offers no framework to resolving any of the three crises faced by the common currency area. Breaking this requires neither harmonization nor more debt issuance, but conditional aid to growth coupled with robust resolution mechanism for banking sector restructuring.

Box-out:

This week’s decision by the ECB to retain key rate at 1% - the level that represents historical low for Frankfurt.  However, two significant developments in recent weeks suggest that the ECB is likely to move toward a much lower rate of 0.5% in the near future. Firstly, as signalled by the euro area PMIs, the Eurozone is now facing a strong possibility of posting a recession in the first half of 2012 and for the year as a whole. Secondly, within the ECB governing council there have been clear signs of divergence in voting, with Mario Draghi clearly indicating that whilst previous rates decisions were based on a unanimous vote, this time, decision to stay put on rate reductions was a majority vote. A number of national central banks heads have dissented from previous unanimity and called for aggressive intervention with rate cuts. In addition, monetary dynamics continue to show continued declines in M3 multiplier (which has fallen by approximately 40 percent year on year in May) and the velocity of money (down to just under 1.2 as opposed to the US 1.6). All in, the ECB should engage in a drastic loosening of the monetary policy via unsterilized purchases of sovereign debt and cutting the rates to 0.25-0.5%, with a similar reduction in deposit rate to 0.25% to ease the liquidity trap currently created by the banks’ deposits with Frankfurt. The ECB concerns that lower rates will have adverse impact on tracker mortgages and other central bank rate-linked lending products held by the commercial lenders is misguided. Lower rate will increase banks’ carry trade returns on LTROs funds, compensating, partially, for deeper losses on their household loans.

21/6/2012: Few thoughts on G20 report on Euro Area

Joint G20 assessment of the euro area (emphasis and comments are mine):

"Efforts on several fronts  are still needed to build a stronger monetary union. Specifically: 

1. moving toward a pan-euro-area financial stability framework, which inter alia implies centralized powers in banking supervision and resolution, and common deposit insurance; [banking union, consistent with my view of what is required to shore banking sector, but absent a pan-European insolvency resolution regime, not sufficient condition for sustainable crisis resolution]
2. stronger fiscal integration, including national fiscal rules, as envisaged by the Fiscal Compact, complemented by fiscal risk sharing to ensure that economic dislocation in one country does not develop into a costly fiscal and financial crisis for the entire region; [Naive, or rather politically correct, statement. The Fiscal Compact can be expected to have any real effect on fiscal performance in the medium-long term. Precisely the time scale over which it will be most likely non-enforceable.]
3. structural reform to strengthen competitiveness and improve the  ability to adjust to shocks, including by a wage-setting mechanism that is more responsive to firm-level economic conditions, reducing labor market duality and in general barriers to hiring and firing, and lowering barriers to domestic and foreign competitions in product markets. [This is another weak policy orientation. Structural reforms are needed, beyond any argument, but these must start not from altering cost competitiveness but from creating institutional and operational platforms for entrepreneurship and investment. Europe lacks growth dynamics not because its labour costs are too high or there is a difficulty with hiring and laying off workers. These are important factors, but they are not primary ones. Europe lacks growth because the Governments take up 50% of the economy, because taxes are prohibitive to investment and jobs creation, consumption and saving, because the structure of European institutions favors incumbents over newcomers and thus retards fully social mobility and renewal.]

There is growing awareness among European policy makers to move along these lines and
active efforts are underway to build the necessary consensus."

Overall, G20 is still held hostage to:

1. Consensus policies represented by the IMF-think - of micro-fixing sub-structures of specific politically correct markets for inputs (labour) instead of focusing on the larger scale imbalances that lead to unsustainable expansion of the state over private sector opportunities and returns.
2. Politically correct 'non-interference' in specific solutions designed by the euro area - most visible in the acceptance of the Fiscal Compact framework as a 'sustainable' solution to the fiscal crisis.

I find it amazing that the G20 (or rather it is IMF who authored the document) is treating recent adjustments in the economic imbalances in the euro area as if it is something that is consistent with a functional adjustment.

"The global financial crisis has triggered a noticeable narrowing of external imbalances. As world trade collapsed, current account balances of deficit economies improved substantially—well in excess of what would have been expected given the fall in output based on standard trade elasticities (i.e., “residual” changes are large), despite a significant increase in interest costs on their external debt. Substantial demand compression following the collapse of credit, asset and housing booms and a decline in confidence in periphery economies, reinforced by fiscal consolidation, played an  important role in this wrenching adjustment. Many of the factors identified below as contributing to the imbalances—such as excessive optimism and easy financial conditions begetting consumption and construction booms—are out of the picture now. Hence, much of the adjustment observed so far is likely to be lasting."

Firstly, I agree that much of the adjustment outlined above is now engrained into consumer and investor behavior. Secondly, I disagree that the fiscal adjustments have been either significant or sustainable in the long run. Let us keep in mind that there is no decrease in government spending in 2011-2012. There is an increase. But what worries me most in the above is that the adjustments described would be consistent with the rates of growth into the future that are hardly sustainable given debt overhang. In other words, the environment of depressed consumer credit, consumer spending, high interest cost of capital, etc warrants growth expectation for euro area of 1-1.5 percent annually in real terms, if not lower. Working out debt of 90% to GDP (fiscal debt alone) and well in excess of 250% for the total debt at the above rates of growth, in my view, is simply not going to happen. Unless we are talking about double-digit inflation.

An interesting related chart: 

The above clearly shows how deep collapse of economy has driven 'improvements' in Irish external balance (purple area representing collapse in growth) and how our automatic fiscal policy destabilizers (income & transfers) have been a 'break' on the external balance improvements. (Note: I am not suggesting there is a positive value in driving income & transfers down, just observing the fact). As per my term of automatic fiscal destabilizers, here's the quote from the report:

"In some booming economies (e.g., Ireland and Spain), debt ratios declined, but given the extent to which ample fiscal revenues had been linked to unsustainable asset market developments, structural balances remained fundamentally weak. That weakness was unmasked by the crisis."

I'll blog on specific risk assessment report tomorrow, so stay tuned.

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

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

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

Short-term scenarios:

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

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

Longer-term scenarios: 

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

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

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

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

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

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

7/6/2012: Sunday Times May 13, 2012

This is an unedited version of my Sunday Times article from May 13, 2012.

With Greek and French elections results out last week, the European leadership is rapidly shifting gears into neutral when it comes to austerity. Within two weeks surrounding the French elections, the Commission has issued a set of statements pushing forward its ‘growth budget’, and issued new proposals for enhancing European investment bank.

This, of course, is a classic rhetoric of damage limitation, contrasted by the reality of the currency union that is in the final stage of the crisis contagion. Having spread from economic to financial and subsequently to fiscal domains of the euro area, the cancer of Europe’s debt overhang has now metastasised to its political leadership. And the financial pressures are back on. Since the late March, credit default swaps spreads have widened for all but two core euro area states (excluding Greece), with an average rate of increase of 10.6%, implying that the markets-priced cumulative probability of the euro zone country default within the next 5 years is now, on average, close to 24%.

Next stop is a period of extended navel-gazing, with summits and ministerial dinners, contrasted by the European electorate moving further away from the centre of power gravity.

By autumn we will be either in a selective euro unwinding (Greece exiting) or in a desperate policies u-turn into mutualisation of the national and banking debts, supported by a return to high pre-2011 deficits and an acceleration of the debt spiral.

The former is going to be extremely disruptive in the short run. Portugal will be watching the Greeks closely, while Spain and Italy will be sliding into unrest. If properly managed, Greek and, later Portuguese exits will allow euro area to cut losses. With a stronger ESM balancesheet, euro area will buy more time to deal with the markets panic, but it will still require serious structural adjustments to shore up the failing currency union. Mutualisation of debt will remain inevitable, but deficits run up can be avoided in exchange for slower reduction in deficits.

The latter option of starting with mutualising debt, while allowing for new deficit financing of growth stimuli will be a road to either a collapse of the common currency within a decade or a Japan-style stagnation. The central problem is that the current political dynamics are forcing the euro area onto the path of growth stimulation amidst a severe debt overhang. The lack of real catalysts for economic recovery means that a temporary stimulus will have to be replaced by sustained debt accumulation. In other words, the political cure to the crisis a-la Hollande, not the austerity, will spell the end of the euro zone.

There are two sides to this proposition.

Firstly, the villain of the European austerity is a bogey. In 2011-2012, euro area fiscal deficits will average 3.7% of GDP per annum, identical to those recorded in 2010-2014 and deeper than in any five-year period from 1990 through 2009, including the period covering the recession of the early 1990s. The ‘savage austerity’, as planned, is expected to result in historically high five-year average deficits. At over 3.2% of GDP, 2012 forecast deficit for the common currency zone will be 6^th largest since 1990.

Instead of shrinking, euro area governments over-spending will remain relatively static under the current ‘austerity’ path. Per IMF, general government revenues will account for 45.6% of GDP in 2011-2012, well ahead of all five-year period averages since 1990 except for 1995-1999 when the comparable figure was 46% of GDP. The same comparative dynamics apply to the government expenditure as a share of GDP.

In other words, euro area voters are currently revolting against the austerity that, with exception of Greece and Ireland, is hardly visible anywhere.

Secondly, the talk about Europe’s growth stimulus is nothing more than a return to the policies that have led us into this crisis in the first place. In 1990-1994, euro area public debt to GDP ratio averaged 59%. By 2005-2009, the average has steadily risen to 71%. In 2010-2014, the forecast average will stand at 89%, identical to the ratio in 2011-2012. Euro area is now firmly stuck in the policy corner that required accumulation of debt in order to sustain economic activity. Since the mid-1990s, the EU has produced one growth policy platform after another that relied predominantly on subsidies and public investment.

By the mid-2000s, the EU has exhausted creative powers of conceiving new subsidies, just as the ECB was flooding the banking system with cheap liquidity. At the peak of the subsequent sovereign debt crisis, in March 2010, Brussels came up with Europe 2020 document – yet another ‘sustainable growth’ scheme through featuring more subsidies and public investment.

At the member states’ level, private debt-fuelled construction and banking bubbles were superimposed onto public infrastructure investments schemes and elaborate R&D and smart economy bureaucracies as the core drivers for jobs creation. State spending and re-distribution were the creative force driving economic improvements in a number of countries. Amidst all of this, euro area overall growth remained severely constrained. For the entire period between 1992 and 2007, euro area real economic growth averaged less than 2.1% per annum, while government deficits averaged over 2.5%. The only three years when public deficit financing was not the main driver of growth were the peaks of two bubbles: 2000, and 2006-2007.

In brief, Europe had not had a model for sustainable growth since 1992 and it is not about to discover one in the next few months either.

Which brings us to the core problem facing the European leadership – the problem of debt overhang.

As a research paper by Carmen M. Reinhart, Vincent R. Reinhart and Kenneth S. Rogoff published last week clearly shows, “major public debt overhang episodes in the advanced economies since the early 1800s [were] characterized by public debt to GDP levels exceeding 90% for at least five years.” The study found “that public debt overhang episodes are associated with growth over one percent lower than during other periods.” Across all 26 episodes studied, “the average duration …is about 23 years.”

Now, according to the IMF data, the euro area will reach the 90% debt to GDP bound in 2012 and will remain there through 2015. Statistically, the euro area will be running debt levels in excess of 90% through 2017. Between 2010 and 2017, IMF forecasts that seven core euro area states will be facing debt to GDP ratios at or above 90%. Of the four largest euro area economies, Germany is the only one that will remain outside the debt overhang bound. Increasing deficits into such a severe debt scenario would risk extending the crisis.

After two years of half-measures and half-austerity, the euro as a currency system is now less sustainable. The survival of the euro (even after Greek, Portuguese and, possibly other exits) will depend on structural reforms, including change in the ECB mandate, political federalisation and fiscal harmonisation beyond the current Fiscal Compact treaty.

The real problem Europe is facing in the wake of the last week’s elections in Greece and France is that traditional European elites are no longer capable of governing with the tools to which they became accustomed over decades of deficits and debt accumulation, while the European populations are no longer willing to be governed by the detached and conservative elites. Not quite a classical revolutionary situation, yet, but getting dangerously close to one.

CHARTS: 

Box-out:

This was supposed to be a boom year for car sales as the threat of getting an unlucky ‘13’ stuck on your shiny new purchase for some years was supposed to spell a resurgence in motor trade fortunes. Alas, the latest stats from the CSO suggest that this hoped-for prediction is unlikely to materialise. In the first four months of 2012, new registrations of all vehicles have fallen 8.5% year on year and 60% on 2007. New private cars registrations have suffered an even deeper annual fall, down 10.2% year on year although since the peak they are down ‘only’ 56%. The news of the motor trade suffering is hardly surprising. Unemployment stuck above 14%, fear of forthcoming tax increases in the Budget 2013, plus the dawning reality that sooner or later interest rates (and with them mortgages costs) will climb sky-high are among the reasons Irish consumers continue to stay away from purchasing large ticket items. Cyclical consumption considerations are also coming into play. Over the last 4 years, Irish households barely replaced their stocks of white goods. Given the life span of necessary household appliances, the households are likely to prioritize replacing ageing dishwasher or a fridge over buying a new vehicle. Families compression with children returning back to parental homes to live and grandparents taking over expensive crèche duties are also likely to depress demand for cars. Lastly, there is a pesky consideration of the on-going deleveraging. Irish households have paid down some €36 billion worth of personal debts and mortgages in recent years. Still, Irish households remain the second most indebted in the Euro area. New cars registrations fall off in 2012 shows that in the end, sanity prevails over vanity and superstition, at the detriment to the car sales industry.