EU: Double or quits with a patchy safety net
This post is a quest contribution by Cees Bruggemans, Chief Economist of First National Bank.
How is this for an observation, indeed accusation?
“The stressed European Monetary Union was transformed into a drama where many scrambled to apportion blame for the dismantling of an illusion” (David Marsh, May 2011).
The dismantling of an illusion.
You don’t need to struggle through 300 pages of closely reasoned history to appreciate a few fundamental flaws and blunders in cooking up EMU (European Monetary Union).
Sounds like bye, bye, Euro, nice knowing you.
Many were skeptical from the very beginning, fifty years ago, that Europe could possibly be an optimal currency area. The bits were too divergent, there was no central backup system (fiscal) and there were no brains (political).
Henry Kissinger always wanted to know who he was supposed to phone in Europe. Who spoke for Europe? Cackling Rosy?
In their Presidential duel of 2008, Hillary and Barack wanted to know from Americans who they wanted to pick up the phone at 3am when the balloon went up, him or her?
Turned out to be him, and in the end she must have been very happy with that verdict, retrospection often bringing 2020 eyesight.
For Europe that problem is being solved as we speak. Probably not the elevated British Baroness. But do try Angela’s number when in town.
Indeed, Strauss-Kahn was on his way to Angela earlier this year when he was waylaid for six minutes that changed history (his, France, Europe, the world, something few can claim in six hot little minutes a la carte on the side).
In the olden days all roads led to Rome. Then for a while they led to Venice, Madrid, Amsterdam, London, even for a fleeting decade or two to Paris when Bony was doing the running, and in recent decades mostly to Washington.
But if doing Europe today, try Angela first. Much safer that way if you don’t want to get endlessly redirected.
Technically, EMU is fundamentally flawed and should not have been tried in its present configuration. Ultimately it was not a meeting of minds that could succeed.
It was a setup ready to fail, and duly did. Few saw it coming, but those who did knew how to study architectural drawings, realising from the beginning a few crucial things were missing or had good-naturedly (or very cynically) been overlooked.
Even so, out of 27 European Union (EU) members as many as 17 got into bed over a decade ago to create the Euro-Zone (EZ), in whose Monetary Union there was to be eventually one central bank (ECB), one currency (Euro) and one interest rate to cater for all eventualities (a refined form of torture as any corseted Lady will tell you).
But there was no backup except for a few loose words, promising good fiscal behavior and ensuring efficiency and good growth dynamics eventually assuring structural catch-up and convergence so that, like in WW2 convoys, the slow stragglers wouldn’t endanger the faster ships to the ever present submarine wolf packs.
It was literally like one of those eager bridegrooms who are prepared to promise anything as long as it hastens the proceedings so that they can get to the far more important things.
It used to be when a man’s word was his bond, and among mafia and similar folk this is apparently still so. But the words of politicians? They are meant to square circles that can’t be squared otherwise.
Reading about the proceedings in Maastricht back in 1991 makes one wonder what refined horse-trading has been happening at all those many summits these past two years?
Technically the Monetary Union idea was flawed from the beginning, unless some very stringent conditions were met, such as fiscal backup and reform to make the EZ17 member countries structurally more convergent.
But there was really none of that. Instead, the hope was expressed, if you go back to the templates of Valery und Helmut, and later Mitterrand and Kohl, that although political union wasn’t feasible then, at least the pressure of circumstance would make them hang together and in the end succeed in getting more needed structural convergence going to underpin the monetary union and its monetary institutions (ECB, Euro).
In other words, on a hope and a prayer.
With the EU peripherals succeeding in getting generous development funds allocated in return for not being too difficult in getting EMU consummated.
As we now know, pressure has suddenly been brought to bear on EMU and the EZ17, but catastrophically so, to the point where the technicians can only say “abort”, loudly echoed by markets and their financial interests.
If only it was that easy.
Like most divorces, this thing is messy, and like some divorces, something very special from hell.
The main problem is that all 17 parties are so deeply into each other, financially and legally intertwined, you don’t want to know the hurdles to get them separated.
If it was all clean lines, the Germanic northern tribes would have kissed their Latin southern cousins goodbye a long time ago.
But the lines are not clean. It is barracuda fishhooks all the way along every conceivable line of entry.
Just take Germany as an example, as the richest member supposedly least inclined to lift a finger to save anyone. That’s not strictly true when considering Germany’s many exposures.
Its pension funds, insurers and banks are filled to the gills with bond investments in southern peripherals, be they banks, corporates, households or sovereigns.
That’s a lot of wealth to lose if it has all to be written off. Writing off its share of less than €100bn in private Greek exposures is one thing, doing a few EZ trills is an order of magnitude different. And Germany’s share in that would be huge. As would be the French, the Dutch, the British……….
On a different plane resides the ECB. It has accommodated money outflows from peripheral Europe into northern Europe by getting the northern central banks to lend it (the ECB) the money to balance the books in Europe overall. The Bundesbank share alone is a cool €500bn and rising rapidly. If the Union and Euro had to go, so goes this outstanding balance.
Furthermore, the ECB has been doing some shopping these past two years, absorbing over €200bn in peripheral sovereign bonds direct, and accepting a further €500bn in collateral backing its EU bank funding.
There is potentially a lot of dead fish among those bonds if balloons were to pop, not something the ECB could make good, for which a direct call on the EZ17 shareholders (some of whom would be doing the popping, therefore doubling up on the richer ones still standing).
Just trills of potential losses wherever you look, trills that will never come back if you start really pricking balloons beyond Greece. And that’s before asking about the many legal business wrangles, with every conceivable contract or understanding now written in Euro.
Dismantling of an illusion? Perhaps not quite. ECB President Draghi keeps it simple: the Euro is “irreversible”, the speculation about her breakup “morbid”. Breakup would have extraordinary costs……(Wall street Journal).
And in a manner of speaking he (and his Board) is half the duo to ensure it won’t happen. The other half is 17 political heads of governments plus 17 finance ministers.
Financial markets have done their sums and are unimpressed. The public and private debts in the 17 are too high, the growth stagnant to negative (for many years to come) and the backstops totally inadequate.
The means to buy outstanding debt at market prices so that private investors don’t make a loss, otherwise known as a “bailout”.
And what are we talking about here? A little tricky to know what all to include, but peripheral and soft core sovereigns at risk could be over €5 trill (foreigners holding €1 trill of Italian and Spanish sovereign debt alone).
EU banks holding such paper have funding requirements running at nearly €1 trill annually (and a multiple thereof in terms of balance sheet funding over a couple of years).
Against this, the IMF has committed about €100bn in Greek, Irish and Portuguese support, the EU politicians through their cherished EFSF lifeboat have done another €200bn (all rounded), their future ESM lifeboat may be capable of €500bn, the EZ17 and a few non-EZ countries have promised another €200bn of loans to the IMF whose available firepower thereby would get boosted to €500bn (plus any other non-EU contributions).
And then there is still the ECB, so far directly buying €200bn of peripheral sovereigns to keep stressed debt markets functional while also funding the EU banking system with a few hundred billion more (some €490bn on 3-yr repos to over 500 banks this week alone, over half of it rolling old repos, with another such an opportunity in three month’s time).
But this public firewall doesn’t add up to many trills (yet). Instead, it is barely one trill plus. Still quite a magnificent shortfall, to say the least.
So the markets keep feeling naked, especially uneasy about EU politicians squabbling over governance, fiscal austerity, banks being held to penitence, and in the process forcing a fiscal-austerity-cum-credit-crunch recession onto themselves, severely undermining their growth, making their debt dynamics yet more doubtful, belatedly stampeding the rating agencies whose rating downgrades stampedes yet more private investors, making the debt-cum-growth dynamics yet more doubtful.
A bit of a mess, actually.
The answer from the European elite comes by way of a Two-Speed Europe, or (thinking Shaka Zulu) the Horns of the Bull, with the brain sitting in the middle.
The one part is the EZ17 politicians, lashing themselves together in tight fiscal compacts enforceable in law.
Angela wanted Treaty changes so that EU institutions (European Commission, Court) could keep countries to their professed budget and debt undertakings, or otherwise be ‘penalised’.
Britain vetoed that earlier this month (echoing John Major twenty years ago at Maastricht), leaving the EZ17 to fall back on inter-governmental “promises”.
But as Strauss-Kahn opinioned at a conference in Beijing this week, European leaders generally are in “denial” about the extent of their problems (WSJ).
I suppose he should know, having been part of the setting up of the Monetary Union in the 1990s while French Finance Minister, and having had the luxury recently of quietly being able to think things over.
More interestingly, as ex-IMF head, he also in Beijing expressed skepticism about the sanctioning of countries missing their fiscal targets.
What would happen if a punished country refused to pay? Most likely ‘nothing’ (WSJ).
This is serious, and partly explains why Angela described David’s veto as “terrible” (FT), for he made complex things so infinitely more interesting (as indeed also happened twenty years ago).
Still, it doesn’t take rocket science to recognise the outline of two horns of the Bull.
The Germanic political core is set on whipping the fiscal compact into shape, improving governance and delivering substantial budget deficit reduction and debt stabilisation in all EZ17, probably with a quick debt haircut for Greece making things sustainable a bit longer at over 100% of GDP (rather than the present 200%).
Meanwhile, the ECB will be the other horn, firstly funding the EU banks that can no longer fund privately in the open market due to a catastrophic loss of counterparty trust, and secondly fund them so generously in cost and time that they can be encouraged back into specific carry-trading, mainly their own sovereigns, thus going some way in backstopping the sovereigns, with the ESM lifeboat and IMF assistance at €500bn apiece as special vehicles in case something needs doing (Greece, but there are still a few others to consider).
To the extent that EZ banks don’t quite carry the ball, the ECB could always still resort to a further backstop, namely its own SPM (securities purchase mechanism), in limited quantities buying yet more stressed peripheral sovereigns, to keep stressed debt markets functional.
The beauty of the ECB doing the banks is that it is LEGAL (that’s what the ECB is for), and the banks doing the sovereigns (together with any ECB own buying) could mean that sovereign funding costs stay in (roughly) sustainable territory, while the value of such sovereign debt on bank (and ECB) books also comes up for air.
Still, it is making BOE Governor Mervyn King nervous. He is warning of growing sovereign-cum-banking dependence on central banks, potentially holding great financial risk for stability (Financial Times).
Be that as it may (Ben Bernanke’s favourite turn of phrase before cutting Gordian knots). With EU politicians and ECB holding the ship together and gradually backstopping every conceivable leak, all that then still needs to happen is that global private investors buy all this stuff and resume funding.
Recent days have shown a deep global skepticism, and the promise of the heavens opening up early next year with the next tranche of the EU crisis, for surely nobody is going to settle for so much charlatan stuff?
Then again, the EU politicians are determined (one should never ignore this heavily romantic feature of the past 50 years), the ECB sounds game (for is there really any other way, except double or quits, in which it can survive?), and the printing presses are patient (remember Wall Street’s advice “Don’t Fight the Fed”).
Still, it will take time overcoming non-euphoric skeptics in markets everywhere. It will have to be a rising tide that refloats all ships, including the rotting hulks.
This is where the skull-cum-brain of the strategy comes into focus at the base of the two horns.
Every commentator ONLY wants to talk about the idiocy of fiscal austerity under present circumstances and imposing bank capital ratios inviting credit crunches of the severest kind, leading to years of recession-cum-stagnation and out-of-control debt spirals, basically damning the EU to dismantle its illusion.
For supposedly where is the growth strategy that would make things sustainable?
Yet in every country it isn’t just that the welfare state is being pushed back to more manageable levels. Incentive structures are being changed. Along with other regulatory and institutional changes this should improve the growth dynamic of the EZ17 in coming years, at least on paper.
Ah, and this is where the skeptics become most united, for they don’t seem to believe such accelerated structural convergence to be possible.
Indeed, the markets have a firm demand-focus (and don’t see relief forthcoming) while EU politicians and ECB seem supply-side focused (and are seemingly meaning it, though decried by the many naysayers).
Important also, of course, despite the contrary views of many, is the observation that the world generally isn’t going to pot.
The Europeans are making their comeback within the context of a growing global economy. Slower perhaps, but growing. Faster perhaps in the East and only painfully stuttering in the Far West, but recovering.
That’s a crucial safety net of sorts if you believe it can hold the combined weight of all those wildly dancing on the ceiling.
So do we have here the outline of a bet that may work?
One can see that not everything is in place yet.
There isn’t a fiscal or political union, and for the fiscal compact to work it has to be tighter than tight. Greece is yet to be finalised and markets will take a long time becoming convinced. The ESM lifeboat may be too small and the role of the IMF uncertain. And the ECB is playing a slow game, hoping to get as much structural reform delivered on time.
But that’s why we have 2012 (and 2013 and 2014 and 2015, according to Strauss-Kahn all the way to 2018).
Nicholas faces re-election next year, Angela in 2013, Holland’s minority government is a high-wire act without equal and can be reformatted at any time, unelected technocrats are running Italy and Greece, Belgium finally has a government (barely) and so around the EZ17.
But that’s part of the fun, to get Democratic mandates for what you think you are doing once in a while, with not much difference discernible (yet) between governing and opposition parties. For such is the mess.
Even so, vocal opposition to the new hardships and possibly future financial losses are growing hand over fist. That has a timeline of itself.
Make no mistake, pure technicians and not a few global investors simply want Europe to pull the plug on the EZ17 Project, after which a few like-minded can potentially bond with like, abandoning the weakest elements to their own bond-defaulted-and-currency-devalued devices, getting growth going and fiscal affairs sorted sustainably in the core and starting up again.
The EZ17 and a few more aspirant-members also want to get on, but they see a different way out of the morass, not so much deepening the old illusion as transforming it.
So that’s the real choice on the table as we enter 2012 (as indeed it was in 2011 and 2010).
Are we witnessing the slow dismantling of EMU and Euro illusions, or will the EU politicians refuse to give up, along with the ECB (and IMF) transforming the basics of fiscal arrangements while restoring the growth dynamic through structurally converging reforms (over many years) while carrying the system in the interim through massive bank backing, bond buying (and global growth support)?
The indictment is of the severest kind after so many fundamental mistakes over decades. The verdict of some is most unkind. But it isn’t quite obvious yet that there will really be a hanging.
As Samuel Johnson noted, nothing concentrates the mind as wonderfully as the promise of a hanging in the morning.
This is what one observes most in Europe today, so many searching for a way out amidst a cacophony of naysayers.
Don’t underestimate European elites in wanting to do this THEIR way, though respect markets in their verdict and their power to back it up.
Who will prove the wilier?
Source: Cees Bruggemans, First National Bank, December 25, 2011.
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