We see the outlines of the next cure for Europe. Will it work?
Summary: A brief look at the rumors about proposals coming out soon in Europe. Somehow these plans have to be ready and pre-sold by the G-20 conference at Cannes on November 3-4. This might be Europe’s last chance for an orderly solution. Let’s hope they take it. We can only guess how this will play out.
- The good news for the banks
- Will they boldly go on to solve Europe’s core problems?
- Meanwhile, stress builds in Europe
- Articles explaining Europe’s crisis
- Other articles about Europe on the FM website
(1) The good news for the banks
The new plan appears to focus on recapitalizating the banks. National governments will force their banks to raise more equity (they might not do so voluntarily), with governments (or agencies under their control) lending them additional capital as needed (perhaps at high interest rates). Weaker states (eg, Portugal and Greece) will receive aid from the European Stability Fund and the ECB. This will provide immediate relief to Europe from the rising financial stress. Equally important, this avoids the need for legislative approvals, making successful implementation likely.
Now we see why Europe’s leaders’ focus on the banks: they’re doing what is politically feasible.
(2) Will they boldly go on to solve Europe’s core problems?
Fixing the banks at best buys time to address Europe’s more serious problems. It does nothing to fix the PIIGS’ lack of competitiveness, the cause and most serious problem. Or Europe’s slowing economy, which if continues will wash away any benefits from bank recapitalization. Nor does it address the possible unraveling of public support of project Europe.
These proposals might include a controlled default — a kind of bankruptcy — for Greece. Writing down its debts and providing on-going loans while they restructure their economy. And mechanisms to “ringfence” the other PIIGS, boosting confidence in their sovereign debt (reducing fears that they too will default).
Merkel’s comments about treaty changes imply proposals for larger-scale, perhaps even radical, reforms to the structure of the EU. There are not yet even rumors of specifics. Either the secret is kept among a small group (with little work to sell the deal) — or there as yet few or no specifics to keep secret. Implementation of large changes will take months (6 or more), and approval is uncertain. Even amidst good times, many of the initial approvals were contentious (eg, referenda in Ireland rejected it in June 2008, approving it in October 2009).
(3) Meanwhile, stress builds in Europe
The austerity prescribed for the PIIGS has put those societies under great stress. Depression-like unemployment and falling incomes. Growing riots and strikes in Greece. Getting a primary surplus is nice, but not if your regime collapses under the stress (eg, Weimar, 1932).
Even Germany, the strongest state in Europe, is feeling the pressure, with outbreaks of terrorism in Berlin: 15-18 bombs of train lines, plus burning cars. See these articles for details:
- Left-wing terror group blow up railway line in EIGHTEENTH attack in three days, Daily Mail, 13 October 2011
- Arson attacks disrupt German train system, AP, 12 October 2011
(4) Interesting articles explaining Europe’s crisis
(a) A critic of the EU goes to the heart of the current solutions: their unfairness
“Even a Slovak ‘Yes’ will make no difference“, Ambrose Evans-Pritchard, The Telegraph, 12 October 2011 — Excerpt:
Slovakia’s cry of defiance has not been entirely pointless. Richard Sulik – the speaker of parliament – has caught a mood of popular disgust that goes far beyond his own country. His objections are unanswerable. How can there be any justification for a state of affairs where a poor but rule-abiding EMU state must bail out a serial violator with twice the per capita income, and triple the level of the pensions – a country which is in any case irretrievably bankrupt? How can it be that the no-bail clause of the Lisbon treaty has been ripped up?
But he also touched on the most neuralgic issue, reminding everybody that the EFSF is “mainly for saving foreign banks”. These are French, German, British, Dutch, and Belgian banks, of course.
Mr Sulik is right. The EU-IMF rescue loans have not helped Greece pull out of its downward spiral. They have pushed the country further into bankruptcy. Greek public debt will rise from around 120pc of GDP to 160pc under the rescue programme, and the IMF is penciling in figures above 180pc.
The rescue loans have rotated into the hands of creditor banks, life insurers, pension funds, and even a few hedge funds. ECB bond purchases have allowed to investors to dump their holdings at reduced loss, shifting the risk to EMU taxpayers. It is a racket for financial elites. A pickpocketing of taxpayers, including poor Slovak taxpayers.
“I’d rather be a pariah in Brussels than have to feel ashamed before my children,” he said.
(b) An economist describes the two painful options left for Europe
“The European Troika’s Rescue Plan Will Fail. Time to Choose an Endgame“, L. Randall Wray (Prof Economics, U of Missouri–Kansas City), 12 October 2011 – Excerpt:
So either way, the indebted country gets into the debt trap: if it borrows from markets, interest rates rise; if it borrows from the EMU (or the IMF) its growth falls and tax revenue plummets.
Damned if you do, damned if you don’t.
So one solution for a troubled country is to leave the EMU and return to a sovereign currency issued by the government — ie, the drachma for Greece, the lira for Italy, and so on. The transition would be disruptive, with near-term costs. But the benefit would be to create domestic fiscal and policy space to deal with the crisis. Default on euro-denominated debt would be necessary. Retaliation by the EU is possible. However, this is preferred to the “Teutonic vs Latin” two currency scheme that some have recommended — which would simply tie, say, Greece to another external currency. It would have no more fiscal or monetary policy space than it now has, albeit with a currency that would be devalued relative to the euro.
If dissolution is not chosen, then the only real solution is to reformulate the EMU. Many critics of the EMU have long blamed the ECB for sluggish growth, especially on the periphery. The argument is that it kept interest rates too high for full employment to be achieved. I have always thought that was wrong — not because lower interest rates are undesirable, but because even with the best-run central bank, the real problem in the set-up was fiscal policy constraints.
Update: (c) The best history and analysis of the situation I’ve seen
“The Ticking Euro Bomb”, a series in Der Spiegel (more evidence that the best of Europe’s news media is far better than our best).
- Part One: How a Good Idea Became a Tragedy. The Greeks Jump at the Opportunity. The Critics of the Euro.
- Part Two” How the Euro Zone Ignored Its Own Rules and The Greek Deception Is Discovered
- Parts Three and Four: What Options Are Left for the Common Currency? Greece Adrift. Design Defects, Political Weakness, Public Disinterest. Are European Rescue Efforts Doomed to Fail?
Note the conclusion:
The proposals to solve the euro crisis are manifold — reducing debt with or without withdrawal from the euro zone, a European finance minister or even a European economic government — but they have become little more than an expression of the cluelessness of economists and politicians. There is no precedent for this crisis, nor is there a recipe that could be applied to resolve it. Europe’s politicians have maneuvered themselves and their people into an unparalleled situation. It scares some of them more than it scares their voters, because politicians already know what voters don’t even suspect yet.
In the end, only two possibilities will remain: a transfer union, in which the strong countries pay for the weak; or a smaller monetary union, a core Europe of sorts, that would consist of only relatively comparable economies.
A transfer and liability union requires new political institutions, and individual countries would have to confer a significant portion of their powers on Brussels. Some politicians are warming up to this idea as they consider an economic government or even a United States of Europe, but without explaining exactly what this means.
The second path is the more likely one. It will not be easier, and it might not be any less costly, either. First a firewall would have to be erected between the countries that are in fact insolvent and do not stand a chance of ever repaying their debts, like Greece, and others that have only a short-term liquidity problem. Then the banks would have to be provided with government funds, so that the financial system does not collapse when banks are forced to write off some of the government bonds on their balance sheets. Finally, the countries exiting the euro zone would require continued support, because Europe cannot simply look on as countries like Greece descend into chaos.
Update: (d) The EU looks good, but its parts do not. And the self-defeating circularity of bank bail-outs.
“Europe’s grand plan risks slow death by a thousand cuts“,Jeremy Warner, The Telegraph, 13 October 2011 — “Is Europe’s planned programme of banking recapitalisations going to work?” Excerpt:
Bankers are angry about the fix they are in, and in this regard at least, with reason. The root of the problem this time around is not the reckless lending, of sub prime mortgage fame, that sparked the original banking crisis, but sovereign lending, often imposed on banks by regulatory requirements.
As Mr Trichet pointed out at the AFME dinner, if the eurozone were a single country, it would actually look like a model economy, with a small current account surplus, a primary budget deficit of less than half that of the UK and the US, subdued household debt, low inflation and a little growth.
But of course that is rather the nature of the problem. In fact it is a collection of 17 fiscally sovereign nations.
… That assumption has been challenged, causing old credit risks, buried by the advent of the single currency, to re-emerge and the banking system to seize up for fear of the potential losses. Recapitalisation worked well in stemming the UK and US banking crises back in 2008, so there has been a natural tendency to regard it as the silver bullet that will get the banking system functioning again.
Unfortunately, what worked for UK and US banks suffering from a largely conventional crisis in banking solvency may not act in the same way in circumstances where the underlying problem is of sovereign solvency. Such bailouts risk an Alice through the Looking Glass world where sovereigns are borrowing money to prop up banks that only need propping up because the sovereign has borrowed too much money. There’s a self-defeating circularity about it which raises the obvious question of “who bails out the bailer-outer”.
The hope among European policymakers is that most banks will be able to raise the required new capital privately, and will indeed choose to do this rather than shrink the balance sheet to fit. Dream on.
(e) About writing down Greece’s debt burden (a controlled default), an essential part of any fix
“What haircut for Greece?”, Paolo Manasse (Prof Economics, U Bologna), VOX, 14 October 2011 — Excerpt:
Markets are already prepared for a Greek default. This column says the real question is not whether Greece will default – it is how big a haircut will be imposed on creditors and what the consequences will be. … It is therefore reasonable to think that that the haircut implies a tradeoff between the immediate benefits from regained solvency and the longer-term cost/delay of accessing the capital markets in the future. Thus the haircut will be somewhere in between the 21% implied by the current proposals and the 40-50% required for solvency.
This article also explains the current plan to write down Greece’s debt, that part held by private investors (mostly financial institutions and pension plans).
(5) Other articles about Europe on the FM website
- The post-WWII geopolitical regime is dying. Chapter One , 21 November 2007 — Why the current geopolitical order is unstable, describing the policy choices that brought us here.
- Can the European Monetary Union survive the next recession?, 11 July 2008
- The periphery of Europe – a flashpoint to the global economy, 8 February 2010
- A great speech by the PM of Greece. How soon until an American President says similar words?, 3 March 2010
- Governments cannot go bankrupt, 2 April 2010
- Our government’s finances are broken. How do we compare with our peers?, 8 April 2010
- The EU does Kabuki for Greece. Is it the next domino to fall?, 14 April 2010
- About the Euro crisis: the experts are wrong; the German people are right., 7 May 2010
- Former Central Bank Head Karl Otto Pöhl says bailout plan is all about ‘rescuing banks and rich Greeks’, 20 May 2010
- The Fate of Europe, nearing the point of decision, 13 September 2011
- Europe drifts towards the brink of a cataclysm, 26 September 2011
- Delusions about easy fixes for Europe, dreaming during the calm before the storm, 30 September 2011
- Is Europe primed for chaos, as it was in July 1914?