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We see the outlines of the next cure for Europe. Will it work?

14 October 2011

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.

Contents

  1. The good news for the banks
  2. Will they boldly go on to solve Europe’s core problems?
  3. Meanwhile, stress builds in Europe
  4. Articles explaining Europe’s crisis
  5. 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:

(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.

Bravo.

(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

  1. 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.
  2. Can the European Monetary Union survive the next recession?, 11 July 2008
  3. The periphery of Europe – a flashpoint to the global economy, 8 February 2010
  4. A great speech by the PM of Greece. How soon until an American President says similar words?, 3 March 2010
  5. Governments cannot go bankrupt, 2 April 2010
  6. Our government’s finances are broken. How do we compare with our peers?, 8 April 2010
  7. The EU does Kabuki for Greece. Is it the next domino to fall?, 14 April 2010
  8. About the Euro crisis: the experts are wrong; the German people are right., 7 May 2010
  9. Former Central Bank Head Karl Otto Pöhl says bailout plan is all about ‘rescuing banks and rich Greeks’, 20 May 2010
  10. The Fate of Europe, nearing the point of decision, 13 September 2011
  11. Europe drifts towards the brink of a cataclysm, 26 September 2011
  12. Delusions about easy fixes for Europe, dreaming during the calm before the storm, 30 September 2011
  13. Is Europe primed for chaos, as it was in July 1914?
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15 Comments leave one →
  1. whirlwind21 permalink
    14 October 2011 5:21 am

    May we see a new Bretton Woods agreenment come out of this? A new finincial world order.

    • 14 October 2011 5:34 am

      The previous system resulted from the collapse of the Great Depression, WWII, and the rise of the US as a hegemon. Guessing — more likely a new system will just evolve over time, getting a formal structure as one of its later steps. But anything is possible, eventually. But not in the next few years, IMO.

  2. Duncan Kinder permalink
    14 October 2011 6:39 am

    “Growing riots and strikes in Greece. ”

    IMHO, this is the single most important sentence in your article.

    • 14 October 2011 12:43 pm

      I am astonished at the level of strikes and riots in Greece. It is far lower than I expected. Which was my error. Greece has to adjust, and most of its people know that. Taxes must be collected. Government employees must do useful work. They know that these things will happen, eventually. One way or another. If the EMU dumps Greece, the adjustment will happen fast and hard. Which might be best for Greece.

  3. 14 October 2011 11:41 am

    All the issues that confront the US and the world economically are now systemic and global. They require systemic analysis and systemic solutions on a global scale, and coordination of national policies. The alternatives are war, which makes everyone lose money as technology has made it so devastating, or overexploitation of one’s suppliers or customers, in which case they go belly up, and everybody loses money. Hence, all piecemeal approaches are illusory free lunches, because some country or sector ends up paying for whatever one country or sector gets… and advantages pressed too far rebound to the detriment of the temporary ‘winner.’

    This is the best overall approach I have found so far… Roubini for President of the World;-).

    The Way Forward — Moving From the Post-Bubble, Post-Bust Economy to Renewed Growth and Competitiveness
    By Daniel Alpert (Westwood Capital); Robert Hockett (Professor of Law, Cornell U); and Nouriel Roubini (Prof Economics, NYU)

    What is the alternative?

    • 14 October 2011 12:40 pm

      (1) The need for a global solution

      I agree, and said so three years ago in the third part of my series describing a solution to the Finanical Crisis: Effective treatment for this crisis will come with “The Master Settlement of 2009″ (5 October 2008).

      (2) Who are the key actors to implement a solution?

      As seen in my articles from 2008, writing a solution is the easy part. Economic and political theory can provide reliable guides (unlike 1929, where adequate economic theory did not yet exist). The difficult part is implementation, which requires skilled politicians. Or “statesmen”, if you prefer. We seem to have few these days. Perhaps because we despise them, and don’t pay them well compared to others handling similar sums of money.

  4. whirlwind21 permalink
    14 October 2011 2:54 pm

    Well hopefully there is no economic collapse and Great Depression 2.0 as a result of this. Seems thats what George Soros is calling for.

    • 14 October 2011 6:06 pm

      It’s a widespread fear among economic and financial experts. Recessions are commonplace; depressions are rare (but happen). Under our system of managed economies, a Great Depression requires a large set of public policy mistakes.

      Note that Great Depressions occur even under laissez-faire economic regimes. The original global Great Gepression was 1873-1896, renamed the Long Depression after the 1930s. Like the 1930s, it was sharp recoveries between multiple downturns (in the US, 1873-1879, 1882-1885, 1890-1891, 1893, and 1896). Note that it was followed by a series of mild recessions: 1899-1990, 1902-1904, 1907, 1910-1911, 1913-1914.

      Remember that history when preachers of faux history expain about the wonders of laissez-faire, gold-based economic systems. This long period of deflation and boom-bust wrecked the small farmer and small business classes in America. It worked to concentrate income and wealth, just like the past lost decade now ending — and perhaps the next lost decade we might be starting.

  5. Interesting updates added to this post permalink
    14 October 2011 7:23 pm

    There have two updates to this post, both interesting and insightful articles in the European press. Take a look! There are in the section 4.

  6. About writing down Greece's debt - an essential part of any solution permalink
    15 October 2011 1:26 pm

    What haircut for Greece?”, Paolo Manasse (Prof Economics, U Bologna), VOX, 14 October 2011

    “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.”

    This also explains the current plan to write down Greece’s debt, that part held by private investors (mostly financial institutions and pension plans).

  7. Very bad news for Europe permalink
    20 October 2011 3:11 am

    The lastest sign of rising discord in Europe — the full Bundestag may want to get involved, not just the Budget Committee. The full Bundestag is more senstiive to public opinion than the Budget Committee (most of whom have safe seats). This is a more serious threat to a deal than the likely coming challenge before the Constitutional Court.

    If so, it’s not necessarly a deal-killer. But it might limit the scope of any deal. And would add complexity to an already too-complex process. And add time to an already very tight schedule.

    (1) Opposition vents fury over new EFSF extension“, The Local (Germany’s news in English), 19 October 2011:

    Opposition parties, particularly the socialist Left party, have expressed outrage at the news. “It is unbelievable, what is happening,” Left party head Klaus Ernst told the Süddeutsche Zeitung on Wednesday. He said that the risks of such a measure “would once again be passed onto the taxpayer.”

    He also criticized the EFSF and the aid measures being handed out to debt-laden countries like Greece, saying they did nothing but aid the financial system, not the countries. “It just allows the banks to carry on speculating as they like,” he said.

    The Green party has demanded that the German parliament, the Bundestag, have a say in any measures that would extend the EFSF. Green party parliamentary leader Volker Beck said that such a measure would “substantially change the modalities” of EFSF guidelines. That means, argued Beck, the measure would require the approval of the parliamentary chamber, and not just the approval of the parliamentary budget committee.

    (2) A Trillion Euro Insurance Policy for the Common Currency“, Der Spiegel, 19 October 2011:

    Still, the measure is likely to be unpopular in Germany. In the days leading up to the German parliamentary vote approving the original expansion in September, several lawmakers insisted that they were against any further leveraging. Indeed, Finance Minister Wolfgang Schäuble himself sought to downplay reports that the EFSF would be leveraged, though he never outright denied such speculation. The Free Democratic Party (FDP), Chancellor Angela Merkel’s junior coalition partner, even threatened to strike down the EFSF expansion if a leveraging were planned.

    The FDP now appears to be changing its tune. “For me it is essential that the total sum of guarantees agreed to by the Bundestag (Germany’s federal parliament) not be increased,” the FDP’s floor leader in parliament, Rainer Brüderle, told the Financial Times Deutschland.

  8. Amazing news about "Greek haircuts and Greek myths" from EU economists permalink
    23 October 2011 12:35 am

    Greek haircuts and Greek myths — the details“, Financial Times, 21 October 2011 — Opening:

    European leaders on Friday received some interesting weekend reading. FT Alphaville has also taken a look at “Greece: Debt Sustainability Analysis”, an assessment prepared by European Commission economists for discussion on Friday among European finance ministers. We’ve put it in the usual place (and extensively quoted excerpts below).

    The headline: it suggests private bondholders will be pushed to take 50 or 60 per cent haircuts. From the report’s summary: …

  9. Münchau: "Europe is now leveraging for a catastrophe" permalink
    25 October 2011 1:51 am

    Europe is now leveraging for a catastrophe“, Wolfgang Münchau, Financial Times, 23 October 2011

  10. Bonjour Tristesse: France Stares into the Euro-Crisis Chasm permalink
    26 October 2011 1:02 am

    Bonjour Tristesse: France Stares into the Euro-Crisis Chasm“, Der Spiegel, 24 October 2011 — Summary:

    “Falling productivity, a stagnating economy and growing debt: France’s economic health leaves plenty of room for improvement. Markets have begun to notice and the country threatens to become mired in the ongoing European debt crisis.”

  11. "Europe's debt deja vu" - a look at past bold statements by EU leaders permalink
    26 October 2011 1:07 am

    Europe’s debt deja vu“, Uri Friedman, Foreign Policy, 24 October 2011 — Excerpt:

    EU leaders seem surprisingly optimistic about their ability to strike a deal by their next summit on Wednesday — an agreement that will likely involve measures to cut Greece’s debt as the country continues to flounder, recapitalize European banks as they struggle with exposure to Greek debt, and beef up the eurozone bailout fund as Spain and Italy waver.

    “Progress has been made,” Sarkozy proclaimed on Saturday. “Between now and Wednesday a solution must be found, a structural solution, an ambitious solution, a definitive solution.” Polish Prime Minister Donald Tusk, who currently holds the European Union’s rotating presidency, added, “We all have a sense that the crisis in the euro zone is reaching very worrisome levels. We have to be happy that the decision-making progress has gained some momentum, although we can’t say we have reached the finish line today.”

    Markets are responding positively to these glimmers of hope. But the words — however heartening — are hard to believe. After all, we’ve heard these back-against-the-wall, do-or-die pledges of a comprehensive and decisive solution to the debt crisis before. Let’s take a look at some of the other statements that have come out of what seems like a perpetual procession of emergency Brussels summits:

    Date: 9 May 2010

    Action: Shortly after bailing out Greece, European officials create a €440 billion European Financial Stability Facility (ESFS) that can lend money to troubled eurozone countries by selling bonds (this is the fund that European officials now say needs more firepower).

    Assurances: “The Council and the Member States have decided today on a comprehensive package of measures to preserve financial stability in Europe,” European finance ministers crow in a statement. A month later, the European Investment Bank’s Philippe Maystadt says the creation of the fund “constitutes evidence that, when the stakes are high, member states — together with the European Commission and the E.I.B. — can sit down together and work for the common interest, within a tight deadline.”

    Date: 16 December 2010 …

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