Summary: Rumors circulate of complex ways to bail out Europe’s banks and conceal the cost to France and Germany. These new programs expend scarce political capital AND even more valuable time, while fixing nothing but the banks. This shows recognition about the seriousness of Europe’s problems, but a political tone-deafness that suggests bad times lie ahead. Here we look at the bases that must be touched to reach a solution. At the end are links to other posts about Europe.
Other chapters in this series:
- Can the European Monetary Union survive the next recession?, July 2008
- The Fate of Europe, nearing the point of decision
- Europe drifts towards the brink of a cataclysm
Contents of this chapter
- Summary of the Euro-story as of today
- The way forward
- A calendar, each event a potential spark to the endgame
- Some useful analysis by Edward Harrison
- For more information
(1) Summary of the Euro-story as of today
Europe remains locked into overlapping problems. The causes are almost irrelevant now (it was a systemic error, not moral failure; for details see What Really Caused the Eurozone Crisis? by economist Kash Mansori).
Uncompetitive nations (the PIIGS), carrying too much debt (some in the private sector, some government debt). The banks hold much of this debt, so defaults will bankrupt them. Europe’s complex and fragmented political attempts to deal with these problems, torn between its leadership’s desire to unify (for good reasons described in chapter one) and its peoples’ nationalism. The economic and financial problems have technical solutions; the political problems dominate the situation — and political decisions will determine the outcome.
The current program (already acknowledged as inadequate) is version 2 of the European Financial Stability Facility (EFSF), approved yesterday by the Bundestag, with expanded powers and increased lending limits (from 255B to 440 B Euro). It’s like the US TARP II program.
(2) The way forward
Broadly speaking, Europe’s peoples must choose between a combination of three solutions.
- Full economic unification, which probably requires a political federation
- Some combination of default, bank recapitalization, and reform of the European Monetary Union (probably with fewer members)
- Massive monetization and probably inflation (IMO this is the least likely; perhaps impossible)
This week the rumor wires sang with stories about programs combining elements of #2 and #3, focused on massive bailout of banks (some discussed in the previous chapter). These leaks from anonymous officials and proposals from think tanks were probably trial balloons, testing alternative plans for public acceptance.
The key questions to ask about these are (as always) who benefits and who pays? We see the answers in the common elements of these plans.
- They create paths for Greece to default (or even leave the EMU and devalue).
- They provide massive gifts to Europe’s banks (especially those of Germany and France), mostly from the taxpayers of Germany and France.
- They consist of complex shell games that conceal who takes the loss when Greece defaults (and perhaps leaves the EMU).
These proposals — perhaps none of which will be realized — tell us much about the thinking of Europe’s leaders. They slowly realize that stopgaps will not work, and Greece (perhaps others) need fundamental restructuring. But their narrow vision probably prevents success.
- Just like America’s leaders, banks are first in their hearts. So they focus on Greece’s debts, drafting plans to shift the banks’ bad loans to government balance sheets. While fixing banks is a vital part of the puzzle, their love blinds them to other (less banker-friendly) solutions — and to other and equally important problems.
- This is a decision point about the nature of Europe (unify or divorce). Fiddling with banks does nothing to resolve this political decision.
- This is a technical question about the PIIGSs’ lack of competitiveness under an interest and currency regime designed for the EMU’s core nations (debt is a result of their uncompetitiveness). A new Greek drachma might require a 50% discount to the Euro (per Roubini Global Economics). Fiddling with the banks does nothing to resolve this issue.
- This is about austerity as a remedy for recessionary conditions in the GIIPS, despite its consistent history of failure without devaluation. Fiddling with the banks does nothing to fix this incorrect macroeconomic prescription.
- This is a crisis of confidence, with Europe’s peoples losing trust in their leaders’ competence. Fiddling with the banks exacerbates this slowly festering sore. Germany’s governing coalition advocates measures tying together Europe; the opposition coalition supports unification (choose “potato” or “potahto”)
The focus on solutions for banks (and bankers) obscures the need for a complex solution to both political and economic problems, one that reduces debts and increasing competitiveness not just for Greece — but for all of the PIIGS.
- Any solution will involve writing down asset values (aka realizing losses via some form of soft or hard defaults), transitional funding for the PIIGS, and reducing the export bonanza that has driven northern Europe (especially Germany).
- A solution almost certainly will change the political structure of Europe, either unification or some form of fragmentation. The latter ends any hope of great power status for Europe. They might forge new institutions or reforge existing institutions (perhaps keeping the names to disguise their evolution).
- A solution will become mechanically more difficult to implement during a crisis (a disorderly solution), but perhaps only a crisis will forge a consensus on making the necessary decisions. Time is Europe’s enemy, relentlessly closing potential solutions.
Forging a political agreement looks difficult, and might require a crisis to force solutions. Imagine if setting economic policy in America required the approval of each State and regional Federal Reserve Bank. That’s similar to the actual situation in Europe.
Imagine running a modern state in pre-civil war America, where the three regions disliked and mistrusted each other. Then the US government was small and relatively simple; even so regionalism resulted in a long bloody war. Europe had its wars, leaving a legacy not promising for the cohesion required to form a nation.
Is there support in northern Europe for funding the bank bailouts required for both unification or divorce? Or for the transitional aid required to avoid a chaotic divorce? Telegraph Business Editor Ambrose Evans-Pritchard — although not always a reliable source — has good connections in Germany; he reports rising opposition to more aid to the PIIGS (see his articles on 26 September and 29 September).
Is there support in Greece for even more austerity? They must know its pointless without a devaluation to restore competitiveness.
(4) A calendar, each event a potential spark to the endgame
- October 3-7 – Greece likely to vote on additional austerity measures and ways to raise cash
- Early October — Officials of the “Troika” (EU-ECB-IMF) return to Greece and evaluate its compliance with their demands
- Mid-October — Approvals completed for EFSF 2 (Neatherlands and Slovakia)
- October 1 — Bitlateral talks between President Sarkozy and Chancellor Merkel
- October 3-4 Eurogrop/EcoFin meeting — Finance Ministers review the Troika’s report and decide if to release the next tranche of aid to Greece
- October 14-15 — G-20 Finance Ministers’ meeting
- October 17-18 — EU Council meeting
- November 3-5 — G-20 meeting in Cannes
- December 9 — EU meeting, perhaps deciding to undertake new programs
(5) Some useful analysis by Edward Harrison
(a) “Spain is the perfect example of a country that never should have joined the euro zone“, 16 May 2011 — Accurate diagnosis must precede treatment; which Europe’s leaders have failed to do. See this excerpt for a clear look at causes:
Nevertheless, if you look back to the previous decade, things were looking much better due to the property boom. In particular, the government’s finances were stellar.
Notice how the government’s budget is in surplus throughout most of the 2000s. Moreover, if you look at a list of countries in the world and rank them according to public debt as a percentage of GDP for 2009, Spain is well down the list (#44). In fact, it is much lower than Germany (#18) on the list. Below are the most recent figures for the crisis-ridden countries and Germany. Once again, notice how Spain has the lowest debt to GDP ratio, even after a remarkable deterioration in its fiscal position over the last two years.
I would also add that Germany’s fiscal record is significantly worse than Spain’s over the last decade. … In short, it is total nonsense for people to act like Spain’s government has been reckless and irresponsible in managing its finances. The numbers tell a completely different story.
If you pointed to Portugal, Greece or Italy, you might have a point. But Spain had been a paragon of fiscal virtue. We are witnessing historical revisionism due to the unprecedented downturn in that country.
What happened? The Euro happened – and that has been a decidedly mixed blessing. I have been pointing this out for two years on this blog. … we got was an unbalanced Euroland in which Germany and the Netherlands exported and Spain, Portugal and Greece imported, running up enormous current account imbalances in the process.
These imbalances are a direct result of a monetary policy that was geared to slow-growth core Europe. The result was an enormous property bubble in Spain and Ireland in particular. It’s not as if a robust regulatory environment could have overridden these forces either; the Banco de España, Spain’s central bank, is widely credited as having run one of the more solid regulatory regimes in Euroland. Yet, this did not stop a runaway property bubble from forming and imploding.
Moreover, what these two charts also point out is that, in Spain and Ireland, enormous property busts turned what were fairly large government budget surpluses in 2006 – the largest in the euro zone except for Finland – into an enormous government budget deficit by 2009. …
(b) “The political economy of the European sovereign debt crisis“, Edward Harrison, 30 June 2011 — Excerpt:
As I indicated on BNN, Nicolas Sarkozy has been deft in getting a French person installed at the ECB as a quid pro quo for allowing Mario Draghi to become its head. And he has been equally effective in getting Christine Lagarde, his finance minister installed at the head of the IMF. In that sense, France now has greater input throughout the Troika institutions, the ECB, the EU, and the IMF, now dictating terms on bailouts, restructurings and defaults in Europe. And clearly, as the French banks are very exposed to potential defaults in the periphery, there will be enormous pressure on the Troika through their French representation to accede to the interests of the French banks. Again, I am not advocating a position here. I am trying to forecast likely scenarios.
… The French plan is another example of Europe’s extend and pretend strategy. … I would go further and say that the extend and pretend strategy is inevitable because that’s how large hierarchical systems respond to crisis. Seeing this, I also understand this is the template we are likely to see going forward for Ireland and Portugal as well. Eventually, the extend and pretend approach will fail after successive rounds of the same policy response in Greece, Ireland and Portugal. Eventually, a combination of four things will occur:
- the people in the periphery countries rise up and overthrow the existing order forcing a default;
- the poor economy that austerity entails forces leaders to move to the hard restructuring route as fiscal consolidation fails
- markets become skittish about Spain or Italy, which cannot be bailed out. So EU leaders will cut Greece loose
- popular unrest in core countries against bailouts grows so severe that they force a hard restructuring or default
The point for policy makers is to socialise enough of the bank losses onto taxpayers in order to recapitalise the banks, survive the crisis and maintain the status quo. Taxpayers will accept this if the economy is robust enough. As an investor, you should see this as an uncertain political situation. more than most. That means avoiding periphery sovereign debt until the situation stabilizes.
(c) “On Greek Haircuts“, 28 September 2011 — “Now it seems that Europe is moving to a hard restructuring for Greece and recapitalisation for bank creditors. The word is the haircut will be 50%”
(5) For more information
- 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
- Our government’s finances are broken. How do we compare with our peers?, 8 April 2010
- Governments cannot go bankrupt, 2 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