Earlier this week I wrote a post called "Europe edges closer to the endgame" in reaction to the French and Greek elections. Today I want to expand on this for the weekly members’ post.
While I think we are finally arriving at the changes which presage the endgame, I do not think the events in France and Spain are going to be the catalyst for seismic change in policy responses. More likely, the sovereign debt crisis will impose policy change upon European policy makers after markets seize up and Europe risks breaking apart. Right now, Spain and its banking sector must be the focus for analysts looking to gauge the policy responses that will determine the European endgame. This post will cover all of that ground – Greece, France, Spain – and a lot more.
This post will be a much expanded version of the original post that takes a more European-wide perspective.
Fusing Germany into Europe
When analysing situations like the European sovereign debt crisis that have the potential to cause seismic shifts in the economic landscape, one must develop a macro framework that produces discernable outcomes and then re-analyse the details as they come to light to understand whether that framework fits and how the details change the picture. So I want to frame Europe’s problem for you here, first with a historical account and then using an economic frame to illustrate where the political and economic constraints lie.
After World War II, it was clear was that the Germans had committed unspeakable atrocities and that the nation’s only hope of redemption was in rebuilding a demilitarized society integrally fused into the Western European body politic. The European Union and its predecessor institutions accomplished this quite well. But when the Soviet Union fell and Germany was reunified, there was again great fear in Europe about the balance of power and of the German juggernaut. Therefore, after German reunification, leading politicians in Europe were keen to further bind Germany into Europe. German Chancellor Helmut Kohl called it a "bit of a peace guarantee."
The question at the time of the Maastricht Treaty in 1992 was which institutional structures Europe would build and what policy framework Europeans would use to support the single currency. The Deutsche Mark had been a strong currency and this strength was seen as a major source of the German economic miracle. The Dutch had followed this model closely and prospered in equal measure. With Germany as the leading power in western Europe, the German model became the dominant driving force for institutions and policy.
Thus, the major institutional goals of the euro area were to maintain price stability and fiscal probity in order to ensure long term growth. Eventually, these goals were formalised as the Stability and Growth Pact (SGP) which set strict limits on fiscal policy via an annual budget deficit of no greater than 3% and a debt-to-GDP ratio either of no greater than 60% or declining toward that mark.
We now know from German government documents of that era that the Germans did not want Italy to be a part of the euro zone despite Italy’s having been a founding member of the EU. The Germans looked at the Italian Lira as a soft currency and the Italians as fiscally irresponsible. But politics ruled the day and eventually Italy was admitted along with several other countries with similar economic profiles.
It was well-known that Europe could not simultaneously achieve free trade, capital mobility, independent national monetary policies, and fixed exchange rates. Despite the political aims of European leaders, Europe was not ready for fiscal or political union. So leaders embarked on monetary union alone without any fiscal institutions to support it. Member states within the euro zone, therefore, cannot run independent monetary policy and they cannot depreciate a national currency. But, they also cannot depend on a central bank backstop, nor can they run sufficiently countercyclical fiscal policy to deal with a large downturn. These are the policy tools that euro zone members have given up to benefit from the single currency due to a perceived free rider problem when the Maastricht Treaty was formulated.
Framing the problem
Without some kind of a countervailing supranational fiscal agent or sovereign risk pooling, this arrangement invariably means some sort of crisis will arise when the unharmonised economies of the euro zone result in large enough current account imbalances. Hands are tied; in a currency union, there is no devaluation to recoup competitiveness, no room for fiscal freedom, and no control over monetary policy. This leaves so-called internal devaluation and/or sovereign default as the remaining ways to escape crisis. Put simply, the euro zone is made for crisis. It is designed to fail.
One of the euro’s chief architects, Tommaso Padoa-Schioppa, called for greater fiscal cohesion in order to prevent crisis, quipping when the euro finally came into being that the euro was "a currency without a state". The divergent fiscal and economic policies in the unharmonised euro area led to wildly differing growth rates and economic outcomes. While Germany laboured under the strains of re-unification and the bust of the speculative mania which followed it, Spain and Ireland grew at fantastic levels. Germany suffered from chronic budget deficits while the Spanish and Irish rushed ahead. See the post "Spain is the perfect example of a country that never should have joined the euro zone" for more detail here.
My belief all along has been that each nation in the euro zone is committed to its success. The European body politic has grown to support it as indispensible. Moreover, unravelling the euro is a very difficult task. And so, I believe political inertia alone will help see the euro through for most countries unless we see a catastrophic banking system collapse. The goal 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.
To date, the indebted periphery has accepted internal devaluation and austerity as the way forward. However, this has caused their economies to collapse into depression with each country missing deficit targets as the economy worsens. Internal devaluation and austerity in isolation cannot solve the problem as this is politically unsustainable; the election in Greece shows you this policy response has reached a breaking point.
At heart, there are two interrelated problems for Europe. There is the sovereign problem because investors doubt whether indebted sovereigns will have the tax base necessary to repay their obligations in full, given their debt levels and the likely growth in their economies. Then there is the bank problem with banks already lacking sufficient capital to weather large exogenous economic shocks. Now these banks are imperilled because of the potential writedown of sovereign debts on top of the private debts they have incurred.
Policy inertia is a big problem in all this. The Europeans have a policy view on how to respond and will resist moving from that view. You have to have crisis to get a permanent solution. The Europeans have had an opportunity to deal with the fundamental problems of its financial sector’s undercapitalisation and the sovereign indebtedness at the euro zone’s periphery. They have dithered, choosing superficial and phony approaches like stress tests instead of addressing fundamental issues. Now, given the tandem bank and sovereign problems in the restrictive euro institutional framework, markets are asking whether policy makers have the capacity to consistently bail the banks out. And the answer is no.
So what can Europe do?
Solutions: Greece as an example
When looking at the Greek elections, the questions one has to ask is whether these election results change the commitment to membership in the euro? My answer to the question for Greece is yes. The commitment to the euro by leading political figures in Europe is still strong. But in Greece, there is the potential for change.
The train of events may work against Greece’s staying in the euro zone. Alexis Tsipras, the leader second largest party, Syriza, campaigned against austerity and is an admirer of Venezuelan President Hugo Chávez. Any government with Syriza as a coalition member will renege on its austerity commitments. ECB executive board member Jörg Asmussen says that there is "no alternative" for Greece but to implement the agreed=to restructuring program if it Greece is to remain in the euro zone. That tells you that it will be nigh impossible to form a coalition government and so a caretaker government is likely until new elections are called in June. The risk, then, is that Greece runs out of money. Without more assistance from the Troika, Greece has enough money to make it only to the end of July. Afterwards, re-default would be likely.
It is clear that Germany may already be preparing for Greece’s exit from the euro zone. Angela Merkel, Germany’s Chancellor has made clear repeatedly since that Greece is expendable and that her goal is to ring fence it by insulating the rest of the periphery from what happens there. Even if a government is formed, to follow the present austerity path, Greece not only lacks basic economic infrastructure on things like taxation to raise the revenue that would reduce the debt quickly, unlike Italy, Greece has been running a primary budget deficit across the business cycle. It is clear to everyone then that cutting expenditure and raising revenue poses a real challenge that Greece cannot meet. In Greece’s case 120% debt to GDP is still too high.
Moreover, unless you have true fiscal integration and convergence, Greece will continue to run current account and budget deficits even after the initial cut is made. So the problems we see now are endemic and they will re-occur. Greece is simply not competitive as part of a currency union with Germany – and it never will be. That means almost permanent fiscal transfers and a loss of Greek fiscal sovereignty. The political will necessary to support this solution does not exist. And so Greece will exit the euro zone. The question is when and under what circumstances.
Greece will exit the euro zone. I wrote a trilogy of posts on this in February. See Running through unilateral Greek exit scenarios, How and why Greece will leave the euro zone, and The political economy of a Greek default (and euro zone exit)
Solutions: Spain as an example
The worry with Greece is contagion to countries like Spain. As Marshall Auerback writes Spain is the new Greece. What he means is that Europe’s policy response to the sovereign debt crisis is a textbook trigger for debt deflation. The global recession in 2008-2009 made private debt in Europe and the US a problem. High levels of private debt have forced a deleveraging in many European countries, weakening public sector receipts. Euro governments’ lack of fiscal space as currency users has meant public cuts. This austerity must meet the private sector’s desire to increase net savings and be resolved one way or another. Because defaults loom in the private sector, deleveraging will continue and austerity invariably induces an additional reduction of private demand. And so austerity ends with more private sector defaults, higher unemployment and a potential for boomerang onto asset prices. That’s what we have seen in Greece and are now seeing in Spain and other peripheral nations. And that’s how austerity works in a fixed currency system.
While all of that is true for Spain, the complicating factor for Spain is the insolvent banking sector. The Spanish should resist nationalising their banks without forcing creditors to take haircuts because this heaps their insolvency burdens onto the sovereign. We see that with the bailout of Bankia, which has asked for €4.5bn in loans, which were converted into shares that are ultimately owned via other institutions by the Spanish government. But If Spain had let Bankia fail and administered haircuts to bondholders, a bank run would have ensued. That choice is out.
The option that the Spanish government had wanted to employ was to calculate what the capital hole is and have the private sector fill that hole by having the institutions raise capital amongst those private investors. That is certainly preferable. But now the Rajoy government is being forced to fill that hole themselves just like the Irish before them. Analysts estimate that this could mean 75 billion euros of government money but with property prices still falling, the needed amount is a moving target and is likely much larger. Investors rightly fear that government debt will skyrocket. That means Spanish yields will spike, putting the euro zone in crisis again.
Secret EuroTARP discussions are now ongoing. They will be accelerated. I believe Germany is against this right now but if the yields do spike this is the only option they have. The ECB offered up an implicit backstop in the LTRO. Investors jumped at the chance to get higher yielding ‘risk-free’ government bond investments on the back of this. But the backstop has lost credibility, saddling Spanish banks with losses. So the monetisation route has effectively ended despite the likelihood of further use of the Securities Markets Program by the ECB.
Enter EuroTARP, Nouriel Roubini writes today that we should get ready for the Spanish bailout:
Spain’s credit boom peaked in 2008 when the supply of cheap, external finance began to fall sharply. Four years later, Spanish banks’ asset quality continues to plummet. The sector will require €100-250bn in recapitalisation later this year to maintain a 9 per cent core tier one capital ratio, the minimum stipulated by the European Banking Authority. In the meantime, there are concerns about the capacity and appetite of Spanish banks to support the sovereign, particularly amid rating downgrades and deposit withdrawals.
Ideally, a bailout for Spanish banks should come immediately and in the form of direct capital injections from the EU bailout funds. Germany remains staunchly opposed to this, as it would mean giving up the stick of conditionality and feeding Spain the funding carrot. Such an option is also resisted by the Spanish authorities as the EU taxpayer will effectively take over their banks.
Instead it looks like a bailout for Spanish banks has been postponed until the very last minute. The cost of a bank bailout would then be foisted on to the Spanish sovereign’s balance sheet.
Bank bailouts on this scale may well bring the Spanish state to its knees. If they don’t, Spain’s public and external debt positions will.
I think the EuroTARP is gaining momentum as an idea to stave off the next crisis. Likely this will use the ESM and EFSF facilities for direct bank injections rather than for sovereign bailouts. In Spain’s case, this would prevent government debt from increasing by effectively spreading risk across euro nations. I have speculated in the past that this could be done across the euro zone to forestall the political backlash:
What I suggest then is that the bailout we see for Spain will be a bank recapitalisation plan. Why? Even the Spanish giants like BBVA and Santander which are said to be the best capitalised and have largely escaped crisis are now feeling the pain. Santander’s profit has collapsed by 24%. So, I am hearing that Brussels is quietly preparing for a bank recapitalisation bailout. The variant being most discussed is making the ESM/EFSF bailout funds directly accessible for Spanish banks. Up to this point only countries could use these facilities. The implication then is that the risk for Spanish banks becomes transferred from the Spanish sovereign to the EU as a whole, making the sovereign’s debt path sustainable. I believe this will happen and I will keep you abreast of the developments. If it does happen, it will have very big implications not just for Spain but for sovereign debt, European equities and the global economy.
Solutions: France as an example
European policy makers are shifting their policy stances, though. And while the shift is slow, it is in the right direction. The election in France means that France, a leading and driving force of euro zone institutional arrangements and economic policy, is now less committed to those arrangements and that policy. France has a mandate to redesign the institutional framework to include growth. So Mario Draghi’s growth compact will take form. The election in France does not mean that Europe has not voted "no" on austerity or that austerity is over. Rather, the election will shift policy, but the shift will be less than the media frenzy suggests. What will happen is that a "growth compact" will be bolted onto the stability and growth pact, ending in a temporary relaxation of the 3/60 Maastricht deficit/debt hurdles. Nowhere is there any evidence that a seismic shift in policy is about to occur.
Everywhere you hear talk about the need for structural reforms to enable growth. For example when the centre right New Democracy party in Greece talked about reforms/austerity, according to Paul Mason:
it has never, in its heart, supported the Eurozone-imposed austerity plan. [Mason was] told publicly and even stronger in private by its economic experts that the Troika plan, with its reliance on tax rises to obviate even deeper spending cuts, will not work.
The Greek centre-right would have preferred a much faster and steeper cut in public spending combined with tax cuts, and – in its head at least – much bigger and faster proceeds of privatization. That’s why they wanted an outright mandate – to attack what they see as the vested interests of civil servants and public sector unions. Instead their vote collapsed.
The same is true for what the Germans mean when they say "growth". The Hartz reforms carried out by the centre-left SPD government speak to this. The goal is less red-tape, less government, reduction in pension costs, and more flexible labor markets. These are supply side reforms and something entirely different than what Keynesians mean when they talk about growth stemming from stimulus and increased aggregate demand.
So what I anticipate will happen is that we might see an EU infrastructure funding budget developed to allow for economies to transition into these reforms without a collapse in demand. There has already been talk of using the European Investment Bank (EIB) as the vehicle for this. But the basic plan will not change. Fiscal discipline and price stability will remain the orders of the day. At some point, however, crisis will force a more draconian change. Greece will certainly bring contagion if it re-defaults or leaves the euro zone. And so that means the endgame is in sight.
Conclusion
Policy makers remain committed to the euro. They will go to great lengths to protect it from dissolution and a catastrophic outcome. European policy makers understand they erred in not setting up the right institutional structures to deal with sovereign debt issues. They will rectify this problem under the knife hand of market-induced crisis.
Therefore, over the medium term, we are likely to see
- Monetisation via the ECB’s Securities Market Program but this will be a stop-gap only as the Europeans are not ready to give the ECB authority for backstopping sovereign debt.
- EuroTARP either for Spain in isolation or Europe-wide. Clearly the Irish and others will want equal treatment to the Spanish. Moreover, a political backlash against bank bailouts will ensue. Therefore making this Europe-wide and tethering it to the Basel III reforms makes sense.
- Growth pact via the EIB that will invest in infrastructure projects in return for medium-term fiscal consolidation and ‘growth-oriented’ market reforms.
- Target relaxation because that will be a major compromise in order to deal with the Spanish and Italian situations and to assuage French concerns about front-loaded cuts and tax increases.
- ECB backstop will come as well. Even Juergen Stark has intimated that ECB liquidity could be on offer under the right circumstances i.e. “only when important steps toward political union are made can we have common bonds,” the ECB would get a green light after the bilateral agreements to provide unlimited liquidity until Eurobonds are issued.
Over the long-term, we are likely to see more permanent structural remedies like
- Grexit as the euro zone will lose Greece as a member. It could happen over the medium-term too if the European situation is not stabilised. Portugal could also exit.
- But the rest will become more integrated as the Lisbon treaty is amended to add greater fiscal integration and penalties. The big question marks are Italy and Spain.
- Defaults in Greece and elsewhere. Portugal seems most likely, followed by Ireland.
- Eurobonds will eventually have to occur in order to keep sovereign debt from being a problem. Clearly, the fiscal compact and the penalties will have to have teeth for Eurobonds to be palatable. In practice, you could have sovereigns conduct a ‘sovereign debt swap’ whereby the ECB buys an agreed-upon portion of the existing debt from the sovereigns and then uses these funds to back the supranational debt.
For now, my advice remains the same on Europe: avoid bank shares, avoid periphery sovereign debt, and stay defensive in asset allocation. Underweight the periphery until at least three of the four medium-term solutions are in place.