Nobel Peace Prize: Was It Deserved?
Written by Stephen Swanson
A week in which the European Union wins a Nobel Peace Prize and also is chided by the IMF for not doing more to implement a Euro wide banking regime to contain continuing financial threats, provides the perfect backdrop against which to revisit the EMU, take stock of recent events and assess the likely course of future events.
In its report the IMF said:
"Commitment to a clear roadmap on a banking union and fiscal integration are needed to restore confidence, reverse the capital flight and reintegrate the euro area. Despite many important steps already taken by policymakers, this agenda remains critically incomplete, exposing the euro area to a downward spiral of capital flight, break-up fears and economic decline.”
Schaeuble is on a Different Page
Thus far leaders have shown a pattern of responding to crises and falling into complacency when not under duress. Under the most recent plan the ECB would be charged with regulating the area’s banks and given authority to act as a lender of last resort and provide aid to troubled banks by drawing upon bailout funds funded by member countries. But Germany has reservations about the planned start date of January, 2013 along with a host of other concerns. Finance Minister Wolfgang Schaeuble believes many aspects of current plans for a common supervisory authority are poorly conceived and the timetable overly ambitious.
In addition to wanting to limit ECB (European Central Bank) supervision to systemically important banks, Schaeuble has warned of possible conflicts of interest for the ECB and, given the possible fiscal costs of a supervision failure under the new system, Germany wants the balance of power to better reflect the risks shouldered by member states with large banking liabilities. Such an increase in influence would give Germany and other states with big financial sectors a much better handle on the supervision work of the ECB – extra clout that EU officials fear could hamper its independence. Along with adjusting voting weights, Berlin is also calling for a separate supervision board, comprised of national supervisors, to chose its own chair and vice chair – stripping control from the hands of the ECB’s governing council. German, Finland and others want to both control and limit their liabilities.
The issue of who will be responsible for bailing out weak eurozone banks was cast into futher uncertainty last month after finance ministers from Germany, Finland and the Netherlands insisted the ESM (European Stability Mechanism) would not take on debts incurred while banks were being supervised by existing national regulators. The statement followed a June decision taken at a high-profile EU summit on a eurozone banking union that many in the financial markets and in other EU countries believed would lead to a transfer of Irish and Spanish bank debt to the balance sheet of the ESM.
The June deal would allow the ESM to take on those debts once a single eurozone bank supervisor is up and running under the auspices of the ECB. Ireland currently has euro 64bn in bank bailout debt on its sovereign books, and the Irish government believed the June agreement would enable them to move a good chunk of that onto the ESM, radically lowering its debt levels. Similarly, Spain will soon accept about €40 billion in ESM assistance to shore up its teetering domestic financial sector, debt that Madrid had also hoped would be guaranteed by the ESM.
Time is Money
Delays do not come without costs and the IMF warned until there is centralized banking supervision and additional policy steps to stem the financial crisis, deleveraging would weigh on growth and add to increasingly high unemployment levels in the region, and businesses would suffer as bond markets proved unable to plug the gap left by banks European banks could dump $2.8 trillion to $4.0 trillion worth of assets – more than 7 per cent of their balance sheets – by the end of next year. Banks in the periphery would shed just short of 10 per cent of their assets. That would hurt credit and crimp growth by 4 percentage points next year in the peripheral countries of Greece, Cyprus, Ireland, Italy, Portugal and Spain.
Bank deleveraging is being driven by five main factors, the IMF said. The impact of weaker earnings and higher asset impairments on capital level funding pressures from frozen inter bank markets and declining deposits, growing trend for banks to match loan and deposit levels in some subsidiaries, pressure to increase domestic government bond holdings at the expense other assets as well as rising sovereign debt spreads.
Divergences between North and South and risk of capital flight were reinforced Thursday when the ECB released data showing that monetary aggregates continued to grow in the euro area, with M2 up 3.2% year over year through August. However, M2 growth was negative in Spain (-7.3%, August ), Greece (-15.0%, July), Portugal (-6.2%, July), and Ireland (-3,5%. July). The ECB’s data also showed that lending by monetary financial institutions (excluding central banks) to the private sector plunged by euro 766 billion SAAR over the past three months through August largely attributable to a big drop in loans by MFI’s to other financial institutions.
Spain Rhymes with Drain
And this brings us to Spanish Prime Minister Mariano Rajoy’s seemingly bizarre behavior and continued refusal to take advantage of the ECB’s offer to sop up almost unlimited amounts of Spanish debt in the secondary market through OMT (outright monetary transactions) if Spain applies for assistance to the ESM (a bailout vehicle) which would establish conditionalities and offer support in the form of sovereign debt purchases in the primary market. While wanting to avoid austerity and economic reforms that would come with conditionalitites, it’s only a matter of time before Rajoy submits though it’s unlikely ECB bond purchases will help the economy. The economy is worse than thought and continues to deteriorate
Standard & Poor's downgraded Spain's long-term credit rating to one notch above junk, to BBB- from BBB+, with a negative outllok because of mounting risks to the country's public finances. The ratings agency said that tensions between Spain's regional governments and the central government are rising, leading to less effective policy decisions. Also, the country faces a GDP contraction of 1.8% in 2012 and 1.4% in 2013, which will only worsen already painful unemployment of 24.6%.
S&P said in a statement:
"The pace of private sector deleveraging, together with the government's budgetary consolidation measures, is likely to lead to an even deeper contraction of investment and consumption in both the public and private sectors."
Even without OMT the ECB is already propping up Spain’s banking system with 411.7 billion euros in MTRO and LTRO loans, necessary to offset massive deposit and capital outflows. The IMF said that “both Spain and Italy have suffered large-scale capital outflows” in the 12 months through June, loosing $296 billion and $235 billion, respectively. By comparison Greece is a sideshow but we should hear from the troika next month.
Amid riots, protests and tear gas, members of the troika and representative of the Greek government are presently hammering out details on the latest round of spending cuts and reforms with goals of enshrining in legislation structural reforms promised for over two years and additional spending cuts of €11.5 billion. What is particularly sad is that austerity is falling hardest upon the weakest members of society while very little is being done to privatize state assets, enforce tax revenue collection, eliminate regulatory red tape, trim bloated bureaucracies, break professional cartels and diminish the outsized influence of unions.
Including this author, many take a cynical view of these discussions and fully expect the troika will issue a report authorizing the next tranche of aid of euro 31.5 billion from Bailout II whether it’s deserved or not as neither default nor exit from the EMU are viable options. As noted by the Economist:
“...the motives for rescuing Greece are transparent. The euro zone is in such bad shape, with the potential for serious meltdowns in Spain and Italy, that politicians are determined to avert a "Grexit."
The consequences of a Greek withdrawal from the euro zone seem incalculable, and the rest of Europe is terrified at the prospect. The domino theory is no longer being discussed as a possibility, but rather as a likely scenario. Europe's leaders are determined to avert a total collapse of the euro zone. As a result, the current approach is to plough ahead, no matter what conclusions the troika reaches in its report -- or rather, the report will reach the conclusions it is supposed to reach, no matter what happens, or doesn't happen, in Athens.
The inability of governments to undertake meaninful reform programs and take political heat can be seen in Portugal, where various reform were, until recently, on track. But this changed following the emergence of significant shortfalls in tax revenue and the government’s decision to withdraw a planned social security reform after street protests.The social security plan, described as a “fiscal devaluation”, was replaced with an enormous tax increases, equivalent to about 2 per cent of economic output next year.
Policy vacillation and worse than expected fiscal results has slowed Portugal’s progress on fiscal consolidation and the Eurogroup finance ministers granted the Pedro Coehlo administration a one-year extension on meeting troika-mandated deficit-reduction targets, and the first 4.3-billion-euro tranche of a total of 78 billion euros in international aid.
IMF Change of Heart
And finally the IMF included in its World Economic Outlook a discussion of fiscal multipliers and an admission that it may have contributed to the slowdown within the EMU by understating the magnitude of fiscal multipliers, raising the spectre that tax increases and public spending cuts might be so harmful as to be self-defeating. But before we go out an anoint ourselves as unreconstructed Keynesians, it’s more than of passing interest that the FT tried to replicate the IMF findings and noticed that time intervals and countries sampled are critical variables.
Interestingly, the IMF excluded from its sample countries that have successfully executed deficit reduction strategies, including New Zealand, Estonia, Latvia and Lithuania. This seriously dilutes the intellectual integrity supporting the fiscal multiplier argument but even if multipliers are larger than what has been assumed, it does not make a case for relieving pressure for structural reforms which will increase competitiveness by making countries more cost-effective through lower labor rates, more flexible labor markets and enhanced productivity. And as noted by ZeroHedge, Christine LaGarde likely has more interest in Hermes pret-a-porter than fiscal multipliers.
Inventory of Failure
In rereading and thinking about the foregoing, it’s fairly clear the policy steps taken by the European Commission, the ECB and IMF are not working as planned.
- Greece has received two bailouts and is struggling to receive its first tranche of aid under Bailout II;
- both Greece and Portugal are behind schedule in instituting promised fiscal reforms;
- citizens subjected to conditionalities imposed by EFSF/ESM are outraged and have taken to the streets in violent protest;
- economic growth is contracting far more than foreseen with excruciating increases in unemployment;
- economic divergences between North and South are very evident, although the contraction contagion is drifting towards the core;
- capital flight and redenomination risk persists though interest rate spreads have tightened;
- in many countries a vicious feedback loop persists between insolvent sovereigns and insolvent host banks;
- no country has taken advantage of Draghi’s pledge (announced July 26th) to do whatever it takes through OMT;
- policy announcements are frequently reversed, reducing credibility and increasing risk; and
- serious divisions remain within the EMU with countries most in need happy to expose the wealthiest countries to unlimited liability.
Longer-term, the EMU as presently constituted will only succeed if rapid, concrete steps are taken to
(1) centralize banking supervision, including regulation, deposit insurance and resolution authority,
(2) differentiate between fiscal consolidation/austerity and real competitiveness,
(3) eliminate intra EMU trade imbalances,
(4) stop capital flight,
(5) allow the ECB to become a lender of last resort,
(6) allow some countries, such as Greece, to write-down official sector debt (EFSF and/or ECB),
(7) move towards fiscal coordination and consolidation and
(8) forfeit national sovereignty to a supra-national body.
Given enough time, I think political leaders will take the decisions needed to satisfy each and all of these conditions but circumstances and markets are unlikely to indulge leaders with such luxury (time) and demand action faster than leaders can deliver. Political constraints are a serious issue. As a result, it’s more than likely several countries will forced to exit leaving us with a truncated EMU.
About the Author
Stephen Swanson has a degree in economics and an MBA. His corporate experience includes several executive positions including a divisional VP assignment. More recently he has left the corporate world and has been investing in financial instruments and real estate, with interests expanding into S&P futures and commodities. Stephen is known on the internet under the pseudo nom CautiousInvestor and is a frequent commentator at Seeking Alpha where he also posts blogs.