Euro Watch

Monti, The Full Version

2012-01-18T11:44:00.002+01:00

The version in question is an interview with the Financial Times. A summary was available here, but now they have gone live with the whole interview. If you can raise it on Google or something then it is well worth a read. For one thing it will offer you a trip down memory lane. Anyone remember this? “If you’ve got a bazooka, and people know you’ve got it, you may not have to take it out.” The reference is, of course, to former U.S. Treasury Secretary Henry Paulson, who famously used the remark in 2008 congressional testimony. But as Republican Senator Bob Corker pointed out in a subsequent hearing:

“I do want to remind you that the theory behind the bazooka was that if you have a bazooka in your pocket and the markets know that you have it, you will never have to use it. I would like to point out that you not only pulled it out of your pocket and used it, huge amounts of ammunition was pulled out of the taxpayer arsenal to solve that. I think you’ve done some very deft things and I compliment you on that, but the point is that things don’t always work out the way people, in their best efforts, think they’re going to work out.”

Well, the idea just surfaced again, this time from the lips of Mario Monti:

“I’m convinced, and the IMF is also convinced, that the more pledges are made [to the rescue fund], the higher the volume of pledges made, the smaller the probability that a single euro of cash will have to be disbursed.”

But, as former IMF Chief Economist Simon Johnson once explained, the latest version of the "bazooka" is unlikely to be any more successful than the previous one.

"Today’s proposed bazookas are about providing enough financial firepower so that troubled European governments do not necessarily have to fund themselves in panicked private markets. The reasoning is that if an official backstop is at hand, investors’ fears would abate and governments would be able to sell bonds at reasonable interest rates again. This idea is just as dubious as Paulson’s original notion. Markets are so thoroughly rattled that if a financial backstop is put in place, it would need to be used -- probably to the tune of trillions of euros of European debt purchases from sovereigns and banks in coming months. Whether or not it is used, a plausible bazooka would need to be huge."

Fortunately the ECB has deep pockets, and as I argue in this post, these will probably suffice to keep short term bond yields down to acceptable levels, and help the banks fund themselves and recapitalise. What the ECB's LTRO's won't do is get new credit moving (one significant part of the initiative involves banks in the troubled periphery economies not having to write down the asset side too much too quickly, so there will be little room for "creative destruction"). As fund managers Bridgewater put it recently:

"We believe that a) there are logical limitations to the amounts of debt that creditors will choose to lend to debtors, b) at this time numerous debtors have passed their limits, and c) the projected rates of adjustment that policy makers are using, which generally mean slightly slower rates of increase in indebtedness rather than debt reductions, cannot happen. In other words, despite attempts of policy makers to push this debt expansion further, they can’t. Significant funding gaps will remain....... understandably, central banks are now trying to fill the funding gaps with abundant liquidity. At the same time, banks must contract and consolidate as they can’t adequately recapitalize."

Leaving aside the tricky issue of the extent to which the latest Euro management initiative will work, Monti does have more interesting things to say. He is, for example, quite positive about Standard and Poor's:

“If I ever dictated anything, it must have been what S&P had to say about domestic Italian economic policy,” he chuckles, before quickly correcting himself: “I never said the three letters BBB,” a reference to Italy’s new S&P rating of triple B plus........“It’s very interesting when they go through the various factors, and concerning the political risk factor they say there is one negative: ‘The European policymaking and political institutions, with which Italy is closely integrated’,” he says. “And then they go on, saying, ‘Nevertheless, we have not changed our political risk score for Italy. We believe that the weakening policy environment at European level is to a certain degree offset by a strong domestic Italian capacity’. “I think I’m the only one in Europe not to have criticised the rating agencies,” Mr Monti boasts.”

As Peter Spiegel and Guy Dinmore not unreasonably conclude, the reason for this positive tone is clear: "Mr Monti’s 60 days in office have been enough to convince the agency that his government is on a path of reform that could return the country to growth and shrink its debt levels, but that European Union mismanagement of the eurozone debt crisis is dragging down struggling countries, including Italy with its €1,900bn ($2,400bn) debt mountain".

"Over the course of the 90-minute interview, Mr Monti is careful not to challenge his counterparts directly. Asked whether the S&P analysis is a condemnation of Ms Merkel, who is widely viewed as the driver of the current response to the eurozone crisis, he is diplomatic: “I don’t think we can really single out one country or one person,” he says. Later on, when asked how concerned he is that strikes by taxi drivers and pharmacists could derail his reforms at home, he insists that when he wakes up in the morning, he is more concerned with “European leadership” than domestic unrest. “European leadership – not the German chancellor,” he quickly clarifies."

The Massendowngrade Effect

2012-01-16T13:49:00.000+01:00

Well, that was the week that was, wasn't it? It started with a cheerful, upbeat market response to both the impact of the ECB's 3 year LTRO and the growing impression that Hungary was going to make some sort of "one-off" deal with the IMF, and ended near the depths of despair as S&P's announced the downgrade of 9 Euro Area countries, while the EU Commission worked hard to reinforce the impression that it was about to launch legal proceedings that could even lead to the temporary suspension of Hungary from the EU. It was a time of bitter sweet experiences, which started with Tamás Fellegi (that's him smiling in the photo below) heading off for his scheduled interview with Christine Lagarde. Then we learnt that the German economy had grown by a brisk 3% in 2011, only to have our hopes dashed by the clarification that most of the growth was in the first 9 months of the year, and in fact the country probably entered recession in the last quarter.

Just as we were recovering from that initial shock, Irish stockbrokers Goodbody poured even more cold water on our breakfast cornflakes by telling us that Ireland would probably need a second bailout, since economic performance in 2012 was likely to be below expectations, while prevailing financial conditions would make an early return to the financial markets virtually impossible. Our spirits were fleetingly brightened by the news that Spain had managed a successful bond auction, but the cork was just as swiftly rammed back into the bubbly bottle as it had been pulled out when we discovered that Italy had not, and that LCH Clearnet had promptly reacted by raising the margins on the country's debt when posted as collateral.

On the other hand Thursday did give us another brief soothing interlude, as Mario Draghi reminded us of all the beneficial consequences of the recent 3 year LTRO (Long Term Repo Operation), and cheered our spirits by informing us that he was not lowering interest rates again at this stage due to the growing signs of stabilisation his technical staff had been able to identify. “According to some recent survey indicators, there are tentative signs of stabilization of economic activity at low levels,” he told the assembled journalists, although he did go on to warn that the debt crisis continued to pose “substantial downside risks” to the economic outlook and the ECB stood “ready to act” if need be.

Apart from the evidently weakening inflation, possibly the most important single indicator he will have had in mind in making the above statement would be the monthly PMI survey. The composite index (which combines manufacturing and services) shows economic activity contined to contract in December, but at a rather slower rate than in November, and in fact the rate of contraction in November was slower than the one recorded in October. So things are getting worse more slowly!

Despite the evident differences between countries in their rate of deterioration, the stabilisation pattern is pretty generally reproduced across the Euro Area. In Spain, for example, where services activity plummeted in November (at rates reminiscent of the last recession), the decline was significantly slower in December, although it was still, of course, a substantial decline.

Even Greece's war-torn manufacturing sector showed signs of "contraction weariness" in December, although I fear that had the contraction continued at its earlier breathtaking pace we would soon have little left.

The EU sentiment index has also fallen much more slowly in the last two months, indicating that confidence is not deteriorating as rapidly as it was.

And the widely followed German IFO Business Climate index has perked up slightly in the last couple of months.

So Mario Draghi is absolutely right, stabilisation is precisely what we see. But this is stabilisation during a decline, and there is little in these indicators to tell us which way the next move will be, and in fact the few forward looking components we have suggested things might be about to get worse rather than better, a point which was not lost on Markit's Chief Economist, Chris Williamson, who said in his comment accompanying the monthly PMI report:

"The uplift in the Eurozone PMI in December does little to dispel fears of the region sliding back into recession. Despite the upturn, the fourth quarter saw the steepest contraction since the spring of 2009, and forward-looking indicators suggest that a further decline is on the cards for the first quarter of 2012. In particular, orders for goods and services continued to collapse, suggesting that output and employment will be cut as we move into the new year".

Of course, as everyone is by now only too well aware, the week finished on a crescendo as S&P's announced the widely anticipated downgrade of nine Euro Area countries. That being said, surely pride of place in this agitaed week must belong to Hungary, whose bleary eyed Prime Minister Viktor Orban can be seen in the photo below. It is early morning, and he probably hadn't slept that well after learning that the IMF would defer to the EU on all matters relating to whether his country was in compliance with its Treaty obligations before taking any decisions on future loans.

As one country after another temporarily surrenders its right to an elected government to put itself in the hands of the technocrats (as Hungary did in 2009, before the election of the Orban government) I cannot help asking myself whether recent developments are mainly the result of the countries peculiar (and almost unique) history, or whether it is giving us an idea of the sort of thing we can expect to see if simple austerity as it is being practised all along Europe's periphery doesn't work out as planned. Certainly Mario Monti is alive to this possibility, as he said in an interview with Die Welt Online this week (German only I'm afraid), unless Europe's policy is flexibilized it will be a case of "after me the populists".

All Alive And Well On ECB Cool Aid?

Perhaps the main point to take to heart from the events of the last week is the way the recent ECB liquidity measures have apparently been able stabilised the debt crisis, at least for the time being, even while it is not clear that they will have the same success stabilising the deterioration in the respective real economies.

In a liquidity-providing operation which some have described as "unleashing a wall of money", in the week before Christnas more than 500 EU banks borrowed a total of €489 billion in three-year loans – equivalent to roughly 5 per cent of eurozone gross domestic product and the largest amount ever provided in a single ECB liquidity operation. In fact only about €190 billion of this was new money, since the majority of the borrowing involved the consolidation of lending that had already been taking place on a shorter term basis.

Despite the size of the demand, and some relatively succesful bond auctions, much attention is still focusing on the way Eurozone banks' overnight deposits with the European Central Bank have been rising in the wake of the move. In fact these themselves hit yet another all-time high last Thursday according to the ECB, with the quantity deposited hitting €489.906 billion, up from €470.632 billion the day before. This phenomenon has lead some analysts to suggest the operation may be a failure. Such a judgement would be a premature and erroneous in my humble opinion.

It's The Real Economy, Stupid!

In order to assess the extent to which the recent ECB measures have succeeded we need to think about what the objectives really were. In the first place the bank clearly hoped the commercial banks would use some of the money borrowed to buy new issue government bonds in the primary market, and earn themselves a bit of "carry" (the difference between what it costs them to borrow from the central bank and what the bonds purchased pay) in the process. The much needed additional income will help them improve their bottom lines and allow them to accumulate some additional capital to help with their capital ratios. This has lead some observers, like Nomura's Kevin Gaynor, to argue that the ECB is now doing overt (as opposed to covert) QE. In some senses this is surely the case, since the bank was already doing what some called QE by stealth way all the way back in 2009 (as Claus Vistesen argued here, and I argued here).

But before digging into all this a bit further, let's go back to the issue of those growing overnight ECB deposits. For some observers the very size of these deposits constitutes evidence that the ECB 3 year LTRO isn't working as anticipated.

This argument, as Danske Bank's Senior Economist Frank Hansen argues, is misleading, since the volume of ECB deposits only give us a measure of aggregate excess liquidity across the Eurosystem, and doesn't tell us anything about the distribution of that liquidity between countries or between banks.

"Does this mean that the operation has failed to stimulate government bond purchases? No, not really. If a bank uses money from the LTRO to buy government bonds (or any other paper) in the secondary market, the amount will still show up as a deposit at the ECB (now on behalf of the seller’s bank). If a bank buys government bonds in the primary market, the amount will also show up as bank deposits at the ECB if the government spends the receipts or places them at a private bank. Thus, the increase in deposits does not imply that the 36 months LTRO has failed to stimulate government bond purchases (or other trading for that matter)".

So basically, if we think for a moment about maturing, and not new, additional issue, government bonds, then commercial banks along the periphery buying the replacement issue can allow their peers in the core to recover their investment, and park the money. The only way the money from these sort of bond transactions doesn't show up as excess liquidity is if the national government concerned places the takings on deposit at the central bank, or if an investor takes the money they have recovered from a redemption out of the Eurosystem. The same goes for private bank debt, which often just moves from being a liability one bank has with another commercial bank in the Eurosystem to being a liability with the ECB. Naturally the bank that recovers its money may well then park the proceeds on deposit and hence it will show up as excess liquidity at the ECB.

So, while short term liquidity needs may be being catered for (at least up to 3 years), there may be a deeper phenomenon at work via the LTRO, whereby the core leaves the periphery. In fact that seems to be happening. The charts below (which were prepared by Citi Research) show the situation up to the end of October (latest data), and make clear that it is commercial banks on the periphery who are, in the main, making increased use of the ECB's open market operations, while it is banks in core Europe who are using the deposit facility.

There is no reason to suppose that data post October will reveal any fundamental shift in tendency. Spanish banks, for example, increased their ECB borrowing from roughly €70 billion in September to €118 billion in December (nearly a €50 billion - or 75% - increase), while use of the deposit facility only went up from €9 billion to 15 billion, so the Spanish banking system clearly needs this liquidity.

Another area where the transfer of liquidity doesn't show up as a change in aggregate excess liquidity is when banks offload their wholesale liabilities to other EuroArea banks and refund via the ECB. Here again, if they do it smartly, they can even earn a bit of "quasi carry" in the process, by buying back their debt at well below face value from those who are anxious to exit the periphery, and then refinancing at the ECB without writing down the underlying asset. This could be termed a liability "write down", and again the procedure earns the bank a nice bit of income which can subsequently be used to help the recapitalisation process.

Take the Portuguese Bank BPI (the country's fourth largest), which is making public tender offers to buy back its debt. If all concerned tender their bonds to BPI, BPI will pay something short of €1.5bn cash to investors. Mortgages which were previously sitting in one of their SPVs will return to their balance sheet, and ECB money will now be on the other side financing them allowing significant profits (and capital) to be reported. In this particular tender the smallest discount is 35% and the largest is 65%. Investors may initially baulk at the offer, since they will nurse a heavy loss (equal, naturally, to BPI´s profit) but ultimately they will probably be only too happy to be able to walk away from Portugal, and with some cash in their pocket to boot.

Iberian banks were already aware of the benefits of this kind of restructuring during the 2009-2010 liquidity wave, and went about quietly repurchasing their bonds (bank capital, securitizations, senior bonds) on a selective and private basis at a discount. Much of their reported profits in those years in fact came from either the ECB carry trade or this kind of transaction. So when we read that another Portuguese bank - Banco Espirito Santo - has just had €1 billion of debt guaranteed by the Portuguese state (a soverign which can't itself go to the markets) it isn't hard to imagine that the process going on in the background is something similar to that seen in the BPI case, and that the debt is being guaranteed so it can go over to the ECB to be posted as collateral.

The National Bank of Greece has been doing something similar. They recently offered to buy back some €1.5 billion in covered bonds and preferred securities, offering 70% of face value for the covered bonds and 45% for the preferred hybrids. As the bank itself says, “The purpose of the offers is to generate core Tier 1 capital for the group and to strengthen the quality of its capital base....The offers would generate a gain for the group.”

And Italian banks would seem to be doing something similar, since they issued around €40 billion in government backed bonds specifically to take to the ECB. The bonds are held by the banks themselves and stay on their books to maturity, their only purpose being to provide collateral for use at the ECB. In fact Italian banks took something like €116 billion from the LTRO, or almost 25% of the total. Perhaps this is why Unicredit CEO Federico Ghizzoni and other European top bankers met ECB officials in Frankfurt back in November, to discuss new rules for collateral.

In Spain securitised mortgages sitting on the balance sheets of the bank-owned Fondos de Titulizacion de Activos could also be recycled in this way (here's a complete list, although note that these Funds are regulated by Spain's CNMV and not the Bank of Spain, which is why their presence is relatively unknown and people are able to accurately say that the central bank has been very strict on SIVs, since they weren't their responsibility).

That something like this may be happening, with the ECB "buying into" public and private Euro Periphery debt while investors are discretely getting out is suggested by this report in Bloomberg:

The euro is losing the relationship with riskier assets that underpinned the currency in 2011 as the deepening sovereign debt crisis reduces the creditworthiness of even the biggest economies in the region. The 17-nation currency has fallen 8.7 percent against the dollar since October, while the Standard & Poor’s 500 Index has gained 3.4 percent, and the correlation between the two dropped to 58 percent from a record 91 percent in November, according to data compiled by Bloomberg. The euro had moved almost in lockstep with investments linked to growth, including stocks and the Australian dollar, since January 2011.

This decoupling is taking place as European Central Bank President Mario Draghi cuts interest rates and promises banks unlimited cash for three years to rein in soaring borrowing costs for governments... Strategists also anticipate more losses as the US economy improves while the euro zone shrinks, driving international investors away from the region’s assets.

So if the first two objectives were to help the struggling sovereigns, and enable the commercial banks to refinance their debt, then to some extent these objectives have been met. But what about the third objective, moving credit on the periphery to get the real economy moving again? Well, here the ECB's measures are likely to have far less effect, and indeed what effect they do have may be in some way a mixed blessing, since the banks seem far more worried about demonstrating they have an adequate level of core capital than they are about participating in solutions to real economy problems.

To understand why this simply increasing aggregate liquidity doesn't necessarily help individual countries, it is important to realise that credit conditions in the Euro Area member countries are not uniform (a much more detailed exposition of this point can be found in this earlier post). In countries like Germany, Finland and the Netherlands, credit is more or less freely available, even if demand for it is limited - German corporates are awash with cash, and it has been a long, long time since German households were digging their way into debt.

In France and Italy, banks are drawing in their horns, but credit is a long way from being frozen.

Although in France, the rate of new loan generation in the private sector has been sliding since mid summer, especially if you look at the thin black line in the chart below (Bank of France), which shows the rate of change on a three monthly rather than an annual basis.

A similar position can be seen in the case of home mortgages.

Now in the French case, given that the private sector is not heavily overindebted, unemployment is not excessively high, and a demand for credit from solvent clients exists, it is quite possible that the ECB measures can help stabilise the situation, and put a brake on the implosion.

On the periphery, however, where populations are heavily endebted either directly, or via their sovereigns, where the economy isn't functioning properly, and unemployment is high and rising, the problem isn't only the unavailability of credit, but also the shortage of solvent clients who actually want to leverage themselves.

For increased liquidity to mean that credit becomes expansionary for the real economy again, it is the banks themselves who need to deleverage (and not simply write down their liability side), by disposing of the large volume of continually restructured but basically non-performing credit they have on their books. Behind the credit crunch in these countries lies a problem of massive economic structural distortion, produce by the lending and borrowing boom during the "good" years. What is needed is what Joseph Schumpeter referred to as a process of "creative destruction", whereby some enterprises die so that others can be born, and naturally some loans are written off, despite the fact this has unpleasant effects on bank profitability and capital ratios. To really get credit moving again in some of these periphery economies, a large chunk of loans need to be written down, and support needs to be offered by the sovereign to enable this to occur.

Unfortunately the ECB's liquidity provision could have precisely a perverse effect in this context, as it may well enable those who should die to stay alive. Commercial banks, at the discretion of their central bank, may now package straighforward bilateral commercial loans to present as collateral at the ECB. This measure, which in theory was intended to enable the banks to extend "good credit" may now enable them to restructure and keep on their balance sheet loans that should really be classified as "impaired" and somehow resolved.

In the case of Spain, for example, in addition to the properties they have acquired, banks still have oustanding loans of over €300 billion to developers on their books according to Bank of Spain data. The majority of these loans are not classified as either non-performing or sub-standard, and are hence considered to be "good" (I will refrain from saying "excellent"). In principle there is no reason why a significant number of these "good" loans cannot be packaged in some way or other to serve as collateral to be posted at the ECB. Naturally this takes some of the pressure off Economy Minister Luis de Guindos to establish a bad bank, since for the time being the ECB can, in part, serve this purpose for him. And if the banks write down their liability side a bit, then this may also help him with the €50 billion or so he estimates will be needed for bank recapitalisation. No wonder he feels the amount of public money needed will be minimal! The only real downside on this is that foreign investors may well be dumping Spain, while the country (which still runs a current account deficit) continues to have an external financing requirement.

None of this is either uniquivocally good, or unequivocally bad, it depends. What the liquidity move will do is buy the banks time to sweat out some capital onto their balance sheets, and make them better able to withstand more of those dreaded "stress tests" (assuming, that is, that the European Banking Authority allows some "wiggle room" to enable them to keep maintaining their risky sovereign debt holdings). What it won't do is help put the real economy straight, or allow the banks to get back to what some would consider is their basic task which is guaranteeing a normal supply of credit to the economy.

All of which brings us nicely back to those horrid S&P downgrades. According to S&P's own literature, the dowgrades were prompted by a number of concerns:

Today's rating actions are primarily driven by our assessment that the policy initiatives that have been taken by European policymakers in recent weeks may be insufficient to fully address ongoing systemic stresses in the eurozone. In our view, these stresses include: (1) tightening credit conditions, (2) an increase in risk premiums for a widening group of eurozone issuers, (3) a simultaneous attempt to delever by governments and households, (4) weakening economic growth prospects, and (5) an open and prolonged dispute among European policymakers over the proper approach to address challenges.

If we look at the list of 5 issues they identify, the recent 3 year LTRO may do something to help ease the first two of their concerns, especially in core countries as far as credit conditions go, and at the short end in terms of peripheral sovereign debt spreads, but it will do virtually nothing to resolve the other key issues, and it will not alter the course of the crisis in the longer term. In other words it is not a game changer, even though it will buy time.

But time is - if we look over to Hungary - something we will eventually run out of. Handing over the adminsitration of one country after another to a group of approved technocrats may well work for a while, but it won't work forever. One day or another, if the measures taken don't work, Mario Monti will be replaced by the populists, and a new chapter in European history will open. At the present time the policy emphasis on fiscal rectitude and structural reforms, to the neglect of the deep competitiveness and imbalance problems which exist within the Euro Area, is leading us all to no good place. A quick glance over in the direction of Hungary might suggest to us what that place could look like.

Well, that really was the week that was, wasn't it. It's over, let it go, there's another one coming just around the corner, and my initial impression is that it is unlikely to be a quieter or more relaxing one.

On one level, Friday’s news was not really surprising. The French rating downgrade was a shock foretold. As was the breakdown in talks between private investors and the Greek government about a voluntary participation in a debt writedown. A proposition that was unrealistic to start with has been rejected. We should not feign surprise.And yet both events are important because they show us the mechanism behind this year’s likely unfolding of events. The eurozone has fallen into a spiral of downgrades, falling economic output, rising debt and further downgrades. A recession has just started. Greece is now likely to default on most of its debts and may even have to leave the eurozone. When that happens, the spotlight will fall immediately on Portugal, and the next contagious round of downgrades will begin.
Wolfgang Munchau, Financial Times, Sunday 15 January 2012.

This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".

The Rain In Spain Falls Mainly On The Journalists, It Seems

2012-01-01T16:44:00.000+01:00

Things in Spain are never exactly what they seem to be. This is a painful lesson that even Angela Merkel must have learnt in recent days, especially since she put her credibility so much on the line in backing the country's deficit reduction efforts. "Spain has really done its homework and I think it is on the right track," is the message she has been trying to sell to the world.

Naturally then she will not have been amused to learn last Friday that rather than the 6% promised under the Spanish stability programme, the country's deficit in 2011 is going to be something like 8%. Some sort of overshoot was long being anticipated, but such an overshoot? Naturally it isn't (quite) Greek proportions, but it is still hardly evidence for a credible and praiseworthy effort. This is the thing about Spain, it obviously isn't Greece, but still all isn't quite what it should be. Add to this deficit result the fact that the Bank of Spain is reported to be frantically pressuring banks into revising the valuation of their property asssets following the publication by ratings agency Fitch of a report which claims they are currently on average 43% overvalued. Naturally any major downward revaluation of the repossesed assets will give an entirely new reading for the balance sheets of many of the institutions involved (the Caja de Ahorros del Mediterraneo went from having a 50 million euro profit at the end of 2010 to 1.7 billion euros in losses in June 2011 following the application of just such a mark-to-market procedure - and the savings bank was finally sold to Banc Sabadell for the princely sum of one euro). Put two and two together here, and it is clear that the country's bond spread may once more be in for a bumpy ride when investors finally recover from their yuletide hangovers.

Excuses are, of course, already being prepared for this lamentable state of affairs, and in particular the argument is being run that in fact the responsibility here does not lie with Spain's central government (which was entirely composed of choirboys and girls), but with a lamentable set of constitutional arrangements which give far too much spending power and control to the country's regional governments. To some extent this is true, but as I say, it is important not to take everything here at face value, since as ever, all is not what it is made out to be.

This advice could, as it happens, have proved useful to New York Times reporter Suzanne Daly who vertently or inadvertently seems to have been taken for a complete ride with the article she wrote for the newspaper last Friday. The focus of the article was purportedly on regional extravagance in Spain, but in the event she seems to have allowed herself to be used to float a political agenda which primarily seeks to take the attention away from the country's central government, and the responsibility it has for the current lamentable state of affairs. Naturally examples of regional extravagance certainly abound (hell, the entire country was living beyond its means), but I started to smell a rat when I saw the example she chose to highlight in her article - the prison at Puig de Les Bases, Figueres (which just happens to be located only a few kilometres from where I live).

What worried me is that the prison you can see in the photo above is NOT an example of something that isn't needed, like a phantom airport, or a golf course where no one will ever play golf. The problem with Puig de Les Bases is not that there aren't prisoners waiting to be moved there from the two outdated prisons which are scheduled to close (there are, 300 of them, to which can be added an additional 450 once the new one is open). No, the problem here is that there isn't enough money to run the place after it opens. This situation is not untypical, since many town halls and regional governments, not to mention the central government itself with its new high speed train network that the country can ill afford, find that they invested money on projects using the extraordinary income they were receiving during the years of "excess" but that now they don't have the current revenue to keep the facilities created operating.

In fact Suzanne Daly does notice this, but she seems to get so carried away with the force of her own rhetoric that she doesn't catch the significance of the point.

"Evidence of the regional profligacy dots the countryside. On the top of a hill here in the birthplace of Salvador Dalí, in northeastern Spain sits a giant, empty penitentiary. But even without a single prisoner in residence, the prison is costing Spain’s heavily indebted regional government of Catalonia $1.3 million a month, largely in interest payments. If prisoners were actually moved in, it would cost an additional $2.6 million a month. So it sits empty, an object of ridicule around here, often referred to as the “spa.” "

So the question is, is this an example of regional profligacy, or an example of cuts which are biting, and a country which is coming to terms with its new reality?

The issue, however, goes deeper. The offending prison is in Catalonia, and Catalonia is a region which has long been seriously underfunded by the central government - indeed as was suggested by the regional minister of economics, Andreu Mas Colell, it looks suspiciously like the central government were not paying funds owing to some key regional governments to make the regional deficit look worse, and the central deficit look better.

Mas Colell, who is a former Harvard professor, and distinguished micro-economist in his own right, recently told the central government that it should be ashamed of itself for withholding money which legally belonged to someone else (in this case 759 million euros for investments which have already been completed) and basically acting in complete bad faith.

"Els hauria de caure la cara de vergonya", "és una mala jugada poc honorable i que no oblidarem", "estan fugint i fent servir excuses de mal pagador", "són molt poc exemplars", "no poden desentendre's amb arguments pobres", "els avergonyirem". Són algunes de els expressions que ha utilitzat el conseller d'Economia per referir-se a l'impagament dels 759 milions per part de l'Estat...... Amb tot, el conseller veu una clara intencionalitat en el no pagament d'aquests diners. "L'Estat vol que se'ns carreguin a nosaltres els quatre punts de dèficit que suposen aquests 759 milions i no a ells. I no paga perquè no vol pagar i no vol augmentar el seu dèficit",

"They should be ashamed of themselves... its an injustice without honour, and we won't forget... they are running away from their responsibilities using the typical excuses of someone who doesn't pay their debts... this is hardly setting a good example... they can't ignore the situation isung pathetic arguments... we will make them feel ashamed". These are some of the arguments used by the Catalan economy minsiter with reference to the non payment by the Spanish government of the 759 million euros ... The minister did not mince his words when it came to the reason behind the non payment. "The central government want to put on our account the 0.4% percent of deficit which these 759 million euros will involve for us, and they don't want to add them to their deficit. They aren't paying simply becuase they don't want to pay, and they don't want to increase their deficit."

Naturally, the Catalan government is taking the central government to court over the issue, but given the efficacy with which justice is executed in Spain, I don't think I'd be waiting for the result before finding solutions to the problem all this represents.

The central point here is picked up on by a group called Collectiu Emma, (an association of activists which spends it time correcting factual inaccuracies which appear about Catalonia in the international press, inaccuracies which in no small part have their origin in a constant public relations campaign conducted from Madrid). As they say:

"One key point that is overlooked in your otherwise informative article on Spain's economic difficulties (As Spain Acts to Cut Deficit, Regional Debts Add to Woe, December 30, 2011) is that Spain is not a federal State. Under the country's fiscal arrangement taxes are collected by the central government, which will keep part of the proceeds for itself and distribute the rest among the regions to pay for the services that have been devolved. There is no correspondence between what the regions get to spend and the wealth they have generated."

"For the last year Catalonia, one of the most productive and most heavily taxed communities, has been undergoing painful cuts in services. And yet, the share of tax money that it contributes to the State and never comes back is estimated today at a staggering 8-9 per cent of its annual GDP. If Catalonia could use even part of those funds to finance essential services for its own population, it would have no deficit and no debt, and could even afford one or two extravagant schemes like those that other regions -and the central government itself- can enjoy as long as they are paid for with somebody else's money. Catalans would not mind a serious revision of the regional setup, but only if it envisages fiscal responsibility on the recipients' part, better control over their own money by those who have earned it and more transparent procedures by the central government".

Now one of the points Collectiu Emma didn't make, but could have, is that Catalonia is one of the few regional governments (and maybe the only one) which has responsibility for administering the prison service. Catalonia also received so little money from central government in 2011 that it effectively ran out of cash in December (not because it is "extravagant" but because it is seriously underfunded) to such an extent that it was not able to pay all public servant salaries for December before the end of the year. So in fact one of the reasons the prison is lying idle is that the central government is not forwarding money it has a legal responsibility to transfer, and the reason it is doing this is to massage its own deficit, and encourage people like Susanne Daly to write the article she wrote.

It gets worse, since some of the "misinformation" about the situation in Catalonia has, in my opinion, a deliberate political intent - to recentralise Spain. This is certainly the objective of tax minister Cristobal Montoro, since many in the Partido Popular are already very fed up with the fact we insist on using our own language, and doing things our own way (like banning bull fighting).

"And while Spain’s overall fiscal status is nowhere near as dire as Italy’s, it has another problem all its own, as the new budget minister, Cristóbal Montoro, made clear Friday: serious budget shortfalls in its 17 autonomous regions, which have spent recklessly in the past decade".

It is also striking how the article also draws attention to spending issues in the community of Andalusia (which is the only community the socialist PSOE really controls now, and which the PP hope to win in elections in the spring) while there is no real mention of communities like Valencia, or Galicia, which are controlled by the PP and where there are plenty of examples which could be mentioned, like the phantom airport in Castellon, built under the eager eyes of former Valencian President Francisco Camps, who had to resign and is now facing corruption charges in a trial which is currently attracting a lot of media attention.

Now I am sure, as the Collectiu Emma people point out, there are many examples here in Catalonia of projects which were not needed (the Alguaire airport in Lleida would be one), but the key difference here is that Catalans overspent using their own money, while many regional governments (some of them ruled by the PP) did so using Catalan money. So it is curious, to say the least, that the author decided to kick the article off with a big picture (see above) of a prison in Catalonia to serve as the stylised example to epitomise the problem.

But there is another issue being raised here, since it is not clear whether all the attention which is being focused on the Figueres prison is not - in some warped way - a by-product of protests by prison staff unions against the all the recent spending cutbacks. Searching around for background information, I discovered a most interesting article in El Pais (sympthetic to the Spanish socialist party PSOE) entitled "locos por ir a la carcel" (desparately seeking to go to prison). The gist of this article concerns the plight of a number of unemployed people who have passed the exams needed to have places in the prison service, but who can't be offered work since the prison is not open.

What the El Pais article offers us is the view of a heartless Catalan government making swingeing cutbacks on important social projects. Far from putting the blame on the outgoing socialist lead catalan government who built the prison in the first place, the article blames the new justice department head, Pilar Fernández Bozal, who hasn't opened because she hasn't been able to obtain the funding needed. The impression I get is that in this game it is hard to win.

At the end of the day the lesson I would advise Suzanne Daly (or Angela Merkel if it comes to it) to learn from this whole affair is that nothing in Spain is exactly as it appears to be, and that few of the arguments politicians and so called "experts" advance are entirely innocent. Mostl "information" circulating in Spain is highly politicised. Really "independent" analysts are virtually unknown.

Government and opposition in Spain operate like a revolving door. Crickey, I even saw outgoing Minister in the Zapatero government Alfredo Rubalcaba on TV yesterday, openly criticising Mariano Rajoy's government for all the cutbacks that have just been announced and for having no policy up to the task of dragging Spain out of its crisis, without even blushing or mentioning that the cuts in question were so big because his government overspent - or tolerated overspending - or that the policies the new government are following were basically identical with those which guided his own government.

Far from suggesting that the prison project was an extravagant excess, El Pais implies it is badly needed (since space in the Catalan prison system is extremely scarce), and my feeling is that with crime on the rise after 4 years of continuous crisis, El Pais is probably more right about this than the New York Times author is. Lesson to be learnt: simplistic answers to complex situations are rarely satisfactory. And if you want to come to Figueres and look for a spending white elephant, well, you need go no further than the high speed railway line linking the town with Barcelona. The track has been up and ready for around a couple of years now (see the bridge to nowhere in the photo above), but there is no sign of any train, since there is not sufficient money available to finish the job. But then this particular piece of short term redundancy was planned and executed by the central government on a live-now-pay-later basis, but that wouldn't fit the story we are being sold, now would it?

Italy Braces Itself For The Full Monti

2011-12-26T09:48:00.000+01:00

The Italian government, Mario Monti informed the country's parliament last Thursday, is now planning to concentrate its attentions on achieving economic growth. A timely decision this, since the statistics office announcement a day earlier that the country had once more fallen back into recession, while not being a surprise nonetheless does constitute a cause for concern. Not that Italy is any stranger to recession, since the country has now had five of them since entering Europe's Monetary Union at the turn of the century. In fact the Italian economy has now contracted in eight of the last 15 quarters, and GDP is back in the good old days of 2003, stuck below the level it first attained in the first three months of 2004. And of course it is now going backwards in time again. Depending on the depth of the recession now being provoked it is touch-and-go whether the economy might not at some point even revisit levels last seen in the closing years of the 1990s. And remember, this is not deflation ridden Japan, this is real, not nominal GDP we are talking about here. So far Italy hasn't been experiencing deflation, or at least not yet it hasn't.

All in all, it would be hard to say that the Euro has worked well for the Italians. Maybe it was a great opportunity that the country was unable to take advantage of, but in any event all they are going to see from here on in is the downside part of it. The inability to adjust the value of a domestic currency they don't have to compensate for all that wantonly lost competitiveness means they are going to have to do things the hard way, subjecting themselves to a collective ingestion of codliver oil the like of which the country has not seen since the harsh days of the1920s.

Sinking Below Ground

The extent of the problem the country now has can be easily seen in the chart below, which shows annualised growth over a decade (as a moving average). What is absolutely shocking is that in the ten years up to 2010 Italy had an average annual growth rate of just 0.28%. Assuming growth of about 0.5% in 2011 (which may now be generous), in the decade to 2011 this will drop to 0.15%, and if we pencil in a contraction of 1% in 2012 (perfectly realistic, in fact it will probably be worse) then the number turns negative. That is to say, on average the Italian economy will have shrunk every year for a decade.

Some may say that this result is in part a by-product of the global crisis, and they would be partly right. But look at the trend over the last three decades, far from seeing some stylised version of steady state growth hovering around a constant mean, the rate of expansion in Italian output has been heading relentlessly downwards, so logically it was always bound to cross the zero line at some point. That point now seems to be about to arrive in 2012, a year which may mark a before and after in modern Italian history.

Naturally, the reason why Italian growth has fallen so far is the big point at issue here. One of the reasons is obviously a competitiveness loss resulting from higher than Eurozone average inflation sustained over a long period, but another component is possibly the impact of population ageing, which has hit Italy more than any other European country except for Germany, and it is with Germany, of course, that Italy has the largest competitiveness loss. Demographically speaking Italy is Germany minus all that export competitiveness.

Looked at from another angle, like many other countries Italy probably grew rather over trend in the years between 2004 and 2007, and then dropped back sharply in 2008. But the Italian economy fell further than most of its peers, and subsequently really failed to recover. This is the clearest demonstration of the competitiveness problem, and it won't be easy to address.

It's The Competitiveness Silly!

As is well known Italy is weighted down by a massive burden of public debt (120% of GDP). Even before the recent surge in Italian bond yields servicing this debt consumed an onerous volume of government income. But this debt alone does not explain why Italy has such a poor track record. Japan, for example, has a debt burden of over 200% of GDP and still manages to eke out a better growth trajectory. The two countries are similar in that domestic demand is permanently weak (they both have elderly populations, with a median age of around 45) yet difference between the two countries is obvious, since Japan (like Germany) has a large and dynamic export sector which generates a trade and current account surplus, and this buoys investment and GDP growth. Italy, on the other hand, has a trade and current account deficit, and both of these have been worsening since the end of the last recession.

Naturally a negative trade balance weakens the GDP reading, given the impact of the net trade effect, but curiously the recent GDP slowdown has been associated with a drop in government spending (which is what previously had been sustaining Italian GDP in positive territory), a fall in domestic consumption, and a consequent fall in imports (which is why the trade balance has been improving somewhat of late). Indeed, the reduction in imports meant that the net trade effect was one of the few positive points in the latest GDP reading - even while the economy contracted by 0.2% net trade added 0.8 percentage points to what would otherwise have been a devastatingly bad number. So there is no need to call in inspector Clusot to find out what happened, it was clearly the sharp cut in government consumption that finally killed off the fragile Italian recovery, although naturally, given that government debt was - and has been for some years - on an unsustainable path, the spending tap had to be shut off at some point. What Italy now needs - like so many of the countries on the EU periphery - is a sharp improvement in international competitiveness and a significant surge in investment into the export sector. The two of these naturally go together, since few will invest in activities which are unlikely to be competitive and profitable.

Italy does have a stronger export sector than some of its Southern European counterparts, and exports did surge as the global economy started to recover (see chart above), but they never managed to reach their pre crisis level, and now, at least according to the latest PMI surveys, they are weakening once more as the European and global economy slows.

Italy was far from having a consumer boom during the good years of the first decade of this century. In fact household consumption grew by less than 5% between 2000 and 2008, and in any event the pace was much slower than in the 1990s (see the shift in steepness of the slope in the chart below).

Retail sales have been falling since 2007.

And construction spending has been one steady slide down.

And yet, despite all the pressure on Italian banks there is (as of October) no sign yet of a sharp credit crunch affecting either firms or households, since private sector credit is still growing at an annual rate of around 4%, a stark difference from the picture in Greece, Spain, Ireland and Portugal where private sector credit is steadily contracting.

No Boom, No Bust

So to be clear, Italy did not have any sort of housing or credit driven boom during the first decade of the century, Italian households and companies are not massively in debt when compared with their Euro Area peers, and credit is not in especially short supply. Ageing population dynamics lead domestic consumption to be weak in Italy (following a pattern which is strikingly similar to that seen in Japan and Germany), yet Italy's export sector has been allowed to drift as competitiveness has been lost. Really the most telling chart I have is this one, which shows how as the current account surplus has widened (ie as competitiveness has been lost) long term growth has steadily declined.

With neither exports nor private consumption able to pull the economy the state has been under constant pressure to offer support via deficit spending, leading to the accumulation of an unsustainable quantity of government debt. This deficit spending is about to come to an end (permanently according to the latest EU agreement), and under these circumstances the economy is likely to remain in or near contraction for as long as it takes to recover competitiveness. The question is, how long is that going to be, and what will happen to the debt dynamics in the meantime.

To take the second question first, one of the reasons that many are confident Italy will make it on through with the debt challenge is the country's recent record in controlling the deficit. According to OECD data, while Italy ran a cyclically adjusted primary deficit every year between 1970 and 1991, it ran a cyclically adjusted primary surplus every year since 1992. That is to say, before allowing for interest payments Italy has not been running a deficit for many years now, and it is simply the burden of servicing the accumulated debt which is causing the country to spend more than it receives in revenue. As many of those who are in the "optimistic" camp on the question of the country's ultimate solvency eagerly point out, Italy’s cyclically adjusted primary balance as a proportion of GDP has remained in a better shape than those of the largest developed countries as well as those of European peripheral and core countries since the onset of the crisis. It is only the legacy of the past which acts like a dead weight pulling the country down, but what a legacy this is, and especially as yields on Italian debt have steadily risen.

Poised On A Knife-edge

But given everything it is clear that Italian debt, and with it the future of the Euro, now sits poised on a knife edge, as is illustrated in the chart below (which comes from Barclay's Capital). If you take a neutral scenario where Italy has a balanced budget and a sum total of zero nominal GDP growth (ie growth+inflation = 0) debt stays put at 120% of GDP out to infinity.

But then imagine the average finance cost of Italian debt rises, and stays high. In this case the only way to compensate is by running a larger primary surplus (ie more spending cuts, or revenue increases to compensate for the extra interest cost). The net effect of this would either be to generate deflation or a more sustained economic contraction, in which case debt to GDP would start to rise indefinitely. Think of it like this, either prices fall by one percent and GDP (via exports) rises by 0.5% (for example), in which case nominal GDP falls 0.5% a year (the Japan type case), or prices rise by 0.5%, exports lose more competitiveness, and so growth falls by 1%. I mean, this example is only illustrative, but it is meant to give some sort of feel for what "knife edge dynamics" really mean.

In fact, before the recent surge in the spread, average interest costs on Italian debt had been falling in recent years, but now they are evidently rising again. It is very important here to remember that yields in bond auctions only affect new emissions of debt (and changes in the secondary market only really affect banks, and sovereigns through possible needs to recapitalise banks). So it is a question of years before the higher levels "lock in" - the average maturity on Italian debt, for example, is around 7.2 years, and indeed since governments finance at fixed and not floating rates (not at a certain % above 3 month Euribor, for example), debt costs are at much at risk from increases in ECB base rates as they are from the actual spread with German bonds. Any substantial increase in interest costs naturally makes selling debt more expensive. Fortunately for peripheral sovereigns, the likelihood of ECB rate rises in the foreseeable future is near to null.

No Way Back Home

But again, let's do another thought experiment. Imagine I am right, and Italian debt is on a knife edge path, and suppose the average interest rate on the whole debt creeps up by 1 percentage point. With debt at 120% of GDP, then the primary surplus to cover the added interest costs and maintain a balanced budget would be 1.2% of GDP. But suppose, for the sake of argument, that increasing the primary surplus by 1.2% pushes Italian debt to gdp up to 125% (via a combination of either deflation or economic contraction), then the next year the primary surplus would need to be up by an additional 0.05%, helping force debt to GDP up even further and so on and so forth. This is why people call this the debt snowball. The point is, whichever way you turn, you seem to find the exit door locked.

Coming back to the details of the present situation, the Italian government has committed itself to a consolidation program worth €74bn over the next two years amounting to roughly 3.7% of GDP. This is designed to bring the budget into balance (or the deficit to zero) by the end of 2013. On quite conservative assumptions, just to tread water, and maintain the debt level where it will be in 2013 (which will be more than 120% of GDP due to the recession), Italy will need a primary surplus of 2.3% of GDP.

But then we need to think about the recently undertaken commitment to reduce the debt (the last EU summit). The exact numbers have yet to be agreed for the new pact, but it looks like a cyclical maximum of 0.5%, and (even more importantly) a commitment to reduce outstanding debt over 60% of GDP by 5% a year. This, in Italy's case will mean the country is going to need (from 2014 onwards) a primary balance of something like 5.5% of GDP (depending on the evolution of interest costs) over the rest of this decade. Which means the Italian economy is going to face an even more restrictive fiscal environment.

Now, those who argue the Italian crisis will have a happy outcome point to history, and argue that Italy was able to achieve a primary surplus of around 5% on average during the years 1995-1998, so why shouldn't the country be able to do this again? The main counter argument would be that that was then, and this is now. That is to say, these were the years of Italian "coupling" with monetary union, sizable privatisation programmes, falling (not rising) interest rates, and basically Italian trend growth had not fallen as far as it has now.

Moreover, the external environment in Europe will not exactly be conducive to boosting exports. Even core Euro Area countries are commited to undertaking additional fiscal consolidation beyond what is currently envisaged in order to comply with the new debt rule. Taking 2014 as the starting point, debt to GDP for the Euro Area as whole might be something like 90%. Hence the 1/20th rule would imply that on aggregate the Euro Area will need to reduce its debt ratio by around 1.5 percentage points per year. If this agreement is complied with the adjustment will almost certainly imply a net fiscal drag on growth in the years following 2013. Of course, if it is not complied with then it will almost certainly be "bye bye Euro" (assuming the common currency still exists that far up the road).

It's All About Structural Reforms, Or Is It?

So basically, what the whole argument about whether or not Italy can make a final burst and reach the finishing line is all about structural reforms, and whether the country can get enough growth (quickly enough) to turn the "knife edge trap" around. Personally I am extremely doubtful that it can, which is why I placed so much emphasis on the growth performance in the first section. The turnaround needed here is massive. It is a 30 year decline we are talking about, and I doubt short of outright default and substantial devaluation we have historical examples of anyone doing this. The adjustment made in Germany between 1999 and 2005 was much smaller in comparison.

One of the proposals is to introduce labour market reforms to increase participation rates, but in fact the Italian labour force grew substantially between 2004 and 2008 (due to large scale immigration), with employment being up by over a million (or around 5%, see chart above), yet the increase in output was ridiculously small. On the other hand we know the Italian working age population is contracting (and the average age rising), while the elderly dependent population is increasing rapidly. Conventional economic models tend to be silent on this issue, but common sense should tell us that this is going to take its toll on growth - a factor the "structural reform answers all our problems people" don't seem to have given enough thought to.

The Monti government needed just five weeks in office to push through an additional 30 billion-euro emergency budget package, but how long will he need to get GDP growth back up above 1% annually? And how much time does he have? Investors initially cut him some slack, but judging by the reaction to the final approval of the package by the Senate - the yield on Italy’s 10- year benchmark bond was pushed up by 12 basis points to 6.91%, dangerously close to the key 7% level (although still somewhat below the Euro era record hit on November 9, just before Monti took charge). 7% is widely considered to be critical if sustained for any great length of time, partly due to the cost of debt servicing but also because of the level of dependence of Italian banks on the ECB that it would produce.

Till The Dowgrades Fall

So the "Full Monti" effect now seems to have been priced in, while investors nervously wait to see what the real plan for Spain and Italy actually is.

The first quarter of 2012 looks to be critical for Italian debt, with about one third of the total Euro Area debt maturing being Italian. Indeed the battle starts this week with the Treasury having to sell an assortment of T-bills and 2 year and 10 year bonds. In addition the Italian government is now increasingly guaranteeing bonds issued by Italian banks to be used as collateral at the ECB - with about 40 billion euros being issued last week according to some estimates. So effectively Italy is now more or less guaranteeing the banking system with the likely outcome that ratings agencies will be even harder on the sovereign rating.

Not that the outlook was exactly bright on that front anyway. Understandably, Italy was among the 15 Euro Area countries Standard & Poor’s placed on review for a possible downgrade on December 5. This follows an earlier downgrade to a single A by the agency in September. In addition, Spain and Italy were both warned by Fitch (which cut Italy's rating to A+ on October 8) on December 15 to brace for a further debt downgrade after concluding that a "comprehensive solution to the eurozone crisis is both technically and politically beyond reach". And to complete the set, Moody's, which cut the country to A2 on October 4, maintained a negative outlook, signifying that a further dowgrade in the coming months was highly probable The bottom line is that Italy is both too big to fail and too big to be bailed out, which is why it is still hanging dangerously in limbo-land. Since, as I argue in this article, some sort of restructuring or other is well nigh inevitable in the Italian case, the sooner Europe's leaders work up a credible plan on how to achieve this, the better. Otherwise it will not only be Italy's citizens who are subjected to the Full Monti, Europe's leaders may also find themselves with their credibility stripped naked.

This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".

Is Finland Really A Closet Member Of The Eurozone Periphery?

2011-12-18T19:50:00.000+01:00

Just as we were recovering from that initial shock, Irish stockbrokers Goodbody poured even more cold water on our breakfast cornflakes by telling us that Ireland would probably need a second bailout, since economic performance in 2012 was likely to be below expectations, while prevailing financial conditions would make an early return to the financial markets virtually impossible. Our spirits were fleetingly brightened by the news that Spain had managed a successful bond auction, but the cork was just as swiftly rammed back into the bubbly bottle as it had been pulled out when we discovered that Italy had not, and that LCH Clearnet had promptly reacted by raising the margins on the country's debt when posted as collateral.

On the other hand Thursday did give us another brief soothing interlude, as Mario Draghi reminded us of all the beneficial consequences of the recent 3 year LTRO (Long Term Repo Operation), and cheered our spirits by informing us that he was not lowering interest rates again at this stage due to the growing signs of stabilisation his technical staff had been able to identify. “According to some recent survey indicators, there are tentative signs of stabilization of economic activity at low levels,” he told the assembled journalists, although he did go on to warn that the debt crisis continued to pose “substantial downside risks” to the economic outlook and the ECB stood “ready to act” if need be. Apart from the evidently weakening inflation, possibly the most important single indicator he will have had in mind in making the above statement would be the monthly PMI survey. The composite index (which combines manufacturing and services) shows economic activity contined to contract in December, but at a rather slower rate than in November, and in fact the rate of contraction in November was slower than the one recorded in October. So things are getting worse more slowly!

The EU sentiment index has also fallen much more slowly in the last two months, indicating that confidence is not deteriorating as rapidly as it was.

And the widely followed German IFO Business Climate index has perked up slightly in the last couple of months.

"The uplift in the Eurozone PMI in December does little to dispel fears of the region sliding back into recession. Despite the upturn, the fourth quarter saw the steepest contraction since the spring of 2009, and forward-looking indicators suggest that a further decline is on the cards for the first quarter of 2012. In particular, orders for goods and services continued to collapse, suggesting that output and employment will be cut as we move into the new year".

"Does this mean that the operation has failed to stimulate government bond purchases? No, not really. If a bank uses money from the LTRO to buy government bonds (or any other paper) in the secondary market, the amount will still show up as a deposit at the ECB (now on behalf of the seller’s bank). If a bank buys government bonds in the primary market, the amount will also show up as bank deposits at the ECB if the government spends the receipts or places them at a private bank. Thus, the increase in deposits does not imply that the 36 months LTRO has failed to stimulate government bond purchases (or other trading for that matter)".

So basically, if we think for a moment about maturing, and not new, additional issue, government bonds, then commercial banks along the periphery buying the replacement issue can allow their peers in the core to recover their investment, and park the money. The only way the money from these sort of bond transactions doesn't show up as excess liquidity is if the national government concerned places the takings on deposit at the central bank, or if an investor takes the money they have recovered from a redemption out of the Eurosystem.

The same goes for private bank debt, which often just moves from being a liability one bank has with another commercial bank in the Eurosystem to being a liability with the ECB. Naturally the bank that recovers its money may well then park the proceeds on deposit and hence it will show up as excess liquidity at the ECB. So, while short term liquidity needs may be being catered for (at least up to 3 years), there may be a deeper phenomenon at work via the LTRO, whereby the core leaves the periphery. In fact that seems to be happening. The charts below (which were prepared by Citi Research) show the situation up to the end of October (latest data), and make clear that it is commercial banks on the periphery who are, in the main, making increased use of the ECB's open market operations, while it is banks in core Europe who are using the deposit facility.

Write-downs On The Liabilities Side?

Another area where the transfer of liquidity doesn't show up as a change in aggregate excess liquidity is when banks offload their wholesale liabilities to other EuroArea banks and refund via the ECB. Here again, if they do it smartly, they can even earn a bit of "quasi carry" in the process, by buying back their debt at well below face value from those who are anxious to exit the periphery, and then refinancing at the ECB without writing down the underlying asset. This could be termed a liability "write down", and again the procedure earns the bank a nice bit of income which can subsequently be used to help the recapitalisation process.

Take the Portuguese Bank BPI (the country's fourth largest), which is making public tender offers to buy back its debt. If all concerned tender their bonds to BPI, BPI will pay something short of €1.5bn cash to investors. Mortgages which were previously sitting in one of their SPVs will return to their balance sheet, and ECB money will now be on the other side financing them allowing significant profits (and capital) to be reported. In this particular tender the smallest discount is 35% and the largest is 65%. Investors may initially baulk at the offer, since they will nurse a heavy loss (equal, naturally, to BPI´s profit) but ultimately they will probably be only too happy to be able to walk away from Portugal, and with some cash in their pocket to boot.

Iberian banks were already aware of the benefits of this kind of restructuring during the 2009-2010 liquidity wave, and went about quietly repurchasing their bonds (bank capital, securitizations, senior bonds) on a selective and private basis at a discount. Much of their reported profits in those years in fact came from either the ECB carry trade or this kind of transaction. So when we read that another Portuguese bank - Banco Espirito Santo - has just had €1 billion of debt guaranteed by the Portuguese state (a soverign which can't itself go to the markets) it isn't hard to imagine that the process going on in the background is something similar to that seen in the BPI case, and that the debt is being guaranteed so it can go over to the ECB to be posted as collateral.

The National Bank of Greece has been doing something similar. They recently offered to buy back some €1.5 billion in covered bonds and preferred securities, offering 70% of face value for the covered bonds and 45% for the preferred hybrids. As the bank itself says, “The purpose of the offers is to generate core Tier 1 capital for the group and to strengthen the quality of its capital base....The offers would generate a gain for the group.”

And Italian banks would seem to be doing something similar, since they issued around €40 billion in government backed bonds specifically to take to the ECB. The bonds are held by the banks themselves and stay on their books to maturity, their only purpose being to provide collateral for use at the ECB. In fact Italian banks took something like €116 billion from the LTRO, or almost 25% of the total. Perhaps this is why Unicredit CEO Federico Ghizzoni and other European top bankers met ECB officials in Frankfurt back in November, to discuss new rules for collateral.

In Spain securitised mortgages sitting on the balance sheets of the bank-owned Fondos de Titulizacion de Activos could also be recycled in this way (here's a complete list, although note that these Funds are regulated by Spain's CNMV and not the Bank of Spain, which is why their presence is relatively unknown and people are able to accurately say that the central bank has been very strict on SIVs, since they weren't their responsibility). That something like this may be happening, with the ECB "buying into" public and private Euro Periphery debt while investors are discretely getting out is suggested by this report in Bloomberg:

The euro is losing the relationship with riskier assets that underpinned the currency in 2011 as the deepening sovereign debt crisis reduces the creditworthiness of even the biggest economies in the region. The 17-nation currency has fallen 8.7 percent against the dollar since October, while the Standard & Poor’s 500 Index has gained 3.4 percent, and the correlation between the two dropped to 58 percent from a record 91 percent in November, according to data compiled by Bloomberg. The euro had moved almost in lockstep with investments linked to growth, including stocks and the Australian dollar, since January 2011. This decoupling is taking place as European Central Bank President Mario Draghi cuts interest rates and promises banks unlimited cash for three years to rein in soaring borrowing costs for governments... Strategists also anticipate more losses as the US economy improves while the euro zone shrinks, driving international investors away from the region’s assets.

So if the first two objectives were to help the struggling sovereigns, and enable the commercial banks to refinance their debt, then to some extent these objectives have been met. But what about the third objective, moving credit on the periphery to get the real economy moving again? Well, here the ECB's measures are likely to have far less effect, and indeed what effect they do have may be in some way a mixed blessing, since the banks seem far more worried about demonstrating they have an adequate level of core capital than they are about participating in solutions to real economy problems.

The Credit Crunch Is NOT Uniform

To understand why this simply increasing aggregate liquidity doesn't necessarily help individual countries, it is important to realise that credit conditions in the Euro Area member countries are not uniform (a much more detailed exposition of this point can be found in this earlier post). In countries like Germany, Finland and the Netherlands, credit is more or less freely available, even if demand for it is limited - German corporates are awash with cash, and it has been a long, long time since German households were digging their way into debt.

In France and Italy, banks are drawing in their horns, but credit is a long way from being frozen.

A similar position can be seen in the case of home mortgages.

Now in the French case, given that the private sector is not heavily overindebted, unemployment is not excessively high, and a demand for credit from solvent clients exists, it is quite possible that the ECB measures can help stabilise the situation, and put a brake on the implosion. On the periphery, however, where populations are heavily endebted either directly, or via their sovereigns, where the economy isn't functioning properly, and unemployment is high and rising, the problem isn't only the unavailability of credit, but also the shortage of solvent clients who actually want to leverage themselves.

Day Of The Living Dead?

For increased liquidity to mean that credit becomes expansionary for the real economy again, it is the banks themselves who need to deleverage (and not simply write down their liability side), by disposing of the large volume of continually restructured but basically non-performing credit they have on their books. Behind the credit crunch in these countries lies a problem of massive economic structural distortion, produce by the lending and borrowing boom during the "good" years.

What is needed is what Joseph Schumpeter referred to as a process of "creative destruction", whereby some enterprises die so that others can be born, and naturally some loans are written off, despite the fact this has unpleasant effects on bank profitability and capital ratios. To really get credit moving again in some of these periphery economies, a large chunk of loans need to be written down, and support needs to be offered by the sovereign to enable this to occur. Unfortunately the ECB's liquidity provision could have precisely a perverse effect in this context, as it may well enable those who should die to stay alive.

Commercial banks, at the discretion of their central bank, may now package straighforward bilateral commercial loans to present as collateral at the ECB. This measure, which in theory was intended to enable the banks to extend "good credit" may now enable them to restructure and keep on their balance sheet loans that should really be classified as "impaired" and somehow resolved. In the case of Spain, for example, in addition to the properties they have acquired, banks still have oustanding loans of over €300 billion to developers on their books according to Bank of Spain data. The majority of these loans are not classified as either non-performing or sub-standard, and are hence considered to be "good" (I will refrain from saying "excellent"). In principle there is no reason why a significant number of these "good" loans cannot be packaged in some way or other to serve as collateral to be posted at the ECB.

Naturally this takes some of the pressure off Economy Minister Luis de Guindos to establish a bad bank, since for the time being the ECB can, in part, serve this purpose for him. And if the banks write down their liability side a bit, then this may also help him with the €50 billion or so he estimates will be needed for bank recapitalisation. No wonder he feels the amount of public money needed will be minimal! The only real downside on this is that foreign investors may well be dumping Spain, while the country (which still runs a current account deficit) continues to have an external financing requirement.

None of this is either uniquivocally good, or unequivocally bad, it depends. What the liquidity move will do is buy the banks time to sweat out some capital onto their balance sheets, and make them better able to withstand more of those dreaded "stress tests" (assuming, that is, that the European Banking Authority allows some "wiggle room" to enable them to keep maintaining their risky sovereign debt holdings). What it won't do is help put the real economy straight, or allow the banks to get back to what some would consider is their basic task which is guaranteeing a normal supply of credit to the economy.

Working Against The Clock All of which brings us nicely back to those horrid S&P downgrades. According to S&P's own literature, the dowgrades were prompted by a number of concerns:

Today's rating actions are primarily driven by our assessment that the policy initiatives that have been taken by European policymakers in recent weeks may be insufficient to fully address ongoing systemic stresses in the eurozone. In our view, these stresses include: (1) tightening credit conditions, (2) an increase in risk premiums for a widening group of eurozone issuers, (3) a simultaneous attempt to delever by governments and households, (4) weakening economic growth prospects, and (5) an open and prolonged dispute among European policymakers over the proper approach to address challenges.

But time is - if we look over to Hungary - something we will eventually run out of. Handing over the adminsitration of one country after another to a group of approved technocrats may well work for a while, but it won't work forever. One day or another, if the measures taken don't work, Mario Monti will be replaced by the populists, and a new chapter in European history will open. At the present time the policy emphasis on fiscal rectitude and structural reforms, to the neglect of the deep competitiveness and imbalance problems which exist within the Euro Area, is leading us all to no good place. A quick glance over in the direction of Hungary might suggest to us what that place could look like. Well, that really was the week that was, wasn't it. It's over, let it go, there's another one coming just around the corner, and my initial impression is that it is unlikely to be a quieter or more relaxing one.

On one level, Friday’s news was not really surprising. The French rating downgrade was a shock foretold. As was the breakdown in talks between private investors and the Greek government about a voluntary participation in a debt writedown. A proposition that was unrealistic to start with has been rejected. We should not feign surprise.And yet both events are important because they show us the mechanism behind this year’s likely unfolding of events. The eurozone has fallen into a spiral of downgrades, falling economic output, rising debt and further downgrades. A recession has just started. Greece is now likely to default on most of its debts and may even have to leave the eurozone. When that happens, the spotlight will fall immediately on Portugal, and the next contagious round of downgrades will begin. Wolfgang Munchau, Financial Times, Sunday 15 January 2012.

This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".

A Deep Seated Hostility Towards European Construction?

2011-12-10T19:14:00.001+01:00

The British decision to veto the proposed new EU treaty is not surprisingly provoking an avalanche of commentary this weekend. Among journalists, at least, there seems to be a consensus that David Cameron committed some kind of major diplomatic blunder.

Possibly this is so, but given the difficulties presented by having to take this agreement forward outside the formal structure of the EU, it is hard to not reach the conclusion that both Angela Merkel and Nicolas Sarkozy have been guilty if not of a similar blunder, then at least a major error of judgement. On the other hand the issues involved in the proposed new arrangements are highly complex and in some senses ground breaking, so it is indeed suprprising that so many (and so diverse) countries were able to reach such rapid agreement on the need for and the broad outlines of a new agreement. While Angela Merkel was probably worried before the meeting that too few countries would sign up (there was talk of only a hard core of countries proceeding), now she is surely concerned by the fact that so many have. In many ways the biggest weakness of her debt brake proposal is that it has become "too successful" to be fully credible.

A Continent Which Has Isolated Itself From The British Isles?

That British "separatism" has again raised its ugly head should not be surprising, since this issue has a long history (as I was only too clearly reminded yesterday when the local TV news here in Catalonia ran footage of General de Gaulle warning that allowing the UK to enter the common market would be a major strategic mistake and a significant setback for the European construction process), but the water in which all this discourse flows is now so mirky that it is hard to separate what is really relevant to the point at issue, and what isn't.

In fact France, Germany and the UK should have reached agreement before the summit even started, and the agreement should have been restricted to measures which were considered necessary to resolving the Euro debt crisis, including the rules and institutions which are lacking. Maybe it is a pity that these three countries have to have such a decisive role in European decision making, but for better or worse that is the way it is.

Now the UK has exercised its veto, and we have a legal mess. According to Peter Spiegel writing in the Financial Times, Britain’s rejection of treaty changes means that the other 26 EU members will now have to jerry-rig an intergovernmental system without the automatic right to use the EU’s institutions, leaving decisions taken vulnerable to continuing legal challenge. As a result financial market participants will have one more reason to doubt the new fiscal pact’s viability and credibility.

"The arcane issue of whether a group of countries acting outside the EU’s treaties can use the European Commission, with its surveillance and enforcement powers, and the European Court of Justice, has been pushed to the forefront of the eurozone debt crisis. Britain, which refused to sign up to a treaty, but does not wish to see itself sidelined altogether, insists that its 26 EU partners must do without the European institutions".

If the European Union's institutional maze was already proving hard for investors and external policy makers to follow, this latest twist in events will hardly make it easier for them.

This is an outcome that should have been avoided at all costs, and indeed I think the most intelligent thing the three of them could do now would be to meet again and find a solution to the real problem at hand before the euro finally blows itself apart, with highly undesireable consequences for all of us.

People say that the EU was created to ensure there were no more wars in Europe but personally I think a West European centred WWIII was never a very likely eventuality. In any event the EU could have been set up with a much more limited objective, namely to end periodic outbreaks of tribalism and jingoisim. This is the real European curse, and this is what we are now facing in one country after another, as - with the local national press in the vanguard - each blames the other for causing the crisis, or for not reaching the much needed agreement to end it. The sad reality is that Europe's leaders fiddle even as Rome is about to burn.

Save The Euro!

The nub of the question is the Euro, and setting up some form of workable common governance for those countries who belong to the monetary union. In this sense an agreement between the 17 countries who share the common currency would have made perfect sense, and in is not clear to me at least why the UK (or countries like Bulgaria and Romania for that matter) would need to be party to this kind of agreement. But, it seems, representatives of the EU Commission and the German and French governments have been so concerned to identifty saving the Euro with the idea of saving Europe that this important point of detail seems to have gotten buried well down in the pile of paperwork.

Countries like the UK, Sweden and Denmark do not use the Euro since they decided not to do so. Countries like Latvia and Lithuania do not use it since they were not allowed to, and the EU even refused a 2008 request from the IMF to allow Latvia to devalue and enter the currency area at a moment when that country was indeed in a situation of most urgent need.

What the latest tiff underlines more than anything else is the way we are lacking a coherent and consistent account of what the relationship between the EU and the Euro is, and this is not something which has only been discovered yesterday. Maybe the seeds of what happened last Friday are the result of having the Euro regulations form part of the EU Treaty itself, rather than being an agreement between a more limited group of countries in the manner that is now being proposed. Again, if the Euro was to form one of the indispensible parts of the EU Treaty, in many ways it didn't make sense to allow the East European members to join until the had fulfilled the Maastricht criteria for Euro membership.

Viewed in this light, last Friday's events were always a problem which was waiting to happen.

It may well be that the Euro was created as a stepping stone towards a form of political union that not all member countries wanted, but now we are apparently seeing a sort of fait accompli shotgun wedding, since without such an enhanced union, not only may the currency itslef fall apart, but entire global financial system, and everything we know and love seems likely to be carried away with it. I'm not sure whether or not this constitutes moral hazard, but it sure as hell constitutes a pretty potent form of moral blackmail.

Fiscal Pact or Fiscal Union?

Then again, what Europe's leaders were talking about last Friday was not just any old kind of political union. Despite all the talk about creating the groundwork for fiscal union (it will be remembered that one of the commonly cited differences between the dollar and the euro as common currencies is that all states in the American Union are backed by the US Treasury, while the world still waits to learn who - or what - is backing the individual states in the European one). What we we are being offered is not a common treasury of the kind which would convince markets that there was something solid standing behind the currency, but rather what Wolfgang Munchau recently referred to as "another one of those Silly growth and Stability Pacts".

"Contrary to what is being reported, Ms Merkel is not proposing a fiscal union. She is proposing an austerity club, a stability pact on steroids. The goal is to enforce life-long austerity, with balanced budget rules enshrined in every national constitution. She also proposes automatic sanctions with a judicially administered regime of compliance".

Doing The Berlin Brake Dance

What Wolfgang is getting at here is that the core of the proposed EU agreement is the introduction of the so called "balanced budget amendment" as a binding principle across all the eventual signitaries. Naturally Germany already has this amendment in place. According to Wikipedia: "In 2009 Germany's constitution was amended to introduce the Schuldenbremse ("debt brake"), a balanced budget provision. This will apply to both the federal government and the Länder (states). From 2016 onwards the federal government will be forbidden to run a deficit of more than 0.35% of GDP. From 2020, the states will not be permitted to run any deficit at all. The Basic Law permits an exception to be made for emergencies such as a natural disaster or severe economic crisis".

This is the role model for the kind of constitutional amendment other states will now be expected to introduce - as the Economist wryly notes perhaps Schuldenbremse will one day form part of the French and Italian languages in the same way “kindergarten” has become part of the English one.

The 0.35% deficit permitted is in fact a form of what is termed "structural deficit", that is to say there is a formula according to which it can be averaged out over the economic cycle, although even after allowing for this the deficit number is not going to be that high, and in any event at no point should the deficit exceed 3% of GDP.

More important even than this deficit restriction, however, is the so called debt brake principle, which implies countries must steadily reduce their debt to 60% of GDP over a specified time period. If, as may be anticipated, growth and inflation in the Euro Area is going to be low, then effectively countries will not be running deficits at all, but rather surpluses, depending on how much over 60% they will be when the present crisis comes to an end, and what the time scale for reduction eventually is. As far as I can see the current proposal for the new pact coming from the finance ministers (Ecofin) is that from 2013 countries reduce the part of the debt which is over 60% of GDP by 1/20 per annum.

At the end of the day one thing is clear, and this has not been emphasised enough in the press reporting of the summit, this is the end of Keynesian demand management as a policy tool as it has been practised in Europe since the end of WWII. That is to say, while it is be one thing to argue that simply creating more debt through fiscal policy may not be the most appropriate way to solve a crisis which has been caused by excessive indebtedness, it is going a bridge further to suggest that counter cyclical fiscal policy should not be practised. Germany's leaders have, it seems, crossed that bridge. Naturally not all German economists agree. As the Economist reports Peter Bofinger, one of five economic “wise men” who advise the German government, is one of them. On a normal Keynesian view, the balanced budget ammendment could choke-off economic recoveries - some would argue Germany's commitment to this principle at this point is an example of this issue. Having a structural component in the target target allows deficits to rise slightly when output falls below trend with the additional deficit being offset by surpluses during upswings. But, as Bofinger argues, this “assumes textbook-like economic cycles,” and garden variety recession. In the real world cycles and crises vary. An externally induced recession followed by a weak recovery can excessively reduce potential growth, while the balanced budget restriction would restrict the deficit spending needed to stimulate demand.

Given the magnitude of these issues, it is surprising how little debate the proposal is generating, and of course it is hard not to be struck by how quickly people who obviously would not have understood what was really involved were to arrive in Brussels and offer to sign on the ditted line without too much attention to the small print. The exact detailing of the amendment varies - in Spain for example the limit is 0.4% of GDP for the deficit, and the limit is operationalised in 2020. In addition the Spanish wording is also interestingly different from the German version, since it stipulates that the limit can only be exceeded in the event of "natural disaster, economic recession or other extraordinary circumstances". This substitutes the wording "economic recession" for the German "severe economic crisis" variant, which really rather than concealing any sinister intention suggests to me more than anything that the Spanish parliament didn't understand what they were voting for, since the idea is (as I say) for structural deficit over the cycle, and "cycle" obviously includes recession, so a mere recession cannot be an exception, though what counts as "severe" in the German case doubtless awaits interpreting in the courts.

Here Comes My Nineteenth Nervous Brake-down

Once more the Economist gets the basic point:

"Germany has yet to put its debt brake to the test. The federal government made things easier for itself by a generous calculation of last year’s structural deficit, which is to be cut in equal annual steps to reach the 2016 target. Flush with cash, thanks to a strong economy, it has found room for giveaways to voters without falling foul of the brake. Civil servants will get a bigger Christmas bonus next year, for example. For the Länder, the 2020 deadline seems a long way off: 13 of them budgeted for increases in structural deficits this year, laments a study by RWI Essen, a research institute. A “stability council”, composed of federal and state ministers, has little power to sanction prodigals. Apparently, it is as toothless as the enforcers of European financial discipline".

There is an imbalance in voting intentions between countries. Angela Merkel is marking out a very long term agenda:"This is a breakthrough to a union of stability," Reuters cite her as saying. "We will use the crisis as a chance for a new beginning." It is hard to see why countries like Romania and Bulgaria with a very poor institutional record are in such a hurry to sign up to this without a lot more reflection. The use of the word "stability" is very important. Merkel is prioritising sustainability and stability in the longer run over short term growth. This is very consistent with a whole German view of things and completely in harmony with the ecological strain of thought in the modern German world view. I have a lot of respect for this (even where I disagree), and especially for the fact that someone in Europe is trying to think in the longer term. But I cannot help feeling many of the people and countries voting for the new agreement were only thinking about their financing needs in the short term, and were not fully cognisant of the fact that they were voting for a new beginining, a new type of Europe, where living standards may be lower, but the debt dynamics will be more stable. Personally I can only make sense of this in terms of Europe's current demographics, and the challenge that is represented by maintaining health and pension systems in the face of low growth and ageing and declining workforces.

Each Unhappy Family Is Unhappy In Its Own Way

Hence perhaps the most worrying thing about last weeks agreement to agree was that each and every one of the 26 countries concerned has stated that "I will stop beating my wife, I promise I will, and soon", but understands what this means in their own special way. Despite the fact that Germany has been quite clear, for example, the much respected Mario Monti is sure that Euro Bonds are almost within reach.

"Italian Prime Minister Mario Monti said Germany and other countries will eventually be convinced that commonly issued euro zone bonds are a useful way of tackling the region's debt crisis. "I believe we have enough arguments to convince the Germans," Monti told Euronews in a television interview". He also is still pushing to have the funding capacity of the EFSF increased, again as if the German parliament had not voted to put a ceiling on the level of its exposure. "Monti said he regretted that European leaders had not agreed to increase the European bailout fund (EFSF) by more than 500 billion euros ($668.25 billion) at last week's meeting in Brussels. A more substantial firewall would have been a better guarantee against market tensions, he said, adding this had been blocked by several European countries that "have a very limited view of what is the common interest".

The worrying thing is not only that Mario Monti believes this but, more importantly, that this is probably what he is telling the Italian electorate, leaving them with a very limited understanding of the kind of sacrifices they are actually going to be ask to accept. Last week's round of 2012 austerity measures will be as nothing when compared with those that would really be required to get Italian debt back down to 60% of GDP.

Thus many of those who were eagerly struggling to be first to sign on the dotted line last Friday didn't get the gist of the point of what they were signing up to, and the agreement will only really be adding to credibility once it is tried and tested. In the meantime everyone is simply following the lead given by Mario Monti, and assuming that what is actually going on isn't the death of Keynes, but the birth of German funded Eurobonds.

Land Ahoy!

But, having said all this, let's go back to where we started, to the isolation of the UK within the European Union. Could it be, as Philip Stevens suggests in an opinion piece in the Financial Times, that the UK is on its way out of the EU? As he says, it all depends on which end of the telescope you look down. Viewed from one one end, Mr Cameron’s veto was the moment Britain signalled the beginning of a long goodbye to Europe; looked at through the other it was Europe bidding its farewell to Britain. But are we sure, even Stephens has his doubts:

"It is important to insert a caveat here. The presumption of everyone in the room in Brussels was that the eurozone countries will indeed succeed in saving the single currency and build alongside it a more integrated political union. That enterprise could yet fail. Some will say after the limited progress made at the summit on rescue plan, the odds have now stacked against the euro. If it were to fall apart, so too would all other ambitions among the 17 eurogroup members".

So advertently or inadvertently David Cameron now has a Euro put. If the Euro survives his fate is sealed, in the most negative of senses, yet if it fails, then not only will he have been proved right, he may also find himself having to assume the mantle of leadership (backbench eurosceptics and all) and instill in a European Union in complete disorder the kind of Dunkirk Spirit for which the islands from which he hails have made themselves famous. And while we are on the question of survival, perhaps it would be to the point to close with John Authers assesment of the state of play in the argument.

Amid all the heated speculation about the European Union summit’s impact on Europe’s economic future and Britain’s role in it, traders are asking a more mundane question: “Has it done enough to get us through to Christmas?” Their answer: probably not. The muted market moves on Friday may be misleading. The euro rose against the dollar – but this may have been driven by banks repatriating assets. European bank shares, while above their lows, trade at half their book value, implying grave fears that some of their assets will be written down. The yield on Italy’s 10-year government bond fell 30 basis points during the day to 6.32 per cent – but this is still higher than at any point in the eurozone’s history until a month ago. The risk remains that the market will test Mr Draghi’s resolve by attacking a peripheral country’s debt in the two weeks before Christmas – particularly if a rating agency provides an excuse.

Amen to that! This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".

Last Days Of Pompeii?

2011-11-27T16:22:00.001+01:00

This week we got what seemed to be some good news in the ongoing Euro debt crisis. Bond spreads in many of the countries on Europe's periphery tightened vis-their German equivalents. Unfortunately we also got some bad news to go with it (no silver lining these days without the accompanying black cloud it seems): the tighter spreads were the result of a weakening of German bunds (or a rise in their yields) following what many considered to be a failed bond auction.

What is becoming clearer to almost everyone is that this is now no longer simply a Euro periphery sovereign debt crisis. It has become a full blown crisis of confidence in the Euro itself.

But just in case anyone was in any doubt, this week Deutsche Bank Chief Economist Thomas Mayer said as much on Bloomberg TV. Naturally he is far from the first to make this point - Commission President José Barroso and European Council President Herman Von Rompuy have been stressing the point for some time now - but it is an interesting reflection of how widely this opinion is now spreading.

One of the reasons for the recent rise in tone and in the level of concern is that it is clear contagion is now spreading far from the periphery. Belgium and French bonds have come under increasing presssure. And, of course, that famous German bond auction seems to suggest that even German yields are not immune to contamination. Actually, one unsuccesful German bond auction doesn't make a season of them, and Germany is well able to finance itself, but obviously markets are now drawing the conclusion that if Germany isn't willing or able to cut loose from the sinking economies on the periphery, then the German economy will eventually be dragged down with them, which means that German bunds are no longer seen as a surrogate Deutsche Mark, but rather as the backstop for all the unfunded periphery losses which might show up on the EU desk.

The frontier between core and periphery is becoming increasingly blurred, with Belgian borrowing costs hitting a Euro era high of 5.8% last Friday.

Of course, this weekend there has been a huge rush to agree a budget and put together a government, but after seven months of dawdling as if the large sovereign debt the country is labouring under wasn't a problem all these last minute efforts somehow fail to convince. Really it is the whole European model of nation states and national identities which lie behind the common currency that often lie at the heart of the problem. If countries like Belgium lack a national consensus, while others like Italy and Spain have minorities (who pay more than there numerical share) who are not really convinced they want to be in the country, then how can a fiscal union which would be based on some countries permanently paying (the so called transfer union) while others continually receive hope to hold itself together politically?

Then the possibility of joint and several responsibilities between an ever diminishing number of "core" core countries is simply leading to impossible pressures on the sovereign debt of the countries concerned. We have seen the first jitters in the direction of German debt this week, but France is a much clearer example as the exposure of the French banking system to Italy (400 billion euros worth, including public and private sector debt, according to BIS data) is leading to impossible pressure accumulating over the French rating, something which makes activating the EFSF as initially intended look increasingly difficult.

And contagion from the crisis is now heading East. Austria is worried about its triple A, and is imposing new restriction on CEE funding by Austrian Banks. Naturally, as Fitch suggest, this is likely to extend the credit crunch out to the East.

Hungary is the obvious "missing link" here.

But Romania is evidently not far behind, and President Traian Basescu is definitely not amused.

Of course the problem is not just a European one. Japan has a massive sovereign debt problem too.

In fact, far from having the "V shaped" recovery from the Tsunami some (not me) were predicting the short term outlook for the economy seems pretty dire. Policymakers in Japan still attempt to pin the problems down to confidence issues stemming from the Euro debt crisis and the high value of the yen, but surely what has been happening in Japan over the last 20 years has something more than local interest, since it was a harbinger of things to come elsewhere.

The Present Crisis Is Generalised One, Effectively Facing All Developed Economies

In the first place there is the problem of debt (whether public or private).

Secondly there is the problem of population ageing. The figures below show the transformation in Italy's population pyramid between 1970 and 2030. In many ways Italy's demography was at the most favourable point for economic growth (supply side) around 1990 (third figure top row) since the proportion of the total population in the working age group was at near its maximum, and the median age of the workforce was still relatively low. The point to get is that it isn't simply the level of debt that is the problem, it is the level of debt in the context of the implicit liabilities (in terms of health and pensions) which such population ageing represents, and the reduced growth outlook that having declining and ageing populations represents. Europe's leaders are essentially in denial on the extent of this problem, and are putting all their eggs in the "structural reforms to raise trend growth" basket.

The third factor which has decisively changed things to the disadvantage of the ageing and endebted developed economies has been the rise of the new emerging economies. This has changed the perception of risk, against developed economies and in favour of emerging ones. It is unlikely that this trend will be reversed. So we have economies with excessive debt plus implicit liabilities who are going to be challenged to sustain growth rates similar in magnitude to those we have observed in the recent past, and it is this which makes the level of accumulated debt unustainable and which makes it possible to speak of a developed world generalised debt crisis.

But, despite this, those countries in the Euro area have a special problem. The common currency was created with a deficient institutional structure, which creates confusion over who is responsible for what. Viewed from outside the EU it almost seems as if you need a PhD in European studies to follow what is going on. In an era where the best policy if you have a financial product to take to market is "keep it simple" this hardly would seem to be a good idea.

Cutting through all the foam and wrapping here, the key question is who is going to sign the cheques and who is going to pay? José Barroso and Herman Van Rompuy may make very nice photo images in Washington, but what exactly does there bank balance look like? So the key question market participants want to know, as President Barack Obama asked in Canberra recently, is who (or what) really stands behind the Euro. The answer so far has simply been a deafening silence.

So what are the institutional solutions that are being toyed around with? The basic point to get is that this is all about money, who is to provide it, and who will take any losses there may be in the longer term. Basically there are three lines of attack on the table.

a) The ECB
b) The EFSF
c) Eurobands

In fact the solution Europe's leaders are likely to come up with involves some variant of all of these. As I suggested in my last piece, the ECB is desparate to go so far and no further. This is understandable given that no central bank likes the idea of finding itself having to show losses. Just how far the bank is prepared to go in order to avoid this is made plain from the rumour circulating this weekend that the IMF was readying up 600 billion Euros to lend to Italy. Just where the IMF was going to find the money was not explained by most of the sources, but thanks to a speedy translation from Edward Harrison at Credit Writedowns, we discover that it was another one of those cockamany schemes whereby the ECB would actually lend the money, but the IMF would guarantee all the risk. Which simply begs the question; is there no one in Europe willing and able to guarantee the risk? And if not, why not? A stunning silence from Berlin.

Under the circumstances it is hardly suprising that the IMF rapidly denied the report. It looks to me like someone, somewhere (someone with responsibilities for funding the IMF perhaps?) put their foot down, and firmly.

Nonetheless it is quite likely that the ECB would be involved in some way, shape or form in any final attempt to rescue the Euro, possibly via some kind of security markets programme, and keeping the banking system supplied with liquidity.

Which brings us to the EFSF, and here we do have some news. According to a report from Reuters, the documentation is all ready and prepared for the EU Finance Ministers meeting tomorrow on formulas for leveraging the EFSF.

The formula being used for leveraging makes the current proposal look very similar to original Alianz Insurance proposal. The documents seen by Reuters specify that the EFSF could offer partial protection to investors buying a country's bonds at a primary auction of around 20-30 percent of the principal amount of the bond, depending on market circumstances.The protection certificate would be detachable from the bond and could be traded separately, but the investor would have to hold bonds of the country before cashing it in. The certificate could be paid if the bond issuer triggers a credit event under the full definition of the International Swaps and Derivatives Association, but, of course, in the wake of the Greek private sector involvement swap investors are now nervous that any future restructuring of Eurozone bonds might be carried out in such a way as to not trigger an ISDA event, so it is not really clear how valuable this insurance actually is, or how it will be perceived by investors.

But this isn't the sum total of the problems faced by the EFSF approach, since according to CEO Klaus Regling, the original levaraging objective is now no longer attainable, due to the loss of market confidence. And with Italy alone rumoured to be looking for something like 600 billion Euros, the doable quantities from the EFSF now fall far short of what will be needed.

Which brings us back to Eurobonds, which must be the last ditch recourse of someone or other. Markets certainly pricked up their ears last week when Angela Merkel issued those famous "now for now" words, but since that time we have simply had confusion. Actually the latest proposal on the bonds have come from the commission rather than the Paris-Berlin axis.

Most observers have reached the conclusion that such bonds will at some point form part of Eurozone policy, but how, and when? The problem is that Angela Merkel is widely perceived as holding back in order to put pressure on recalcitrant periphery governments to bring their deficits into line. But you can only take brinksmanship so far before you risk having things blow up in your face, a point which is very well illustrated by the dilemmas facing Mario Monti's new government. The problem is the timescale of debt reduction is one thing, and that of market confidence another.

Germany is insisting that any advance towards Eurobonds is dependent on moves to what Angela Merkel calls a fiscal union. But by this she doesn't mean the type of common treasury they have in the US, where stronger states help the weaker ones, what she means is common fiscal discipline, with powers from the centre to enforce.

The only thing that can be said with any certainty about this situation is that it is very confused. One leaked proposal follows after another, while representatives of the EU Commission in Brussels can barely conceal their frustration with the "go it alone" approach being promoted in Paris and Berlin. Matters reached a head today with an article in the German newspaper Die Welt (allegedly based on a leak) asserting that Germany was preparing to issue "top tier" Eurobonds with a select group of other triple A countries.

This could be read as a first step to a two tier Euro, which would at least be a step towards something. But it is too early to answer the question of whether it is, or whether it isn't.

Readying Up For The Transition

In the meantime market participants are walking with their feet. Both banks and ratings agencies are sounding their loudest warnings yet that the euro area risks unraveling unless those responsible for decision taking intensify their efforts to stop the rot.

Just this morning I got a research report from Mehernosh Engineerand Gregory Venizelos of the PNB Paribas European Credit Research team.in which they argue that capital flight is already effectively taking place.

On the other hand Citi's European Research Team are on "deposit watch", and claim to see signs of deposit outflows from periphery to "core", not retail deposits but corporate ones.

Meanwhile over at Nomura they are already speculating on how assets will be denominated after break up:

and giving advice to clients on the legal ins and outs of asset redenomination. Closing time in the gardens of the west anyone?

In this environment, it is hardly surprising that Wolfgang Munchau was his usual cheerful self in the FT this morning.

While perennial optimist Paul Krugman puts the situation really quite succinctly on his blog.

Incidentally, if you can't read any of the inserts, try clicking over them to get a magnified version.

How Would You React To The News Your Local Central Bank Just Went Bust?

2011-11-21T09:55:00.001+01:00

Well, it's been more time than I care to remember since I posted anything on this site. In the interim many things have happened, especially on the European sovereign debt front. I think I now have plenty of stuff lined up to waffle about, but maybe one simple way to ease myself back in to the world of blogging would be to republish the lengthy interview I just gave to the website Barcelona International Network. The topics covered range from the debt crisis itself, to prospects for Spain under the new Partido Popular government of Mariano Rajoy, and to the kinds of tensions with might arise in the months and years to come between Catalonia and the rest of Spain, and, of course, how this relationship might itself in turn have an impact on the debt crisis itself.

Barcelona International Network: There seems to be some chaos and confusion surrounding the future of the euro and the sustainability of a cohesive eurozone at the moment. Can you briefly summarise the background to the present crisis?

Edward Hugh: You are right. The situation is far from clear. To understand what is happening now it is important to understand the evolution of this crisis from the beginning. Europe's monetary union was founded on the idea that with time the various economies which make up the Euro Area would ultimately converge towards one common prototype. This unfortunately has not happened, indeed what we saw during the first decade of this century was quite the contrary: the divergence of the constituent economies. Thus, while it is common to talk of "core" and "periphery" it is important to understand that the so called core economies are not identical, while those on the periphery do not all suffer from the same ailment. In Greece the problem has been excessive (and indeed almost fraudulent) deficit spending. In Italy the problem is accumulated government debt - debt which has been amassed during two decades now. In Spain and Ireland the problem is the bursting of a housing bubble, a bubble which was made possible by the application of an excessively loose monetary policy by the ECB. In Portugal the problem has been one of very low economic growth. etc, etc. So if there is not one common illness it is hard to apply one common cure.

In many ways it is unfortunate that the Greek crisis was the first one to break out, since this has reinforced earlier stereotypes that the problem with the Euro is the lack of sufficiently strong fiscal controls from the centre. This is surely the case, but it is only part of the problem, and far too much of Europe's leaders time and energy has been devoted to this issue, to the neglect of many others which in many ways have equal or even greater importance. What is true is that lying at the heart of the present crisis (across developed countries, that is including Japan, the UK, the US etc) is the issue of debt, whether this be public sector debt or private debt. That is why what we have is called a sovereign debt crisis.

In addition, another of the characteristic features that make this crisis historically unique is that it is occurring in the midst of an unprecedented process of population ageing in economically developed societies, with rapidly rising elderly dependency ratios - hence the importance given to the sustainability of health and pension spending into the future. It is not only accumulated debt that worries investors, but implicit liabilities, and how these are going to be met.

Thus the crisis of the Euro Area is only the most extreme form of a debt crisis which engulfs almost all developed societies. And the situation is only further exacerbated by the fact that the deleveraging of debt which is now required (and hence the likely low growth levels) have as a backdrop a surge in growth in many emerging economies which makes these an attractive candidate for investment from those who worry about the sustainability of debt in the mature economies. So the relative risk evaluation between developed and emerging economies is changing, and this process is unlikely to go into reverse gear. Developed society debt is unlikely to ever be so cheap to finance and so easy to sell as it was during the first decade of this century.
Barcelona International Network: What do you see as the three most likely future scenarios for the euro from this point, in order of increasing probablility?

Edward Hugh: As I have suggested, the Euro Area crisis is similar to that in other developed countries, but worse due to the institutional deficits with which the monetary union was created. In particular attention has focused on two areas, the role of the central bank (the ECB) and the lack of a common fiscal treasury. To some extent these deficiencies are now being remedied, but the pace of adaptation is slow, and the financial markets are starting to lose patience. Alarm signals have been going off over the last week, not only due to the surge in the yields on Spanish and Italian debt but also due to evidence that the infection (contagion) is now spreading to what was previously considered to be the core (France, Austria) with the evident danger that more countries will lose their triple A rating. Should this materialise it will make some earlier strategies for financing Euro Area debt essentially non-viable.

Thus the crisis is in grave danger of turning critical, with market attention increasingly focusing on the viability and the sustainability of the common currency itself. As President Barack Obama said recently the key question that now needs answering is who (or what) stands behind the Euro? "Until we put in place a concrete plan and structure that sends a clear signal to the markets that Europe is standing behind the euro and will do what it takes, we are going to continue to see the kinds of market turmoil we saw," he told a news conference in Canberra last week. The key point to grasp is that we are talking about money here. What is the financial backstop which lies behind and guarantees the currency?

This has put the spotlight on the ECB as an institution, but the bank is reluctant to adopt the role of ultimate guarantor. This is not principally due to the so called "inflation fear" - demand driven inflation is extremely unlikely in the Euro Area in the near term - but rather due to a fear of accumulating sizeable losses in the event that large quantities of bonds are purchased and then countries like Italy and Spain have to restructure their debt. The fear in Germany is that the German treasury could then be asked to shoulder the central bank recapitalisation. Hence there is a great reluctance to let this happen. Naturally some argue that a central bank can simply accept losses, since the bank doesn't necessarily need recapitalisation and could be allowed to carry on regardless of the red ink on the bottom line. I am not very convinced by this argument, in part because banking and currencies are all about confidence, and it is not clear to me how the world would react to a headline like "European Central Bank Goes Bust". I think my fears are shared by the Bundesbank, and my intuition is that they are not at all keen to run the experiment just to see what actually happened. As Mario Draghi recently put it, “losing credibility can happen quickly – and history shows that regaining it has huge economic and social costs”.

Hence we have a logjam, with the investor world asking for clarification about who stands behind the Euro, and no one stepping out from behind the curtain to say "I do". In addition there is a kind of "dialogue of the deaf" taking place between the investor community and Europe's political leaders, with the latter asserting that what we have is simply a liquidity crisis, while the former are not convinced, and often consider that what we are facing to be a solvency crisis. The lastest proposal to emerge - that the ECB lend to the IMF who then lends to countries like Spain and Italy - simply highlights the sum total of all these difficulties.

According to the argument as it is going the rounds, the ECB is not allowed, according to its charter, to purchase sovereign bonds in the required quantity, or to lend to the stability fund (the EFSF) for the same express purpose. But the EU normally has little difficulty finding its way round initial regulations and treaty clauses when needs must (wasn't there an opinion once that bailouts would be illegal?), and in this case I am sure that if there were a will there would be a way. The problem is, as I am suggesting, there is no will for this solution from the German political leadership, due to the kind of losses which could be incurred. So the ECB asks the IMF to accept a loan and then lend on its behalf, but is this solution really credible? If a bank doesn't want to lend to a client due to concerns about the ability of the client to repay the loan, why should a neigbouring bank accept a loan from the first bank in order to lend to a client the latter does not want? What is involved here is a risk transfer, and it is not clear that non-European members of the IMF have any more stomach for accepting the losses which have been generated by 10 years of the Euro experiment than the core members of the Euro Area have. The UK posture in this regard is indicative - "you made the mess, now you clean it up".

Of course, matters are not that simple. In the first place the global economy is experiencing a slowdown, a slowdown which is in part being fuelled by the decline in global risk sentiment associated with the European debt crisis. So everyone has an interest here in finding solutions. The rise in bond spreads in both France and Austria is associated with a similar process.

In the French case investors are worried about the sustainability of French debt should Italy be forced out of the Euro, or be forced to restructure. French banks have something like 400 billion euros in exposure to Italian debt (both public and private), and were anything bad to happen to Italy then something bad would also inevitably happen to France. Which illustrates another feature of the crisis, the interconnectedness - via debt chains - of all the Euro Area economies. In principle the French economy is sound. It doesn't have an irresponsible government spending problem, and it didn't have a housing boom. Certainly the French economy is in need of structural reforms, especially in the labour market area, but it is not a deeply sick economy in the way that most on the periphery are. So the fact that French sovereign debt stability is now in question is a huge warning signal that things here could rapidly get out of hand.

The Austrian case is similarly worrying. "Contagion" means what it says, that parts of the body economic which get infected risk passing the infection to previously healthy parts if the underlying issues are not treated rapidly. This is what is now happening, and the clearest example is in the East, where many economies are now slowing rapidly as a result of the crisis in the Euro Area. This is putting pressure on debt instruments in the region - and in particular in Hungary - and this increase in risk aversion is then feeding back into Austrian bond yields due to the Austrian bank exposure to the East of Europe.

So basically we are all in this together, whether inside the Euro Area or out of it, here in Europe or in China or the United States. It is vital that some clear solution is found to the problem, and in particular that Europe make some rapid institutional changes which put real money on the table, and in sufficient quantity to calm the markets. Basically this means a common fiscal treasury in tandem with a much more interventionist ECB. Will this happen? At this stage in the game it seems unlikely, but then the alternative is the abysss, and peering directly into the abyss does have the strange property of concentrating people's minds, so you never know. Another possibility, which I have actively advocated, would be to divide the Eurozone in two, between a Northern core and the Southern periphery. This would be doable technically, and while being far from perfect would certainly go a long way towards easing the present stresses, but again, it would need clear, co-ordinated and determined action from the European leadership, and given everything we have seen so far there is little to suggest they will be able to rise to the challenge.

So we have the last "alternative" which is simply that markets push the issue to the limit, the centre does not hold (Germany, for example could be threatened with being stripped of its triple A), and the whole thing flies apart in the most disorderly and disaggreeable of fashions. If you were to ask me at this point which of the three above alternatives I considered most probable, I would have to say the latter, although naturally in no way do I wish this to happen, it is simply the risk that Europe's leaders are now taking. The worst part is that if involuntary Euro fragmentation did occur it could all happen very quickly indeed, as was the case with the initial attempt at EMU in 1992, although unfortunately this time round the consequences would be much more serious.

Barcelona International Network: What can the incoming PP government do in the face of this situation?
Edward Hugh: Despite popular beliefs in Spain - where a great deal of importance and attention is focused on the political dimension of economic crises - the sad truth is very little. This reality is even evident in the last statements of Jose Luis Rodriguez Zapatero (who called for the ECB to act vigorously) and Economy Minister Elena Salgado (who stated bluntly that the problem was a European and not a Spain specific one) just before leaving office. The new government will be caught on the horns of a dilemma, since the 2011 fiscal deficit is widely expected to come in at over 7% of GDP as opposed to objective set in the Stability Programme of 6%. Mariano Rajoy can either try to dodge the bullet or accept the challenge that this situation presents.

If he tries to dodge it - and according to one theory currently going the rounds the PP would like to pospone any deep cuts till after the Andalusian elections in the spring - then he will be dead on the starting block, despite being elected with the largest majority ever obtained by his party in the Spanish parliament. People who talk of trying to hold out till the spring are simply totally out of touch with the reality and the urgency of the present crisis. On the other hand, if he accepts the challenge, he could wind up a victim of market sentiment just the same.

Basically Spain's economy barely recovered from the previous recession and is now entering a second one. House prices have not ceased falling, and unemployment has been rising uninteruptedly since the end of 2007. This situation is putting enormous strain on the financial system, with all parties effectively agreed that the Spanish financial sector needs a second restructuring. The problem is there is no funding available for this at the Spanish level, hence eyes had been looking towards the European Stability Fund (EFSF) for support in this sense. But in the current environment the EFSF is also struggling to finance itself, and herein lies the problem. The present situation is unsustainable, not only due to the high cost of funding Spanish debt, but due to the liquidity pressures that the falling value of Spanish government bonds is placing on the banking sector. The latter problem is much more important than the former in the short term, and indeed it was this pressure on bank liquidity (and not the sustainability of sovereign debt as such) that pushed first Ireland and then Portugal into a bailout. If we add to this problem that Spain's initial financial restructuring process is already leading to an acute credit squeeze which is basically strangling the real economy on the vine, then basically you have all the seeds of a truly full blown crisis.

According to the latest EU Commission forecast, the Spanish deficit next year is expected to be 5.9% of GDP rather than the 4.2% objective set down in the EU stability programme. If Mariano Rajoy applies the kind of spending cuts which would be required to bring the deficit into line with targets in the context of an economic recession, then the probability is that Spain would have a rather severe economic contraction in 2012, similar to that which is currently occurring in Portugal. On this scenario the impact on unemployment would be severe (JP Morgan is already forecasting Spanish unemployment could rise to 27% in 2012), and the knock-on effect of this on non-performing loans in the banking sector correspondingly negative, and so on and so forth. So whichever way you look at it, Mr Rajoy is certainly facing a "heads I lose tails you win situation", with no easy solution.

Which is why I say at the outset that the response has to come at the European level. The era of single country rescues has really come to and end with the arrival of Spain and Italy in the casualty unit. Both countries are of course, too big to save in the conventional sense, while at the same time if they both fail then the Euro in its present form is surely finished. In addition, the political dimension is much larger. Italy is not Greece, and Spain is not Ireland. It would be impossible to treat either country in the way which their smaller peers have been treated, and Europe's leaders are well aware of this.

So we are back to the backstop for the Euro, making large quantities of funding available to both sovereign debt issues and to the financial sector restructuring one, a restructuring which would almost certainly involve the costly creation of a bad property bank in order to take the large accumulated volume of toxic assets of balance sheets and free the system up for the provision of more normal credit. But as I said earlier, all we have from Europe's leaderes at this point are vague promises coupled with silence on the key issues. A silence which becomes more and more deafening with each passing day. As ECB President Mario Draghi put it at the end of last week - highlighting the failure of governments to make operational the European Union’s bail-out fund, the European Financial Stability Facility, launched 18 months ago - “Where is the implementation of these longstanding decisions?”

Barcelona International Network: What specific effects are future developments likely to have on Catalonia's relations with the rest of Spain? Given the substantial PP majority in the Spanish Parliament, do you see increasing political tension between a centralist nationalist government and a Catalan administration under increasing citizen pressure to exercise the right of self determination, or do you believe sufficient common ground will be found to make agreement and cooperation achievable to address the current economic issues?

Edward Hugh: Well, as you probably know the situation here in Catalonia is very difficult. The cutbacks in public spending here have been very severe, more or less 10% across the board including in key areas like health and education. Yet despite this the underfunding of the region is so severe that the government is not going to be able to comply with the 1.3% of GDP deficit target laid down for 2011 by the central government. This year's deficit is likely to be around 2.6% of Catalan GDP but the government in Barcelona has made no secret of this, since it always considered the proposed reduction too drastic to carry out in one year. It is important to understand here that Catalonia has a large fiscal SURPLUS with the rest of Spain, maybe 8% of Catalan GDP.

Catalonia is one of Spain's richest regions, and effectively subsidises spending in other parts of Spain. Most Catalans accept this, and accept that their region should make some contribution to balancing disequilibriums across the Spanish territory. What Catalan citizens cannot understand is the extent of their contribution, and why it is that their regions should be receiving swingeing health cuts while other areas seem to be able to avoid them whether by hook or by crook. So this is a very unstable situation.

Catalans are also pretty fed up with the lamentable efforts of the previous Zapatero adminstration to find solutions to the economic crisis and to find ways of improving their financing problems - it is important to remember that Catalonia is one of the richest and most productive regions in Southern Europe, yet Catalan debt is treated scarcely better than Greek debt by the financial markets. We do not deserve this.

My feeling is that the new Rajoy adminstration will go to some considerable lengths to try to avoid confrontation with the Catalan administration, and many Catalans will be ready and willing to respond to such overtures. I well remember close Mariano Rajoy adviser Baudilio Tomé saying to me "Edward, you are one of those Catalans who recognises when Spain goes well, Catlonia goes well, and for Spain to go well, Catalonia has to go well". And yes I, like many others, take this view. The thing is, Spain isn't going well, and in the near future it is unlikely so to do.

In addition the new government's room for manoeuvre may be very constrained. The Catalan Parliament is preparing a new financing proposal, but in the short term anything which improves Catalonia's situation is inevitably going to make the position in some other parts of Spain worse, so this is going to be an aspiration which it will be hard for a Spanish nationalist party to fulfil. So while in the short term there will be conciliation, in the longer run confrontation would seem to be far more likely, given the diametrically opposed aspirations of the various parties.

Naturally, any kind of disorderly Euro disintegration would add to these strains enormously. I recently attended an experts meeting on the legal background to state creation. It was really fascinating stuff, but what I was most surprised to learn was that in the event of a Catalan declaration of independence, and absent an amical agreement between Spain and the new state, the liability for servicing existing debt issued by the Spanish state would fall on Spain and Spain alone. This would mean that the country without the Catalan financial contribution would be virtually immediately bankrupt. This is a daunting thought, and should serve to concentrate everyone's minds in the months and years to come. Catalonia could easily finance itself and live up to its responsibilities outside Spain. The same cannot be said of the parent country absent Catalan financing. I think it's high time for a change of mindset in Spain about this reality, and time that Catalonia's problems were treated with the respect and importance which they deserve.

Crying All The Way To The Bank

2011-09-12T11:27:00.000+02:00

Ireland's Minister for Finance Michael Noonan is an optimistic man. He is also a persistent one. He is optimistic, since he clearly feels that his country's 85 billion euro IMF/EU programme is going to work as planned, and he is persistent as he patently refuses to let sleeping dogs lie. The dogs in question here would be the bondholders of Anglo Irish Bank and Irish Nationwide Building Society senior debt. The heir to these banks owes them some 3.8 billion euros, and the first repayment of 719 million euros of Anglo debt falls due on November 2.

In the other corner of the ring, the horse who is in danger of having himself flogged to death by Mr Noonan's persistence is none other than ECB President Jean Claude Trichet, who has been being constantly pestered by journalists since the issue was first raised, and who had difficulty concealing his frustration last week on being asked for the umpteenth time whether he would accede to Mr Noonan's request to procede with some kind of restructuring on the bonds. Just in case his remarks were misinterpreted he did work in a very favourable “When I look at Ireland, I see a country which is gaining credibility regularly,” comment, of course, since Ireland is once more the poster boy for the Eurozone periphery, and he wouldn't want to undo all that good work by taking a clear swipe.

As I say, Mr Noonan is a very persistent man, and will hardly take no for an answer, which is why he has not been deterred and is now reportedly seeking a meeting with Mr Trichet to discuss the matter during this week's EU finance ministers meeting in Poland. Of course, you can understand his frustration, since despite all that positive kudos which the monetary union's institutions are able to garner from the performance of their most studios pupil, relatively little is being visibly done in the way of cutting the country some slack in the face of the oncoming deterioration in global economic conditions.

And this despite Christine's Lagarde's recent most urgent warnings that no policy stone should be left unturned in the battle to protect vulnerable countries from the oncoming shock, if necessary by the stronger ones making sacrifices. Arguably if any EU country has earned sufficient brownie points to merit protection that country is Ireland.

Mr Noonan's insistence on some sort of movement from the EU side is pretty understandable, especially in the light of last week's decision by the IMF (who are not, it would seem, opposed in principle to the bond restructuring request, see below) to reduce the country's GDP growth outlook for this year and next given the stronger headwinds it will be facing. The Fund now expect the Irish economy to grow by 0.4 percent in 2011 and 1.5% percent in 2012, revised down from the earlier 0.6 and 1.9 per cent respectively. What this effectively means is that meeting budget targets will be just that bit harder for the country.

So although Mr Noonan tries to put a brave face on it - declaring that next years budget will be only “two thirds” as difficult as this year's - the harsh reality is that austerity measures bite a lot harder as countries enter contraction than they do during an expansionary wave. The austerity measures applied so far have been in the context of a strong global expansion (and hence have been counter cyclical), the ones which are to come will be applied as the external environment becomes more difficult (which is why the IMF have lowered their forecast) and as such they will be pro-cyclical, and will only serve to add additional force to the headwinds blowing straight into Mr Noonan's face.

Ireland has done well so far, but I think this relative success needs to be put into some kind of context. In the first place, while GDP may increase 0.4% this year, it fell by 1% last year, 7,5% the year before and 3.5% in 2008. Which means that at the end of Q1 2011 it was still 12% below where it stood at the end of 2007, and is thus still at levels first seen in 2005. At the moment (beyond the positive spin) what we have on our hands are six lost years.

More to the the point, the past has left a very problematic legacy: debt. According to IMF data Irish public debt to GDP has risen from 25% in 2007 to an estimated 114% this year. If things go well the IMF now estimate that debt will peak in 2013 at 118%, but as we all know these are very dangerous numbers, and things may not go well. Growth for 2012 has already been revised down from the 1.9% on which the estimate was based, and may well not reach the 2.4% currently forecast for 2013, in particular since the presence of so much household debt may mean the consumption growth projections may not be fulfilled..

So just why may growth not reach these reasonably optimistic levels? Well one reason could be the external environment, which may not be as propitious to Irish exports as 2010 and the first half of 2011 have been.

But another reason - as suggested above- would be the overhang of private debt which still weighs down domestic consumption in Ireland. According to data from the Irish Central Bank there were 128.5 billion euros in outstanding loans to the household sector at the end of July, while loans to non financial corporations were around 89.5 billion euros, making a total of 218 billion euros or around 130% of GDP. So public and private debt combined is now not far short of 250% of GDP, which is a lot in anyone's book, and especially in an economy which is barely growing due to various years of competitiveness loss.

The result of this substantial debt overhang is that Irish household consumption has contracted sharply, and shows no sign of recovering.

Of course, those who have been following closely other debt-strapped economies struggling to throw off the impact of the credit bubble without devaluation (like Spain, or Latvia) should not be too surprised to see the pattern here. And of course gross fixed capital formation (which was largely driven by property "invesment") has also plummeted.

Meanwhile the government is struggling to reduce the deficit, which means of course (in a no-growth/low-growth environment) that government consumption is falling constantly, and will fall even more as deficit targets are complied with in an environment where even nominal GDP hardly moves upwards. I think Mr Noonan has it wrong, this year's fiscal effort is likely to be only two thirds of the one which is demanded in 2012 if targets are to be maintained.

It's All Down To Exports

So really, it isn't simply that Ireland needs exports to help the economy chug along, in the short run Ireland depends on exports for what little growth it can get, which is why, of course, the recent recession warning from the IMF is so important.

And if we come to look at the runes, those indications we have - like the most recent PMI readings - all point towards a serious slowdown/contraction, with no evident end in sight. Ireland's August manufacturing PMI revealed that conditions had deteriorated for a third consecutive month, impelled by a substantial drop in new orders, even though among those export orders actually increased slightly, offsetting the domestic trend.

Loss of momentum in the services sector also continued in August, even though the survey continued to indicate marginal growth (51.1). Total new business decreased for the fourth month running, and at the sharpest pace in the present sequence according to the report. Again, in contrast to the downward trend for overall new business, new export orders increased, even if the rate of expansion was only marginal. Respondents in particular noted higher new orders from the Middle East, UK and USA.

So, even though we still don't know the second quarter GDP numbers but exports were strong, and the trade deficit continued to improve, so growth - such as it is - should remain relatively robust.

Unlike many of the other economies on the Eurozone periphery, Ireland not been running a massive current account deficit, and has enjoyed an underlying trade surplus. Consequently, the IMF are now forecasting surpluses of 1.75% and 2.5% of GDP in 2011 and 2012 respectively. On the other hand, as the IMF also notes, the large role of multinational companies in Irish trade activity means that rising net exports will to some extent be offset by sizeable income outflows, reducing the spillover impact on domestic demand. Which is another reason for being cautious when it comes to predicting positive movements in consumption.

Unemployment - at 14.5% in July - remains high, and has continued to rise, with the natural consequence that bad housing loans also continue to mount.

According to the central bank of Ireland, at the end of June there were 7.2% of residential housing mortgages in arrears for more than 90 days, up from 6.3% at the end of March. The rate of mortgage arrears by value rose to 9.4 percent in June, from 8.3 percent in March, with arrears of over 180 days constituting around three-quarters of the total. Residential property prices continue to decline, and in July they fell by an annual 12.5%, bringing the total decline since the 2007 peak to 42.5%.

The central bank also estimated that roughly 13 percent of mortgage borrowers are likely to have negative equity, with a much higher share - about one-third among those with mortgages approved from 2004 on. The IMF take the view that negative equity is less important than mortgage repayment to income ratios, given that Irish mortgages are granted on a full recourse basis. In fact this situation has not yet been tested, since relatively few properties have been repossessed (less than 1,000, well, that's understandable in a context were people are being forced to pay taxes to bail out the banks), while more than 60,000 mortgages have been restructured, mostly through rescheduling via interest only loans. Which suggests that the pile of non performing mortgages may be potentially much greater than so far seen, especially if there is a long delay in the economy gaining sufficient momentum to start generating employment. Also, Spanish experience suggests that eventually this "under water" negative equity problem grows with time, and that pressure for changes in the full recourse condition may become unstoppable, especially where the only alternative left to young mortgage holders is family breakup and long term emigration.

The only real piece of good news in all this is that the ECB may now be about to lower interest rates again, bringing relief to some struggling Irish home-owners, but if unemployment continues to rise under the impact of the global slowdown, then the non-performing mortgages rate will undoubtedly tick up with it. Certainly there can be no doubting the fact that Ireland is still stuck in a pretty violent credit crunch, with loans to households down 3.9% in July (interannually), while mortgages were down 2.4%. Corporate lending also remained tight.

Ireland On The Knife Edge

So really, and despite all those earnest endeavours, Ireland's debt problem is not in essence that different from the one facing Greece, or the one facing Italy. The country's debt is perched on a knife edge, and its future evolution depends on a small number of key parameters: interest rates, inflation and GDP growth. As the IMF themselves underline, any negative shock to their baseline growth forecast could put Irish debt straight back on an upward path. As they say in illustration, a simple one-third permanent standard deviation shock would lower the average growth rate from 2.5% to 1.25% over the 2011–16 period, and this would see debt spiralling upwards to 132 percent of GDP by 2016. Leaving aside negative events in the external environment (a sharp correction in China in 2013, for example), all that would be needed for this (nearly nightmare) scenario to be fulfilled would be for domestic demand not to recover in the way the IMF are forecasting it will. Unfortunately, and for the reasons advanced above, I think the IMF have got it wrong here. Domestic demand isn't going to recover to the extent anticipated over this time horizon.

The second factor which will also influence the future of Irish debt is the inflation rate, since what matters is the growth in nominal (ie not inflation adjusted) GDP. As many observers have noted, what also differentiates Ireland from other troubled parts of the Eurozone periphery is the fact that there has been considerable wage and price moderation (the so called "internal devaluation") since the start of the crisis, and this has resulted in lower than Euro Area average inflation (see chart below). This is above all an indication that Ireland's economy is more flexible that some of the others, but (in the context of a currency union) it also presents a problem, because this moderation is essentially deflationary, and very low levels of inflation (especially when combined with weak growth) can have very negative effects on the debt dynamic, as we have been seeing in Japan. So Ireland, like other Eurozone countries who have lost competitiveness are on the horns of a dilemma. The need to recover strong GDP growth means they need very low levels of inflation to restore competitiveness, while the need to contain the debt means they actually want (some) inflation.

In fact the only real answer is to reduce some of that debt by writing it off, and this Mr Noonan well knows, hence his insistence with Mr Trichet.

The third factor which is critical to the debt trajectory is the rate of interest charged on the debt. Irish government debt has predominantly fixed interest rates, hence higher market interest rates only affect interest payments on new market borrowing. Were interest rates on new borrowing to remain at current levels the IMF calculate that this would mean a ½ percentage point higher average interest rate on the full debt stock over 2012–16 and a 1½ percentage point higher average interest rate in 2016. In this case, debt would reach 119 percent of GDP in 2014, and remain at 119 percent through 2016. Hence a reduction in sovereign spreads from their current levels is critical to putting Irish debt firmly on a declining path.

Fortunately there is some relief in sight on this front following the July 21 European Council announcement regarding the terms of EU financing. While firm details are still lacking official sources suggest that the interest rate on all EU loans may well be reduced by something like 200 basis points with an increase in maturity on future EU loans to 15 years, compared to a current average maturity of 7½ years. As a result, Irish interest rate payments should be reduced by about 3 percent of GDP cumulatively over 2011-16. This means, all other things being equal (which they won't be) that the debt ratio would peak at 117 percent of GDP, and then decline to 112 percent of GDP by 2016. Would that resolving real world dilemmas were as simple as churning out scenarios!

The Decoupling Argument Returns

One of the main problems facing policy-makers is deciding when on earth it might be possible for the Irish administration to once more gain access to market financing. Ireland needs to return in a limited way in 2012, and more substantially in 2013 (or it will need a second bailout just like the Greeks). Evidently recent market developments have been raising doubts about just how feasible the expectation of regaining market access really is, even though the concerns relate to other Eurozone countries (Greece, Italy) rather than to Ireland itself. But if the second Greek bailout falls through, and the country defaults, it will be very hard for Ireland not to get caught up in the ensuing contagion, whatever the recent evolution in bond spreads suggests.

In fact attitudes towards Ireland in sovereign bond markets have improved since the July agreement, in a way which mirrors the improvements in the Spanish situation following the May 2010 decisions. The decline in Irish yield spreads was also reinforced by the ECB’s renewed bond purchases under the Securities Market Programme (SMP) announced in early August. The two-year spread over German bunds fell from about 1,350 basis points to about 900 basis points within a few days. Irish two-year spreads have since declined further and are now below 800 basis points, leading to a good deal of speculation that markets are finally starting to differentiate Ireland from other periphery countries. For reasons outlined above I would say such speculation is rather premature, since there are now far too many downside risks to the Irish situation to simply ignore, even if Ireland's short term prospects are still seen as being rather better than Portugal's.

The shape of spreads curves has also changed. Spreads were generally higher for shorter maturities in July, in line with market concerns about shorter-term financing issues. The “spreads curves” have flattened considerably for Ireland and Portugal, reflecting less near-term uncertainty about the future of Irish finances given the July 21 EU agreement on Greek debt restructuring, more favourable financing terms for the bailout loans, and the ECB’s announcement of more bond purchases.

Having Your Cake And Eating It!

One of the big issues identified here is the capacity of the Irish export sector to sustain the sort of growth the country needs to pull down the weight of the debt. This is one of the most misunderstood topics in modern macroeconomics. Even the IMF itself seems to be caught up in the general lack of clarity, since in one moment it suggests that strong export growth will do the trick.

"As before, the decline in domestic demand is expected to be outweighed by the positive contribution from net exports.........Continued solid export growth is projected to be sufficient to generate GDP growth of about 2 percent, even as import growth rises somewhat".
IMF staff report for the Third Programme Review, August 8 2011

While in the next it suggests that slowing export growth won't be such a big deal, since the import content of Irish exports means the value added component is not that high.

"The services sector PMI indicates falling new export business, and the PMI for manufacturing suggests a slowdown in the growth of new export orders.Staff have therefore lowered projections for growth in demand for Irish exports, especially in 2012, although the impact on activity will be cushioned by the high import-content of Irish exports".
Third Programme Review - Supplementary Information Provided by Staff, August 29, 2011

So come on now, which is it?

On a more general level Ireland also present Europe's leaders with a "having your cake" type challenge, since reading the reports it is hard not to get the impression that Ireland has done almost everything which has been asked of them, and yet the programme still may not be able to work. It is high time politicians in Berlin to started to recognise that fiscal austerity is not the be all and end all of the policy issues they now face. Ireland is applying fiscal austerity, but this alone may well not be enough. A better distribution of the pain needs to be found. As the IMF itself notes in its latest staff report: "there is a strong sense that burden-sharing between taxpayers and creditors for the cost of supporting the banks has been unfair". In recognising the legitimacy of this feeling the IMF stressed with the authorities the need to effectively mitigate the contagion risks such burden sharing would present. Containing contagion when the restructuring inevitably comes will require - as the IMF argue - a robust legal and institutional framework which strikes a reasonable balance between offering creditor safeguards and fairness. This kind of institutional framework will, I imagine, be right at the top of the list of topics Mr Noonan will be looking to talk about when he seeks out Monsieur Trichet during this weeks Econfin meeting in Poland.

This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".

High Noon Approaching for Greece?

2011-09-08T21:18:00.001+02:00

The Greek tragedy in several acts would appear to be approaching a climactic moment. The warnings coming out of Berlin all week have been hard to ignore: "Greece either puts up or shoves off" would seem to be the blunt message being offered.

Only yesterday, German Finance Minsister Wolfgang Schaeuble informed members of the parliamentary budget committee that Greece is now perched on a "knife's edge". This follows hints from other leading German politicians (including Angela Merkel herself) that a Greek euro exit is no longer the unthinkable taboo topic which it had been to date. If Greece does not meet the conditions it agreed to, as assessed by monitors from the International Monetary Fund, European Central Bank and European Commission, then payments will stop, Wolfgang Schäuble told listners to Deutschlandfunk radio during an interview today. “Then Greece has to see how it gets access to financial markets without help from the euro zone,” he said. “That’s Greece’s problem.” Mr. Schäuble did point out, however, that at present there is no legal mechanism to expel a country from the euro area.

The fact that an expulsion mechanism doesn't presently exist doesn't mean one couldn't be created, and this was a possibility which the Dutch Prime Minister Mark Rutte explicitly advocated this week in an article in the Financial Times.

The backdrop to all this heavy language is, of course, the sudden suspension of the quarterly program review by Troika representatives at the end of last week. The message that is being put across to the Greek administration is that they need to come up with the goods by next Monday when discussions on their review are set to resume—or else.Naturally, the easiest thing to assume is that all of this is simply a bout of strong rhetoric to try and force the Greek government to fall into line.

But there is another issue looming which could also threaten to upset the apple cart if the ball bounces the wrong way, and that it the proposed bond swap that constitutes the core of the private sector involvement (PSI) included in Greece's second bailout program at Angela Merkel's insistence.One of the little-discussed features of this swap, which involves some 135 billion euros in Greek debt, is the effect it will have on the legal framework governing Greek bonds. At the present time, some 90 percent of those bonds are governed by Greek law, a state of affairs which would evidently give the Greek authorities a certain advantage were there ever to be a hard default.

As veteran debt lawyer (and current adviser to the Greek government) Lee Buchheit put it in a 2010 paper on Greek debt restructuring: “No other debtor country in modern history has been in a position significantly to affect outcome of a sovereign debt restructuring by changing some feature of the law by which the vast majority of the instruments are governed.”Given this, it's hard to understand why anyone in such a uniquely favorable position and facing the possibility, nay the probability, of a hard landing would wish to voluntarily surrender it.

Yet this is just what will happen if the PSI bond swap goes ahead, since the new bonds will be issued under international and not Greek law.All of this explains why I personally was not that surprised by today's statement from OECD Chief Economist Pier Carlo Padoan that the plan wasn't working out as planned, since there had only been a 75 percent take-up. The Greek government itself raised more than an eyebrow or two when it laid down a minimum 90 percent participation as its condition for proceeding, in a letter the government sent to global finance ministers at the end of August. In theory the deadline for responding was to be tomorrow (9 September) but such is the disorder now reigning in Athens, and even in the headquarters of the National Debt Office, that even this is no longer clear. According to one report early today from Reuters Greece correspondent delays in the Asian roadshow meant the acceptance date would be put back, but then later in the afternoon the same correspondent came out with this story, which clearly suggests that the intention is to maintain the timetable, even though only 70% of bondholders are thought to have responded positively: "September 9 is the cutoff date and it is very likely that we may have a bigger response rate as bond holders rush on the last day," a source close to the procedure is quoted as saying on condition of anonymity.

If the PSI falls, then so does the second bailout plan, and judging by the prevailing mood in Northern Europe at the moment, it seems unlikely that all parties are in the frame of mind to go all the way back to the drawing board. So when the Troika inspectors are on their flights back to Athens, it isn't hard to imagine that they will have more than the fiscal slippage implied by Greece's second-quarter 7.3 percent drop in GDP on their minds.

The above is an ammended version of a post which originally appeared on the CNBC blog.

Life On PMI Cold Comfort Farm.

2011-08-25T20:02:00.015+02:00

As the heat wave which has been hanging over Southern Europe for the last couple of weeks steadily eases off there is little sign that any of the warm air which is disippating is reaching the chilled motors of the European and Chinese economies. The results of this months flash PMI readings are at best more of the same, and at worst show continuing deterioration. While current conditions stabilised in some areas, new orders, and especially new export orders often hit new post-recovery lows. There is every likelihood that the final August global readings will be much more of the same.

The Eurozone story is one of read the details carefully. The composite index was unchanged at 51.1, which means a very sligh expansion in activity (50 is the neutral point), so the sharp deterioration seen in recent months did grind to a halt. But to understand the "why" of this we need to drill down into some of the individual country aspects.

French services activity would be a good place to start, since it is here that the greatest improvement was to be found. The services activity index rose from 54.2 in July to 56.1 in August, showing that despite the recent stagnation in French GDP there is life in French consumption yet awhile. At the same time manufacturing conditions deteriorated, and at 49.3 the indicator fell into contraction mode.

In Germany things were a little bit the other way round, with services falling back sharply and scarcely expanding (50.4), while manufacturing held steady at the July level of 52.

But then again, drilling down within the German manufacturing data we find even more interesting details. In the first place the current output reading was up (from 51.8 to 53.1 - it is important to remember that the PMI is a composite of several different components of which current output is only one).

At the same time, survey participants reported weaker growth of overall business activity which they primarily attributed to lower intakes of new work in August. As the PMI report notes, "although the decline in new business volumes was relatively modest, it represented a change of direction after a two-year period of continuous expansion. Both the manufacturing and service sectors registered falling levels of incoming new work".

In particular the fact that manufacturers suggested that weaker export sales had contributed to the reduction in new orders in August is more than worthy of note. In fact, the latest data pointed to the fastest drop in new work from abroad since June 2009. So the indicator remained stationary due to the combined impact of heavier current output and deteriorating export orders. What we call in Spain "pan para hoy, y hambre para mañana (bread today at the price of hunger tomorrow).

Basically the rise in manufacturing output this month seems to have been largely the result of inventory increases. According to the PMI report, "the forward-looking new orders to stocks of finished goods ratio in the manufacturing sector deteriorated again during the latest survey period. It was at its lowest level since April 2009, following a survey-record accumulation of post-production inventories in August".

This general picture is confirmed by other recent German surveys. The IFO index - and most notably the businesses expectations part - fell back again in August. indeed, German business morale posted its steepest drop during the month that at any time since the aftermath of the Lehman Brothers collapse in late 2008.

The Munich-based Ifo think tank said its business climate index, which is based on a monthly survey of some 7,000 firms, fell to 108.7 in August from 112.9 in July, well below the Reuters consensus forecast for a 111.0 reading. The last time the index fell so sharply was in November 2008, just after the collapse of Lehman Brothers when the German economy was in its deepest post-war recession. This month's was the lowest reading for the index since June of last year. Even more importantly there was a sharp decline in the Ifo's expectations subindex which fell to 100.1, its lowest in almost two years, and down from 105.0 in July.

German consumer confidence (as measured by the GFK survey) weakened again.

This drop in German consumer confidence forms part of a much wider European pattern, since Eurozone consumer optimism also plummeted in August at the fastest rate for 20 years The European Commission said its consumer confidence indicator fell 5.4 points to minus 16.6 in August – a larger monthly fall than was seen in October 2008 after the collapse of Lehman Brothers.

Just as importantly, there are signs that the German labour market may now be turning. Survey respondents reported a slowdown in job creation across the service sector, and the latest increase in employment levels was the slowest for 12 months. Across the German private sector as a whole, jobs growth was the weakest since October 2010, despite a further robust rise in manufacturing workforce numbers.

In addition the impression offered by the survey data is confirmed by the employment numbers released by the German Statistics Office, which show that new job creation peaked in February/March, and that the rate has been slowing since. If this trend continues then Germany will experience a real change of economic course.

It is here that it is important to understand the key difference between the two main Core Euro Area economies. Germany is export dependent, and subject to conditions in external markets. France has a stronger domestic consumption dynamic (hence the recovery in services activity) and is to some extent shielded from sudden movements in external conditions. Having been stationary in the second quarter, it is by no means a done deal that France will contract in Q3.

Contraction Continues On The Periphery

Turning from the core to the periphery, given that the overall PMI remained unchanged, and that the core deteriorated slightly, it may well be that some of those on the periphery did slightly less badly than they did in July. This would not be totally surprising, since many of these economies have significant tourist industries, and the season so far, according to reports, has not been an especially bad one, and in general terms an improvement over 2010. However, what we are talking about here are economies which contracted rather more slowly in August than they did in July.

On the inflation front, price pressures eased again markedly during the month. Average prices charged for goods and services showed only a modest increase, the rate of inflation moderating further from April’s high to reach a nine-month low. Service sector charges showed a particularly weak rise, the smallest monthly gain since services charges began rising in February. But, according to the report, it is in manufacturing where the steepest turnaround in price pressures has been evident. Prices charged for goods showed the smallest monthly increase for a year in August, in marked contrast to the survey-record high seen back in March.

Respondents suggested that the slower rate of increase of selling prices reflected a combination of sluggish demand and a further substantial easing in input price inflation. Service sector input costs rose at the slowest pace for ten months, while manufacturers’ input price inflation eased to a 20-month low, taking the overall rate of increase across both sectors down to the weakest since February of last year.

Which means, Monsieur Trichet and his team have even less justification than previously for proceeding with their ridiculous rate increase programme. It is now very unlikely that we will see any more of these in 2011, and an even bet whether the next move will be up or down.

China Hovers In The Limbo Between Growth And Contraction

Finally, moving briefly on to the Chinese reading, conditions seem to have improved slightly in August, and even the decline in export orders was to some extent arrested, but it is far too soon to draw any definitive conclusions on this count.

Commenting on the Flash China Manufacturing PMI survey, Hongbin Qu, Chief Economist, China & Co-Head of Asian Economic Research at HSBC said:

“The flash manufacturing PMI reading picked up slightly to a level close to the break-even mark in August, which is still consistent with around 13% y-o-y IP growth. Despite the turmoil in global financial markets, the new exports orders index rose to a three-month high, albeit still marginally below 50. All these data suggest that the hard landing risk is still remote. This provides leeway for the PBoC to keep the current tightening measures in place.”

The Policymaker's Fear Of The Italian Penalty Shot

2011-08-17T21:32:00.000+02:00

“While the impact of service-sector liberalization and privatizations may be positive on medium-term growth, the budget cuts are likely to have quite negative effects on the short-term GDP dynamic. We expect Italian GDP growth to slow to close to zero in 2012 and 2013.” Giada Giani, Citigroup

According to one anonymous German official speaking off the record to reporters from Der Spiegel, "a country like Italy can't be saved". We will have to trust that he was referring to the country's size when he made the statement, and not its existential core. If he was, he may well be right, at least under the Euro Area's current institutional arrangements. Let's take a quick look at why.

The ECB Backstop Works For Now

The Italian debt markets are a lot calmer this week than they were the week before last. Evidently there is a simple explanation for the phenomenon, and that is that the level of Italian bond yields is now more or less completely guaranteed by the European Central Bank (the ECB). Systematically and meticulously, the Italian ten year bond yield is being maintained at or around the 5% level by a team of dedicated bond traders in national central banks dotted around the Euro Area.

The process whereby this result is achieved is not that dissimilar to other more common central bank interventions, for eaxmple to target a certain exchange rate, or a given overnight interest rate. Basically, when the yield rises above a given threshold the ECB's representatives simply step in and buy bonds. This happened last week to the tune of some 22 billion euros, with bonds being acquired from a set of 5 EU peripheral countries, although we don't know how the purchases were broken down at national levels. One thing was for sure, there were a hell of a lot of Italian bonds tucked in there somewhere.

The problem for the bank now is that once you initiate a programme like this, there is no easy way to stop. Despite many voices who argue the contrary, Italy's problem is not simply a short term liquidity one (funding a deficit), it is a long term solvency one (servicing an enormous pile of debt and growing at the same time). While the country has long maintained a primary surplus, the weight of the debt has drifted steadily onwards and upwards. Italy is caught in a conundrum. With low growth you need inflation to be able to make the books balance, but this excess inflation makes the country's competitiveness problem steadily worse. If you implement the reforms needed to make the economy more competitive then you don't get the inflation, and if you take away the deficit in the meantime then you simply don't get growth. This is a zero sum game in which all the numbers don't add up.

At the push of an ECB "buy" button, Spanish and Italian sovereign bonds have effectively been taken out of the markets, and it is now hard to see how (without some sort of restructuring or other) they can now ever get back in again.

In ceding to pressure from Europe's leaders to take this decision, the central bank has now gotten itself locked onto the horns of a huge dilemma, and they are going to have great difficulty finding a way to extract themselves from it. Monsieur Trichet has lodged his finger well and truly inside the wall of the dike, and should he even momentarily take it out again, the whole structured could easily rupture, with many of the things we now know and love getting carried away in the ensuing flood.

Of course, the mere threat that he might one day do this does serve to concentrate all the various minds involved, but what is involved is a form of brinksmanship which could in itself one day become a problem.

A glimmer of what the bank is now getting itself involved in can be seen in last week's ECB balance sheet reading, since it grew to the year-to-date high of 2.073 trillion euros last, largely as a result of increased lending to eurozone financial institutions and additional sovereign bond purchases.

The balance sheet was up by 68.736 billion euros over the previous week, and 119.94 billion euros over the same period one year ago. In part the balance sheet surge was due to an increase in net lending to credit institutions (which increased by 98.3 billion euros to 393.3 billion euros). And in part it was up due to the 22 billion euros spent in bond purchases. Curiously the weekly fixed term deposit levels remained unchanged at 74 billion euros (the quantity spent in periphery bond purchases to date), which sort of settles the issue of whether the bank were going to "sterilise" the new purchases, or create additional money to pay for them. For the time being at least they seem to be doing the latter, since going by the size of the banks current account holdings (which jumped to 286.783 billion from 159.814 billion euros a week before) they seem to have offset the purchases through money creation.

Basically central bank bond purchase intervention is deemed to be "neutral" in monetary policy terms if an equivalent quantity is drawn back from the banking system by attracting new term deposits at the central bank. That the bank may be carrying out a "money printing" exercise (and especially one to monetarise the debt of certain countries in particular) is raising fears of impending inflation. My feeling is that, in the context of heavily over a leveraged private sector and congenitally weak domestic demand, this is not a real concern at present for the Euro Area. I think the ECB's own inflation alert was always overdone, since most of the inflation we have seen of late has either been imported (via rising energy and commodity prices) or adminstratively generated via consumption tax increases. There has been very little in the way of second round effects.

The real worry then should not be inflation, but whether or not the Italian government will ever be in a position to honour the bonds in full, and on time. At the present time this is only a theoretical question, since additional bond purchases can always enable the Italian state to meet its obligations, with the ECB facilitating debt rollovers by using the commercial banks as proxies in the primary markets. But just how deep in do you want to get? At the present time the bank owns something like 20% of outstanding Portuguese, Irish and Greek debt. 20% of Italian debt would be something like 380 billion euros, a volume of bonds which would already be difficult to pass over to the EFSF (or its heir the European Monetary Fund). But in this case the force of tradition is not strong, and there is no real reason why the bank need stop at 20%. The sky could be the limit, and the ECB could be transformed into the new Bank of Japan, effectively light years away from the earlier visions of the Bundesbank founding pioneers. And, of course, we would all be into one of those processes which can go on for just as long as they can.

The Balanced Budget Ammendment

At the heart of the recent ECB decision lay something known as the balanced budget ammendment. First introduced in Germany in 2007, this is a constitutional change which (in the German case) makes a deficit of over 0.35% of GDP illegal as of 2016. One of the conditions the ECB imposed on Italy was that they also change their constitution, but in this case outlawing deficits as of 2013. Effectively, and at a single stroke, this brings to an end a whole era of Keynesian counter-cyclical fiscal policy and economic management. So the implications are large, and hard to separate from the rapidly ageing population phenomenon.

While it was the size of the latest package of cuts which hit the headlines (Rome orders €45bn in cuts and taxes), the key issue was really the balanced budget ammendment, since this has one clear implication: as of 2013 there will be no new bonds. So at least now the outer limit of ECB exposure is a known fact.

Chronicle Of A Crisis Long Foreseen

While the Italian crisis may have crept up on markets all at once and unexpectedly, issues about the sustainability of Italian debt are not new. As FT Alphaville's James Coterill noted when the latest wave in the Italian crisis broke out: "In the original ‘why the eurozone will break up’ papers of the 1990s and early 2000s, it was never ever high Greek deficits, or Irish (or Spanish) bank losses going on to public balance sheets that were forecast to destroy the single currency. It was always Italy. High-debt, low-growth, Italy".

Exacty, Italy was always the greatest worry on everyone's minds, including the ECB's. Indeed, the now long forgotten minimum rating requirements for collateral posting at the bank were first muted by them with precisely Italy in mind. I myself wrote one blog post after another (see links below) warning of the danger which was looming, buried in Italy's toxic combination of low growth, rapidly ageing population and high accumulated debt. It was simply a crisis waiting to happen, and now it has. As the New York Times' Landon Thomas noted in the Blog Prophet of Eurozone Doom article he wrote about my work, "Mr. Hugh’s demographic thesis is not airtight: in fact, it was Italy, not Greece, that attracted his early attacks. But Italy, perhaps because its overall debt level was already so high and its population was older, pursued a policy of greater fiscal rectitude than its neighbors and avoided a real estate bubble".

Not airtight, but nearly-so it seems, since behind the short term obsession with fiscal rectitude there lie the longer term preoccupations about solvency and debt. And here Italy (and eventually Japan) jump right back into the cockpit. As Landon mentions, Italy didn't have a housing boom worthy of mention, so private debt didn't surge during the first decade of the century, and during the crisis Finance Minister Tremonti pursued a policy of flying under the radar by keeping deficit spending low. But now short term deficit issues are waning, and longer term solvency questions are surfacing in the wake of the renewed Greek crisis. Thus, while historians of the future may well struggle to understand just how it was that a simple fiscal deficit bailout programme was so badly handled that Greek sovereign debt shot up from around 110% of GDP entering the crisis to around 170% by the end of the "rescue" period (and this without even having enjoyed a real housing bubble, ie with a private sector that was not massively in debt), the Italian case will raise few eyebrows, since every thinking economist had seen it coming for so long (Japan too, see my Italy blog here, here, here and here).

Low Growth and Ageing Workforce Are A Troubling Backdrop

Italy's problem is not its fiscal deficit, in fact in every year since 1991 Italy has run a cyclically adjusted primary balance (that is before interest payments are taken into account), it is the weight of the accumulated debt burden and low growth. The country's trend growth rate has been falling for decades, and during the first decade of the present century it only managed to grow at an average rate of about 0.6% per annum.

Even though the quarterly GDP growth rate accelerated slightly in Q2, and reached a quarterly rate of 0.3% (up from the 0.1% expansion achieved in the first three months of this year), the slowdown in core Europe, and the readings on the most recent PMIs leave little doubt that the respite will be short lived. At this point even the current IMF forecast for modest 1% GDP growth in 2011 is looking very optimistic. And if the country now slips back into recession (certainly not excluded) then the under-performance would be much greater.

The worrying thing is how Italy has been able to get so little growth out of so much. This is especially the case when you take into account the fact that during the last decade the country's labour force grew steadily, following the arrival of several million new migrant workers. Between 2002 and 2010 the number of non-Italian citizens officially residing in Italy was up by 3 million (or 200%).

During this time the labour force grew by about a million:

while employment was up by around 1.5 million.

Yet GDP barely rose. In fact, since Italy left recession the number of those employed has hardly risen, while the percentage of those who are formally unemployed has remained near its crisis highpoint, which has been good for productivity, but not for consumer consumption. The ideal combination would be to see both output and employment growing in tandem, but with output growing faster than employment. At the present time employment is hardly growing, and the rate of increase in output is slowing notably. That is to say we do not have "lift off".

Slamming The Debt Brake Pedal Down To The Floor Won't Work

Despite the fact that the real leverage M Trichet now has over the Italian government is being exercised in order to obtain the constitutional change required for the balanced budget rule to be put in place, the severity of the fiscal tightening that Italy will now experience should not be taken lightly. In the first place something like 45 billion euros in new cuts will be implemented in 2012 and 2013, and this will be on top of the previously agreed package of 47.8 billion euros in cuts between now and 2014 agreed in the July budget.

In addition Italy will now aim for a general budget deficit no greater than 0.2% of GDP in 2013 (Germany will not achieve this result till 2016), and will maintain that ceiling into the indefinite future. Basically, this will mean the post 2012 Italian budgets will need to aim for an average primary surplus of just under 5% of GDP during the subsequent years, as the weight of the debt is gradually ground down, and the burden of interest costs reduced. This is a difficult, but not impossible task.Between 1995 and 1998, when Italy’s undertook its maximum effort to enter the monetary union, the average primary surplus was 5.0% of GDP. However, during the second half of the 1990s Italy was benefiting from both decreasing interest rates and also from the depreciation of the Lira. In addition the Italian government also implemented a significant privatization programme which helped to reduce the debt/GDP ratio. Most of these positive tailwinds will not be available this time round.

As Deutsche Bank analyst Marco Stringer puts it: "While there are no doubts that Italy needs to maintain a very prudent fiscal policy, there is a risk that an excessive fiscal consolidation could be counterproductive were it to have a significant negative effect on growth".

There is a very real possibility that Italy's fiscal consolidation, like Greece's, is so sharp as to be counter-productive, with the low inflation, low growth and revenue shortfalls making it extremely difficult for the country to reduce to debt to GDP level, even if the ECB maintains 10 year bond yields around 5%. Writing in the Financial Times, International Monetary Fund managing director Christine Lagarde makes exactly this point. “We know that slamming on the brakes too quickly will hurt the recovery and worsen job prospects. So fiscal adjustments must resolve the conundrum of being neither too fast or too slow. Shaping a Goldilocks fiscal consolidation is all about timing. What is needed is a duel focus on medium-term consolidation and short-term support for growth and jobs", she said.

So we really do now have a very high risk stand-off, with Monsieur Trichet and his colleagues holding the whip hand for the time being, as the threat to take the finger out of that dike concentrates attention on the issue in hand. But this upper hand has a definite sell-by date looming if the implementation of the debt-brake principal in a context of global slowdown (or recession) proves too severe for Italian voters to accept. Then the Italian politician's fear of the penalty shot from someone on his own side might just become stronger, despite his apprehension before the technical superiority of M. Trichet's footwork. In which case, someone should remind them over at the ECB that, as Paul Krugman puts it, "once once a country takes on the fixed cost of default, it might as well impose a big haircut on creditors". As the United States discovered in Vietnam, it's easy enough to get yourself bogged down in a mess, but a lot harder to extricate yourself from one subsequently.

This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".

Going Dutch - One Possible Solution To the Euro Debt Crisis?

2011-08-15T16:33:00.019+02:00

Looking back over the last 18 months of Europe’s debt crisis, European Central Bank Executive Board member Lorenzo Bini Smaghi recently invoked Winston Churchill’s famous quip, “You can always count on Americans to do the right thing -- after they’ve tried everything else.”

Europeans too, he assured his audience would also get it right, eventually. Unfortunately all the coming and going, procrastination, denial and half measures we have seen since the Greek crisis first broke out have not come without a cost, and this cost can be seen in the growing lack of confidence in the markets that a lasting solution to the underlying problems of the common currency will finally be found. Only adding to the problems, even the Americans seem to be having difficulty finding the right thing to do this time round, or at least doing it at the right moment, as the market turbulence following the S&P downgrade has served to underline.

It’s probably too soon to say whether what Europe’s leaders are about to agree on what will ultimately be the “right thing”, but at least there now does seem to be a general recognition that a defining moment is fast approaching, and fundamental changes to the continent’s institutional structure are now on the table. Among the options now being openly advocated and debated is to be found a measure thought unthinkable a year ago -- ending Europe’s 13 year experiment with a single currency. But even if this ultimate possibility – the so called nuclear option – were to come to pass, as always there would be a right way and a wrong way of going about it.

Few Now Doubt The Gravity Of The Situation

The latest round in the European sovereign debt crisis has been, without a shadow of doubt, the most serious and the most potentially destabilising for the global financial system of any we have seen to date. Pressure on bond spreads in the debt markets of the countries on Europe’s troubled periphery have become so extreme that the European Central Bank (ECB) has been forced to make a radical and unexpected change of course, intervening with “shock and awe” in the Spanish and Italian bond markets. During the first week following the change in policy the bank bought bonds worth a minimum of 22 billion euros. To put this number in some sort of perspective, the entire bond purchasing programme to date for Greece, Ireland and Portugal has only involved some 74 billion euros, and this in over a year of intervention.

Along with earlier interventions in Ireland, Portugal, and Greece, the central bank has become the “buyer of last resort” of peripheral Europe’s bonds, but this can only be an interim measure, since the volume of bonds which would need to be purchased on an ongoing basis simply to stop the Spanish and Italian bond yields rising is so massive that it would put the bank well outside the limits of its original founding charter. It would also put the central bank in need of substantial recapitalisation should Italian and Spanish debt need to be restructured at some point.

And as if all this was not enough, adding urgency to difficulty even core countries like France are now finding themselves drawn into the fray, while the risk of contagion spreading to the East is now far from negligible. The French spread, the extra yield investors demand to buy 10-year French debt rather than German bunds, has jumped to 87 basis points, even though both carry AAA grades from the major rating companies. According to Bloomberg data, this is almost triple the 2010 average of 33. Credit-default swaps on France now trade at around 175 basis points, more than double the rate for protecting German securities.

In addition pressure in both the US and Europe over the debt issue have lead other currencies like the Swiss Franc or Yen (in addition to gold) to very high levels, which in the case of the Franc has a direct impact on households and companies in those East European where borrowing in CHF has been prevalent. This surge in the Franc has already produced worrying repercussion in Hungarian financial markets raising the spectre of contagion spreading to the East.

The gravity of the situation was highlighted when the European Commission President Jose Manuel Barroso explained to waiting reporters at the height of the latest crisis that the current "tensions in bond markets reflect a growing concern among investors about the systemic capacity of the euro area to respond to the evolving crisis."

To be clear, the issue involved is no longer one of the mechanics of Greek debt restructuring, or of the extent of private sector involvement in any such debt adjustment, or even the of the value of the already agreed upsizing of the capacity of the European Financial Stability Fund (EFSF, the bailout mechanism). The current crisis is an existential one, which if left unresolved will rapidly become a matter of life of death for the single currency. In a portent of what may now be to come, at the very same moment in which the board of the ECB was reaching agreement on its latest programme of bond purchases preoccupations were already being aired in Berlin that the sums involved in a generalised rescue might be too large for even the richest countries in the core to accept.

In fairness to Mr Barroso, what he was suggesting was not that the Euro itself was on the verge of collapse, but that there had been a deep and significant shift in market perceptions of the crisis, and that this shift required a new and much more fundamental response from Europe's leaders and institutions. It is the capacity of these leaders to agree on even the broad outlines of a viable and effective response which is at the heart of all the market nervousness, and in this sense the recent decision by the rating agency Standard and Poor's to lower downgrade the US sovereign has only served to complicate further an already complicated situation.

So why this abrupt and dramatic change in the way the game is being played? Undoubtedly the lion’s share of the explanation is to be found in the arrival of a new, and to many unexpected, elephant in salons of European power. With something like 1.9 trillion Euros in outstanding debt, Italy is the planet's third largest issuer of sovereign bonds (following Japan and the United States) and although the relatively high savings rate of the Italian private sector (both families and corporates) means that much of the debt is in Italian hands, the deep interlocking of Europe's financial system (which is a by-product of the deep and liquid bond markets which came into existence following the creation of the common currency) means that a considerable portion is not.

In a certain sense the Italian crisis has crept up on market participants and caught them unawares. The reason for the relative unexpectedness of the scale of Italy’s problems is in part historical accident (that it was Greece, and not say Ireland, that got into trouble first) and in part a reflection of the need for market discourse to find a single and unified focus, and in this case the focus was on deficit and not debt. To put it simply, all too often market discourse could be described as suffering from some kind of “one track mind” syndrome.

The high profile given to the Greek issue meant that to a large extent Europe’s problems were perceived as being fiscal deficit ones, with more fundamental issues like lack of convergence, current account imbalances, cumulative debt and low economic growth all being pushed well into the background. Now things have changed. As former UK Prime Minister Gordon Brown put it recently: “Now no number of weekend phone calls can solve what is a financial, macroeconomic and fiscal crisis rolled into one”. Solving the crisis involves “a radical restructuring of both Europe's banks and the euro, and will almost certainly require intervention by the G2O and the International Monetary Fund”.

Historic Issue With The Euro

Perceived by many as being ill-gotten and ill-born, the issue of Euro parentage has long been a topic of intense debate and controversy, most notably between economists on one side of the Atlantic and those on the other, and between micro- and macroeconomists. There simply has been no consensus on what in fact the problem is, and criticisms from the United States of the way the crisis has been handled in Europe are often felt to be unfair and misplaced. As ECB Executive Board Member Lorenzo Bini Smaghi put it in July speech to the Hellenic Foundation for European and Foreign Policy, in the United States a significant financial crisis does not call into question the whole institutional and political set-up, and the dollar itself is not considered to be at risk. In Europe, in contrast, a crisis is often considered by outside observers as putting the euro, and the Union itself, at risk of disintegration. “Academics and other experts deliberate on whether the euro area is viable and how it can be rescued. Closet eurosceptics suddenly reappear, dusting off their I-told-you-so commentaries”.

Whilst Mr Bini Smaghi undoubtedly puts his finger on the core of the issue in this statement, and most certainly reflects the level of frustration felt by key players in European decision making, analogies with individual states in the Union simply fail to get to the heart of the reason for much of the preoccupation. It is not simply a question of “closet” (or open) eurosceptics suddenly reappearing, but of the monetary union repeatedly showing fault lines exactly where many of those much berated macroeconomists had expected they might appear. This is why Mr Brown is undoubtedly right to focus on the fact that beyond an immediate fiscal crisis, what we have in Europe is also a crisis of macroeconomic management and of financial stability. As he so eloquently puts it, what many were worried about was the fact that the initial Euro design contained "no crisis-prevention or crisis-resolution mechanism and no line of accountability when things went wrong".

Naturally Gordon Brown is far from being the first to have voiced such views. The fact that economies in Europe’s core and those on the periphery far from having converged have actually been diverging under the watchful eye of ECB monetary policy has long been a cause for concern in macroeconomic circles. In particular, at the heart of the monetary union’s current problems lie the huge imbalances which have been generated between the economic “surplus” countries in the core, and the external deficit ones on the periphery. Europe’s leaders have long avoided biting the bullet, and indeed could be considered to be in deep denial, over the significance of this issue. Referring to the prevailing voices among European policymakers former IMF Chief Economist Simon Johnson put it this way:

“I vividly recall discussions with euro-zone authorities in 2007 — when I was chief economist at the I.M.F. — in which they argued that current-account imbalances within the euro zone had no meaning and were not the business of the I.M.F. Their argument was that the I.M.F. was not concerned with payment imbalances between the various American states (all, of course, using the dollar), and it should likewise back away from discussing the fact that some euro-zone countries, like Germany and the Netherlands, had large surpluses in their current accounts while Greece, Spain and others had big deficits”.

The fig-leaf of Europe’s nations being somehow equivalent to US states has long been held up to justify the idea that the common currency was in general working well, and that the problems involved in managing it were being greatly exaggerated. With the arrival of the Italian elephant onto the centre stage at a stroke this argument has become as outdated as the institutional structure which lay behind it, since few of core Europe’s leaders are really willing to accept the responsibility for giving full and lasting guarantees for the country, quite simply because it is not just one more state in a fully integrated union, but a sovereign nation with all that that implies.

Having said this, there can be no doubt that Europe’s leaders have made huge strides forward in their attempts to get to grips with the issues as they have presented themselves, even if the measures taken so far continue to fall woefully short of what will eventually be needed. As the crisis has moved on from the initial concerns about Greek accounting methods, the piecemeal approach adopted by European policymakers has lead them to erect what is now a veritable production line of crisis resolution instruments and departments, with each of the needy patients being situated at different stages of the treatment process. In the Greek case the underlying issue is now acknowledged to be a solvency one and teams of experts are hard at work in a seemingly endless struggle to try to decide just what degree of restructuring (and/or reprofiling) Greek debt will finally need. In the Irish and Portuguese cases the task still remains one of monitoring programme implementation, with the focus being on whether or not they will eventually require (Greek style) a second stage bailout package. Meanwhile in the antechamber, the Spaniards and the Italians patiently wait their turn, while the doctors and health system administrators hold a heated debate as to whether there is enough space available in the emergency ward, and whether the patients have sufficient insurance to cover them should the surgery need to be drastic.

Too Big To Fail (Or Save)

What now brings a renewed sense of urgency to the whole process is the question of whether Spanish and Italian bonds could soon find themselves shut out of the financing markets in the way their smaller predecessors were before them. The latest ECB decision to intervene in their bond markets would seem to make it more rather than less likely that they eventually will be, since it is hard to see how they can now move back to unsupported market prices.

One of the curious anomalies about how the debate is currently being framed is the way in which banks and money funds who have invested in Europe’s periphery are being told that it is only right they should now assume some part of the anticipated debt restructuring burden due to their earlier policies of “irresponsible lending”, while these very same investors are also being urged to purchase new issues of just this very debt, on the argument that risk is exaggerated since the countries concerned have essentially sound economies, and are only suffering from short term liquidity and balance of payment type problems.

The underlying dilemma for such institutions has been highlighted by the decision of the Italian market regulator Consob to request information on the recent move by Deutsche Bank to reduce its exposure to Italian government debt. Banks have some responsibility to their clients, and will not normally knowingly take decisions which will lose money for them. So it is only rational for them to try to “lighten up” their positions on some of Europe’s weaker sovereigns. What isn’t credible is for political leaders to at one and the same time tell the banks that they are lending irresponsibly and urge them to purchase debt which may well end up being restructured. Thus the recent insistence on private sector involvement in Greek restructuring is often not unnaturally seen as one of the triggers for financial institution flight from Spanish and Italian bonds.

The Deutsche Bank case is a good illustration of the problem being faced by both the banks themselves and by those trying to maintain confidence and stability in the sovereign debt markets. According to data from the bank’s quarterly results it reduced its net exposure to Italian sovereign debt from 8 billion euros in December 2010 to 997 million euros at the end of last June. To put this in some sort of perspective, over the same period it cut its exposure to Spanish debt by some 53% (to 1,070 million euros) while the reduction in their Italian debt holdings was of the order of 87.5%. It is this difference in velocities of sell-off which in large part explains the recent surge in Italian bond yields, making it now potentially more expensive for Italy to finance itself than it is for Spain. And the reason for this is simple: previously Italy was seen as effectively isolated from contagion problems on the periphery, while Spain was not.

While yields on 10-year Italian government bonds have now fallen back significantly from their earlier euro-era highs, Spain’s have fallen further, and before the ECB intervention Italian yields had risen 1.26 percentage points since the end of June while Spanish yields had only risen by about half that amount.

Really the Italian situation is by far the most complex one facing the Euro system at this point in time. In the years prior to the outbreak of the financial crisis in 2007 Italy’s debt had long been a focus of attention among those who were worried about the effectiveness of the Euro Area’s Stability and Growth Pact whereby countries were expected to maintain deficit levels below 3% of GDP annually, and cumulative debt levels below 60% of GDP. In fact, according to IMF data, gross Italian government debt hasn’t been below 100% of GDP since 1991, and the country entered the financial crisis with a level of around 103% of GDP. During the crisis the country remained beyond the searching gaze of financial market interest by keeping its annual deficit at comparatively low levels, but a combination of recession, low growth and a substantial interest payment burden on the already accumulated debt has seen the level rise steadily to an estimated 120% of GDP this year.

Effectively Italy is poised on what is often termed a “knife edge”, since in order to stop this percentage snowballing upwards the country needed a growth rate in nominal GDP (that is uncorrected for inflation) of around 3% a year, and this at the rates of interest being paid before the recent surge. This effectively means a growth rate of 1% and an inflation rate of 2% (on average, and over a significant period of time). This growth number may not sound too ambitious, but as the Italian economist Francesco Daveri points out, Italy’s average annual GDP growth rate has been falling by around 1% a decade since the 1970s, and average growth between 2001 and 2010 was only around 0.6% per annum.

After falling by something like 6.5% during the crisis the Italian economy did manage to grow by 1.3% in 2010, but growth in the first half of this year has already been weak, while all forward looking indicators suggest it will be weaker in the second half. Thus analyst estimates of an eventual 2011 0.8% growth rate seems if anything optimistic, and with the IMF forecasting 1.9% inflation during the year, the numbers just don’t add up.

And that, of course, was before interest rates started to rise. While the new higher interest rates won’t have a huge impact in the short term, as existing debt needs to be steadily refinanced the extra cost will simply mount and mount. Which is why the Italian government is in a huge bind. It doesn’t have a debt flow problem, it has a debt stock problem, and as the risk premium charged on Italian debt rises and rises, and as the growth outcomes fail to meet the often optimistic targets, then the snowball of debt steadily slides its way down the mountain side with little the government can do to stop it growing as it moves. Like some modern Sisyphus, they are condemned to struggle with a monumental task where advance seems well nigh impossible. Out of good taste it would be better not interrupt them in their labours to ask whether, Camus style, they are still able to maintain a smile on their face.

They Ain’t Coming to Bailout, No..., No..., No..., No..., No!

Those who most definitely are not smiling at this point in time are German politicians and voters. As Christian Reiermann comfortingly informed Der Spiegel readers recently: “The euro zone looks set to evolve into a transfer union as it struggles to overcome the debt crisis. There are a number of options for the institutionalized shift of resources from richer to poorer member states -- and Germany would end up as the biggest net contributor in every scenario”. These are emotive times, but feelings of outrage are not necessarily the most reliable guidelines to steer by in the search for durable solutions to complex problems.

The Italian hit may well be the most recent and the most spectacular the common currency has suffered in the 10 short years of its existence, and it may have created the problem which is quite literally too big to handle with the present institutional structure, but it really is only the latest example of that complex mix of fiscal, macroeconomic and financial issues that have come to plague the Euro which Gordon Brown draws attention to, and these issues do, by and large, go back to a design fault which was in there from the start. So while Europe’s unhappy families may all be unhappy for a variety of different reasons, the root of the problem is that the project as it was set up contained all the mechanisms for creating the problems, but few of the ones which would be needed for resolving them.

Large structural distortions were able to build up over the earlier years of the currency’s life, but now it is very hard to see where the much needed remedies are to come from. Some sort of fiscal union is now widely if belatedly seen as forming a necessary part of a well-functioning monetary union, but trying to introduce one at this stage in the game, when many of the countries along the periphery have suffered a substantial competitiveness loss in relation to those in the core seems to lead to only one conclusion, the kind of transfer union that so worries Christian Reiermann and so many of his fellow citizens.

Europe already has examples of just this kind of transfer union between higher growth and richer regions and their lower growth and poorer neighbours in Germany, Italy and Spain, and in no case can it be said that such arrangements have proved popular with those who are asked to be the net contributors. So it is not hard to reach the conclusion that this kind of fiscal union would be simply unsustainable in the Euro Area context at the present time.

The only real way forward is for those who have lost competitiveness to somehow regain it. This, as we are seeing, is far easier said than done. Most of the proposals which have come from the EU Commission and the IMF to date involve some kind of micro-level productivity-enhancing structural reforms, but these are not able to raise growth rates sufficiently quickly (indeed there is very little real evidence of the extent to which they are able to do this in any event), and inevitably involve the countries involved trying to “out-Germany” the Germans, which culturally on the face of it seems to present them with an almost impossible challenge, especially when German companies are hardly marking time themselves.

Normally, the classic solution in this situation would have been some kind of devaluation, but obviously these countries have no currency left to devalue. Another possibility would be the kind of “internal devaluation” process which has been tried in the Baltics, and a number of macroeconomists (myself included) have been arguing for this, but the complete lack of any kind of positive response makes the viability of even this approach hard to contemplate, and anyway, systematic deflation would in many cases only make the debt problem worse.

Euro At The Crossroads

So the Euro is now at the crossroads, and important decisions need to be taken. Preserving the Eurozone -- as it is now -- might be workable if it were possible to transform the Eurozone into a full fiscal union where budgetary policy was coordinated across nations by a central treasury in the way major programmes are between states in the US. But such an arrangement is a now a political impossibility, as Europe’s core economies would inevitably reject what would be seen as a permanent transfer union between high-growth regions and their poorer neighbours.

However the present debate about creating Eurobonds is resolved, these alone will not solve the problem at this point, and, as many observers are noting, may even make matters worse by weakening the sovereign credit ratings in the core. In the longer run they could form part of a more general solution, but the moral hazard dimension they entail means that in the absence of a fix for the immediate competitiveness problems on the periphery they only risk making the common currency project even more politically unstable. Such is the price for so much procrastination and denial. As Citibank’s Chief Economist Willem Buiter so delicately put it recently, attempts to transform the current bailout mechanisms into a transfer union would be doomed to failure since “the core euro area donors would walk out and the periphery financial beneficiaries would refuse the required surrender of national sovereignty”.

So, with fiscal union effectively off the table, there are basically three possibilities. The first is to stay more or less where we are, maintaining and even expanding the bond purchasing programme of the ECB, and simply trying to hang on in there. The stability fund could be increased, but the more numbers start being accounted in detail the further away the various parties get from being able to agree. If this continues the ECB is likely to reach a ceiling beyond which it will be more than reluctant to continue buying, since the bank takes the view that the resolution has to come from the politicians.

But with Italy and Spain’s combined sovereign refinancing needs between now and the end of 2012 totalling something like 660 billion euros, and the financing needs of the banks to take into account on top, reaching agreement to expand the bailout mechanism on this scale looks like a pretty improbable outcome, especially when you consider that once you are that far in you will simply have to continue all along the road. So at some point the spreads will start to widen again as markets force the issue, with the inevitable outcome that the monetary union is pushed towards the brink of breakdown.

The second possibility would be to disband the union entirely, leaving everyone to go back to their own national currency. This would be a disastrous outcome for all concerned, and for the global financial system. Coordinating the unwinding of cross country counter liabilities would be a nightmare given the level of interlocking in the corporate and sovereign bond markets, and the sudden disappearance of one of the major global currencies of reference would cause havoc in financial markets. The dollar would most likely be pushed to unsustainably high levels in the rush for safety, and it is only necessary to look at what is currently happening to gold, the Swiss Franc and the Japanese Yen to catch a glimpse of what would be in store.

Evidently this kind of violent unwinding would never be undertaken voluntarily, but that does not mean that it is an eventuality which might not take place, if solutions are not found and the force of market pressure continues and even augments.
Fortunately there is a third alternative, even if it is one that at first appears no more appetising than either of the other two: the Eurozone could be split in two, creating two different euro currencies. Naturally the composition of the groups would be a matter of negotiation, since some countries do not easily belong in either one group or the other. The broad outline is, however, clear enough. Germany would form the heart of one group, along with Finland, Holland and Austria.

In addition Estonians have been making it pretty that they would also be up for the ride. Spain, Italy and Portugal would naturally form the nucleus of the second group, with Slovenia and Slovakia being possible candidates. Some countries, Ireland and Greece for example, might simply choose to opt out.

The big unknown is what France would do. In many ways it belongs with the first group, but cultural ties with Southern Europe and political ambitions across the Mediterranean could well mean the country would decide to lead the second group. Naturally if what was involved were not ultimate divorce but temporary separation, then French participation with the South would also have a lot of political rationale. The term Franco-German axis would gain a whole new meaning.

Naturally the technical challenge would be enormous, but it would not be insurmountable. The great advantage of such a move would be that two of the major burdens under which the monetary union is labouring – the lack of price competitiveness on the periphery and the lack of cultural consensus between the participants - would be resolved at a stroke.

No one knows the values at which the two new currencies would initially operate, but for the purpose of a thought experiment let’s assume a Euro1 at around U.S. $1.80 (the euro/USD is currently around US$ 1.40), and a Euro2, at around $1. Obviously, in the short term the winners of this operation would be the members of Euro2, who would get the devaluation their economies have been yearning for. Why would this be? At a time when the countries concerned are loaded down with debt and domestic demand is correspondingly weak, export growth is the only way for their economies to move forward, and the change would allow cheaper labor and production costs, giving them an enormous push in this direction.

And it would encourage growth in other ways. Take Spain as an example. The country has at the present time a large pool of surplus property, on many estimates of around 1 million unsold new housing units. Many have criticised the banking sector for not dropping prices sharply to enable the market to clear, but the banks are understandably reluctant to do this due to the impact this would have on their balance sheets, and due to the knock-on effect on their existing mortgage books. The beauty of this solution is that no further drop in price would be needed, since for external buyers the real price of all this housing would suddenly become much cheaper.

The case of tourism would be somewhat similar, since not only would more tourists come to Spain, they would come for longer and they would spend more. The shopping bags would certainly not be empty on the plane home.

Spain’s troubled savings bank sector has been desperately looking for foreign investors to help them recapitalise, but while many have shown interest virtually none have participated to date. After the devaluation all this would change since they would be able to buy shareholding at attractive prices, and without having to worry about a sudden drop in prices and hence loss of capital.

Spain’s 4.5 million unemployed would gradually start to go back to work, new investment could steadily be attracted for other productive projects in manufacturing industry, no one would doubt the solvency of the Spanish state, and the private sector would be in a better position to start paying back its debts as the economy grew.

Now obviously, as we all know, in economics as in life there are no free lunches, so there must be a catch here somewhere, and of course there is. In fact there are two big “catches”. In the first place those countries who joined together to form Euro1 would be making a big sacrifice, since many of them also depend on exports for their livelihood, and their manufacturers would suddenly and sharply find themselves at a disadvantage. In particular Germany would suffer.

However, assuming that all can agree at some point that the current arrangements are unworkable, and that going back to individual national currencies would be a disaster, then the German sense of responsibility and the country’s commitment to the European project might well make the acceptance of some sort of sacrifice (and especially if it were a sacrifice which offered longer term solutions) bearable. Fortunately, recent German historical experience provides us with two concepts which might just help everyone see their way through this. The first of these is the Treuhandanstalt, the Privatisation institution (and bad bank) which was created to handle East German assets between 1990-1994. The second is Lastenausgleich, or burden sharing, and this refers to the mechanism which was used to share the unequal outcome of WW II between Germans who found themselves living in the West: between those who had come from the East and lost everything and those who were from the West and had retained something.

The Treuhandanstalt experience is useful in helping us to think about how to handle the common set of assets/liabilities acquired during the initial Euro stage. Think about Spain’s banks and their property assets. These would now be sold in Euro2, but many of the liabilities which correspond to them are in fact liabilities with institutions who will find themselves in Euro1. Marking them to market immediately, and in Euro2, would produce sizeable losses in the Euro1 financial sector. Some of these losses are inevitable and to some extent correspond to the kind of restructuring haircuts which are now being contemplated. But in the initial period (and for reasons which will become clearer below) it would be advisable not to mark them to market, but to hold them for a specified time in a common institution of the Treuhandanstalt kind.

As I say, some losses are now inevitable, and this is where the second concept from recent historical experience – Lastenausgleich, or burden sharing – becomes important. Despite protests to the contrary from Lorenzo Bini Smaghi (link) the Euro experience to date has not been a success for any of the participants once you add-in the potential losses which are now looming. At the same time the common currency has been a shared experience, in which all have taken part, so it is not unreasonable to assume that all should share when it comes to the downside. The problem with the measures adopted to date is that they are perceived on both sides of the fence as unfair. Those who are funding the bailouts feel that they are being asked to pay for the “excesses” of the recipients, while those who receive feel that what they are getting is not help, but loans which make it easier for the financial sector in the donor countries to avoid declaring losses. This “communicational impasse” is one of the major reasons the current approach won’t work.

What is needed at this point is an appeal to the European spirit of the Euro1 countries, in a way which helps them to see that some costs are unavoidable, but that any agreed costs will be shared, and above all that the game-changing solution is workable and offers some sort of constructive positive future for all Europeans. Put in other words, what we need is a mechanism which contains both realism and idealism in just sufficient proportions.

The advantage that the split Euro option has over all the other proposals on the table at the present time is that it would address the growth issue head on. The countries on Europe’s periphery could return to growth, and once the economies involved start growing rather than shrinking the proportion of the liabilities incurred during the earlier period which they will be able to pay rises significantly. It is much more difficult to collect debts from an unemployed household than it is from one which is gainfully employed.

Another attractive feature of this proposal is that no “in principle” decisions would need to be taken about the long term structure of the European financial system. The ECB could be retained as a kind of holding entity and clearing house for the outstanding financial mismatch, and the current national central banks could be grouped into two separate sub-entities. This would leave open the possibility of reconvergence at a later date should conditions obtain which would make the move viable. The first stab at creating a currency union has failed, but this doesn’t mean that any possibility of creating one in the future should be abandoned. Hard and costly lessons have been learned, and what is now needed is a full and open discussion of the reasons for failure, precisely to avoid similar mistakes being made in the future.

Having the move co-ordinated by pan-European institutions has another advantage, and that is to do with the degree of conditionality the process must involve. Devaluing their currency would, as I have suggested, give a great short term boost to growth in countries along the periphery, but this short term boost would only be converted into a long term sustainable improvement in trend growth if a lot of other things were done too. It is very easy to laud the great advance Argentina made on breaking the dollar-peg, but look where Argentina is today. This “short sharp shock” treatment only has a lasting impact (as it did in Scandinavia in the 1990s) if measures to improve institutional quality (reformed labour and product markets, productivity and innovation drives) are implemented and maintained. Here again partnership is needed, since while giving back to the periphery “ownership” over its own reform programmes would be another significant advantage of the arrangement, the reform process would need to remain under the auspices of a common European project, one which could lay the basis for a consensually grounded lasting political union, a union which would be the essential precondition for any future attempts to move back towards greater monetary integration.

Effectively Europe’s leaders are caught in a kind of Pavlovian trap. There are no easy choices, although there are good ones and bad ones. Staying where they are leaves them in a kind of permanent electric shock zone where their constant feeling of failure only serves to further deteriorate their own sense of personal and political worth. Advancing also seems painful, but more than the intensity of the shock it is the sensation of fear and angst which dominate. Still there is no alternative but to advance, since you cannot stay where you are. Simply applying administrative measures to force stability onto a financial system which resists with all its might will only result in increasingly destabilizing behaviour (read “speculation”) by the agents within the system. Administrative fiat simply represses and pushes forward instability (read” kicks the can down the road”), leading the system itself to become ever more inefficient. In any malfunctioning financial system, as the late Hyman Minsky famously said, “stability is itself destabilizing”.

Perhaps it is appropriate to close this essay where it started, with a quote from ECB Board member Lorenzo Bini Smaghi: “as J.K. Galbraith observed: “Politics consists in choosing between the disastrous and the unpalatable”. To see disaster looming before choosing the unpalatable is a dangerous strategy”.

This article is an expanded version of one which was originally published on the website of the US magazine Foreign Policy, under the title "The Euro and the Scalpel"

Appendix - The Way To Split The Euro

This article was written during 4 days I spent in Marbella earlier this month in the home of my friend and colleague Detlef Gürtler (author of the recent book Entschuldigung! Ich Bin Deutsch (Sorry, I'm German, Mermann Verlag GmbH, Hamburg).

While I was busying myself with the text, Detlef was working on the images (which can be found above), and on some illustrative material for the technical side.

These graphics only give some illustration of just how complex any unwinding of the commen currency would be, given how interlocked the financial sectors of the participating countries have become.

Some sort of holding entity would need to accept responsibility for a whole range of problematic assets during any transitional period. This entity could be the ECB. The though behind the idea that not everything should be marked to market immediately is that the Euro2 countries are nothing like so weak as the initial value of the new currency would suggest, nor are the Euro1 countries so strong as is often thought. So inevitably the parity at which the two would exchange would converge towards a much tighter band, which would be much closer to the real competitiveness difference between the various countries. Naturally it would make a lot more sense to mark to market at this point, since the losses to be borne on both side would be that much smaller.

It is also worth stressing that this solution is far from perfect. We do not live in an ideal world. It is only one possible way of breaking the vicious circle into which the Euro Area countries have now fallen. It is one possible way, and as far as I can see the only viable and realistic one.

This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".

Is The Risk Accompanying Estonia's Eurozone Membership Really So Low?

2011-08-15T15:36:00.001+02:00

"But the go-ahead Estonians are already scenting the next challenge. Should the single currency crumble, they are determined to be on the inside track for any new German-centred “super-euro”. Goodbye “eastern Europe”; welcome to the “new north”."
Edward Lucas, writing in The Economist

Estonia's economy put in another sterling performance in the second quarter of this year, even if the expansion rate fell back to quarterly 1.8%, down from 2.4% in Q1, and 2.5% in the last quarter of 2010. Well, you didn't expect the economy to keep growing at such strong rates for ever, did you? Evidently not. The interannual rate peaked at 8.5% in the first quarter, and dropped back slightly during the last three months to 8.4%, still this is no mean pace.

But given that the good things in life don't last forever, the real question now facing analysts and policymakers is not whether a fall of a tenth of a percentage point is significant, but rather the much more critical one of just how long the Estonian economic expansion can be kept going in the face a a more general European slowdown, given that the economy is now almost entirely dependent on export expansion for GDP growth?

Exports have been very strong so far this year. Although imports have more or less risen in lock-step.

Consequence, while the goods trade deficit has been substantially reduced, what remains stubbornly resists being eliminated.

Which draws attention to another feature of Estonian goods exports, a lot of them are processed products which are effectively re-exports of previously imported components, hence the value added component supplied by Estonian manufacturing is comparatively small. The share of value added in manufacturing (as a % of GDP) has risen sharply in recent quarters, from the earlier crisis lows, but at around 19.5% it is still up only about 1.5% on the pre-crisis levels. However, within this the share which is oriented to exports has undoubtedly risen.

Still, with value added in manufacturing under 20% of GDP, driving growth forward in the future is not going to be easy, especially now that a Europe-wide slowdown is gradually taking hold. And in a sign of what may now be to comme, exports fell sharply in June, to around 950 million Euros, from an average of 1.1 billion euros in the March to May period.

Indeed industrial output hit a local high in March, and has subsequently fallen back.

Retail sales are barely up from their sharp drop, and are unlikely to give much momentum to the economy in the months and years to come due to the substantial debt overhang which the household sector is still struggling with.

Likwise there is not much sign of a return to life in the construction sector outside government sponsored infrastructural activity.

Unemployment has fallen, but continues to remain high, and in fact the 7,000 drop between Q1 and Q2 is really quite small when seasonal factors and the fact exports were growing furiously are taken into account. It would thus not be surprising to see the numbers of unemployed once more rising going into the winter.

So the big question here is not whether Estonians worked hard to contain their fiscal deficit (which they obviously did), or whether they carried out some form of internal devaluation (they surely did). The key question is whether their internal devaluation went far enough, and whether the exchange rate with which the Estonians entered the Euro was not too high for their needs (a mistake the Germans made in the late 1990s, and which they subsequently paid for in quite costly fashion).

What does not seem to be generally understood in this whole "Estonia" debate is what the expression "export dependence" means. It doesn't simply mean that exports will play a significant part in forthcoming Estonian growth (I think that all parties are now agreed that this will be the case). It means that the level of household indebtedness coupled with the ageing population phenomenon means that domestic consumption driven growth is now a thing of the past, and what is worrying about the Estonian situation is the comparatively small size of Estonia's manufacturing industry.

New credit growth has all but disappeared in Estonia.

Something which is in many ways reminiscent of what happened in Germany following the unwinding of their 1990s consumption boom.

People are still waiting for the return of a housing boom in Germany (see mortgage chart below) but they will wait idly, demography virtually guarantees that, just as they will wait idly in Estonia for a return of the good old days, and meanwhile precious time is being lost.

Estonia's current account has now corrected:

Just as the German one did before it.

But Estonia still has some way to go before it realises CA surpluses on the scale which Germany does. And it still has even more way to go before it recovers the level of economic output attained before the onset of the crisis. Despite the strong recovery of the last year, Estonian GDP is still 10% down on its earlier peak.

Which is why it is worrying that Estonian inflation continues to run above the Euro Area average. This is not the way to improve competitiveness, and it is horribly reminiscent of the path which was trodden by peripheral economies to the West and the South after they joined the common currency. It doesn't really seem that too many lessons have been learnt here.

Strangely, as a country which has recently entered the common currency, country risk seems to have followed a path which is rather nearer to that of its Baltic peers than to that of equivalent Euro Area countries. Credit Default swaps on Estonia have fallen and remain down, whilst those of its East European Euro peers (Slovenia and Slovakia) have risen as one might expect as the crisis of confidence in the currency has grown.

It is not my intention here to single out Estonia for special - negative - treatment (that would not be warranted) but the value being placed on the CDS really is incredibly low for a country that just entered a Euro Area whose outlook could, at the very least, be considered as reasonably uncertain. It is being priced as part of core Europe, when in reality it forms part of Europe's periphery. Evidently, were the Euro to break in two, Estonia would incline towards riding with the German lead group, but given the fact that the country now has a totally export dependent economy, and a currency which was arguably over valued at the time of Euro entry (and continue to have ongoing above-Eurozone-average inflation) it is not clear how prepared the country would be to handle the challenges of being attached to the new, and ultra-high value, currency which would be created.

Thus we find that a country which two years ago was being valued as having the third-riskiest sovereign debt in the European Union is now trading in quite another league, and finds itself included among the European "top ten" sovereigns in terms of price. Last week, while French CDS were hitting Euro era highs of around 160 bps, Estonian ones were sitting pretty at around 115. And just after S&Ps downgraded US sovereing debt, they upped the Estonian rating by two notches to AA-.

Their Valour Is Not In Doubt

"That he which hath no stomach to this fight,
Let him depart; his passport shall be made,
And crowns for convoy put into his purse;
We would not die in that man's company
That fears his fellowship to die with us".
William Shakespeare, Henry V, the Saint Chrispin's Day Speech

So the question I ask myself (as I did in this earlier post), is whether this kind of realignment in valuations makes any kind of economic sense? Of course positive comparisons with the United States and France are flattering, but am I the only one to see something funny going on here? Is contagion risk being reasonably priced in, is the risk of Euro Area break up being adequately priced, and if it isn't, do we not face the risk of a sudden (and hence destabilising) adjustment in the not too distant future?

Is there now nothing left to economic life but fiscal policy, or have we all collectively lost our sense of perspective? How can an economy which still shows the living scars of its earlier sharp distortions be so highly rated?

Obviously, it is clear that the Estonian Sovereign was never, even during the worst moments of the financial crisis, and under the most severe of worst case scenarios, the third riskiest to be found within the frontiers of the EU (Estonia was the only EU country to have a budget surplus last year - worth 0.1 percent of GDP - while public debt totaled a mere 6.6 percent). On the other hand it is the case that Estonia faced an extremely challenging crisis in 2008/09, and had the Euro peg collapsed in one of the four East European countries who had one at the time then the pressure of private debt could certainly have confronted the country with some very complex and difficult choices.

But Their Wisdom, And Sense Of Foresight.........

Following the argument along a bit, it is far from clear that the current level of Estonian CDS prices risk in in any more satisfactory way than it did at the height of the crisis, since membership of the Eurozone has brought with it both positives and negatives. The 0.28% contribution of the country to any future EFSF bailouts may not seem like a very big deal, but in comparison to Estonian GDP the sums involved may well be far from trivial. The country does not have, and is not likely to have, either a fiscal deficit or a sovereign debt problem, nor does it have a home grown banking system which might need bailing out. The risk to Estonia comes from elsewhere, from its association with Ireland, Spain, Greece, Portugal and Italy. Depending on how far the core EU countries are willing to finance debt and absence of growth in those countries the Eurozone's future is far from clear. If, as Edward Lucas speculates, a division to go with the strong currency German lead component which could be created in the case of break-up, Estonia's leaders may live to rue the day they missed the opportunity to make a substantial devaluation in the currency before entering the Eurozone.

This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".

Could There Really Be A Recession Risk In Germany?

2011-08-04T07:52:00.000+02:00

Oh, come on Edward, surely this time you are going too far? The Germany economy is the strongest in Europe, time and again we have been told it is powering and powering ahead. It has just demonstrated record growth performances. So where the hell could you possibly get the crazy idea that Germany might be in for a double-dip recession? Must be the summer Spanish heat.

Well, no. Perhaps the idea is not as absurd as it seems at first sight. Try taking a look at this chart (exhibit A), for starters. This is what just happened to German manufacturing industry.

It is the monthly manufacturing PMI chart, and note the sharp smooth downward line, which stretches from February's high point of 62.7, down to July's 52. Yes, German manufacturing industry is still expanding, but only just, and it is the pace of the slowdown which is remarkable.

And this months report made plain there is worse to come, since as Tim Moore, senior economist at Markit informed us: “New order levels went into reverse in July, as fewer export sales helped end a two-year period of sustained growth". The report also highlighted a reduction in export sales, with the pace of contraction being the fastest since June 2009.

We can also find a reflection of what we are seeing in Germany out in East European economies like the Czech Republic, where the rate of economic expansion has also slowed sharply. This is not surprising, since these economies are all tightly roped together via the German export machine.

Well, OK, German manufacturing industry is slowing, but that's only one part of German activity, surely the rest of the economy will have sufficient momentum to keep moving forward? We this is where I bring in what I consider to be my "killer app", which is the fact that Germany has an export dependent economy.

In Germany movements in GDP follow movements in the rate of expansion of exports. Let's not get into why that is for the moment (think Germany's particular demography), and just consider the possibility, despite all the talk over the years of Germany finally "decoupling", that it can't. Export dependence could well be the key explantaion for why the performance of the German economy is so "extreme" and so volatile, with quarters of record growth being witnessed just before the onset of substantial recessions, recessions which often register record falls in output only to be followed by massive recoveries. The reality is not that Germany is either a growth or a contraction champion, but that export dependency simply makes the German economy more volatile and more susceptible to sudden changes than those of some of its neighbours (like France).

In fact Germany's long term trend growth has been falling steadily.

We Can See The Slowdown Everywhere, Except In The ECB Rate Policy

But why do you insist that this won't simply be a slow patch, or a soft spot? Even the bundesbank is saying that German growth in the second half of the year won't be as strong as in the first half. Well, here comes exhibit B. The slowdown is global, and for an economy which needs growing exports to grow, then a global slowdown is a real problem.

Even China (that other great export driven economy) is feeling the heat, with new export orders also having slid into contraction territory.

And there are more indications than simply the PMI that the economic outlook in Germany is deteriorating. We have the IFO sentiment index, which has now entered overall decline.

And then there is the latest European Confidence Index reading:

Naturally, none of these readings are definitive, but they are what we have at this point, since data from June is hardly helpful to tell us what will happen in August, which is why we need to rely on the "softer" forward looking indicators.

And obviously I can only discern something about the situation such as it is now. Should Ben Bernanke (as I argued in this post here) decide to go ahead with another bout of quantitative easing, Germany would probably be one of the leading beneficiaries, but that is the world we might have, and not the one we actually have as of this moment. So summing up I cannot do better than Tim Moore, senior economist at Markit and author of the PMI report, who said in his final comment:

“July’s final PMI data confirmed a sharp slowdown in German private sector growth, with output levels rising at the weakest pace since the autumn of 2009. The month-on-month loss of growth momentum was also the steepest since the recovery began two years ago. New business gains meanwhile hit a stumbling block in July as heightened economic and financial market uncertainty encouraged clients to delay spending decisions. The latest overall rise in new order levels was the slowest since the start of the upturn, which in turn is likely to weigh on business confidence and job hiring in the months ahead.”

This post first appeared on my Roubini Global Econmonitor Blog "Don't Shoot The Messenger".

Spain's High Risk Election Process

2011-08-03T17:18:00.001+02:00

As Mr Zapatero put it on Saturday, when he announced the date of Spain's general election, the decision "is in the country's interest" since from now on there will be certainty, and "certainty is stability". While it is quite possible that almost all of Spain's politicians shared this sentiment, and welcomed the bringing forward of the election date, they may very well be the only ones to do so. Certainty is undoubtedly a strong positive, but when the only thing about your country which people can be certain of is the election date, then maybe on balance you won't have gained much.

In fact, as we are now seeing, you may well have lost a lot, and thus many of those who assented to the announcement with a knowing nod of the head may already be rueing the careless moment when they did so, as the country's debt crisis escalates, and the sovereign spread with Germany hits ever higher levels. Could they not comprehend that, seen from the outside, the very fact that the coming of these elections could be seen as good news inside Spain simply constituted one further illustration of just how parochial the country's politicians are, and how detached from economic realitities of their country they have become? They have simply turned themselves into the victims of their own propaganda, since if they hadn't been watching too much Spanish television they would have realised the the country's economy was on the verge of a double dip contraction, and not the imminent recovery which was used as justification for the election call.

Had they read their own official and Eurostat reports they would have known that unemployment was rising not falling - it hit 21% in June according to Eurostat data, and went up by a seasonally adjusted 29,603 between June and July, according to the monthly report from the Spanish labour office.

And had they been following events on the ground rather than election timetables they would have been aware that the housing market,far from having bottomed out had just entered another downward slump. The interannual rate of price decline according to the TINSA valuers index has risen steadily from 3.71% in March, to 4.38% in April, to 5.88% in May, to 6.6% in June. Back in October last year Mr Zapatero famously informed a stupified Maria Bartiromo from CNBC that Spanish house prices had bottomed:

MS. BARTIROMO: Are you expecting real-estate prices to continue coming down? Have they hit the bottom or not yet?

PRIME MIN. ZAPATERO: I think that the price of housing has hit the bottom. It won’t go down any more. For the past two or three months, what we see is that not only has it not dropped. But in certain parts of Spain, the price of housing has gone up. This is especially the case in those areas of — not where people are buying their second house, if you like, with the prices there have still gone down a bit, but rather where they’re buying their first, there the prices have gone down in the housing sector. So in general the prices have been stable recently, and they’ve even been increasing. So demand seems to be ticking up again.

Even more importantly, the recent rise in the 10 year bond yield (and spread) had been giving clear signals that the whole "decoupling" thesis behind whose figleaf the Spanish administration had been guarding their chastity had now become bereft of all credibility.

So the only (and I do mean only) positive Spain had to cling onto before the markets was the credibility it could have earned by coming in with a 6% deficit result on target this December.

If Spain needed a change of government (and I fully accept it did), then what it needed was some kind of "save the nation" (and the euro) coalition, to thrash out what would effectively be a new set of Pactos de la Moncloa, such is the gravity of the situation facing the country, and indirectly the European Union. (The Pactos de la Moncloa were the agreements reached between the various parties to facilitate a bloodless transition from dictatorship to democracy in the initial post-Franco years). But times have changed, and far from being able to achieve major aggreements of state, Spain's political parties are typically too heavily committed to endulging themselves in squabbling over the post boom-years leftovers to busy themselves with more pressing concerns like finding collective solutions to their country's (and Europe's) problems.

Outside Spain things are seen in a rather different eye. Victor Mallet, writing in the Financial Times, put it like this: "neither the certainty of an election date nor the probable victory of the rightwing opposition Popular party will necessarily soothe investors’ fears about where Spain is headed", he said, just before citing Nicholas Spiro of Spiro Sovereign Strategy to the effect that “Spain’s debt market needs this election like it needs a hole in the head". Well, some of the country's leaders might be forgiven for feeling, in the light of what has now transpired, that it is they and not the markets who have been left with a hole in the head, or at least a large gaping hole in the side of their already leaky ship.

Mr Zapatero's actual choice of words was at one and the same time interesting, and revealing. “On January 1, the new government must work on economic recovery and on reducing the deficit.” Excellent, the thread will be picked up again at the start of 2012. And in the meantime? The real issue facing investors and financial market participants at this moment is what is going to happen to the deficit between now and the 31st December. By no stretch of the imagination can Spanish pre-election periods be considered to be propitious for spending cuts.

Concerns about regional spending were already widespread before the election announcement. Commerzbanks Ralph Solveen in a report expressing widely shared views and revealing the sense of frustration already felt by many analysts and observers, desribed the possibilty of Spain achieving the 6% target by the end of this year as increasingly remote. And his reasoning was impeccable:

The Spanish central government is still only managing to reduce its budget deficit at a very slow pace. According to figures published today, its deficit for the first half of the year was just €5.6 billion lower than in the same period last year. In addition, most of the Spanish regions reported higher deficits than last year, so this year's target for reducing the overall government deficit ratio from 9.2 per cent to 6 per cent, is now receding into the distance.......This figure is only slightly higher than the reduction of €4.5 billion that was reported at the end of May, such that the reduction per month fell.

Consequently, the target set for reducing the overall government deficit by more than three percentage points this year is becoming even more remote, all the more so because the first quarter deficits reported for the regions were, on average, even higher than last year. The figures for the second quarter are not yet available, but reports for individual regions such as Castile-La Mancha bring little hope of a significant change for the better.

Part of the reason for the slow rate of deficit reduction has been the fact that economic growth is slower than forecast, a problem which is hitting revenues. Naturally a further batch of measures really are needed, but what sort of "swingeing cuts" can we realistically expect to see from a government which is in the midst of a battle for its political life? Telling government employees that they will lose half of their 2 extra monthly payments (one policy option strongly rumoured to have been under consideration before the election announcement) would hardly be likely to win them votes.

As I say, the tragedy in all this is that achieving the deficit target was about the one (and only) thing the government had going for it. The only real proof of its seriousness. Despite all the scepticism about (and slippage in) regional finance, I would have been prepared to sign on to the idea that Spain's deficit would still come in around the 6% mark. But now,.......

The deficit progress was what Spain had to put on the table, since when you come to all the rest, economic growth, employment and unemployment, financial sector reform, the housing market the only thing the sky was really full of were black clouds.

Naturally, the election declaration was only what the Greek historian Thucydides would have called the efficient cause (or trigger) for the next stage in the crisis, the final cause is the inability of either Madrid, or Brussels, or Washington (the IMF) to come up with an adequate policy mix to drag the Spanish economy out of the hole into which it has fallen, and into which (short of viable remedies) it will soon drag the Spanish and then the European financial systems along behind it.

Going naked (not a fig leaf is left) into the conference chamber sounds like a very apt and appropriate desciption of where Mr Zapatero and his team are right now. The situation can hardly be comfortable for them, but then, at the end of the day sympathy would be misplaced, since the only people responsible (or should that be "irresponsible") for the decision and hence the situation are they themselves and those who lead the governing PSOE party. Unfortunately though they will not be the only ones who pay the consequences.

This post first appeared on my Roubini Global Econmonitor Blog "Don't Shoot The Messenger".

Recession Warning On Europe's Periphery

2011-07-25T16:24:00.019+02:00

As Europe’s leaders struggle to convince markets that their Greek debt problem-resolution-proposals are actually viable, and will really do the trick, last week's flash PMI readings seem to have attracted rather less attention than they might. Nonetheless, the fact of the matter is that it is steadily becoming clearer that the current slowdown in Eurozone economic growth is turning into something more than just another one of those pesky “soft patches”. The pace of economic expansion in core Europe has slowed dramatically, falling back in July for the third consecutive month, according to the latest flash PMI. Commenting on the flash results Chris Williamson, Chief Economist at Markit said: “The Eurozone recovery lost almost all of its momentum in July, recording the weakest growth since August 2009 when the recovery first began. Excluding the financial crisis, the July survey was the most downbeat since the Iraq war in 2003, and consistent with a flat trend in quarterly gross domestic product.

In fact the rate of expansion – the composite indicator registered just 50.8, only slightly above the dividing line between growth and contraction - was the lowest since August 2009, when the recovery was just starting out. More importantly (for the longer term) new business coming in showed only a very marginal increase in July, registering what was the smallest rise since demand for manufactured goods and services first started to return to growth back in September 2009. Levels of incoming new business fell in manufacturing for the second month in a row, declining at the fastest rate since June 2009 – with new export orders actually falling for first time since July 2009.

What this means, of course, is that the slowdown has now extended, spreading deep into the heart of the core, with both services and manufacturing in both Germany and France affected.

The German composite index fell to 52.2, from 56.3 in June, and while the latest reading still remained comfortably above the 50.0 no-growth value, the month-on-month index fall of 4.1 points was the largest since the November 2008 post Lehman drop. Tim Moore, Senior Economist at Markit said in his report “Almost in the blink of an eye, German private sector output has gone from rapid growth to a slow crawl.

But even as growth in the core economies approaches stall speed, out on the periphery a new recession seems increasingly on the cards, and most importantly in countries like Spain and Italy which have so far managed to keep their heads just above the waterline. Growth in the second quarter of the year looks likely to have been minimal in both cases, and the outlook for the third quarter suggests we are entering a bout of economic shrinkage.

The PMI readings also coincide with the impression offered by monetary indicators.

As Henderson Global Investors’ Simon Ward points out, in late 2010, while real (ie inflation adjusted) current bank deposits were contracting in Spain and Italy, they were still growing robustly in both Germany and France, implying a solid economic growth economic outlook in the core for the first half of 2011 (this monetary indicator is often thought to give an indication of activity with a 6 month lag).

But currently, as can be seen in the above chart (which shows rates of six monthly growth) real deposits have even started to contract in the core, while in Italy the rate of shrinkage has accelerated considerably, suggesting that the earlier “two-speed” Eurozone recovery may now be about to give way to a period of much more generalised weakness, reinforcing the impression given by the PMI order indexes. What is most striking is the way Italian M1 deposits have been contracting much more strongly than Spain’s have of late, although this development should not take us completely by surprise, since, as I have been consistently pointing out (see here, here and here) it has been clear from both real and survey data for some months now that Italy was heading towards recession again.

And looking at the second monetary chart that Simon provides, it is evident that the weakness in Spain and Italy forms part of a much more general contractionary phenomenon on the periphery, but then I imagine that the idea that Greece and Portugal might be in recession comes as a surprise to no one.

Part of a Bigger Global Picture

Of course, the vulnerability we are seeing on Europe’s periphery is being played out in the context of a global economy which is itself clearly losing momentum. This generally weakening in global growth has been clear from the evolution in the global manufacturing PMI for some time now.

And the latest China manufacturing flash PMI (which showed contraction for the first time since the middle of 2010) suggests the ongoing pattern will be once more confirmed in July, with global manufacturing moving closer to the critical 50 dividing line which marks the frontier between growth and contraction.

Even more importantly the Chinese export order component (which could be considered as a long leading indicator giving us information about possible activity levels three to six months from now) reinforced the idea that the slowdown is likely to be extended in time.

This impression (of an extended period of lower growth globally) is also confirmed by the business expectations component of the German IFO. I would about anticipating an early termination of the slowdown till we see some real sign of sustained improvement in Chinese new export orders and a solid uptick in IFO expectations.

So Why Don’t We All Be Just That Little Bit More Vigilant?

Where does all this that leave Europe in policy terms? Well, in principle recent developments in the real economy should present the ECB with significant monetary policy dilemmas, given the risks to the integrity of the monetary union that could result from a combination of reform/recession weariness out on the fringe and bailout fatigue in the core. Evidently the slowdown will make it harder to meet deficit targets in Spain and Italy, and will most likely mean there is a need for new measures which will become harder and harder to sell to voters, while any deterioration in the jobs market in Germany (we should be watch the unemployment numbers in Germany in the coming months) could well make bailout contributions harder to drum up. As John Hussman put it in a note to investors this morning:

"As I've noted several times in recent months, bond market spread imply very low near-term (3-6 month) probability of default in any Euro-area country. A sovereign default is much more likely to occur near the end of the next bear market, whenever it occurs, than at the start. As Ken Rogoff and Carmen Reinhart noted in their book This Time It's Different, "Overt domestic default tends to occur only in times of severe macroeconomic distress." The most likely window for a Greek (or other Euro-nation) default will be at a point when France and Germany are experiencing economic downturns sufficient to douse the political will to bail out their neighbours at a cost to their own citizens".

So in theory what these leading indicator readings should be telling us is that we should expect little more in the way of rate rises during what remains of 2011. Continuing to raise rates into an economic slowdown where there are clear risks of financial instability would not seem to be sound monetary policy.

In addition, given the way the pace of manufacturing input price inflation now seems to be cooling rapidly (see chart below), it would not be surprising to see a change the wording of the risk assessment for price stability from ‘on the upside’ to ‘balanced’ at the next meeting. This would avoid a lot of potential communication difficulties in the months to come, and would open the door up to a much more flexible interest rate policy.

One critical point to grasp is that the ECB decisions themselves have now become one of the main factors which will influence the outcome of the slowdown, not simply via the standard monetary policy path on Europe’s core economies but via the impact its decisions will have on policy sustainability on the periphery, and though this channel on the level of global risk sentiment.

In this sense ensuring economic growth is not the only distraction which could divert the ECB’s attention from its principal mandate in defence of price stability, since there is also debt stability to think about too. Recent days have show that large peripheral economies like those of Spain and Italy, far from having totally decoupled from the smaller and weaker countries, are now once more being drawn back into the maelstrom.

In particular Italy’s government debt to GDP level of 120% has been attracting growing attention. Simple calculations show that just to stabilise debt at this level with the previous prevailing interest rates the country needed a 3% annual growth in nominal GDP. Now, of course, they are likely to need slightly more. But real GDP growth this year will be significantly under 1%, while all those earnest efforts by the ECB to push the country’s inflation rate down below 2% will simply serve to help nudge the debt level upwards, in the process raising the premium investors will ask to buy Italian debt, with the implication that next year the country will need an even higher rate of nominal GDP growth, and so on, and so forth.
And the situation is Spain is hardly better, with 85% of mortgages being attached to variable rates, pushing Euribor upwards simply starts to weaken the hitherto comparatively robust performance of the bank mortgage books, while the slower economic growth will make government deficit targets even harder to maintain.

So really, the issue is not whether the ECB was right to go ahead with this months rate rise given its main mandate, the issue is whether members of the Governing Council could by any chance prove themselves sufficiently flexible in the future to change their discourse in the face not just of Greek default woes, but also of heightening recessionary and debt management risks? In his report just before the last rate meeting, Deutsche Bank’s Gilles Moec argued that the situation was “not bad enough” for the Bank not to raise. I wonder if the deterioration we have seen since that time makes it “now bad enough”? Just how bad do things have to get for us to reach that point, and just what is prudent and what is risky behaviour in current circumstances? Certainly Council members need to be vigilant, but in particular they need to be vigilant that their attempts to avoid one problem do not inadvertently generate another, even more difficult to handle, one.

This post first appeared on my Roubini Global Econmonitor Blog "Don't Shoot The Messenger".

Red Lights Flashing For Eurozone Growth

2011-06-25T16:35:00.019+02:00

The June Flash PMI reports, which were out on Thursday, make do not make agreeable reading, in the sense that while the French and German economies both continued to expand during the month, their rate of expansion, and in particular in the leading manufacturing sector, seems to have dropped sharply, and for the second month running. In contrast, the economies on the Eurozone periphery moved closed to outright contraction. All in all the survey results only add to concerns about the global recovery which came into focus after the May PMI results (see my To QE3 or Not to QE3).

At this point detailed information is only available for the French and German economies, but there is little doubt that the pace of the slowdown in the core will mean that the peripheral economies are about to experience a double dip (and particularly worrying in this sense is the way Italian growth has been drifting downwards) and may well fall back into recesssion (in those cases where they have not already done so). Outside of France and Germany, manufacturing output (the PMIs are composite diffusion indexes, and the headline reading measures the aggregate of various components of which output levels are only one) fell for the first time since November 2009, with the rate of decline being the fastest since September 2009. So this is nothing to be sneezed at! As can be seen from the chart below, in all cases indicator readings are falling, but in the periphery case they are falling into recession territory.

Most importantly, we should note that it is the manufacturing sector which is falling most sharply, and in an export driven recovery this has to be THE leading indicator for Europe's economies. In addition export order growth is now at its lowest level in the nine months.

New business rose at the weakest rate since November 2009, led by the first (albeit small) decline in manufacturing new orders since July 2009 (see chart below). New export orders for manufactured goods rose only modestly, posting the smallest increase since September 2009.

This impression of slowing global demand for exports was also confirmed by the Chinese manufacturing PMI flash reading which showed that Chinese export orders actually declined during the month (China is the only country beyond the Eurozone to do a flash PMI, and Chinese manufacturing as a whole barely expanded). These manufacturing export indicators are important, as they constitute what could be called long leading indicators (and here's ECRI's Managing Director Lakshman Achuthan explaining on Fox TV what long leading indicators are, why this slowdown isn't simply about Japan supply chains, or the weather, and why what we are facing - barring recourse to QE3 - looks like something more than a "global soft patch").

Another "long leader" came in with a strange reading in June, and that was the German IFO. On the face of it, the gung-ho analysts thought the reading was a good one, but that interpretation could be rather simplistic. Let's look closely at the chart:

What we should be looking at here isn't the composite (red) line, but the sub components, and the one to get your head round is the business expectations component (yellow line). This peaked in February, after moving sideways from November 2010, and there is no sign of it turning up again. This is the sort of thing Lacksman Akerman talks about in his interview. If we want to argue that what is happening is just a "soft patch" then we need to see indicators like the expectations component of the IFO to start turning upwards again, and at present there is no sign of that, so at present we lack grounds for asserting the "soft patch" argument, and in this context the fact that conditions in June were better than expected is neither here nor there, since that only tells us June was a batter month than expected, but virtually nothing about the future.

If we look at the German services PMI we can get some clues as to why the IFO overall business climate reading came in above expectations (up at 114.5 from 114.2 in May, while consensus expected a fall to 113.4): the expansion in services activity accelerated during the month, following a loss of momentum in the two previous months.

In contrast manufacturing activity fell sharply.

As the markit report says:

"Sector-specific data nonetheless highlighted a marked divergence between manufacturing and services in June. While services business activity increased at a robust and accelerated pace, the latest rise in manufacturing output was the slowest since September 2010. Consequently, an improved performance from the service sector boosted the overall figures for the German private sector in June. The moderation in manufacturing production growth coincided with another sharp slowdown in new order gains. June data pointed to the weakest expansion of new business in the sector since July 2009. Manufacturers also indicated the least marked rise in new export orders since the current period of growth began in October 2009".

Yep, the slowest rise in new export orders since July 2009. Now there's another long leading indicator for you, and it is showing red. If German export orders don't grow then finally the German economy doesn't grow, since Germany is an export driven economy, whatever those who live in eternal hope of a recovery in German domestic consumption may tell you.

Now if we go back to the IFO chart for a moment, note that the assessment of the current business situation hasn't peaked yet, although it must surely be close to doing so. The last time this component in the indicator peaked was at the end of 2006, and guess what else coincided with that peak? The cyclical wave of the last German GDP expansion (in terms of year-on-year growth) peaked at (more or less) exactly the same time.

Now obviously Germany didn't go on to enter recession for over a year (5 quarters to be exact), which means we probably aren't talking about a recssionary slowdown in Germany at this point, but what we may be talking about is a German economy which is passing its cyclical high point (shudders go out along the periphery on reading this, since the peripheral economies haven't even gotten their recoveries seriously started yet), and if this is the case there will be clear implications for Eurozone momentum.

As I say, we have no flash PMI's for the periphery, but if we look at the May reading, it is clear that while Greece is in a world of contraction all of its its own, Italy and Spain have been steadily weakening, and it is quite possible they both countries will register contraction this month (Ireland has somehow escaped the trend up to this point).

As Chris Williamson, Chief Economist at Markit said in the comment accompanying the report:

“The euro area’s economic growth surge has lost momentum at a worrying rate in the past two months. While the average PMI reading for the second quarter as a whole suggests that the economy grew by around 0.6%, down from 0.8% in the first quarter, the reading for June was consistent with a quarterly growth run rate of just 0.4%. Manufacturing growth has slowed especially sharply, slipping close to stagnation in June. Even German manufacturing, the driving force of the region’s recovery, has seen a marked deterioration in output and new orders growth – linked to a large extent to a severe weakening of export order book growth. Meanwhile, the euro area excluding France and Germany has fallen back into contraction for the first time since late-2009".

Curiously, just this week Goldman Sachs European Department have published (European Weekly Analyst June 16) a new set of leading (not long leading) indexes (attempting to identify trends for the three months ahead), and their findings broadly corroborate the PMI outlook. What is especially noteworthy in their list is the very weak showing from Italy (see my Is Italy Not Spain The Real Elephant In The Euro Room? for background).

As they say in their report:

Italy and Spain languish. As expressed in our latest views published on Italy (see EWA 11/18) and Spain (see our European Views “Spain: Mitigating concerns about regional deficits, but mixed views on short-term growth prospects”, June 6, 2011), Italy and Spain may lack momentum in the quarters ahead, as suggested by the quasi-flat EURO-LIs in May.

To Raise Or Not To Raise In July?

Which brings us to the ECB, and the potential policy implications of these results. The first thing to note is that the flash PMIs suggested that inflation continued to ease back in June, particularly in the leading manufacturing sector. As the accompanying report states, "the easing in output price inflation in manufacturing was driven by a further steep easing in input price inflation from the survey-record rate of increase seen in February. A ten-month low in the rate of manufacturing input price inflation was accompanied by a five-month low in the service sector. Measured across both sectors, input costs rose at the slowest rate since October, down sharply from March’s peak". I don't know if that is clear enough for decision makers over at the ECB yet, but supply side inflation is definitely on the wane at this point, and since economic activity is also weakening this environment is hardly supportive of a rate rise decision.

Which really raises the question as to whether the ECB will proceed with its already pre-announced interest rate rise in July. I for one now have serious doubts. The only real justification for raising would seem to be that Monsieur Trichet used the expression "strong vigilance" at the last post meeting press conference, and it may be that they now feel bound by their word (for the avoidance of uncertainty), foolish as this approach may seem to everyone else. Really, if it is doubt in the markets you want to avoid then they may as well have raised rates in May, but then I suppose someone will add that they don't like giving the market surprises. The rejoinder to this might be that showing a little flexibility now and then might not be a bad idea either.

Really, the issue is not whether or not the ECB would be right to go ahead with a further rate rise in this situation - personally I think it is pretty obvious they wouldn't as I made plain from the start in my Chronicle of a Policy Error Foretold post on the CNBC blog before this charade even got started. The issue is whether the Governing Council of the ECB will prove themselves flexible enough to change discourse in the face not just of Greek default woes, but of slowing inflation and growing recessionary risks?

In other words, are ECB decision makers moved more by developments in the real economy, or by an obsession with trying to "normalise" interest rates as quickly as possible using the happy circumstance of temporarily above target inflation as the excuse (however much M. Trichet denies they have this kind of agenda)? In fact he even has the justification that - as he said himself on Friday - that the risk signals for financial stability in the euro area are "flashing red". Surely, at this critical moment in the history of the common currency he has stewardship over, he would not want to go down in history as the Montagu Norman of the Great Global Recession. But then, maybe I am being unfair. Possibly it is another ghost that is keeping Monsieur Trichet thrashing around on his pillow at night: the one formed by the precedent of the Bank of Japan in 2007, who when they found themselves forced to call a rapid halt to a previously much paraded rate hike programme after only one measly 0.25% rise. History, as they say, does repeat itself, even the ECB's own recent history, but let us hope that this time we will not have to face an example of "once bitten, twice shy".

This post first appeared on my Roubini Global Econmonitor Blog "Don't Shoot The Messenger".

Is Italy Not Spain The Real Elephant In The Euro Room?

2011-05-22T16:03:00.001+02:00

Looking through the latest round of EU GDP data, one thing is becoming increasingly obvious: when it comes to future monetary policy decisions at the ECB, and to exactly how many more interest rate hikes we are going to see, then the performance of the Italian economy is going to be critical. The growth pattern now is clear enough: Germany and France move forward at a lively pace, while the so called "peripheral" economies (Portugal, Ireland, Greece, and Spain) either remain in or continually flirt with recession. They are constrained bythe combined burden of their lack of international competitiveness, their over-indebtedness and the contractionary impact of their austerity programmes.

In this sense, given its size, Italy is in a key position to tip the balance between core and periphery one way or the other. And the fact that, growth in the Italian economy seems once more to be grinding to a halt is not good news in this sense, with the quarterly gowth rate falling back from a quarterly 0.6% in Q2 2010, 0.5% in Q3, 0.1% in Q4 and 0.1% again in Q1 2011.

Slow Growth Champion?

I suppose it shouldn't really have surprised anyone to find that Italy’s GDP growth rate continued to slip back in the first three months of this year - both in absolute terms and with respect to core Europe - since Italy's average growth rate during the first decade was only about 0.6% per annum. It shouldn't have surprised, but I'm sure it did, since the financial markets have only been thinking of how comparatively low the Italian deficit has been since the start of the crisis, rather than worrying their heads off about how a country with such a low growth rate and such a high pending elderly dependency ratio is ever going to pay down the already accumulated debt. Italy's debt to GDP ratio is currently just short of 120%, while the population median age is 45, so lets just say Italy is Japan without the current account surplus.

Now were the quarterly GDP growth rate not to accelerate beyond the 0.1% expansion achieved in the first three months of this year, then even the current IMF forecast for modest 1% GDP growth in 2011 would start looking very optimistic. And if the country now slips back into recession (certainly not excluded) then the under-performance would be much greater.

Some Do Not Also Rise

The Italian result contrasts sharply with the strong performance in the main components of core Europe, emphasising yet again that despite the fact that it is managing to stay clear of bond market wrath at the moment, Italy essentially forms part of the low-growth high-public-sector debt economies on Europe's periphery. Both German and French real GDP growth in Q1 2011 came in much stronger than expected, with the former posting an impressive 1.5% quarterly increase (6% annualised), significantly stronger than the 0.9% expected by the markets, while French GDP increased by 1.0%, in this case with a strong contribution coming from domestic demand which was reflected in a strong increase in imports, imports which in theory should have benefitted Italy.

France and Germany are in fact Italy’s main trading partners, accounting between them for about a quarter of Italy’s total exports. So although we do not have a breakdown of Italian Q1 GDP yet, the above developments point to a stagnating domestic demand only partially compensated by stronger net exports.

The most recent results mean that German GDP has now passed its pre-crisis peak, while Italian GDP is still stuck at the level it reached at the end of 2004. The chart below (which comes from a recent report by PNB Paribas economist Ken Wattret ) shows the path of constant price GDP in the four largest eurozone countries (plus the UK) relative to where they were in Q1 2008. France is in a similar position to Germany, since fourth quarter 2010 GDP was around 1.6% lower than its pre-crisis peak, and it just rose by 1%.

The picture in the other countries, however, is very different. In Italy, Spain and the UK, GDP is currently 5.2%, 4.3% and 4.1%, respectively, below the peak levels reached in Q1 2008. So what accounts for the differences? In the German case the strength of the rebound is in-part a by-product the exceptional depth of the recession there. Between March 2007 and March 2008, German GDP collapsed by a cumulative 6.6%. This compares with peak-to-trough GDP declines of around 3.5% and 2%, respectively, during the recessions of the early 1990s and during the first years of the present century.

The Italian Economy Resembles The German One, Consumption Is Weak And Growth Depends On Exports: Unfortunately The Italian Economy Is Not Competitive Enough For This To Work

Germany’s strong export dependency, and consequent high sensitivity to fluctuations in global trade, is the key reason why the country goes from strong growth to deep recession and back again (in fact quarterly GDP growth in Q1 2008 was 1.4%, just before the economy fell into recession). This dependency is reflected in the unusually high share of GDP which is accounted for by exports (over 50%), and may well be associated with the unusually high median population age of 45.

As can be seen in the chart, the cumulative contractions in GDP in the other large European economies were typically significantly smaller than in Germany, even in a country like the UK which was extremely vulnerable to problems in the financial sector. A similar picture can be found in the US, where problems in housing and the banks formed a central and archetypical feature of the global crisis, even though GDP declined by only a cumulative 4% from peak to trough, two-thirds of the German drop.

On the other hand, the Italian case offers an evident exception to the idea that the harder they fall the steeper they rise. The cumulative decline in Italian GDP from its Q1 2008 peak to the Q2 2009 trough was nearly 7% - making the output loss bigger even than that experienced in Germany.

But the rebound has been much less impressive than the German one, with GDP still nearly 5% below the pre-crisis high, and basically still on the level of Q4 2003. In large part, this situation is a result of the weak performance of Italian exports. In Germany, exports are now back above their pre-crisis peak, while in Italy exports are still more than 14% under their Q1 2008 high point (See chart).

Productivity Is The Key

Average quarterly growth in German GDP since the economy bottomed in Q1 2009 has been nearly 1%, while in Italy, it has averaged under 0.3%. The geographical composition of German and Italian exports is one factor which influences the relative export performance between the two countries. The share of German exports which go to faster growing developing markets like China, has accelerated sharply since outbreak of the crisis, while Italy is still largely dependent on developed - and heavily indebted - economies. In addition Italy has a major competitiveness problem. Incredibly, and according to Eurostat data, in the first decade of this century the Italian hourly productivity index only climbed by 0.75%, while the German one climbed by 13.3%. That is to say, German productivity was up an average of 1.3% a year over the decade, while Italian productivity barely moved, rising only 0.07% a year. As a result, rising wages meant that Italian unit labour costs surged sharply. So, during the first decade of the Euro the Italians paid themselves more for producing virtually what they were producing at the start of the century. Naturally this is not sustainable.

Labour Inputs Shoot Up, But Output Doesn't

The situation is even more incredible if you take into account the fact that during these years the labour force grew steadily, and the country received several million new migrant workers. Between 2002 and 2010 the number of non-Italian citizens officially residing in Italy was up by 3 million (or 200%).

During this time the labour force grew by about a million:

while employment was up by around 1.5 million.

In fact, since Italy left recession the number of those employed has hardly risen, while the percentage of those who are formally unemployed has remained near its crisis highpoint, which has been good for productivity, but not for consumer consumption, the ideal combination would be to see output and employment growing at a healthy pace, with output growing faster than employment. At the present time employment is hardly growing, and the rate of increase in output is slowing notably. That is to say we do not have "lift off".

Naturally, this lack of competitiveness is to be seen in Italy's deteriorating external position, and the drag on growth which this causes is seen clearly in this current account deficit and GDP growth comparison.

Exports have been growing rapidly since the middle of last year, but imports have been growing even more rapidly, and hence the goods trade deficit has widened considerably.

Growing Your Way Out Of Debt?

Aside from the impact on Italian living standards and welfare services, the big issue which arises from Italy's low and declining long term growth outlook is what this is likely to do for Italian plans to reduce the burden of its outstanding government debt. Is, for example, lower than expected growth likely to jeopardise Italy’s achievement of its deficit target for 2011? Well, if there was no increase in spending to compensate for the economic slowdown (and remember, Prime Minister Berlusconi's party just did very badly in regional and local elections) then the knock-on effect on the deficit would probably be small and probably not a large enough change to seriously call into question the Italian government's commitment to its fiscal policy targets given that the 4.6% deficit achieved in 2010 was 40bps below target and that the Government is aiming for a 2.7% deficit by 2012.

But Italy's problem has not been its high deficit level during the crisis, it is the high debt level the Italian government has accumulated over the years, and the continuing under-performance in growth terms means the government may well struggle to turn the situation round, and that some sort of restructuring (soft or hard) at some point may well be needed. Let's take a look at why.

According to OECD data, while Italy ran cyclically adjusted primary deficits (that is deficits before including interest payments) every year between 1970 and 1991, the country has run cyclically adjusted primary surplus every year since 1992 - even during the depths of the recent crisis. Thus Italy’s cyclically adjusted primary balance (as a % of GDP) has been in better shape than the balance of many of the largest developed economies. Notwithstanding this, the weight of debt as a % of GDP has continued to rise. So, while Eurostat recently confirmed that the Italian 2010 public deficit was 4.6% of GDP, and 40 basis points below the Government target,the debt to GDP ratio was revised up to 119% (in this case higher than the Government’s target number). What makes the difference is the impact of history and the weight of the accumulated debt, since interest needs to be paid on the debt.

Ambitious Targets Which Will Be Nearly Impossible To Achieve

Now Italy has set itself the objective of reducing the overall deficit below 3% of GDP by 2012. Indeed, the government’s 2011 Economics and Finance Document (EFD) sets itself extremely ambitious targets for fiscal policy. The objective is to achieve a broadly balanced budget by 2014 through the achievement of a deficit/GDP ratio of 3.9% in 2012, 2.7% in 2013, 1.5% in 2013 and a 0.2% in 2014 and (as the document says) “so on systematically increasing the primary surplus to continue on the path to reduce the public debt”. The aim is to maintain the fiscal balance within a range which is compatible with reducing the debt. But just how realistic is this objective?

Well, to make a comparison, back in March, ECOFIN proposed quite far-reaching changes to the current Stability and Growth Pact (SGP). In particular the Finance Ministers proposals included the incorporation of a principle of extra fiscal effort for heavily indebted countries – a principle which has become widely known as the "debt-brake" condition. According to the new proposal excess debt, i.e. public debt above 60% of GDP, should be reduced by 1/20th per annum. This new debt-brake condition has important implications for heavily indebted countries who have so far escaped the full force of market attention, such as Belgium and Italy, since these two have to deal with debt to GDP ratios hovering around 100% and 120% respectively. What is surprising about the fiscal path proposed by the Italian government in its EFD is that it appears even tougher than that implied by the new EU debt-brake condition.

Of course, assuming Italy meets its fiscal deficit objectives - which naturally imply no counter-cyclical stabiliser deficits during recessions (is this really realistic??) - the key variable to watch for the debt/GDP ratio is nominal GDP. Now Italy managed to achieve nominal GDP growth of around 4% a year in the decade before the crisis, and a rough and ready calculation suggests that with nominal GDP growth of around 4% debt to GDP would be down under 100% following the Econfin criteria, and under 95% following the Italian government's own EFT.

Catch Me (Out) If You Can

But is a 4% growth in nominal GDP realistic for the rest of this decade? It is important to remember that the composition of the earlier 4% average annual growth, since only around 1% of it came from real GDP growth, while 3% came from inflation. And, of course, during this time, as we have seen, Italy lost considerable competitiveness with Germany. So what may help with one thing (debt to GDP) may be positively harmful to another (international competitiveness, the current account defecit). As Goldman Sachs economist Kevin Daly put it in a recent report:

"For countries attempting to address these twin imbalances within a currency union, there is a ‘Catch 22’ situation: competitiveness can only be regained via real exchange rate adjustment (i.e., by running lower inflation than the Euro-zone average). However, in order to boost public sector finances, economies need stronger nominal GDP growth and, thus, relatively low inflation (or deflation) has the effect of exacerbating the public-sector deficit problem. In other words, it is difficult to address one imbalance without exacerbating the other, and vice versa".

If we simply take this years outlook as an example. Italy, as we have seen, is unlikely to achieve more than 1% real GDP growth (and this a year of strong global expansion), but the country might just get nominal GDP growth of 4%, since inflation is currently running near to 3%. At the same time Germany may have GDP growth nearer 4%, and inflation around 1% lower than Italy. These kind of inflation differentials just don't make sense, when you consider that it is Germany that is booming, and Italy that is near to falling back into recession. Such differences are symptoms of deep economic rigidities in Italy.

So what if Italy were to have 1% inflation, and 3% real GDP growth? Well, just how plausible is this? Germany, as we have seen, has only been able to get 1.3% annual growth in productivity over the last decade, and it is hard to see Italy doing better, no matter how deep the structural reforms introduced. Indeed, Italy's long term trend growth has been slipping steadily over the last half century, at the rate of about 1% a decade, according to the Italian economist Francesco Daveri:

"Italy’s per-capita GDP growth was 5.4% in the 1950s, 5.1% in the 1960s, 3.1% in the 1970s, 2.2% in the 1980s and 1.4% in the 1990s. A rough-and-ready extrapolation of this decade-long continued slowdown would lead to expect no more than 0.5% in the 2000s."

Since he wrote this in 2006, and growth over the decade was something like an average of 0.6% I would say that his expectation wasn't a bad guess. What puzzles me at all the people who now "guess" that Italy will be able to put in enough a much higher growth rate over the next decade.

All Together Now: "I Believe In Structural Reforms"

The IMF are expecting real growth of about 1.3% between 2012 and 2015, and the EU forecasts are not substantially different. As average growth rates this seem very optimistic to me, especially given the recent performance.

All efforts seem to be directed towards impelling structural reforms, and this in itself is worrying, since what we seem to have is something more akin to blind faith than to sound empirical economic analysis. The most recent IMF Article IV Report concludes that: “only a bold and comprehensive structural reform program will unleash Italy’s growth potential”. But what is the likelihood of such a bold and comprehensive programme being introduced, and anyway, how much do we really know about Italy's real growth potential at this late day in its demographic history? While echoing the "structural reforms" mantra, the OECD is rather more cautious:

Italy’s economy has passed the deep recession triggered by the global crisis and seems set for a gradual recovery. The strength of this recovery is uncertain: it would be wise to plan for no more than the rather sluggish growth seen in the decade prior to the crisis.

The problem is, like many on Europe's periphery, after a decade of Euro membership the Italian economy is seriously distorted, and badly in need of devaluation, but of course, as elsewhere there is no currency left to devalue, hence some sort of debt restructuring to reduce the burden of interest payments may be the only alternative while we await the jury's verdict as to whether all these structural reforms work or not.

Many, of course, will say that Italy is a lot richer than it seems, since so much economic activity takes places in the informal sector. But this is entirely beside the point, since the informal sector by definition does not pay taxes, and I will believe a promise to reduce the importance of the informal sector when I see the results. In the meantime Italy is, at best, a country which is much richer than it seems where government finances are in danger of spinning off into an unsustainable debt spiral.

As Standard & Poor's put it in the statement accompanying their decision last week to put Italian Sovereign Debt on rating watch negative: "In our view Italy's current growth prospects are weak, and the political commitment for productivity-enhancing reforms appears to be faltering. Potential political gridlock could contribute to fiscal slippage. As a result, we believe Italy's prospects for reducing its general government debt have diminished."

Greece: Last Exit To Nowhere?

2011-05-15T23:34:00.003+02:00

"Some economists, myself included, look at Europe’s woes and have the feeling that we’ve seen this movie before, a decade ago on another continent — specifically, in Argentina" - Paul Krugman: Can Europe Be Saved

"Think of it this way: the Greek government cannot announce a policy of leaving the euro — and I’m sure it has no intention of doing that. But at this point it’s all too easy to imagine a default on debt, triggering a crisis of confidence, which forces the government to impose a banking holiday — and at that point the logic of hanging on to the common currency come hell or high water becomes a lot less compelling."
Paul Krugman - How Reversible Is The Euro?

Krugman is certainly right. Looking over towards Athens right now, you can't help having that horrible feeling of deja vu. Adding to the uncomfortable feeling of travelling backwards rather than forwards in time (oh, I know, I know, when history repeats itself it only piles one tragedy onto another) is the uncomfortable presence of Charles Calomiris, a US economist of Greek origins. I can still remember reading, back then in the autumn of 2001, an article by the then Argentine Economy Minister Domingo Cavallo published in the Spanish newspaper El Pais which proudly proclaimed that everything was going well, and that the country's reforms were being generally well received with the regretable exception of "a small number of neurotic US economists who continue to insist that we will default and break the peg". He was, of course, referring to Calomiris, and at the time we were only a matter of weeks away from the dramatic moment when Adolfo Rodríguez Saá (the man who was President for a mere 8 days) would enter both history and the Argentine parliamentary chamber to utter the now immortal phrase "vamos a coger el torro por los cuernos" (we are going to take the bull by the horns). A phrase which was obviously belonged to the class of so called Austinian performatives, since at one and the same time as uttering it he effectively ended the peg. Well today Calomiris is again with us, and he is still hard at work going through the numbers, only this time round he is using his special insights to scrutinise his family homeland, for which he is prophesying not only eventual default, but also the generation of sufficient contagion to bring the whole Euro project itself to an untimely end. In an article in Foreign Affairs entitled "The End Of The Euro", he tells us:

Europe is living in denial. Even after the economic crisis exposed the eurozone's troubled future, its leaders are struggling to sustain the status quo. At this point, several European countries will likely be forced to abandon the euro within the next year or two....The only way out of this conundrum is for countries with insurmountable debt burdens to default on their euro-denominated debts and exit the eurozone so that they can finance their continuing fiscal deficits by printing their own currency. Here's a hint for Europe's politicians: If the math says one thing and the law says something different, it will be the law that ends up changing

Really, I don't think of Calomiris as a prophet (or even as a Cassandra), I don't even think of him as an especially insightful economist when it comes to the macro problems of the real economy, but I do think he has one exceptionally strong merit: he can do the math, and as he says, if it gets down to a battle between legal details and arithmetic, arithmetic will always win.

Easy Said & Easy Done, Down the Argentina Path We Go!

As it happens, the issue of Argentina as a reference case for Greece has surfaced again this week, in the form of an Op-ed in the New York Times by the co-director of the Center for Economic and Policy Research Mark Weisbrot.

Weisbrots's argument is not new, but it is different, not only because he thinks Greece would be better off leaving the euro (many economists share that opinion), but because of the apparent eulogy he makes of the Argentine case.

"For more than three and a half years Argentina had suffered through one of the deepest recessions of the 20th century......Then Argentina defaulted on its foreign debt and cut loose from the dollar. Most economists and the business press predicted that years of disaster would ensue. But the economy shrank for just one more quarter after the devaluation and default; it then grew 63 percent over the next six years. More than 11 million people, in a nation of 39 million, were pulled out of poverty"

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Now these are strong claims. But let's leave aside the issue of whether or 11 million people were pulled out of poverty or not, and dig a bit deeper into what actually happened in Argentina, and let's do this by comparing it with another country, one which arguably has similar social and economic development characteristics, Chile (see chart above). At the turn of the century Chile had a population of more or less 15 million, as compared with the 39 million Argentinians mentioned by Weisbrot. Now in 1998, just before Argentina entered its depression, Chilean GDP was some 79 billion dollars, while Argentina's was 299 billion dollars. Now let's fast forward to 2010, Argentina's GDP at the end of last year was 370 billion dollars, and Chile's 203 billion. That is to say, between 1998 and 2010 Argentina's GDP (as measured in dollars, we'll come back to this) increased by 24%, while Chile's increased by 156%. As they say in Spanish "no hay color" (there is simply no comparison). Especially when you take into account when that Chile has only 38% of Argentina's population, while it has 55% of Argentina's GDP. So over the 12 years between 1998 and 2010 Chile (which maintained a floating currency throughout) evidently did a lot better than Argentina (despite Argentina's abandonment of the float). And here's another relevant piece of information: between 1998 and 2010 the Argentinian price level rose by 143%, while in Chile the price level rose over the same period by 48%.

So why use USD as the measure of comparison? I do this since it gives the most convenient yardstick evaluation (euros would do equally well) of the relative external values of the two economies. This is important, since Argentina apparently high growth levels have been also associated with high inflation levels, which have been constantly compensated for by devaluing the peso. In fact Bank of America Merrill Lynch currency strategist - and former IMF economist - Thanos Vamvakidis makes an essentially similar point (although with different conclusions) in a research note covered recently by FT Alphaville's Tracy Alloway:

"In our view, ...(the results of our study).... point to the conclusion that exchange rate devaluations do not lead to permanent competitiveness improvements in rigid economies, such as in the Eurozone periphery. In this context, tail risk scenarios about EUR exit are misplaced. Structural reforms are the best bet to improve the periphery’s growth prospects, within or outside monetary union".

Does this whole debate sound familiar to anyone? Anyone remember when Italians were paying themselves in million lira notes? In fact, it was precisely to break the Southern European countries from the high inflation, high interest rates, periodic devaluation dynamic that the Euro was thought to be such a good idea in the first place. It hasn't worked as planned, but that doesn't mean that the most traditional and the most simplistic solutions are necessarily going to be the best ones.

On the other hand, does this mean we should then go on to dismiss the coming out of the euro option out of hand for Greece? Evidently not. Let's look at another comparison, this time Argentina and Turkey.

Now in 1998 Turkey had a dollar GDP of $269 billion, and by 2010 this had become $742 billion. That is it had nearly tripled. Yet Turkey's dollar GDP dropped sharply in 2001 following a substantial devaluation of the Lira. Conclusion, competitive devaluations are sometimes useful, so what makes the difference?

Well Paul Krugman got near to it, when he said in his article on Weisenbrot's proposal:

"Greece, as a relatively poor country with a history of shaky governance, has a lot to gain from being a citizen in good standing of the European project — concrete things like aid from cohesion funds, hard-to-quantity but probably important things like the stabilizing effect, economically and politically, of being part of a grand democratic alliance".

We can sum the essence of all this up in a couple of phrases "institutional quality" and "structural reforms". Or put another way, Turkey devalued as part of an IMF programme (it was actually recommended, in the days before the heavy hand of the EU took management control at the IMF), while Argentina broke the peg and devalued in order to get out of one. Turkey was not only able to benefit from the reform pressure instigated by the IMF (the stick), but also by the promise of EU membership under certain conditions (the carrot). Indeed, curiously, EU cultural reservations about Turkish membership have probably lead to far stricter reform hurdles than were either applied to the current members in the South or the East, and Turkey is undoubtedly the great beneficiary of this strictness.

Which brings us to the main point: should Greece leave or not leave the Euro? Well, let's go back to something Krugman said in another blog post (How Reversible Is The Euro):

"Think of it this way: the Greek government cannot announce a policy of leaving the euro — and I’m sure it has no intention of doing that. But at this point it’s all too easy to imagine a default on debt, triggering a crisis of confidence, which forces the government to impose a banking holiday — and at that point the logic of hanging on to the common currency come hell or high water becomes a lot less compelling."

or as he argues in his latest post:

"That said, Weisbrot is right in saying that the program for Greece is not working; it’s not even close to working. At the very least there must be a debt restructuring that actually reduces the debt burden rather than simply stretching it out. And the longer this situation remains unresolved, the less hope I have that Greece will be able to stay in the euro, even if it wants to".

The present situation is unworkable, and unsustainable, not only because the accumulated debts are unpayable by Greece alone, but also because the tiny size of the manufacturing industry Greece has ended up with and the general lack of international competitiveness of the Greek economy make an export-lead growth process with the present state of relative prices virtually impossible. There are solutions to both these problems consistent with remaining within the Eurone and without default - issuing Eurobonds to accept part of the Greek debt and enforcing a substantial internal devaluation to restore external competitiveness, for example - but since the adoption of these two strategies is virtually unthinkable given the current mindsets in Brussels, Frankfurt, Berlin and Madrid then we are more or less guaranteed to find ourselves facing some kind of Greek default, and given that the programme as it stands isn't working (this is where the situation so resembles pre-default Argentina as the extent of the fiscal correction means the economic contraction feeds on itself given that exports cannot expand fast enough to counteract the decline in government spending and domestic consumption), it would be strongly advisable to accompany this default with some sort of devaluation.

Put another way, if the most valid argument against going back to the Drachma always was that this would imply default, now that default is coming, why not allow Greece to devalue? As Krugman says, the issue isn't whether Greece would openly decide to exit the euro, the issue is what happens if the markets force this solution on Greek and European leaders against their will? Given the programme isn't working, the likelihood of this kind of event occurring in the next 2 or 3 years is far from being negligible, so why not be proactive rather than always relegating ourselves to being reactive? What matters is whether Greece becomes Turkey (oh, what a historical irony) or Argentina. If the powers that be can agree on an ordered restructuring of Greek debt, and a controlled exit from the Eurozone, then Greece has some possibilities of turning the situation round. If exit is forced on Greece in order to escape the clutches of both the EU and the IMF then the move will be, as I suggest in my title, simply the last exit to nowhere. And especially in a historic context of ageing populations and rapidly rising elderly dependency ratios, ratios which will only rise further if thousands of young people exit Greece in the search for work elsewhere, as young Argentinians did in 2002/3. That's another difference most people who make this comparison don't mention: when Argentina devalued the country still had a fertility rate which was slightly above replacement level. Greece has just had more than 30 years with a total fertility rate in the region of 1.3. So while Argentina could look forward to years of demographic dividend and rapid "catch up" growth, if things go wrong Greece can only look forward to an ever older population and ongoing social and economic decline

The tragi-comic events surrounding the fate of IMF Director General Dominique Strauss Kahn may well mean that we are about to see significant changes in that organisation. It is to be hoped that, if this is the case, such changes will also involve a rethink of the IMF's role in Europe's crisis, and in particular of the objectives and means of implementation of the Greek programme, with the Fund moving towards a less-eurocentric and more balanced position, one which would be in the collective interest of the community of citizens of the wide variety of countries the institution represents.

The Great Greek And Spanish GDP Mystery - One Hypothesis

2011-05-15T13:00:00.001+02:00

Many an economic eyebrow must have been raised last Friday when Europe's first quarter GDP data was released, and people discovered that the Greek economy had suddenly surged forward, rising by 0.8% over the level it had attained in the last three months of 2010 (or at a 3.2% annual rate, or faster than the US). Since almost everyone with knowledge of the situation is forecasting a further contraction in the economy this year, the result may have been thought to be a surprising one.

Well, there is no need to call in Sherlock homes just yet, or even the strong-arm boys from Eurostat, since I think I may have worked out what happened to Greek GDP in Q1, or at least I have a good working hypothesis. In the process we will also examine why it was that, against all prognoses, and against a colossal amount of anecdotal evidence that the Spanish economy is falling back towards recession, Spanish GDP actually accelerated.

But first, a brief intro to Econ 101 macro. It is important to grasp the fact that GDP isn't the be all and end all of economic analysis, and certainly doesn't give us a complete measure of economic activity. Indeed there are many economic processes which may be of interest to economists - levels of indebtedness, for example, which are simply not captured by the measure, since GDP is what it is: a measure of domestic value added, according to the following formula:

GDP = Consumer Demand + Investment Demand + Government Spending + Net Trade (change in exports minus change in imports) + Net Change in Inventories

Now, in general we know that the first three items on the list are falling in Greece. even if there does seem to have been some slight improvement in retail sales during the quarter, after a very steep fall in the autumn.

But what about the net trade component? Well, before going further it is important to consider is how this calculation works. Basically net trade can improve either by the rate of export growth accelerating, or by the rate of import growth decelerating. Now in Greece we know that exports have improved, but Greek exports are proportionally so small, and form such a limited part of total economic activity, how can they possibly pull the economy upwards in this way (causing a 0.8% q-o-q increase in GDP)? Well, looking at the chart for imports it can be seen that just as exports have been accelerating, imports have been decelerating, so the combined impact might be quite large (please note we don't yet have the March data).

This impression that it was as much a drop in imports as a rise in exports that was behind the sharp quarterly rise in GDP is further reinforced if we look at the year on year performance of the two variables. In recent months Greek imports are sharply down y-o-y (despite the surge in energy prices) while exports are up.

So GDP rose, but what about does this tell us about living standards? Well, this is just the point. Since the fall in imports reflects a fall in demand, it implies a fall in living standards,and this is the strange thing about what GDP measures and what it doesn't measure. GDP can rise sharply, even when unemployment is rising, and people are getting poorer. This is largely because one of the things GDP doesn't measure is the evolution of what some call the "financial balances" (for more explanation of this idea see the pioneering work of the Canadian economist Rob Parenteau (here in somewhat polemical form, and here as a more technical explanation).

In countries running an ongoing trade and current account deficit, the rise in living standards which comes from an increasing excess of imports over exports figures in national accounts as an output negative (apart from the transport and retail outlet activity which are a spin-off), and the counter party to all that "living beyond our means" feel-good added credit-driven purchasing power really only shows up as a negative item on the financial side of the accounts, as money borrowed from the exterior, money which is used to finance the deficit. It is a negative item, because all that potential capacity to spend is being diverted away from national activity to external activity. So while you pay for the products consumed (through debt) others get the long term benefit of your spending. Which is why it is such a bad idea to run sizeable current account deficits over any great length of time, since they are financed by credit, and credit is only a way of transferring demand from the future to the present, which means you will feel richer now, and poorer in the future, and this is exactly what is happening to Greece. It is also why the only way to put the situation straight is to export more, and run a trade and current account surplus, since then the value of your net external debt falls. So the correction is necessary and inevitable, although the curious thin is that while it is taking place, and while exports are rising and imports and living standards falling GDP rises, even though people feel much worse off.

Obviously, having an economy appearing to accelerate like this is a bit counter intuitive. Evidently it is not the same as having a devaluation-induced import-reduction with demand remaining equal, and more productive activity taking place inside the country as relative prices result in steady import substitution, but then demand deflation policies have these peculiarities attached. Maybe we could think of the type of correction Greece is engaged in as less future demand being brought forward to today, under the hope that the subsequent path of the economy will eventually be on a higher level than it otherwise would have been. Pay now, live later.

In the Greek case, since private sector borrowing is at a total standstill, and public sector deficit borrowing is being steadily reduced, the current account deficit is being forced to close, with the consequence that since exports can't rise much (due to competitiveness issues, and their low base) imports will need to fall while unemployment will probably continue to rise.

If this analysis of what has been going on in Greece is correct, then it can also help us understand the latest set of Spanish GDP numbers a bit better. According to the latest data, in the first quarter of this year Spain's GDP rose by 0.3% over Q4 2010 and by 0.8% over the year earlier quarter. This surprised many analysts since the Bank of Spain has previously estimated growth to be around 0.2%, and a number of 0.1% was often anticipated.

In theory the Q1 performance marks an acceleration over the 0.2% quarterly rise registered in the last quarter of 2010. Such an acceleration seems odd, since all the recent data, industrial output, retail sales, unemployment has been negative, and doubly so since the government is in the process of a very sharp (3.2%) fiscal adjustment process.

Yet, if we come to look at the relative import/export performance, we will see a milder version of the same phenomenon. It seems exports rose and imports fell in the first quarter, creating a very special kind of "win-win" situation.

This is a much milder version of the Greek story, but possibly similar processes are at work in both cases, as Spain's previously large current account deficit is also being steadily forced to close.

On the other hand, in Spain's case other factors might be at work, like overspending before this month's regional and local elections. In any event, I am describing all the above as a hypothesis because we still don't have either the March trade data or the detailed GDP data. When we have access to both of these we will have a better idea of just how valid this hypothesis of mine actually is. At the end of the day, one swallow doesn't make a summer, and one month's GDP surprise is simply a drop in the ocean in relation to the major challenges which face these economies in the quarters and years ahead.