Friday, 28 October 2011

Magical thinking in Euro Wonderland

After a tense few days, EU leadership have finally come up with a draft proposal for easing Greece's debt problems, recapitalising banks and helping other debt distressed countries to finance their debt more easily. The full text of the EU leadership's statement is here (downloadable pdf).

The devil will be in the detail, of course, which is pretty sketchy at the moment. But my initial impression of the report is that it contains far too much magical thinking. External agents will apparently willingly provide money to distressed Eurocountries when the ECB won't; growth will somehow appear in highly-indebted countries despite severe spending cuts and lack of inward investment; countries with uncompetitive business sectors and large trade deficits will somehow balance their budgets. And financial conjuring tricks will create the amount of money the report says will be available. How these will work in practice remains to be seen.

Media interest in this report has focused on three areas:

- Greek debt restructuring
- bank recapitalisation
- the "big bazooka": use of the EFSF to provide financial assistance to debt-distressed Eurocountries and if necessary to provide capital to insolvent banks

According to Gavyn Davies in the FT, all three of these are inadequate. I'm afraid I have to agree.

1. Greek writedown.

Gavyn Davies says:

"The 50 per cent haircut on private debt passes the litmus test, but there has been no participation by the official sector. The effect is to reduce the Greek debt ratio from 152 per cent of GDP in 2020 to 120 per cent, assuming that all of the Greek fiscal restructuring can be implemented in the meantime (which seems highly improbable). These debt figures are higher than expected, and may well prove unsustainable once again. So the Greek headache has not been definitively solved, and probably will not be until there is a significant write-down of official debt."

The proposed Greek debt writedown involves private creditors only. Once again, public creditors - notably the ECB - have got off scot free. Quite apart from the fact that this is unfair to private creditors, it also means that the writedown is far smaller than it needs to be to make any significant dent in Greece's debt mountain.  The ECB should now acknowledge that it must write down the value of its Greek collateral.

Greece is now in partial default and it remains to be seen whether ISDA will declare a credit event. So far it seems they won’t because banks did actually agree to the 50% haircut.

2. Bank recapitalisation

I've commented already that the 9% capital requirement might not be quite what it seems. Gavyn Davies is lukewarm:

The litmus test said that €300bn of recaps would be impressive, while €100bn would be skimpy. Predictably, the summit has chosen the skimpy end, at €106bn. This will only be enough if the rest of the package, designed to calm the sovereign debt markets, is highly successful.  Clearly, European leaders were worried about the possible effects of making excessively onerous capital demands on the banks, given they were threatening to lever their loan books in order to hit the new capital ratios. Regulators have been told to ensure that this does not happen.

But there is a glimmer of light:

.....there appears to be an intention to introduce a new EMU-wide guarantee scheme which will help banks to secure unsecured medium term funding. This could be a very important step towards restoring confidence in the banks...."

3. The "big bazooka"

The supposed extra 1tn euros available to distressed sovereigns and undercapitalised banks through the EFSF facility is fictional.  Gavyn Davies says:

"It is important to be clear that this does not involve bringing any new money from the eurozone itself to bear on the problem. At most, it involves a subsidy of about €200-250bn (which was already committed in existing EFSF guarantees) from the stronger members of the eurozone to attract new investors into the market for Italian and Spanish amounts to 8 per cent of the outstanding debt of these two countries, which may not prove compelling. Talk of a trillion of new money, apparently conjured out of thin air by financial engineering, is inherently misleading....."

So the EFSF will be leveraged, not funded. Exactly how that will work is yet to be disclosed, but the idea seems to be that there will be some combination of taxpayer guarantees from member states to insure bondholders against default (some sort of CDS insurance, I suppose), plus hopefully some actual funds from external sources such as the IMF and China. The IMF probably will cooperate but it is unclear (to me, at any rate) what the incentive would be for China to provide money to the EFSF rather than investing directly in Eurozone countries. I wouldn't have thought that propping up distressed sovereigns without any real prospect of even recovering the investment any time soon would be particularly attractive to them.

It remains to be seen whether banks can raise the necessary capital from private sources. If not, then it seems the EFSF can be tapped for this as well. How far is 1 trillion euros expected to stretch?

At this point the media lose interest. But actually there is much more to this report, and the implications of it are far-reaching. These are the matters that the media are not discussing - and should be:

1. The provisions of the European Semester regarding economic coordination between member states are to be fully adopted. That means the European Commission will review national budgets before they are implemented to ensure compliance with the Stability and Growth Pact.

2. Despite the statement that the Eurozone is "committed to growth", there are no measures whatsoever to promote economic growth in the debt distressed countries. Instead, the Eurozone is still adhering to its ridiculous austerity agenda, which will only serve to drive those countries further into recession and eventually drag the rest of the Eurozone down too. Concerns have now been expressed about this from around the world.  Because of this, reduction of Greek debt to 120% by 2020 looks extremely unlikely and further default and restructuring seems inevitable.

3. Countries in deficit reduction programmes will be supervised by the European Commission to ensure they comply with the economic (i.e. austerity) measures imposed on them as the price for their bailouts.  This supervision is to be introduced immediately for Greece. But economic supervision of Greece is not accepted by its population and is likely to be fiercely resisted, especially as it is certain to involve even harsher cuts and austerity. There is no democratic mandate for this provision in the EU statement as far as I can see.

4, Legislative commitment to balanced budgets "in accordance with provisions of the Stability and Growth pact" is now required from all member states. But for deficit countries to achieve this they need inward investment and exports. Germany and the Netherlands therefore should invest invest their trade surpluses in their European neighbours and encourage domestic spending to attract imports. There is NO discussion of the large trade imbalances between the Eurozone countries and no commitment from either country to increase inward investment in deficit countries. And both Germany and the Netherlands have large fiscal surpluses. The Stability and Growth pact limits deficits to no more than 3% of GDP but imposes no limit on surpluses - so "balanced budget" doesn't quite mean that, does it? Are Germany and the Netherlands going to adopt expansionary fiscal policies to reduce those surpluses despite the lack of incentive to do so? Or are EU leaders so economically illiterate that they don't realise that fiscal tightening in deficit countries must be accompanied by fiscal expansion in the surplus countries or the whole area will end up in recession?

Financially, all this proposal does is kick the can down the road for a bit longer. But I’m very concerned by the authoritarian tone of many of the pronouncements in the report.

For me the really striking feature of this report was the evident intention to use the opportunity created by near-collapse of the Euro to push forward the "cause" of the single currency. New measures to promote fiscal convergence are principally aimed at further embedding the Euro, not sorting out the very real economic problems that Eurocountries face. The EU leadership are not really interested in fixing what is wrong with the Euro model as it is at present. They are buying themselves time to move the Eurozone further towards the model they really want - full political and economic union.

If you read the statement in this light, suddenly everything makes sense. Eurozone leaders believe that eventual political and economic union is not only possible, it is inevitable and will be achieved within a short timespan. Wave the magic wand of European unity and - hey presto - Wonderland will be restored.

So there is no need to provide adequate funding to the EFSF, no need for more than minimum Greek debt relief, no need to do anything to relieve the real economic tensions in the Eurozone. The only thing that matters is the austerity measures that they believe will turn all Eurocountries into mini-Germanys. And any country that can't or won't implement those measures obviously hasn't sufficiently bought into the Euro project so must be coerced with economic supervision and - eventually -with sanctions. Never mind the cost in economic ruin and human distress. Never mind whether the people of the country concerned support those measures. They will be imposed by an unelected, unaccountable outpost of the European Commission residing within the errant country and with carte blanche to override the elected government's decisions regarding the conduct of their economy.  Furthermore, ALL countries in the Eurozone will now have to consult the Council of Ministers before implementing economic policies mandated by their electorates.

I don't oppose the aim of political and economic union in the Eurozone. Far from it. In my view full political and economic union is the only way the single currency can survive. But it must be achieved with the full knowledge and consent of the PEOPLE of the Eurozone. Using this crisis to force through far-reaching changes designed to move the Eurocountries towards such a union by undermining national democracy smacks of Shock Doctrine.

Behind the mask of economic aid to debt-distressed countries lies a very real attack on democracy. This statement is deeply disturbing and to me abhorrent.


  1. Euro bailout - an animated explanation
    Are you confused about what the Euro bailout actually is? So were we! Tom Meltzer tries to explain with the help of his animated friends …

  2. This comment has been removed by the author.

  3. I totally agree, I'll just add comments as an appendix.

    The Stupidity Pact (Stability and Growth Pact or SGP) version 2.0 is not very user-friendly. The motive is hidden in this quote:

    "There is no example in history of a lasting monetary union that was not linked to ONE state." Otmar Issuing, Chief Economist of the German Bundesbank Council,1991(!)

    When the SGP affected the core (Germany and France) the budget limit rules were changed (2005). They are not changed for small members.

    The transfer of power away from elected governments began with the loss of monetary and exchange policies.

    Independent and elected governments automatically generated deficits and sovereign debts during recessions. Tax revenues fall and unemployment benefits rise. A choice is then presented: accept financial discipline (and Central authority) or face financial terror and chaos. An economic terms of surrender. The dogmatic fixation on austerity enforces it. Democracy is secondary .. something to deal with later.

    The European Semester completes the transfer of power. It is done without electoral consent to unaccountable un-elected officials and institutions, while each country's electorate either blames each other or gasps at the latest display of financial wizardry.

    I remember this quote in July. by Jean-Claude Trichet:

    "Would it go too far if we envisaged euro area authorities a much deeper and authoritative say in the formation of the country's economic policies if these go harmfully astray?" (

    Which means, in a ('fixed-exchange' rate) Euro Zone with a permanent North-South trade imbalance, some countries are always more likely to go 'harmfully astray' Does this imply that some countries will be permanently under EC administration?

    The whole process of EC integration has been very undemocratic. The French and Dutch in 2005 voted against a European Constitution and, when Ireland voted no, it was made to vote a second time to get it 'right'.

    Greece has taken its medicine. It is now in the European funny farm. Nobody listens to a crazy person. They ought.

  4. What is in it for the Chinese?

    European nations with more than 100 million tonnes of goods inwards via maritime shipping*: Belgium. Germany, Spain, France, Italy Holland, UK. One third of that goes to Spain and Italy. Not all of that inward shipping is from China, of course. But it is one example of why maintaining stability in European countries, perhaps for a short period, might be important to China. Nobody wants their distribution channel to break.

    BE 111.7 6.6%
    DE 160.6 9.5%
    ES 248.8 14.7%
    FR 216.9 12.8%
    IT 319.5 18.9%
    NL 333.5 19.7%
    UK 303.6 17.9%
    Total 1694.6
    Spain/Italy 33.5%

  5. This is not so much economic integration as imperialism. With money as the army instead of german tanks or Napoleonic infantry.

  6. Greece should never have been part of the Euro Zone in the first place. This will hopefully make the EU think twice about taking new countries into the Euro Zone and potential entrants as well. Greece and the EU have both suffered fromt this union