piigsty

There has been much debate lately over the Irish economy. Ireland has been held in high esteem across European capitals as somewhat of a poster-child for sticking the bailout conditions laid down by the ‘troika’ (The EU, European Commission, and International Monetary Fund – IMF). This means following a plan to shrink the economy and bring the huge gap between revenue and expenditure closer together. There are, of course, only two levers for a country in monetary union (the euro) to do this – raise taxes and/or cut spending – neither is ever popular buts its same across Europe.

On April 30, the Irish Department of Finance released its report on Ireland’s medium term economic on forecasts called the Stability Programme Update (SPU) which each eurozone country must submit to the European Commission annually as part of the European Semester process (aligning eurozone fiscal policy).  The findings were:

Comparison of SPU and Budget 2013 (Presented December ’12)

In summary:

Growth

• The Irish economy is forecast to grow slower (-0.2%) than the original projections at the time of Budget 2013 in December.

Debt

• The general government (GG) debt to GDP ratio (an ideal ‘compliance’ ratio and precondition for joining the euro being 60%), is now projected to stand at 123% this year, falling to 116% by 2015, marginally better than originally predicted in December.

Deficit

• The other Maastricht criterion, that of the ‘excessive deficit procedure’ or EDP is forecast to be -7.5% this year (total revenue less spending), achieving the required level of -3.0% by 2015, as projected in December.
• The approximate €750m – €1bn savings from the ‘prom’ note deal which will knock a good chuck off the cost of servicing the national debt are assumed to help reduce this figure.
• On the positive side, the 2012 figure was -7.6%, well within the EDP target of -8.6%. The Irish economy is now performing at or above expectations in this area and the economy remains on target to hit -3.0% by 2015. Good news and politically valuable breathing space for Finance Minister Noonan as he crafts the next series of budgets. However, successive government ministers insist that austerity is not option and the proposed €3.1bn adjustment required this year under the EU-IMF programme is going ahead in the mid-October budget.

All this is line with the European Fiscal Compact (also known as the Irish Fiscal Stability Treaty) which was ratified by referendum by the Irish people on 31 May by a margin of 6:4. This allowed Brussels to push ahead with more formalised procedures under the Stability and Growth Pact (SGP) to penalise countries which did not follow their commitments and get their finances in order, as was the cost of joining the euro in the first place.

On May 3, the European Commission released their own Spring 2013 Economic Forecast (more here)

The differences between the SPU and the Commission forecast are, notably, slightly more pessimistic than the April 2013 SPU update with a growth project of +1.1% for 2013 rather than the Department’s forecast of +1.3%. But the pessimism is uniform. The Commission forecasts a more rapid decline in the current deficit fueled by the ‘prom’ note deal, a further public sector wage deal with unions (Croke Park II/Haddington Road) and other adjustment measures taking effect from the 2013 budget.

Why the pessimism?

Simply put,weak demand for Irish exports. The continuing uncertainly in the Eurozone with Cyprus, Slovenia and others, coupled with political uncertainties such as the unpopularity of French President Hollande and the federal election in Germany this November. Another issue which could negatively affect exports is the expiry of pharmaceutical patents the so-called pharma patent cliff.

The main issue is that despite the relative buoyancy of exports, there has been no real material recovery in domestic demand. What these forecasts agree on is that 2013 may be the pivotal turning point.

Irish Business Employers’ Confederation (IBEC) Quarterly Forecast

The IBEC quarterly review follows on from the SPU, making particular reference to domestic challenges such as unemployment (stubbornly stuck at 14%), weak consumer confidence and domestic demand and the issue of debt.

But positively, the Irish economic engine appears primed for re-ignition. The only problem is…Europe.

The key issue is ‘austerity fatigue’ across EU capitals and a renewed emphasis on growth rather than a strict doctrine of austerity. While Ireland appears to be successive, peripherals economies such as Spain, Portugal and Greece remain fragile.  IBEC recommends, as ‘we are 85% of the way toward returning the fiscal deficit (EDP) below the 3% limit…the time is now right to ease back somewhat the pace of fiscal adjustment” – the proposed €3.1bn due in the mid-October budget.

Summary of Irish growth prospects

A number of other studies have also forecast Irish growth ahead, summarised here.

On average, Irish growth is therefore forecast at 1.46% (2013) and 2.8% (2014). Far below the ‘Celtic Tiger’ highs of 7%+ but much better than in recent times.

Read more here.

The Irish AG Sets the Ball Rolling…

When the Irish Attorney General Máire Whelan, decided in late February to throw the decision over the ratification of the European Fiscal Treaty to the Irish  people in a referendum (since scheduled for May 31^st), the euro plunged on world markets and has remained somewhat perilous ever since.  It has become increasingly clear that Europe must be dragged kicking and screaming into making the right decisions for its people, with political considerations eclipsing the need for some proper, sound economic logic. PIIGSty has long endorsed the idea of some degree of European control over eurozone fiscal matters because, put simply, that is what is supposed to glue together every monetary union. Why? Because if you want to play the game, you must adhere to the rules. The rules of the euro are very clear – and all euro-users (including Germany and France) are all culprits of massaging the rules (Stability and Growth Pact – SGP) to suit themselves. Now, its back to basics.

The Historical Background

A recommended PIIGSty study on the euro is provided here. In a nutshell, when the euro began circulating in 2002, the European economy was so strong that any idea of caution was viewed as unnecessary negativity. As economists began to query the honest reporting of the macroeconomic situation in Greece by the Greek finance ministry, the party just continued. Like the drunken older uncle at the wedding, the guests politely ignored him. A bit of an embarrassment – sure! – but hes family now and hes not really having an impact on the grand banquet itself.  When the German Bundesbank in 2005 warned that relaxing strict entry rules to the euro (Maastricht Criteria) and fiddling around with the maintenance rules of the wider euro-union (SGP) to suit those countries who happened to breach them (i.e. France and Germany, at that time – among others) – another huge red light was ignored. To use a separate railway analogy, the eurozone train had been gathering speed down a steep slope, and as the terrain leveled off, the driver worked to release the breaks to maintain the high speed the passengers demanded.

And so we come to the current crisis. PIIGSty has a number of articles on how and why we got here. But what about how Europe plans to avoid a repeat experience. The answer, or part of the answer, is the EU’s Fiscal ‘Stability’ Treaty or Fiscal Compact.

The Point of the Treaty?

The merits behind the Treaty, from the EU’s standpoint, are logical and ultimately imperative – as has frequently been discussed here on PIIGSty.com.  FYI here it is http://www.european-council.europa.eu/media/579087/treaty.pdf

Put simply – centralisation of fiscal control of eurozone national budgets is seen as necessary for both economic and political reasons. Economic – because centralised control means insisting on common standards and avoiding some states freeriding on the backs of fiscally responsible countries (i.e. Germany). Political – because it removes (or at least reduces significantly) the temptation for political leaders to throw taxpayers money around to gain political popularity and advantage. Reasoning is straightforward enough. Considering the complete mess the PIIGS have made of their own finances (some excessively more than others, of course), the Franco-German alliance of Sarkozy and Merkel (‘Merkozy’) agreed at Deauville in 2010 that to protect EMU (i.e. the euro) means achieving 2 particular means:

1. An agreed crisis management strategy in the eurozone replacing the ‘headless chicken’ approach currently in operation thanks to ambiguous ‘bending’ of the Lisbon Treaty
2. Formal powers to suspend an EU member state in the Council of Ministers in the event of violation of ‘basic principles’ of EMU

One particular offspring of the Merkozy Deauville love-in was the controversial EFSF (see here). So, how to enhance coordinate fiscal eurozone fiscal policy?

Simple. A souped up Stability and Growth Pact (SGP) with teeth – actual formal concrete power, forcing euro-users to return to 3% budget deficits and 60% Debt : GDP ceilings  –  the same end targets of the current austerity programmes across the PIIGS  along with a collective power to penalise those who don’t respect the rules.

Unquestionably, the role of the European Central Bank (ECB) in the European debt crisis is paramount but its often misunderstood. Arthur Beelsey in the Irish Times paints an excellent picture “Brooding like a colossus in the centre of the fray stands the European Central Bank, an innately conservative institution that has ditched one sacred cow after another in the chaotic struggle to calm the disruption.” ‘Conservative’ is code word for keeping a very tight grip on the money supply so to keep European exports strong. Problem is – you can’t always have price stability and full employment (they’re two conflicting policy goals, in a normal economic situation). Manipulating the economy, especially one as diverse as the eurozone-17,  is an extremely delicate process which European Central bankers tend to be very cautious about.

The ECB (which the Germans hold the strongest cards) has always assiduously adhered to the model on which it was based – the German Central Bank or Bundesbank- and as such has remained committed to an ‘overseer’ policy of strict price stability (and restricting its functions to setting interest rates) rather than intervening in the market to reduce the volatility of those boom-bust cycles, such as is practiced by the US Federal Reserve. However, its preferred non-confrontational, dormant, staid and strictly collective role overseeing the cautious monetary policy of the eurozone-17 bloc has been changed hugely by various crises in which component nations, notably the PIIGS, find themselves engulfed with.

Article 23 of the ECB statute says that “the ECB may conduct all types of banking transactions in relations with third countries and international organizations, including borrowing and lending operations.”

This effectively rules out the ECB directly intervening in buying sovereign debt from countries under law but it DOES NOT rule out the ECB buying debt indirectly (from secondary sources) including pension funds, European banks etc if the whole point of doing this is to keep the eurozone monetary policy flowing. So its fair to say that a new ECB policy of roundabout intervention in the markets to quell the current crises is a doctrine that many are fundamentally opposed. The controversial policy of ‘printing money’ or quantitative easing, as practiced by the Bank of England, the US Federal Reserve and others, is an absolute non-starter for inflation weary ECB officials.

But the ECB has been forced into a bit of a U-turn (and a sort of compromise). After all, it is the responsible Central Bank for the eurozone at a time where commentators appear to be endorsing the collapse of the euro or, at the very least, its fragmentation back into competing national currencies and a ‘return of national sovereignty’. In the meantime, stung by inaction, wealthy PIIGS citizens withdraw billions from PIIGS banks leaving respective governments (and the ECB) to step in to prop them back up. Its a self defeating spiral.

The ECBs Bond Buying Initiative

The credit crunch and the ensuing banking crisis changed everything. For the first time, it appeared that the growth of the European economy would be severely dented and a recession, which appeared preventable, would hit hard. European banks were far too endemic in the European economy and their collapse was unfathomable.

• August 2007/September 2008: ECB pumps money into European banks. After the collapse of Lehman Brothers in September 2008, ECB provides European banks with cheap loans to improve credit and short term funding availability in the eurozone as the interbank market seizes up.
• May 2010 : €100bn-€110bn 1^st Greek bailout sees the ECB, for the first time, get involved in the other crisis, that of sovereign debt by buying sovereign debt (bonds) on the secondary market to prop up Greek, Irish and Portuguese ‘at risk’ bond yields and avoid contagion
• November 2010: Ireland requests a bailout with the controversial conditions attached whereby senior bondholders would be repaid in full.
• February 2011: Head of the German Bundesbank  and member of the ECB Governing Council Axel Weber resigns in opposition to the continuing ECB bond buying programme
• May 2011: Portugal requests a bailout. At this stage, the ECB bond buying programme to prop up Greek, Irish and Portuguese bond yields is clearly proven ineffective. ECB has bought a total of €75bn in bonds.
• July 2011: €110bn 2^nd Greek Bailout announced
• August 2011: The ECB begins a similar action to buy Spanish and Italian bonds. ECB has bought a total of €115.5bn in bonds.
• September 2011: German Jürgen Stark, member of the ECB’s Executive Board (considered ECB  ‘Chief Economist’) resigns citing disapproval at the ECB bond buying programme.
• October 2011: Proposals to bolster the €440bn bailout fund via leveraging (rather than direct financial contributions) to €1tn announced along with a €130bn 3^rd Greek Bailout. Markets remain unconvinced of the sustainability of PIIGS finances and national solvency with the ‘fluffy’ EFSF proposal. ECB has bought a total of €173.5bn in bonds.
• November 2011: Amid soaring bond yields for Italy (and to a lesser extent Spain) IMF and eurozone officials discuss the idea of ECB lending to the IMF to bolster direct bailout funding to European nations in difficulty as earlier EFSF proposal failed to calm the markets. The level of ECB ‘cheap’ loans propping up the PIIGS banking systems is immense, at €180bn in Ireland alone.

IMF Involvement = More Radical Action?

In truth, more radical action is now inevitable, as this series of articles in Der Spiegel makes clear. The form of this action may be something unlike anything the Germans and the ECB ever wanted to contemplate, or it might mean outsourcing responsibility. So, who steps up? Its appears the IMF will, in two ways…

• IMF supervision of national budgets and reform proposals in exchange for aid tranches
• IMF becomes the European lender of last resort by issuing IOUs (and possibly bolstering the EFSF), rather than the ECB which never forecast that as its role (unlike national Central Banks).

Both of these ideas are hugely sobering ones for European technocrats and those supportive of the grand goals of the European project. Supervision of national budgets is effectively an admission of the inability of the European Commission to fulfill that function within the debt bloated PIIGS economies. Direct control of the eurozone debt crisis by the ECB in partnership with the IMF, shifts the onus for action onto the IMF. This might be a technical stroke by the ECB to avoid becoming entrenched in the debt crisis but it represents a clear admission of failure by European politicians in not being able to come up with a lasting, sufficiently funded compromise over the past 4 years. Either way, this equates to subordinating monetary policy to the IMF and running a dual IMF-ECB policy, potentially ruining the effectiveness of both. The Germans are understandably unlikely to support this.

The optics of the IMF effectively taking charge of an internal European crisis is a more destabilising factor for Europe than a mere debt crisis alone. Europe is destroying the very unity it has spent 60 years to carefully mould. By avoiding coming up with a comprehensive solution themselves (instead focusing on patchwork ‘sticking plaster’ solutions), the shift to the ECB and now, possibly, the IMF in Washington D.C. is hardly a shining example of European community action during times of adversity.

Europe has come a very long way from its early days where geopolitics and security concerns trumped pure commonsense economics (great oxymoron there!). PIIGSty is going to go out on a limb here and suggest that, if you strip away the hysteria and overreaction, Europe is more secure than it first appears. The problem in Europe isn’t necessarily the economics. Using the logic from a number of commentators, we have compared a number of European countries most featured in recent debate. The categories are:

• High Risk: PIIGS – Portugal, Italy, Ireland, Greece and Spain
• Moderate/Mid Risk: France and Belgium
• Low Risk: Germany, Netherlands and the UK

Budget Deficits

The correlation between the actual figures and the perceived ‘risk’ according to most commentators is puzzling at first glance. The following table outlines the change since the formation of the euro in 1999 (Greece having joined in 2002 and the UK a non-member for comparative sake).  The slide in budget balances give is uniform across the board. The PIIGS look like the worst offenders…but Italy (@ 2.9% change) looks quite stable. The erosion in the public finances in 2010 gives an insight into why Ireland, Greece and Portugal requested an EU-IMF bailout deal. Spain however, with a worse situation than all three, did not. Italy witnessed a moderate change from 1999  levels of less than 3%, similar to ‘moderate risk’ nations of France and Belgium. The Italian problem must lie elsewhere.

*The Irish figure amounted to a deficit of €50.3bn including an exceptional refinancing cost to prop up Anglo Irish Bank  of around €32bn-€34bn . Without this, the level would be about 12%

Debt: GDP

So, clearly the level of sovereign debt in the PIIGS is quite substantial. Ireland, Portugal and Greece (all EU-IMF bailout recipients) have increased their sovereign debt levels by almost identical levels since the formal creation of the euro in 1999.  Italy and Spain have very different (and more modest) results.

Putting all this together pictorially, we get…

Conclusion

The picture isn’t as straight forward as some commentators suggest. If its all about sovereign debt, then why is Italy suddenly a ‘panic’ problem when the level of debt has changed very little since 1999. Spain has even witnessed an improvement in its position since its entry into the euro.  Looking at budget deficits, its clear that some countries (UK, France, Belgium and the Netherlands) are arguably not in a comparatively better positions than Italy. The ‘High Risk’ category is sufficiently large and feasibly encompasses a wider selection of European countries than is clear at first glance. Truly, the problem of debt and budget deficits is more of a European problem than some countries are willing to admit.

You never know. Is it possible some countries are more willing to pass the burden onto the PIIGS to avoid scrutiny and their own economies by investors? Is this all about governance? Are countries with more stable governments (such as in the UK) more likely to weather the storm and thus their technically ‘High Risk’ position isn’t viewed as serious by the markets?

Food for thought at least…

Hysteria has returned and analysts are running around declaring Euro-doom. Not a rare thing these days but calmer heads should prevail and appropriate analysis shared. Now, for Europe and the euro, its all about Italy. No surprises there as Italy has been on the radar of European leaders as a ‘worst case scenario’ yardstick for months. Effectively, we’re entering the ‘we’re all screwed’ area of European economic diplomacy. Its becoming too late to make the decisions that should have been made when the sovereign bailouts began with Greece in May 2010 (nearly 18 long months ago).

Berlusconi’s Bond Yield Boom

So, Italian bond yields are rising sharply. We all know why this is. First, and foremost, the ECB were actively engaged in frantically buying Italian bonds to keep the yield rate artificially low (to buy the politicians time to come up with a lasting solution…which hasn’t happened). Secondly, and most recently, politics has intervened with Berlusconi’s eventual resignation becoming the key issue…and the likely ‘headless chickens’ election clamour that will succeed his stepping down as PM. Italy isn’t exactly an exemplar model of stable European governance (it has had 62 governments since the end of WW2 – effectively 1 a year). Most Italian PMs rule with a shoestring majority and shifting coalitions with their tenures usually ended before any real ‘governance’ takes place. Berlusconi won an outright majority in 2008 (but has been beset by underage sex scandals and corruption allegations leveled at the billionaires media empire). All this makes for fascinating innuendo and tabloid headlines but nothing for steering Europe’s 4th largest economy (Worlds 8th largest) during a very challenging economic environment.

In a previous in-depth PIIGSty musing , we assessed the ‘tipping point’ for requesting EU-IMF bailouts at around 7-10%. This is the danger zone.

How does Italy fare? (November 9, 2011)

You can see why (purely simplistically) why European leaders are starting to get extremely nervous. Italy, with €1.9tn of sovereign debt is over 7.5 times the ‘new’ level of Greek debt of €250bn after the October 27 Agreement. Italy is also ‘too big to rescue’ under the current €440bn EFSF fund. Even with IMF help, Italy appears a bridge too far. Europe has dithered and participating in reactive patchwork decision making and ‘sticking plaster’ solutions for the past 18 months.

Time might have just run out.

The aftermath of the recent October 27 EU summit, a recent article by Dunstan Prial for Fox Business News summed up the current state of affairs in the eurozone (EZ) debt crisis brilliantly “Europe puts out the fire but theres still a lot of smoke.” And less than a week later, Greek PM George Papandreou, to massive surprise from European leaders, decided to provide a fresh spark – and called for a referendum on the overall Greek bail-out plan to be held as early as December 4th (this call has since been endorsed unanimously by the Greek cabinet).

The Three Pronged Greek Bailout Plan

This ‘plan’ is effectively 3 plans with 3 bailouts in one form or another since May 2010. It ain’t pretty. For the Greek government, this means receiving a running total of €340bn+ of EU-IMF aid in exchange for agreeing a series of tough reforms: slashing public pay, a €50bn privatisation programme (by 2015), deep labour market reforms , new taxes and committing to repayment of the remaining Greek national debt (Just sliced down in the most recent plan to around €240bn from €340bn). Granted, the plan is extremely draconian and is vehemently opposed by working Greeks. A valid criticism does exist with the European obsession with following Merkel – the ‘High Mistress of Austerity’ as the UK Daily Telegraph referred to her – by shrinking the size of economies when they need to grow. Regardless, the plan as proposed and the effective economic leadership of the Greek economy by Franco-German dictat is the only thing keeping Greece credible in the eyes of the markets.

The Almighty Greek Gamble

With a shoestring majority in parliament, Papandreou’s government is already extremely weak and desperate to regain some popular support in the midst of deep social unrest. This is a major gamble. Sometimes, such a gamble can pay off handsomely. On the 26^th of October, Merkel herself gambled by holding a full Bundestag vote on a further expansion of the EFSF prior to an EU summit, when it wasn’t necessary (a special parliamentary committee is gifted by the powerful German Constitutional Court to do this). In the end, she won a mandate in EU wide negotiations, with 503 of 596 MP votes.  For Papandreou, his gamble has put a gun to European leaders heads – and they aren’t in the best mood for more compromise. They’re already rapidly exhausting their own political capital with no short term gain. One could guess that they are gambling that the much more favourable terms of the October plan (compared to the early July version), suggest that forcing Europe to try again will produce another even more favourable (pre-referendum) plan. Thats the presumptive theory, as PIIGSty sees it.

Problems

While all this might make everyone feel slightly more comfortable, there are some very obvious problems…

• Greek Debt: GDP of 120% is more sustainable than the (currently projected) level of 165-175% for 2012 – but who is to say that even this is sustainable. A level of 120% is the same as the current Italian level of indebtedness which is causing such consternation. Studies, notably those by Rogoff and Reinhart have suggested that 90% is the most feasible level which won’t cripple growth or risk insolvency (and so convince the markets)
• EFSF: The proposed increase from €440bn to €1tn is mainly through promises of Asian assistance (or partnership) and providing ‘insurance’ on bond purchases on 20-30% of the value. That still leaves 70-80% ‘uninsured’. Both aspects are far more vague and of debatable relevance than they might first appear. The risk remains AT ANY PRICE!
• The Greek Bottomless Pit (and that Referendum): For Europe, giving Greece nearly half a trillion euro (in either direct bailout funds or write downs) and receiving weak assurances, and reluctance to reform while market turmoil continues unabated – is pushing Merkel and Sarkozy (and their governments) into full and open questioning about whether Greece should remain in the euro and, by natural extension, the EU. Saving Northern European banks, for now, might seem worth the effort. If the Greek bailout ‘referendum’ fails, then – whether the Greeks like it or not – their state will be declared insolvent by the markets and face a messy default. Those Northern European banks which can’t absorb the impact of a Greek default will also find themselves insolvent.
• The Northern European Economies: With a combined €750-€800bn of debts and sluggish interbank funding, the economies of Northern Europe are very aware of the ticking ‘Lehman’ time bombs on their doorstep – considering their exposure to the PIIGS.  Should the sovereign debt crisis require deeper and deeper haircuts on PIIGS debt, the solvency of these banks is put in doubt.  The prospect of large scale bank write downs is the reason European bank shares rise or plummet with the success or failure of sovereign debt plans.

That’s a short summary of the remaining problems…

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