piigsty

After the EU-wide calamity and impending doom of the past few days and weeks, you would rightly query what exactly is now going on. Its pretty straightforward – European leaders are starting to get serious. The key element of the October 23^rd summit was a sea change in the dialogue. The Franco-German duo of Merkel and Sarkozy have stopped insisting on minor sticking-plaster solutions and have belatedly began to talk about more serious surgery including a keystone proposal to write down (haircut) a substantial portion (40-60%) of Greece’s €350 national debt pile. This would make it hugely more manageable. After listening to the weekend views of the G20 (who are, no doubt, in convulsions over the prospect of a European engineered second ‘double dip’ world recession), there is no doubt the conversation has changed.

EU leaders are not formulating a full scale multifaceted rescue plan to tackle the underlying problems. Previously, the focus was skewed to address urgent liquidity problems, with tackling solvency a long term (#2) aim. Now, the short term focus is starting to change, and with good (economic) reason.

The ‘Liquidity’ Era 

For too long, as economist Ken Rogoff outlines in Der Spiegel the discussion in eurozone circles was squarely focused on addressing liquidity problems (getting the day to day financing in order) for those countries most at risk of going bankrupt – Portugal, Ireland and Greece. Remember it was doubt over their ability to pay for the functioning of their own economies which caused their borrowing costs on the bond markets to skyrocket – and caused the creation of the EFSF and the EU-IMF bailouts. But all this has proved ineffective to stop the rot. Greek needed a second bailout less than 7 months after its first and the on-off panic encouraged by the Greek government dragging its feet on meeting its obligations. Releasing the bailout funds in tranches after regular reviews by the troika (European Commission – ECB – IMF) has injected more instability than certainty into the process.  With the Greek government promising to get its debt in order by dramatically altering labour laws enshrined in the Greek populace for generations, drastically reducing the size and cost of the public service and budgetary measures such as increased taxes and deep spending cuts – the calamitous environment is ruining investor confidence and prospects for a return to economic growth in Europe and beyond.

The ‘Solvency’ Era

So, the real problem is Greece or more accurately, Greek solvency and the interdependent solvency of the big European banks. Unlike what was believed previously (in the ‘liquidity’ phase), Greece has very weak structural economic strengths to fall back on). A disorderly Greek default would put the solvency of those indebted European banks into question (and with them, the economies in which they operate across Northern Europe). Therefore, there is no stable bottom to this crisis.

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Here at PIIGSty.com – the issue of the inadequacy of the EFSF has been long discussed, an issue which has recently reared its ugly head again at meetings of the IMF and G20. We decided to sit back and wait for the hysteria to die down in recent weeks and for clarity to replace hyperbole. Since September 20^th, we have learned some key things about the eurozone (EZ) crisis. Heres a run down of some activity in the key players.

Germany

Chancellor Angela Merkel has been triumphantly congratulated on her overwhelming Bundestag vote to expand the borrowing capabilities of the EFSF (as agreed in the July 21 meeting) and rightly so.  The vote also succeeded in stablising her CDU-FDP coalition with a combined 315 votes FOR and only 13 AGAINST) despite huge misgivings, meaning the crossover opposition support from the Social Democrats and Greens wasn’t as critical as some commentators had expected. Of course, the market pleasing 523–85 vote victory is bittersweet. First, the good news. The good ship Europe was steadied temporarily and the media outlets ignored the Greek crisis for at least a day. The bad news. That same ship is essentially still hurtling toward the same reef, likely to founder eventually on those sharp (and self chiseled) Athenian rocks. The cannons can sink some foes along the way but the course is set if the wheel isn’t turned.

Why not turn the wheel? Europe is still playing catch up and continues to woefully and frantically follow events rather than lead them. The ‘Merkel wins’ narrative was always going to change. A €440bn EFSF is inadequate and the return to market turmoil in October confirms that. The fact that even a simple enlargement of the fund (which was more procedural than a sign of proactive EZ economic governance) has shown that any future necessary financing of bailouts or bank recapitalisations are just not on. The EZ’s effectiveness to deal with this crisis has now been formally politically neutered.

Germany will ultimately (after all EZ parliaments pass the EFSF reforms) be responsible for nearly 50% of the EFSF fund, around €210bn. The likelihood the ‘Merkel-Schaeuble (her Finance minister)’ doctrine of ‘no more bailout money’ will change beyond that is just implausible and politically suicidal.

Greece

Greece remains the problem child of Europe. Fostered under a European monetary system it never ascribed to wholeheartedly (since the Greeks were never too fond of following the rules of EMU) the Greek-fueled EZ debt crisis remains poised to cause a financial earthquake, especially if its spreads. To say this is only because of the petulance of some myopic Greek politicians isn’t fair but consensual decision making in Athens is proving elusive. Opposition parties are steering clear of the austerity and privatization plans, even objecting openly to the proposed cull of 30,000 public sector workers, despite the costly historical burden this sector represents – currently 45% of the entire Greek economy.

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As expected, the Berlin (state/city level) elections in Germany did not disappoint analysts seeking to expose Merkel’s shaky CDU-FDP coalition. This time, however, the brunt of the dissatisfaction with the government was felt by the small pro-business Free Democrats (FDP) who have already expressed high level misgivings with voting for EFSF reforms (some going so far as to demand a referendum on the issue).

This excellent graphic from Reuters sums up the situation well.

The red 5% line is the minimum level where parties are awarded seats under the proportional election system. In a stunning rebuke to the established political parties, the fast growing Pirate Party won +15 seats in the 149 seat body, a first for the party in the capital. The pro-internet liberalisation party (now branching into a broader electoral platform including education and citizens rights) was not the only winner. Seat gains were recorded for the Green Party +7 (a strong force in German state and federal politics) and Merkel’s party, the Christian Democrats (CDU) +1. The CDU gained gained +2.1% in what is a friendly district historically for them. The main opposition party to Merkel at the federal level, the Social Democrats, suffered losses of -2.5% and -6 seats respectively.

The overall message is symbolically difficult to swallow for the FDP. The electorate are angry and are clearly demanding a reassertion of German civil liberties. From a European standpoint, this bodes ill. It suggests that political populism and a retrenchment to German priorities is an irrestible notion. For the FDP – holding no seats in the district that holds the federal parliament is a damaging blow to the party and may proof to be a destabilising factor too far for a party seeking to reassert itself against its far bigger and increasingly divided coalition partner. With voices condemning Merkels leadership (or lack thereof) becoming increasingly loud and with German and international media increasingly fixated on the potential leadership contenders, the battle wounds are beginning to neuter the abilities of the government to actually achieve anything – especially on Europe. The knock out blow might come sooner than 2013 when the next federal elections are scheduled.

Expect the route toward the September 29th EFSF vote to get slightly rockier. Even if it does torturously pass, the political capital spent by Merkel on keeping her party and coalition together might mean shes fresh out of ammunition. And the hard work for a future fiscally sound Europe hasnt even started.

In the earlier PIIGSty.com post on ‘Bonds, Bonds and…Eurobonds!’  – the theory underpinning such the drastic jump into European fiscal consolidation was laid out. Continued rumblings over the European debt crisis have seemingly forced  the executive (government) in the EU legislative process (the Commission) to proactively try to jumpstart the spluttering efforts by member states to fix the obvious deficiencies on the EU periphery and by extension to battle the perception of a leadership vacuum in Europe (no small task).

European Commission President Barroso, speaking today in the European Parliament, has announced that time is up for dithering and indecision and has thrown down the gauntlet for other leaders to instill some confidence into the collective European economy. Part of his speech dealt with a reoccuring issue, Eurobonds – which needs more explanation. Heres a quick summary:

• Commission will present options for the introduction of Eurobonds
• This will likely require changing existing EU treaties
• It should be achieved through a Brussels-led ‘community effort’ rather than one led by the Franco-German alliance. Why?
• The solution to the debt crisis must be supranational not intergovernmental as the latter just continues the failed and myopic fiscal direction of the past
  
• Are Eurobonds the best short term solution? Nope. In Barroso’s words  “We must be honest: this will not bring an immediate solution for all the problems we face and it will come as an element of a comprehensive approach to further economic and political integration.”

While Barroso’s speech raises the spectre of Eurobonds again (and all the antagonistic debate that follows between the PIIGS and France/Germany),  Barroso represents a player in Europe which is increasingly subordinated in the pecking order under those with the political and economic brawn to assure and stabilise the markets.

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Cash is liquid. Lack of cash is a lack of liquidity. Hence, the PIIGS (or at least, Greece, Ireland and Portugal so far) have this problem. They’re tackling it with massive austerity programmes to try bring government revenue (taxes) to balance with expenditure (health, education, transport etc). Austerity takes time.

A key question that comes up is: What are bonds? The real question should be: how do governments borrow? How do they pay for deficits? Right now, each EZ member issues its own debt (in the form of bonds) to pay for deficits in their national accounts.

Each eurozone (EZ) member issues debt in the form of bonds. A bond isn’t a physical thing. Its an IOU. You can think of it as an embossed piece of paper with the amount borrowed written on it if you’d like with an interest rate attached i.e. ‘I, Ireland, promise to pay you €1m in 20 years at 4% interest.’

The government gets the money to use now and agrees to pay it later. It is for this reason that bonds are called ‘Treasury Bills’ or ‘Gilt-edged Securities’ because they go to pay for the running of the country and a country is hardly likely to go bankrupt like a business can.

‘The Market’

Lets use Ireland as an example. Ireland uses the euro and needs cash. Ireland issues debt in the form of a bond. What this means is that Ireland asks investors (usually banks at home and abroad) to borrow money at a certain interest rate. Like any loan, the higher the risk, the higher the bank will charge you per year in interest. At the end of a stated period (could be 2 years or 100) the investor/banks get paid the face value of the bond back. The interest is the profit on the deal.

Suppose an investor begin to reckon that his Irish bonds aren’t a great investment after all?

This could be because:

1. Theres high inflation in Ireland and the value of the original bond is declining
2. Theres a risk Ireland wont pay the bond (default)

You’ve probably guessed (2) is the problematic one today in the PIIGS. Investors are even faced with a slightly different version of ‘default’ called ‘debt restructuring’ which usually means investors receive a ‘haircut’ i.e. lose a high % of the initial value written on the bond.

An Investor thinks he might get stiffed. What does he do?

The bond (embossed paper remember!) doesn’t just sit in the investors drawer. He trades it with other investors on bond markets.  If he thinks that suddenly the Irish bonds he owns are going to lose their value (or not be paid up), he’ll sell it!

Well, he charges a higher rate of interest. This makes it very expensive for Country A to borrow. Country A has a problem. It must borrow to pay for its mounting deficits or else it wont be able to pay any of its debts and default.

What if he still holds Irish bonds? No matter. Bondholders get paid back before shareholders do.

So, whats the deal with Eurobonds?

As one recent image from The Economist illustrated well, ‘Eurobonds’ would be issued by the eurozone-17, not single member nations.

The reason why this would be a good thing is pretty straightforward. Imagine you buy your mother a sub-par present for her birthday and want to save face by combining that gift with your brothers much better one and put both your names on the collective birthday bundle. The good balances out the bad. Yin and yang, etc. Of course, the ‘good’ in this case are the six AAA rated eurozone nations and the bad are the PIIGS. Collectively, deficit/debt problems in the EZ look reasonable. For the EZ as a whole, the Debt : GDP ratio is 88% (higher on the periphery balanced by lower levels in the core.) This compares with a level of 98% for the US, 83% for the UK. Deficit levels in the EZ-17 are 4%, far better than the US level of 10% and 8.5% for the UK.

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When you think about options for the eurozone (EZ) – they read as such:

1. Strengthen economic governance – better coordinate EZ economies (from labour markets and tax structures upward…)

2. See point 1

So, no surprise then that the 16 August bilaterial talks between German Chancellor Merkel and French President Sarkozy has resulted in media hysteria over proposals over a ‘new eurozone government!’

The plan they’ve come up with includes the following:

1. Eurozone ‘economic council’ led by EU president Herman van Rompuy (for now, before proper elections later)
2. Constitutional changes to force balanced budgets aka ‘debt brakes’ in the EZ (led by French/German example)
3. EZ Financial transaction tax from September 2011
4. Franco-German harmonization of Corporate tax rates by 2013

Whats been ruled out?

Eurobonds (fiscal integration must come first)

The Reaction?

Ignore the hysteria. Economic governance and fiscal integration both must be achieved if the eurozone is to proceed in tact without fracturing into 2 or more pieces. Thats a fact. As President Sarkozy said yesterday “We have to converge. The status quo is impossible.”

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