Euro area | Wealth and Investment Management Blog

Socrates’ time for the hemlock?

Posted on May 4, 2010 by Wealth and Investment Management

The new IMF-EU bailout package for Greece adds a further 11 percent of GDP of spending cuts and tax rises. A fiscal tightening of this magnitude is the economic equivalence of suicide.

In the latest (April) edition of Signpost Schema, we included a Focus article which made the point that Greece was by no means the only EMU country with significant problems ahead – not just with regard to public finances but also concerning competitiveness.

Over the weekend, policymakers attempted not just to stem the tide, but to turn things around – hoping that a Є110 billion joint IMF-EU bail-out package for Greece would be sufficiently large to convince market participants not to bet on a rescheduling or default occurring. The ECB stepped in too on Sunday, announcing that it would change its collateral requirements – so as to continue to take Greek government bonds no matter what the ratings agencies think of them. (Even though the latter define them as “junk”, the ECB will treat them as being as valuable as their Bund counterparts.) By acting “big”, the authorities clearly hoped not just to rescue Greece but to stop EMU unravelling.

After an initial positive reaction to the proposals – which are not yet ticked up by all member governments, and so could theoretically still run into the sand – today investors again took to their heels, showing little appetite to hold Greek assets. More worryingly, other periphery country bond and CDS markets moved in such a way as to suggest a quite powerful bout of contagion. Portuguese 5-year CDS spreads, for example, jumped 82 basis points to 366bp. Spanish ones rose nearly 50bp.

One reason for the market gyrations is residual uncertainty concerning whether or not the package will indeed be passed or not. (We suspect that it will.) Another more important reason is the fact that, on top of the 6 1/2 % of GDP of fiscal tightening that the Greek authorities had already pushed through, the package over the weekend is projected to add a further 11 percent of GDP of spending cuts and tax rises.*

A fiscal tightening of this magnitude is the economic equivalence of suicide. A severe, and long-lasting, recession is now inevitable. The IMF-EU package anticipates a 4% drop in Greek GDP this year and a further near 2 1/2 % drop in 2011. Only in 2012 is it expected that the economy begins to lift, and then by a miserable 1% or so. Realistically, at best the economy might manage to return to current levels of output again in 2015 or 2016. At worst, it might be more like a decade down the road before Greeks manage to restore current living standards.

For the rest of Europe’s policymakers, the big issue is what to do now. Just watch and wait? (And hope or pray.) Or, might a step or two down the same path trodden by the Greeks raise credibility in their fiscal and structural reform efforts? For the Portuguese prime minister, Jose Socrates, there is no doubt that action is required; hence his announcement over the weekend that Portugal will bring forward its planned 2011 fiscal tightening to this year. In itself, these measures are fairly small beer, at less than a tenth of what Greece is planning in relation to GDP. But, it may be a first step down a slippery slope if the Greek package fails to assuage market concerns. So, just as with hemlock – which used to be used as medicine by the Greeks for treating such ailments as arthritis – it is a dangerous treatment to use, as the difference between a therapeutic and toxic dose is very small. As the wikipedia entry on hemlock points out, one of the side-effects of even a small overdose is that it can be followed by depression.**

* This is an IMF estimate. See http://www.imf.org/external/np/sec/pr/2010/pr10176.htm
** See http://en.wikipedia.org/wiki/Conium

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German and French differences on EMU: cracks becoming a fissure?

Posted on March 15, 2010 by Wealth and Investment Management

Germany wants to increase the short-term pressure on member states failing to reduce their budget deficits. But France favours “soft laws”and puts a greater emphasis on better-placed states boosting demand.

Last week we reported that the Germans had really thrown a cat amongst the pigeons when Wolfgang Schauble (the finance minister) announced proposals for the establishment of an European Monetary Fund (EMF), especially when it was clear that neither the French government nor much of the German establishment was aware that Mr Schaubel was about to drop his bombshell.

On Friday, Mr Schauble went further, in a piece with the Financial Times, in two respects.* First, he argued that “From now on, a member state with an excessive deficit should not receive EU cohesion funds if it is not making sufficient savings”. [My italics.] Second, he argued that “Should a eurozone member ultimately find itself unable to consolidate its budgets or restore its competitiveness, this country should, as a last resort, exit the monetary union”.

The first of these points highlights that the Germans want to increase the pressure short-term on those who are failing to reduce their budget deficits by, in effect, introducing a new penalty mechanism (which would hit southern states especially hard). The cohesion funds would, in effect, become “disintegration” funds!

The second point is more of a long-term issue. It is being seen by many as a hardening of Germany’s stance regarding its willingness to pay for Europe. Absent change, it would be happy for countries to leave EMU – in effect scaling down the European project to a smaller group of, more similar, countries.

Of course, the long-term issue could become a short-term one if markets pushed it. As Mr Schauble pointed out “for the first time, it has become clear that a monetary union member with weak economic fundamentals can quickly lose the confidence of global financial markets”. In such a situation, the EMF is clearly being peddled as something that will help “reduce the risk of defaults” but not eliminate it altogether. A failed EMF programme, and Germany would, in effect, say “Let them swing” – i.e. let/make them exit EMU.

Today, Mr Schauble’s French equivalent, Christine Lagarde, has the front page of the FT almost to herself, after giving an interview to the paper in which she presents a very different vision of the future.** Several things are worth emphasising:

The EMF gets short shrift – as “an adventure that could take us another three, four or five years”.
“Soft laws” were proposed as being better suited to the current situation – i.e. mechanisms that would not require another Treaty and which could help in “creating precedent so that we have, in the case of shortfall and non-compliance, enough determination, compliance within the group and peer pressure that discipline is restored”.
Germany is criticised for failing to boost domestic demand. As Ms Lagarde puts it, “Those with surpluses could do a little something. It takes two to tango. It [i.e. economic policy in Europe] cannot be just about enforcing deficit principles”.

These statements, as the FT points out on its front page, really do break a taboo. German and French differences on EMU are never raised in public. Accordingly, it rather suggests that what Mr Schauble described as a crisis – and by which most people assumed he meant Greece, and perhaps in time the southern euro-area states – actually risks becoming a EMU-wide affair fairly soon. Unless the French and Germans fairly quickly come to an agreement on a (new) common line, it may well be that Ms Lagarde loses her dancing partner.

* See http://www.ft.com/cms/s/0/0da32c0c-2d77-11df-a262-00144feabdc0.html
** For the full transcript, see http://www.ft.com/cms/s/0/78648e1a-3019-11df-8734-00144feabdc0.html

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Cracks in the facade

Posted on March 10, 2010 by Wealth and Investment Management

The establishment of a European Monetary Fund (EMF) would take time, and it would probably be too late to make much of a difference to the key issue facing Europe today – the risk that Greece’s public finance problems percolate through to other markets.

Whatever one thinks of European Monetary Union, from an economic point of view, one thing that has to be admitted is that it has been a real success from a political perspective. In particular, from the very beginning the French and Germans have had a shared vision of what they were setting out to achieve. And, when problems have arisen, they have been surmounted them by a superposing of national interests which, hitherto, has always proven to be more than up to the task at hand. EMU has survived. Some would even say it has prospered.

Now, with country members suffering rather differential impacts from the financial crisis – reflecting their heterogeneous make-ups and differential policy responses – pressures on EMU are growing. Most important perhaps is the market pressure emanating from the fact that finance ministers everywhere are struggling to stem the tide of red ink, but with different degrees of success. Hence the concerns that Greece might not meet its obligations, and might therefore need to be bailed out. And hence, more worrying still, the fact that the likes of Spain and Italy are waiting in the wings, nervous that they might next face the strains of CDS spreads opening out as investors and credit agencies look again at their books, and recalibrate the likelihood of them meeting their debt-service obligations in full.

All this is by way of background to the proposals made at the weekend by German finance minister, to set up a European Monetary Fund. That that should come out of the blue is perhaps not too surprising. After all, that is what happened with the Stability and Growth Pact proposals, made originally by the then German finance minister, Theo Waigel, and subsequently adopted (in 1997).

What is more surprising this time round is the fact that it is not just the French who were clearly taken aback by the proposals, but the fact that the German establishment appears to have been too. Within the ECB, for example, both Axel Weber (the president of the Bundesbank) and executive board member Jurgen Stark (and possible future Buba president) have sounded lukewarm, to put it mildly. Indeed, Mr Stark was stark in his language, claiming that the setting up of am EMF would mean that “public acceptance of the euro and the European Union would be undermined”. The ECB was quick to point out that this is his personal view, and not that of the institution.

What next? We suspect that this will be an issue that will run and run. Even were there full agreement, it is not easy to set up new institutions overnight. When there is not, there is, at a minimum, plenty of horse trading to do. (Where, for example, might such an institution be based?) The important point, from a market perspective, is that the establishment of an EMF, were it to happen, would probably be too late to make much difference to the key issue facing Europe today – which is whether or not Greece’s public finance problems will percolate through to other markets, and especially to Italy. On that, we suspect that what will matter is whether or not Europe’s recovery manages to gather momentum or not: a double-dip might well spell trouble, especially for those who dip first and/or dip most.

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An emulous IMF?

Posted on March 8, 2010 by Wealth and Investment Management

A European Monetary Fund risks being a weak son-of-IMF. But, as worryingly, it appears that only belt-tightening will be permitted. It will not be able to force those with big budget surpluses to rein them in by boosting domestic demand.

Given Greece’s recent travails, the French and Germans have been doing some ‘travaille’ of their own. Talk over the weekend is of Wolfgang Schauble, the German finance minister, presenting proposals soon for the establishment of an European Monetary Fund (EMF), modelled very much along the lines of the International Monetary Fund (set up post-WWII as the ‘stick’ to go alongside the new World Bank ‘carrot’).

The idea seems to be to provide the EMF with powers very similar to the IMF’s.
First, EU countries will have to provide the new institution with information it requires to enable the EMF to judge if their economic policies are sustainable.

Second, having made this judgement, the EMF will be able to exert some duress on countries that are not doing well to make required policy shifts.

Third, when this fails, the EMF will be able to punish those who have failed to meet up to expectations.

Mr Schauble highlighted, in particular, the need for “an institution for the internal equilibrium of the eurozone”. This is likely to mean having fiscal policies that ensure debt burdens do not get out of hand, as Greece’s have. But it is also likely to mean analysing countries’ competitiveness to see if countries can maintain their market share in global markets and earn their way in the world.

What teeth the EMF would get are far from clear. Some suggestions are that countries that ignore the new body’s advice might be cut off from EU cohesion funds, or temporarily lose their right to vote in EU ministerial meetings. But these – like the Stability and Growth Pact’s that went before it, and failed, in part because its teeth were few and blunt – seem not only generally speaking to be small measures but variable across country members (and so hard to defend).

Most likely, therefore, an EMF would be a weak son-of-IMF. Worse still, if – as Mr Schauble suggests – the idea of the EMF is to stop EMU-member countries from approaching the IMF, the ‘conditionality’ (or ‘stick-size’ to put it another way) that would end up being applied to European countries with economic imbalances that need addressing would be less in future than under current arrangements. Hardly, it would seem, a step forward for global economic policymaking?

One other potential policy failing that might follow from the introduction of an EMF, were one to be set up, is hinted at by Mr Schauble, when he says that he wants to avoid any suggestion that ‘budget disciplinarians’ (such as Germany) could be pushed by the EMF into loosening policy, so as to promote domestic demand within the euro area.

Only belt tightening would be permitted, it would seem. So, the EMF could only help reduce demand by forcing those with big budget deficits to rein them in. It could not point out that the consequence would be a greater need for Europe to export its way out of a slowdown, as domestic demand would be being cut back, increasing its reliance on overseas demand, and thus that a looser policy in some EMU countries would provide an offset.

This issue is reminiscent of the debates that went on behind the scenes ahead of the Brettons Woods institutions (the IMF and World Bank) being set up in the 1940s.* The only real difference was that the IMF was originally set up to deal with external imbalances. It ended up being able to hurt those with (current account) deficits, but not able to force those with big surpluses to rein them in – by promoting domestic demand.

That failure, more than 60 years ago, is the main reason we have big global imbalances today. For, because of it, there is little pressure on China, Japan or Germany to promote home demand. An EMF would not change that. Indeed, it would likely make things worse. So, the recent ‘travaille’ of the French and Germans may all be in vain, if by solving one small (internal) problem, they make a big (external) one worse.

It is interesting to note that the original meaning of ‘travailler’ (the French for ‘to work’) actually comes from vulgar Latin (‘tripaliare’) which meant ‘to torture’. By getting it wrong, again, policymakers may well ensure that, a few years down the line, the Greek problem has been exported elsewhere in Europe, and the ‘solution’ will be for those inflicted to be tortured into making policy changes which lead to the situation becoming even more dire. Greece, for sure, given its 6.5% of GDP fiscal tightening is now heading back to recession, if not depression. Others may well follow in their tracks a year or two hence.

* The 3 volume version of Skidelsky’s biography of Keynes is excellent on this subject, highlighting how the Indians, in particular, got the defence right but nevertheless lost the argument.

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Greece centre stage: but who’s waiting in the wings?

Posted on March 4, 2010 by Wealth and Investment Management

Further fiscal tightening by Greece makes it more likely that other countries will come to their aid. But remember that the real issue is competitiveness, not the country’s debt/GDP ratio.

The news yesterday – that the Greeks have buckled under the pressure and at last made a substantive additional fiscal effort (of about 2% of GDP) to add to the near-4% tightening announced back in December – raises significantly the probability that other European countries will now come to their aid.* Although this particular odyssey has a lot longer to run, yesterday may well mark the day that the tide turned for Greece.

From here, it should now gradually fade from the scene -although there will still be more market-moving acts to the tragedy, as it will need to borrow more from markets and the fact that the drop in GDP will almost certainly be significantly greater than they are assuming could well mean that this particular exercise in what the IMF term ‘financial programming’ will fail. (In other words, there is a good chance that the Greeks go through a second set of fiscal adjustments again a year or two down the line, finding that Plan A didn’t quite manage to deliver the goods. Even if that happens, however, we suspect that markets will likely realise that we have been here before, and not get overly excited about ’round 2′.)

When it comes to the bigger production, Scene 2 is likely to be one in which new actors take to the stage, albeit reluctantly. Here it is worth making two crucial points, not sufficiently emphasised by most commentators:

Greece’s debt-to-GDP ratio is not really the big issue. People always start with these data, on the assumption that GDP represents the income that can be raided, as it were, in order to meet the obligations on the debt – the interest payments and repayments of principal. When it comes to a potential default situation, however, what really matters is whether or not there is capacity for the authorities to print money, creating inflation and eroding the value of the public debt (as we wrote about yesterday in the case of the United States). In the case of a currency union, that possibility is ruled out for all its members. So, the public debt ought to be measured not against GDP but against exports. For that represents the true capacity of the country to pay.
Competitiveness is actually the key issue. Although everyone is focussing on raising taxes and cutting spending, to stop the haemorrhaging of public finances – i.e. to stem the red ink: the huge budget deficit – what really matters is Greek competitiveness, especially versus the likes of Germany. (By way of illustration, Greece’s relative unit labour costs have risen about 8% since 2005, whereas Germany’s has fallen by about the same amount.) The only way that Greece’s precarious situation be remedied, in a long-run sustainable sense, is for Greece begin to stem the loss of export market share it has experienced. (In nine of the past ten years, Greek export volumes have risen less fast than foreign demand has risen, or dropped by more than overseas demand has done. Or to put the facts another way, since 1995, its relative unit labour costs compared with Germany’s have risen by a fifth.)

These two facts help explain why the issue of ‘foreign’ debt is not going to go away. Take a couple of the other ‘PIGS’, for example, and start by assuming they haven’t been telling porkies.** What do we find?

First of all, that Spain’s public debt to export ratio is close to 2 – quite a bit higher than Germany’s (at 1.6) – and that Italy’s is roughly 4. The latter is not just a big number, but it more or less spot on what Ken Rogoff and Carmen Reinhart have identified as being a key ‘tipping point’ for identifying when crises become likely. Owing four times your revenues – when you’re a country – typically ends up with you deciding to default in some fashion (say by rescheduling or declaring a moratorium).

Second, when comparing indices of relative unit labour costs, or ‘RULCs’, it is clear that both Italy and Spain have way bigger competitiveness problems than does Greece. Since 1995, when they peaked, German RULCs have dropped by a fifth. But Spain’s have risen by nearly 30% over the same time period. And Italy’s are up by three quarters! By comparison, Greece’s actually fell a little – by just shy of 5%.

Putting the data another way, back in 1995, Greece’s manufacturers were keeping up OK with Germany’s (with their RULCs 98% of Germany’s). Today, they are nearly one fifth less competitive. But this is small beer compared with what has happened in Spain or Italy. Spanish firms’ RULCs were about three quarters those of Germany’s back in 1995 but are now 20% higher (so that their relative-to-Germany RULCs have deteriorated by 60%). Fifteen years ago, Italian manufacturers enjoyed RULCs that were only 60% of Germany’s. Now their competitiveness advantage has given way to a massive disadvantage, of around 30%. So, their RULCs relative to Germany’s have deteriorated by about 120% over the period.

As a check that this stuff matters, take a look at German export volumes and Italy’s. Since the millennium, the former had risen (pre-crisis) by about 70%, and look set to return to that level again next year. Italy’s, by contrast, rose by just shy of 20%, and do not look set to get back to their old peak this side of 2013, if even then.

What’s the bottom line of all this? Well, more likely than not, Europe’s problems aren’t going to go away. If, for example, the continent double-dips – a real possibility in 2011, if not most people’s best-guess scenario – then pressures on the weakest members of the currency union are likely to rise. Markets are likely to try to pick off the likes of Italy and Spain if, as would be quite likely in such a scenario, their firms are continuing to lose market share, and thus cutting back aggressively both output and employment. The current strategy employed to deal with Greece doesn’t look likely to ring-fence the Greeks successfully: in a slowdown market forces would likely breach the firewall.

* The ‘threat’ of the Greeks turning to the IMF in the absence of more forthright support from Ms Merkel at her meeting with Greek PM Papandreou tomorrow doesn’t cut much ice in Berlin. In Paris there is much more sympathy for the idea that Europe should sort out its own problems.

** ‘Porkies’ is slang for lies. Few people believe countries straining to meet the Maastricht requirements were entirely open about their true levels of public debt, but, for our purposes, we will take the official data as god-given.

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