After some reasons to be optimistic that Europe’s leaders were ready to finally grasp the bank debt\sovereign debt nettle, the developments of the last few days have been exasperating to watch. My latest thoughts here.
Category Archives: Euro Crisis
Memo to Draghi: Dead Central Banks Don’t Have Credibility
Mario Draghi today effectively ruled out the idea of ESM getting a banking license. I think this was a very bad move on his part. Article on Forbes.com here.
Eurosummit: Much Ado About Something?
I’ve agreed to write some posts on European issues for Forbes.com. They have a far higher readership than I get from this blog or my Twitter feed, so it’s a good opportunity to get more readers. That said, I’m still going to post content here as before. Everything I write for Forbes will be linked to here and, of course, I will continue to post my usual mix of Irish-related posts and links to presentations and papers, so there will be no reduction in content here.
Anyway, here‘s my first post for Forbes, which is a quick summary of the problems facing the euro area and my reaction to the summit. Yes, my reaction is quite positive. No, I haven’t been captured by aliens and replaced by a clone.
Presentation on Ireland’s Bank Debt
Today, I’m giving a presentation titled “Ireland’s Bank Debt and What Can be Done About It” at the IIEA’s conference Exiting the Crisis. The slides from my talk are available here as a PowerPoint slideshow and here in PDF.
The presentation is based on this earlier blog post, though I think that post failed to emphasise enough that I prefer a restructuring of the promissory notes within the current ELA arrangement to replacing ELA with a loan from the ESM.
The slides were prepared prior to today’s EU banking announcement but are, if anything, more rather than less relevant as the summit did actually make some progress towards EU risk-sharing in relation to bank recapitalisation costs.
Despite this morning’s euphoric claims from Enda Kenny and Eamon Gilmore that this is a “seismic change” and a “deal changer”, I would recommend serious caution. Ireland’s bank debt is a complex sui generis issue and its resolution will not fit easily into the tools the EU is now developing to deal with banks elsewhere. There is lots of negotiating still to be done and premature celebrations can be counter-productive.
Presentation: Target2 and the Euro Crisis
Yesterday, I gave a presentation on “Target2 and the Euro Crisis” at the Bank of England’s Centre for Central Banking Studies. The slides from my talk are available here as a PowerPoint slideshow and here in PDF. Probably needless to say but the content of the presentations reflects only my own views and its presentation at the Bank of England does not imply their endorsement.
A History Lesson for Professor Sinn
Hans-Werner Sinn has an article in today’s New York Times. The main point of the article is to rebut arguments from President Obama that Germany should be doing more to resolve the euro crisis.
Sinn argues that Germany has done enough:
Should the euro fail, Germany would lose over $1.35 trillion, more than 40 percent of its G.D.P. Has the United States ever incurred a similar risk for helping other countries?
Most of this $1.35 trillion potential loss figure comes from the possible loss of the Bundesbank’s Target2 credit, something which I have argued can be dealt without any new taxes on German citizens.
But, forgetting that for a moment, it appears that Sinn views “Has the United States ever incurred a similar risk for helping other countries?” as a rhetorical question to which the answer is “No”. In fact, I suspect the vast majority of US citizens are perfectly aware that the answer is “Yes”.
One example that the good professor has probably heard of: World War 2. Once the United States entered World War 2, defense spending rose from 1.64% of GDP in 1940 to 37.19% in 1945. The US debt ratio went from below 40% of GDP in 1941 to over 120% of GDP in 1946. And this doesn’t put a price on the tragedy of over 400,000 deaths of US troops.
The readers of the New York Times are likely to be aware that the freedom and prosperity that modern Europeans enjoy is due in no small part to the massive financial and human costs incurred by earlier generations of Americans. Perhaps Professor Sinn should consider an apology.
Presentation on Euro Crisis at INFINITI Conference
A Better Deal for Spain?
Much of the reporting and instant commentary on the announcement of the deal involving EFSF\ESM funding for Spanish bank recapitalisation has focused on the idea that “Spain got a better deal than Ireland”. The principal points being cited are that the Spanish deal has “no conditionality” and there will be no visits from the troika.
This strikes me as a wrong-headed way to view the Spanish and Irish deals. At least for now, Spain is only borrowing to recapitalise its banks. And Spain must satisfy conditions relating to this programme. The Eurogroup statement on this has only just over a page of text so it’s not hard to find this:
the policy conditionality of the financial assistance should be focused on specific reforms targeting the financial sector, including restructuring plans in line with EU state-aid rules and horizontal structural reforms of the domestic financial sector.
Unlike Ireland, Spain is (for now at least) still borrowing from financial markets to fund its deficit. And Spain’s projected deficit for the year, at 6.4 percent, is about half the underlying deficit that Ireland was running in 2010. Because the EU and IMF were agreeing in 2010 to provide very large amounts of money to fund Irish budget deficits, it was hardly surprising that they insisted on being able to monitor how this deficit was closed.
Note also that the IMF are not involved in the Spanish deal, so there is no need for troika visits. Furthermore, Spain is already implementing an Excessive Deficit Procedure programme so any fiscal conditionality requested by Europe would just look the same as the current Spanish fiscal adjustment programme, making such conditionality redundant.
On RTE’s This Week today, the FT’s Peter Spiegel argued that Spain got a better deal than Ireland because it was banking debt that locked Ireland out of financial markets and a “banks only” deal (without troika monitoring of fiscal policy) would have been sufficient for Ireland. However, there is nothing about the way the current Spanish deal is being done that would have improved Ireland’s prospects of retaining access to sovereign bond markets in 2010.
The reason banking problems contributed to shutting Ireland out of the sovereign bond market is because bank-related losses were transferred onto the sovereign. The current Spanish deal is no different. The fact that the money is being loaned to the FROB does not mean the Spanish government doesn’t have direct responsibility for it. Again, it’s not hard to find this in the one-page statement.
The Eurogroup considers that the Fund for Orderly Bank Restructuring (F.R.O.B.), acting as agent of the Spanish government, could receive the funds and channel them to the financial institutions concerned. The Spanish government will retain the full responsibility of the financial assistance and will sign the MoU.
If, as was the case with Ireland, the FROB’s “investments” in Spanish banks turn out badly so it is unable to generate the funds to repay the EFSF\ESM loans, then the Spanish government must pay the money back. As with the Irish case, the burden of recapitalising insolvent banks or loss-making acquisitions of solvent banks will fall on Spanish citizens.
For this reason, this weekend’s announcement may well end up shutting Spain out of the sovereign bond market. And if the EU agrees to provide funding for Spanish budget deficits then more intense monitoring of fiscal developments (and other areas such as structural reforms) is likely to feature in a revised MoU, even if the fiscal targets will probably remain the same as the current EDP targets.
So there really is nothing in this deal that should make Irish people in any way jealous or resentful. In contrast, this “banks only” deal from EFSF or ESM possibly sets a precedent that would make the kind of retro-fitting of Ireland’s banking arrangements that I discussed here (acquisition of bank stakes and refinancing of promissory notes) more likely to happen. And that would be good news.
Another Week, Another Target 2 Article
Another week, another academic hyperventilating about the crucial importance of Target2. This week’s entry is from Michael Burda of Humboldt University. It summarises the situation with Target2 balances as follows:
Bundesbank surpluses with the ECB have swelled to well over €700 billion, or about 30% of German GDP. Germany has now become a hostage to the monetary union, since a unilateral exit would imply a new central bank with negative equity.
However, there’s no follow-up explanation for what this means. Apparently “a new central bank with negative equity” is something so unthinkable that it means that Germany has no choice but to be a “hostage” to monetary union.
My assessment, as argued in this article is that the Bundesbank losing its Target2 credit would be no more than a minor inconvenience to Germany. We now live in a world of fiat currencies. The man that accepted that euro for your cup of coffee this morning didn’t do so because he believes the central bank has “positive equity”. He did so because it’s the legal tender of the land.
The post-EMU Bundesbank (it wouldn’t be a new central bank) won’t have to worry about its equity position because it won’t have the same kind of solvency concerns that you and I have because it has the power to print money. (See this recent Bill Mitchell blog post “The ECB cannot go broke – get over it”).
Another disappointing aspect of Burda’s article is that while there is a single mention of “capital flight”, the use of language in the article predominantly links Target2 balances with the traditional trade balances associated with David Hume specie-flow theory. I’m sure Burda knows this but it is worth reminding people again that the ever-growing Bundesbank Target2 balance relates far more to capital flight from the periphery than current account balances. Here’s a graph of current account deficits as a percent of GDP, including the EU Commission’s forecasts for 2012.
And here’s a nice graph from an FT blog post by Gavyn Davies from a few weeks ago. Note that current account imbalances are getting smaller while the Target2 balances are getting bigger. Capital flight, not trade imbalances, is what’s driving the Target2 balances.
Me on the Euro, Two Years Ago
I came across this today and had a bit of a laugh at my own expense. Me, two years ago after EFSF was set up. The paper’s a funny read. I certainly underestimated the scale of the existential threat to the single currency. Still, I didn’t get it all wrong:
One can point to a number of issues related to the EU Stabilisation fund that may contribute to undermining the common currency:
1. Countries that avail of the EU Stabilisation fund will have to enforce severe budgetary adjustments. One might argue that, by definition, these adjustments would be required in the absence of a bailout fund. However, it is likely that the EU (and hence the euro) will get assigned much of the blame for the pain associated with the adjustment plan in the same way that the IMF often gets blamed for the pain associated with the adjustment plans to which it provides financial support.
2. If the Stabilisation Mechanism’s goal of eliminating sovereign debt defaults in the eurozone was actually achieved, it would set up a serious moral hazard problem. European governments would no longer have any fiscal discipline imposed on them by bond markets, as these participants would consider eurozone bonds to be risk free because of the safety net. Whether the European Commission would be up to the job of applying sufficient surveillance to ensure the fund would not be needed again is not at all clear.
3. An increased role for the European Commission in budgetary formulation in eurozone countries is an inevitable consequence of the existence of the Stabilisation Mechanism. This development may be welcome in light of the poor budgetary management in many of these countries in recent years. However, the Commission’s role in the budgetary process will be resented by some citizens as undemocratic and will be cited regularly by Eurosceptic groups as a reason to leave the Euro.
4. The Stabilisation Mechanism has been sold as a gesture of cross-country solidarity across the eurozone. The contributions to the Fund are to be provided in proportion to each member state’s share of the ECB capital subscription. However, the truth is that the benefits of this approach are not evenly spread. Some countries are more likely to avail of the fund than others. In addition, because some countries have banks that are clearly more exposed to the debt, a fund to pay off this debt will disproportionately benefit those countries, most likely saving them from further expensive and unpopular banking system bailouts. The realisation that the benefits of the Stabilisation Mechanism are unequally distributed may have negative political consequences in the future.
Over the longer term, the biggest threat to the euro will not come from countries such as Greece choosing to establish a new currency. The biggest threat would come from citizens, and ultimately politicians, in a large EU country such as France or Germany deciding that they are not happy with the single currency. One scenario that could lead to such an outcome would be if membership of the single currency became associated in the minds of citizens of these countries with repeated bailouts of less disciplined peripheral members. While this is not a likely scenario over the coming few years, I suspect that the announcement of the Stabilisation Mechanism has pushed Europe a bit closer to this outcome becoming a reality.
The bits about austerity being blamed on the EU and increased fiscal surveillance being grist for Eurosceptics were correct enough. Unfortunately, with the weak support for Greece staying in the Euro coming from its “partners” in Europe, it looks like I got the “Germans-getting-sick-of-bailouts” threat to the euro right as well.