Crisis update

Tom McDonnell: FT Alphaville is reporting that Moody's is now talking about multiple defaults and a Eurozone break-up. See here for the Moody's press statement while the Guardian is reporting on the widespread market rumours of an impending IMF bailout of Italy. The success or failure of the Belgian, French, Italian and Spanish bond auctions this week should give us a clearer picture.


Wolfgang Munchau has taken a fevered turn and is talking about the Euro zone in terms of days to avoid collapse here. He does point out that technical solutions still exist. These solutions involve the introduction of Eurobonds, the ECB as ultimate lender for sovereigns, and the creation of a Eurozone treasury with oversight over fiscal policy.

Meanwhile Paul Krugman is having difficulty finding a plausible scenario under which the Euro survives.

Gawyn Davies looks at breakup scenarios here.

The EU Summit on December 9 may be the most important yet. This WSJ article provides clues as to the likely strategy from Germany and France. According to the IT Germany is considering elite 'AAA' bonds to be issued jointly with France, Finland, Netherlands, Luxembourg and Austria. Presumably this is predicated on France making it through the year as a AAA country.

One positive development is the increased pressure the ECB is coming under from national Governments to step up its bond buying.

The Euro Crisis: is history repeating itself?

Jim Stewart: It is a “common view ... that the world was headed for a massive payments crisis in which several European countries would default on their debts, setting the stage for a general restructuring of all international commitments”.

So writes Liaquat Ahamed in his book ‘Lords of Finance’ (p. 326) in describing the prelude to a conference in 1929 called to reach a final settlement to the German Reparations issue. The conference succeeded in reaching agreement but on terms which eventually lead to financial chaos in Germany and helped precipitate the great depression of the 1930s. Policies that are now regarded as disastrous, were held widely by key decision makers and dogmatically argued. The analogy with policy making and events in the period preceding the great depression of the 1930s and today are striking.

Personal animosities, then as now, are widespread. In 1929 the Governor of the Federal Bank of New York and in effective control of The US central banking system described his German opposite number as an “.. ..exceedingly vain man. This does not take the form of boastfulness as it does a certain naive self assurance” (Ahamed, p. 281). For recent 2011 examples, see Lord Myner's comments on Michael Barnier, the Commissioner for internal regulation. Media reports often cite German annoyance with French Government policies and proposals, see for example here. At an EU summit in October, President Sarkozy is widely reported as telling The Prime Minister of the UK "You have lost a good opportunity to shut up.". Kauder (a leading member of the CDU) has described UK policy as irresponsible and self interested.

But the main problem is the prevailing consensus (held for example by the President of the ECB, the new Prime Minister of Italy, the Governor of the Irish Central Bank etc) that the solution to current economic problems is austerity plus maintaining the solvency of the banking sector at any cost. For short hand this can be termed the Goldman Sachs consensus. The increasing irrationality of such a policy is becoming obvious even to some former supporters. Some examples:-

(1) Ireland, even though it is dependent on IMF and EU loans, and has suffered a hugh recession and economic collapse, was required to pay bondholders in a failed bank even though these bondholders were not covered by any guarantee;
(2) The ECB intervenes in the sovereign bond market while at the same time stating such support will be limited and undesirable. The net effect is that those who wish to sell government bonds such as banks have been able to do so without any medium term effect on bond yields. In effect, such intervention is another support to the banking system.
(3) Where default is both desirable and certain, as in the case of Greece, policy makers perform numerous contortions to try to ensure such a default does not trigger an ‘event’ resulting in the payout on a Credit Default Swap Contract. A Credit Default Swap is similar to insurance on a bond. If the bond defaults the insurance is paid. Such contracts would appear to be one of the greatest financial frauds perpetrated in recent history. Given that policies to ensure debt write downs are not technically a default, buying a CDS contract on government debt, means that the contract will not pay up in the event of default. In any case, in the highly desirable event of a write down of Government debt generally in indebted countries (where Government debt was greater than 60% of GDP, as in the case of Belgium, Ireland, Italy and Portugal), CDS contracts would also not pay out because the counterparty would become insolvent. This is because it is most unlikely that, following the bailouts due to the subprime crisis of AIG and other financial firms, there could be a second massive transfer of resources from the state to the banking sector.

As in earlier periods of financial crisis, commentators assume rationality by decision makers. However key decision makers should be judged by what they say, as distinct from what we hope they think. Take the case of the recently appointed President of the Bundesbank . In a recent interview with the Financial Times, the Bundesbank President stated that the correct response to Greece is “implement what has been decided”. The problem is what has been decided cannot be implemented. Greece does not have the necessary administrative or technical skills, never mind the political will, to implement IMF/EU proposals. The problems with Italy are seen as a problem of “confidence”. Italy has many problems, both political and economic. These reforms will take many years to implement. The lack of confidence in Italian Government bonds is immediate. The Bundesbank President considers the key competitive strength of Germany results from labour market reform. The key strength of Germany relates to its innovative, high productive economy, with a skilled labour force, extensive infrastructure and success in tax compliance (for example using leaked information on deposits held in Swiss bank accounts by German nationals to ensure tax compliance).

There is widespread support for issuing Eurobonds. There are arguments for and against such a proposal (see for example the recent Green Paper on Stability Bonds (Annex 2). Issuing eurobonds could help in the current crisis if applied only to new bond issues, and if existing bonds were not converted into new bonds. Instead they could be transferred to a debt management agency for all or some of the most heavily indebted countries. These bonds could then be written down in value and held until redemption. This is in contrast to the proposals in the EU Green Paper on Stability Bonds, which does not envisage or discuss writing down the value of existing bonds. In addition, the Green Paper does not refer to or discuss the very different economic policies pursued by central banks in the US, UK and Japan, that is large scale intervention in the bond market referred to as ‘quantitative easing’, and the consequent effect on bond yields.

But comments by key decision makers on such a vital topic have been meaningless. For example, the President of the Bundesbank has dismissed arguments in favour of Eurobonds by stating such a policy would be “like drinking sea water to kill thirst”. These and other comments do not give any confidence that key economic policy makers are intellectually equipped to deal with the current crisis.
There is no modern equivalent to Keynes. As in the 1930s, we may have to wait until current policies have demonstrably failed, and are widely recognised to have failed, before there is a change in policy. The cost and problems created could be enormous.

The forthcoming Budget in Ireland is given much media attention. The forthcoming EU summit on 9th December could take decisions that will influence our economic destiny for the next decade.

The Future of Europe?

Nat O'Connor: What do the following people have in common? Tony Blair, Marek Belka, Jacques Delors, Felipe González, Jakob Kellenberger, Mario Monti, Gerhard Schröder, Matti Vanhanen, Guy Verhofstadt, Nicolas Berggruen, Juan Luis Cebrián, Mohamed El Erian, Niall Ferguson, Anthony Giddens, Alain Minc, Robert Mundell, Nouriel Roubini, Michael Spence and Joseph Stiglitz.

They are all members of the Council for the Future of Europe and they have signed up to a four-page statement titled: Europe is the Solution, Not the Problem.

They argue for:
1. A expanded European stabilisation fund to be established by 2012;
2. Appropriate bank recapitalisation;
3. Fiscal union in Europe - including eurobonds;
4. Orderly debt resolution - for private and public debt;
5. Macro-economic policy to avoid undermining short-term recovery while pursuing long-term reforms;
6. A growth strategy using EU funds to stimulate growth and job creation;
7. Preparation of social security systems to accommodate an aging population;
8. A vision for a Federal Europe with a mandate across common security, energy, climate, immigration and foreign policy;
9. Broad and deep engagement of the public in the process of further integration.

Despite the high profile of the group's membership, I can only find two references in Irish online media (at the bottom of this RTÉ business news article, and on the online Hibernia Times).

Apart from at least one Guardian article, there seems to be a lack of UK media coverage either.

Greek economist, Yanis Varoufakis, offers a critical review of the nine proposals on his blog.

Meanwhile, the BBC reports another possible breakthrough in the EU crisis involving something similar to three of the proposals made above: "quadrupling...Europe's main bailout fund, the European Financial Stability Facility (EFSF)", "strengthening of big eurozone banks" and debt write-down of 50 per cent for Greece.

The BBC's Paul Mason reported a couple of weeks previously on the 'war games' conducted by another think tank, Brueghel, which involved 100+ policy experts in running simulations of different possible solutions for the eurozone crisis. This was apparently influential in Washington DC (where the IMF is based).

What all these proposals for solving the eurozone crisis illustrate is the need for more public discussion and engagement with the question of Europe's future. There is little doubt that some major changes are coming at EU level, whatever the exact nature of the economic arrangements that are made to address the eurozone crisis. It seems highly likely that any such arrangements could quickly result in new political institutions that have not gained public trust, much less a democratic mandate. This suggests that any solution will have to be both political and economic in combination; including credible ways of strengthening democratic control of decision-making at the heart of Europe.

Euro Bonds are not enough, says Thomas Palley: Eurozone countries need a government banker

This article by Thomas Palley, of the New America Foundation's Economic Growth Programme, was published in the FT Economists' Forum on August 31st. Thomas Palley visited Dublin last year to speak at the FEPS/TASC Autumn Conference.
The eurozone’s public finance crisis continues to fester, reflecting both political and intellectual failure. The intellectual failure is the crisis has been interpreted exclusively as a debt crisis when it is also a central bank design crisis resulting from the euro’s flawed architecture. The flaw is the inability of eurozone governments to harness the central bank’s power to assist government finances. This systemic weakness explains why U.S. and U.K. government bonds are weathering the storm, whereas Spain confronts default rumors despite having roughly similar debt and deficit profiles.

The euro solved the problem of exchange rate speculation by creating a single currency but in doing so made countries vulnerable to bond market speculation. That is because European Central Bank (ECB) support buying of member country bonds is prohibited under the “no bail-out” provision. This prohibition is appropriate as buying one country’s bonds would subsidize it relative to others. However, it means country governments lack access to central bank help to ward off speculative bond market attacks; to finance budget deficits; and to conduct quantitative easing (QE) programs of the sort conducted by the Federal Reserve and Bank of England.

One proposal to address the crisis is the idea of a “blue bond”. Countries would have the right to issue blue bonds up to sixty percent of their GDP that would be guaranteed collectively by euro member countries. This would significantly lower interest rates charged to troubled countries, helping them attain solvency. In effect, financially strong countries would de facto lend their creditworthiness to weak countries.

The blue bond proposal would undoubtedly help solve the current crisis. However, there are two problems. First, it relies on an implicit transfer from the strong who take on a guarantee liability but get nothing in return. That is a political non-starter. Second, it does not solve the structural problem of lack of a government banker. That leaves eurozone governments vulnerable to future crises, and it also maintains persistent market pressure on government finances that will ultimately destroy Europe’s social democratic project.

A second proposal is a “euro bond”. The ECB would issue euro bonds and countries could elect to have the ECB use the proceeds to buy their existing debt up to sixty percent of their GDP. Individual countries would then be responsible for their share of the interest on euro bonds. This proposal would also help solve the current crisis but it too has problems. First, it would violate the “no bail-out” clause because all countries would pay the same interest rate on euro bonds but the ECB would be responsible for the higher interest rate on debt it purchased. Second, perversely, higher income countries could transfer relatively more debt under the sixty percent of GDP rule. Third, and most importantly, the scheme fails to address the government banker problem.

I have advanced a third proposal that solves both the debt crisis and government banker problems. Stage one would have eurozone countries establish a European Public Finance Authority (EPFA) that would be governed by member countries, with votes allocated on a per capita basis. EPFA would then issue bonds that the ECB can buy and sell through standard open-market operations. These bonds would be collectively guaranteed and countries would cover EPFA’s interest on a per capita basis. Bond proceeds would be used to buy existing country debt, again on a per capita basis. Countries with low levels of existing debt (like debt-free Luxembourg) would simply receive their share of EPFA proceeds as cash and they could buy EPFA bonds to cover their EPFA interest obligation. This debt swap would solve the debt crisis; create conditions for the ECB to engage in open-market operations to manage government bond interest rates; and create conditions for QE policies.

Stage two would have EPFA annually issuing new bonds to help finance government budget deficits. The amount issued would be democratically decided by EPFA’s governing council, presumably acting on instructions from national governments. New issue proceeds would be deposited with governments to spend as they wish. Those wishing to run surpluses could retire debt or create a sovereign wealth fund. Three features are important. First, EPFA would never spend money and all spending would be determined by governments. Second, the ECB could assist budget financing by managing bond interest rates just as the Federal Reserve and Bank of England do. Third, the eurozone would have a democratic financial union but no fiscal transfer union.

The critical feature is EPFA bonds have no taint of “national identity”, enabling the ECB to trade them without violating its “no bail-out” clause. Moreover, there are no financial transfers between countries and the per capita rule means all countries are treated equally.

The EPFA proposal solves both the debt crisis and government banker problem, and it does so without imposing unfunded obligations or unilateral transfers on any country. It therefore meets all German objections. Moreover, the EPFA proposal creates the financial space for eurozone countries to grow and continue with their social democratic projects should voters choose. This makes it more democratic than existing arrangements which impose financial constraints that restrict space for democratically determined social and economic policy.

Guaranteed Lender of Last Resort

Tom McDonnell: The often useful VOXEU resource has produced a number of constructive pieces on the debt crisis in the last week or so.

Paul DeGrauwe does a good job of describing the inherent fragility of the Eurozone as currently designed. His main proposal is the establishment of a guaranteed lender of last resort for government bonds. The ECB being the natural candidate to take on this role.

Charles Wyplosz argues there are really just two possibilities to solve the crisis. The first possibility, echoing DeGrauwe, is to make the ECB perform the function of a guaranteed lender of last resort. In this scenario the ECB would simply guarantee the rollover of maturing sovereign debt at face value. The second possibility is to pursue one of the many variations of the Eurobond option that currently has Merkel and the Bundesbank wailing against the dying of the light. Audio version of Wyplosz is here.

Stefano Micossi argues here that fiscal union is inevitable and urges using the ECB to purchase distressed sovereign debt. Micossi also emphasises the importance of using the EFSF to issue union-bonds backed by the joint guarantee of all Eurozone member states.