Friday, March 18, 2011

The Eurozone's Murder-Suicide Pact

On March 12th, EuroIntelligence began a new service in the form of a Policy Brief for members only and the first one arrived by email only and was entitled "What Germany Wants", which was about Germany's negotiating position in the eurozone crisis resolution debate.  In fact, the eurozone countries were meeting that very weekend to discuss that very issue in a prelude to the European Council meeting on March 24/25.

The Policy Brief asserted that Germany is pivotal as the main backstop to the system and said "There is no such thing as a unified negotiating position, but a series of political positions and legal constraints ..." and the cacophony of different statements from within Germany can be confusing to outsiders.  The Policy Brief stated that Germany's definition of the crisis is ) a crisis of imbalances caused by weak competitiveness in the periphery and 2) a fiscal crisis due to direct fiscal indiscipline and irresponsible fiscal policies triggering excessive fiscal guarantees and Germany wants to to solve both simultaneously.  "Germany is prepared to support the EFSF and the ESM as effective crisis mechanisms, but wants to ensure at the same time that these mechanisms are hardly ever used."  The Policy Brief stated Merkel's political position is to sell the crisis resolution mechanism if she can convince her various constituencies that the EU has taken effective action to reduce future crises.  Thus, Germany wants a strong competitiveness pact and a restrictive EFSF/ESM with the latter only acting after an emergency has already arisen and there are no alternatives left.  It has no desire to prevent, provide precautionary credit lines, or issue "indiscriminate" credit lines.  Germany's position is prevention of crisis would be illegal under its national Constitution.  In my opinion, this would make the crisis resolution mechanism ineffective as it could not act until after a crisis had become too hot and contagious to handle in an effective and timely manner.

The Policy Brief attempts to argue that Germany's position is actually more flexible than it appears, because the German government accepts the principle of primary purchase if it meets the above criteria.  However, this would include a debt function in the stability and growth pact, which Italy refuses to accept, as well as the acceptance of a national debt brake.  "The condition for any primary market purchases --- as for EFSF?ESM loans --- would be an agreed restructuring/austerity programme."  Germany would even accept the principle of credits for bond repurchases, although the ECB might object and it would probably be construed as a quasi-default.  While Germany's position may be more open than its public stance, it is always conditional.

Germany has taken a very hard line against Ireland insisting it must accept tax harmonization, although it does not yet exist in the EU, before it will receive an interest rate cut on EU loans.  It also opposes any debt rescheduling (restructuring/default) before 2013 (think Greece) based on the hope that the bank system in the EU can be restructured to weather the losses by then.  This hard-line position plays to the internal politics of Germany and the Bundestag's opposition to any bond market operations, primary or secondary, but it leaves no room for surprises like Portugal, or austerity or budget failures in Greece, the cost of Spanish bank restructuring, or Irish anger over the failure of the EU to share the burden of restructuring the Irish banks after the Irish government went out of its way to guarantee senior bond holders (i.e., German, French, Dutch, and UK banks).  In my opinion, Germany's position is doomed to failure, because "surprises" are born from not acting proactively  and in a timely fashion to prevent crisis situations.

On the 25th of February, a discussion draft of a competitiveness pact was drafted.  It put forward four conditions for success to foster economic convergence within the monetary union: it should add value while being in line with existing economic governance, it should be action focused and cover priority areas fostering real convergence and competitiveness, it should respect the integrity of the single market, and it should be monitored with periodic reports as well as all member nations should consult with the union on any major economic reforms with spillover potential.  The key objectives should be to foster competitiveness through alignment of wages and productivity, "to foster employment by making work more attractive", to contribute to the sustainability of public finances with regard to debt, pensions, and social security programs, and to reinforce financial stability.  When the document tried to break these generalities down into indicators and reforms, the weakness of the concepts of flexible work force, selective opening of sheltered sectors, reducing wage collective bargaining and public worker rights, tax harmonization, and banking resolution are starkly apparent.

The competitiveness pact draft was attacked by Daniel Gros as economically flawed in that wages are endogenous and react to productivity growth, those countries with the highest productivity growth have also had the highest loss of competitiveness measured by relative unit labor costs, and competitiveness measures themselves are of demonstrably little value in predicting export performance.  These are all indicators and not the underlying problems.

Wolfgang Munchau criticized German politicians who believe crises will just go away if you say no loud enough, because they have learned nothing and forgotten nothing.  He points out that you can deal with default by either lack of payment or bailout and Germans have difficulty even having words which crisply express these concepts much less grasp them fully.  One can either act responsibly and reform through a bailout or do nothing and end in disorderly default.  Bond purchases in the primary market would extend the EFSF powers and help stabilize countries.  He believes market stabilization would have to come with conditions.  Without the support to enable the necessary adaptations, the reforms are not realistic.  Failure to provide such support leads necessarily to a messy default with direct impact on German banks and the government's budget, as well as insurance companies and pension funds.  Munchau believes the political position of the German government is illogical: one can say no to bond purchases or to a new bank rescue law but not both simultaneously.  It would create wide spread financial instability even in Germany.  This means either a limited bailout of Greece, Ireland, and/or Portugal or an unlimited bailout of German banks.  Germany is putting its head in the sand, aware of the risks to Germany, but ignoring the larger total risks.

During the March 11 weekend conference, Germany did make some concessions to boost the bailout fund to its full $440 billion euro lending level and allow the purchase of bonds on the open market if the country agrees to strict bailout conditions.  It fell short of the desire of other members to allow the purchase of bonds to calm markets.  They agreed to lower Greek interest rates 1%, but refused to give Ireland the same consideration.  For these concessions Germany exacted conditions for Greece to fire-sale national assets, Portugal must cut pension, welfare, and health expenses on top of wage cuts, Ireland must give up its corporate tax, Spain and Belgium et al must submit to surveillance of their pensions, wages, productivity levels, and yield to demands for mandatory debt-brakes even if it results in deflation.  The surprise deal, the Pact for the euro, was perceived as a German triumph and greeted with mildly positive market response mixed with skepticism that it was not structured in a manner to effectively end crises.

In essence, the surprise deal puts the burden of stopping the crisis on the backs of the countries needing timely and effective assistance within a monetary union.  It is hard to understand how this can be perceived as realistic.  It contains a lot of tough talk, but Greece, as an example, cannot maintain a fiscal surplus 5.5% of GDP year after year as would be required under the sustainability calculation.  The conditions have not been thought through with respect to the consequences for the countries individually.  The can is just being kicked down the road where it will be worse and more threatening.  According to the Bank of International Settlements data, there is over 1.6 trillion euro exposure of EU banks, mostly in Germany, the UK, and France, to Greece, Ireland, Portugal, and Spain.  As the details become more widely known there should be growing questions from those who want an effective resolution mechanism and those who want to blame and hide.  Some critics are voicing the opinion that the problem is not economic but political with increasing tension between the have and have-not countries.  This is compounded by mounting political pressures within all of the countries, including Germany, as the different countries try to politically barter different positions with little regard for the total risks.  In trying to wind her way through a tough electoral season, Merkel (Germany) is demanding austerity policies which undermine the long-term political stability of other countries.  Continued muddling through will lead only to complete economic collapse.  The stabilization mechanism is being lost from view in the confusion of roles within the EU over what the EU is and what it should do and what each member should do to the extent that democratic principles are being shunted aside.

Not without regard to the anger in Germany, the anger in Greece, Portugal, and Ireland may boil over come March 25th at the European Council, because Ireland holds a trump card which is rejection of the bailout agreement and the guarantee of the Irish banks senior bond holders.  While this could result in default (proponents in Ireland insist it national debt would be honored) and unlikely without its own fiat currency, the trump card is still very effective in its threat to the German, French, Dutch, and UK banks which are the senior bond holders.  On the other hand, a positive shared burden of ownership by all eurozone members could be achieved by using the Irish banks as the first bank resolution of European bank restructurings to create financial stability. A 150 billion euro debt for equity sale of Irish banks could make it possible to avoid a possible default and bring the eurozone countries working together.  Despite the elegance of such a proposal, it has drawn little positive attention and criticized as too complicated, a default restructuring, impractical, and, of course, a violation of the new EFSF/ESM operating rules.  The point is a trump is still a trump.  Join an work together or economically kill each other off until the last are doomed to economic self-destruction.  The Competitiveness Pact, the Pact for the euro, is a Murder-Suicide Pact.

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