Thursday, September 27, 2012

A Hobson’s Choice for Europe?

Tom Hirst of Mindful Money opines, Popular unrest in Spain could push Europe into a dangerous new phase (h/t, Yanis Varoufakis):
The eruption of popular unrest in Spain and a rising threat of Catalan secession could push Europe into a dangerous new phase. While central bank action may have calmed the bond markets in recent weeks, it has done little to alleviate the consequences of harsh austerity on the populations of struggling states.

Where one country in a monetary union is running a current account surplus, it is a good bet that a large part of it is being funded by deficit spending from other member states. If there is then a market disruption those countries with a deficit can quickly get into trouble unless they are able to rebalance their economy.

The narrative fits neatly for countries such as Germany and Greece. Between 1997 and 2007, GDP growth in Greece averaged 4% - around twice the average for the region as a whole. This impressive growth rate was financed through low borrowing costs provided by the apparent security of the monetary union and allowed the country to run up huge government borrowings.

In turn it facilitated the increased consumption of, among others, German exports at a higher rate than would otherwise have been possible. However, it also increased the fiscal vulnerabilities of the Greek state so that it was ill prepared when the financial crisis struck and it became difficult to meet its spending commitments.

Unfortunately, while the Greek example may be a useful parable for proselytisers of austerity the case of Spain does not fit the pattern so neatly. As Paul Krugman, Nobel-winning economist and columnist for the New York Times, wrote in April:
"In a way, it doesn't really matter how Spain got to this point - but for what it's worth, the Spanish story bears no resemblance to the morality tales so popular among European officials, especially in Germany. Spain wasn't fiscally profligate - on the eve of the crisis it had low debt and a budget surplus. Unfortunately, it also had an enormous housing bubble, a bubble made possible in large part by huge loans from German banks to their Spanish counterparts. When the bubble burst, the Spanish economy was left high and dry; Spain's fiscal problems are a consequence of its depression, not its cause. "

The point is not that Germany alone was at fault for creating the Eurozone's crisis. Indeed the allocation of blame ignores the interconnectivity that provided the conditions for the crisis. The failure to frame solving the fiscal woes of Southern European countries as a common cause, however, is having real-world implications and is driving fractures in the union ever deeper.

The human condition

A principle failure has been the inability of Eurozone politicians to communicate with their electorates. How opposed would German taxpayers be to fiscal transfers for struggling member states if they were told that a disorderly break up could cost Germany around €1,000 billion in write downs?

Moreover in countries where the need for fiscal consolidation is considered urgent a demonstration of support by European partners could go a long way to assuaging the rising tide of anger against government reforms. Even if politicians deem it accurate, There Is No Alternative neither appears a particularly democratic way to justify policy decisions nor a compelling argument for having almost a quarter of the working-age population out of a job.

This looks to be what is currently playing out in Spain. With the unemployment rate running at 24.6%, news today that the economy is expected to contract in the third quarter of 2012 will make for grim reading. After images of police firing rubber bullets at protestors in Madrid yesterday, who had taken to the streets to protest the "kidnapping of democracy", it seems the mood of the country is turning from indignant to angry.

Adding to Prime Minister Mariano Rajoy's woes, the inability of the government to address the concerns of its citizens has allowed Artur Mas, the Catalan President, to piggyback on hostility to press for greater independence for Spain's richest region. It may be populist politics but Mas is simply exploiting the democratic gulf opening up between elected officials and voters in Europe.

Failure to address the democratic deficit alongside the fiscal one will only increase the likelihood of these types of situations occurring. Across the crisis-hit region anti-austerity parties have been gaining ground, many of which have attempted to use nationalist rhetoric to stoke hostility against the Euro project. Here the European Central Bank (ECB) cannot come to the rescue without a political mandate.

What needs to be done

Firstly, a campaign is required to candidly explain to the public what the consequences of a Eurozone collapse would be and allow them to vote on it. If they decide that it is a risk they are willing to take then they can choose either to continue with current policies or begin a discussion on a route to a more orderly dismantling of the monetary union.

If, however, the majority wish to remain part of the euro then this would provide the democratic mandate to institute thoroughgoing reforms necessary for its long-term survival. These would have to include removing the conditionality from the ECB's Outright Monetary Transactions to cap borrowing costs as well as some form of fiscal transfer from core to periphery.

Only then would a comprehensive package, such as Yanis Varoufakis and Stuart Holland's Modest Proposal for Resolving the Eurozone Crisis, become plausible.

Contrary to what eurosceptics assert, it remains possible for structural weaknesses to be addressed and a democratic solution reached without the full or even partial destruction of the single currency. Yet, as the situation in Spain demonstrates, for policymakers to achieve this political timidity is no longer an option.
That article prompted this response from Yanis Varoufakis, A Hobson’s Choice for Europe?:
Tom Hirst, of Mindful Money, has posted a thoughtful piece on the Euro Crisis, with special emphasis on the deathtrap that Spain is now in.
His analysis of the situation is spot on: so far, Europe’s responses to the Crisis have been piecemeal, disconnected from one another, and based on the denial that this is a Systemic Crisis (that requires a systematic approach) rather than a Greek Crisis that is separate from the Irish Crisis which is different to the Spanish Crisis etc.
His apt conclusion is that: “The failure to frame the solution to the fiscal woes of Southern European countries as a common cause…is having real-world implications and is driving fractures in the union ever deeper.”

In the last section of his article, Tom addresses “What Needs To Be Done”. Here is his verdict:
“Firstly, a campaign is required to candidly explain to the public what the consequences of a Eurozone collapse would be and allow them to vote on it. If they decide that it is a risk they are willing to take then they can choose either to continue with current policies or begin a discussion on a route to a more orderly dismantling of the monetary union.
If, however, the majority wish to remain part of the euro then this would provide the democratic mandate to institute thoroughgoing reforms necessary for its long-term survival. These would have to include removing the conditionality from the ECB's Outright Monetary Transactions to cap borrowing costs as well as some form of fiscal transfer from core to periphery.
Only then would a comprehensive package, such as Yanis Varoufakis and Stuart Holland's Modest Proposal for Resolving the Eurozone Crisis, become plausible.
Contrary to what eurosceptics assert, it remains possible for structural weaknesses to be addressed and a democratic solution reached without the full or even partial destruction of the single currency. Yet, as the situation in Spain demonstrates, for policymakers to achieve this political timidity is no longer an option.”

I could not but agree with the general thrust here. But I do have one significant qualm. Tom seems to be assuming that a referendum on the Eurozone will be couched as a choice between (a) the current policies and (b) a rational alternative that would transform the Eurozone from an unsustainable to a viable currency union. Alas, this would require a German leadership that wants to resolve the Crisis and is prepared to bind Germany irreversibly to this re-designed currency union.
And here is the rub: The very reason this awful Crisis was allowed to go on and on and on is that Germany’s elites have not resolved to do this. Indeed, if anything, they are shifting in the opposite direction, especially now that the Bundesbank has become the de facto champion of a Eurozone breakup. Thus, if a referendum is put to the German people, it will resemble more of a Hobson’s Choice, than any real dilemma on Europe’s future.
Now, I don't agree with Varoufakis on many issues, including the Modest Proposal he and Stuart Holland put forth to deal with the euro crisis (read Andreas Koutras' critique).

Moreover, unlike Varoufakis, my problem with reforms in Greece isn't with austerity per se, but how austerity was implemented in Greece. Instead of chopping Greece's bloated public sector in half (or more) when the crisis began, leaving the rest intact, Greek politicians vying for votes from powerful and corrupt public sector unions, all bent over backwards to appease these unions, effectively condemning the entire population so a bunch of inefficient civil servants can keep their jobs.

Importantly, don't listen to Greek reporters and left-wing academics on the public sector unions' payroll lamenting that the 'troika is milking their country dry' or that tax evasion is Greece's biggest problem. This is pure rubbish. The biggest threat to the Greek economy is a public sector monstrosity that's the result of decades of political bribery from both major parties, promising 'jobs for life' to buy votes. (A friend of mine said it best: "Greece needs a Margaret Thatcher". Couldn't agree more.)

But one place where I do agree with Varoufakis is that  Germany's elites have not resolved to stem the growing crisis in a systematic way. Part of the reason why is that for Germany, the euro crisis is a mixed curse:
For Germany, the European crisis (formerly the debt crisis) was always a mixed curse. German taxpayers found themselves on the hook for a string of sovereign bailouts. On the other hand, the crisis sent the euro into the toilet and that was good news for German exports and job creation.

Before the crisis began in earnest in late 2009, with Greece’s admission that it had lied about its debt load, the euro was trading at about $1.60 (U.S.). Since then, it has been downhill for Greece, Ireland, Portugal, Spain and France. Ditto the euro. It went from a high of about $1.60 to a low, in July, of about $1.20 – a 25-per-cent fall.

German exports, from BMWs for Russians to machine tools for Chinese factories, duly surged and the jobless rate went in the opposite direction. At one point earlier this year, German unemployment went as low as 5.4 per cent – the best reading in decades. It has been rising in recent months, but, at 6.8 per cent, remains far below 11.2 per cent for the euro zone as a whole and a quarter of Spain’s grisly jobless rate of 25 per cent, and rising.

As a bonus, the capital flight to safety pushed Germany sovereign bond yields into free-money territory. On Monday, the 10-year bond was at 1.7 per cent. Only Japanese yields are lower.

Sadly for German exporters, the euro has been on tear. The rally started in August, when European Central Bank boss Mario Draghi said the ECB “will do whatever it takes” to spare the common currency from oblivion. It gained momentum about 10 days ago, when Mr. Draghi announced the relaunch of the ECB’s sovereign bond buying program (with the European bailout funds at the bank's side). It gained even more momentum last week, when Germany's constitutional court rule in favour of the new rescue fund, known as the European Stability Mechanism, Dutch voters endorsed broadly pro-European parties and Greek officials signalled that the European Union might give Greece a bit more time to meet its bailout conditions.

All the good news hit the euro short sellers like a cluster bomb, and they got it again when the U.S. Federal Reserve late last week unveiled its third quantitative easing onslaught, the so-called QE3. The euro went above $1.31 on Friday, though dollar weakness certainly helped to propel the euro's run. Since July, the euro has gained more than 9 per cent. The euro is also at a four-month high against the yen.

On Monday morning, the euro fell marginally and currency strategists were busy wondering whether the euro had temporarily peaked out, was set for a new plunge or might even rise as the open-ended QE3 program weighs on the dollar. To be sure, a renewed euro zone crisis, such as a Spanish sovereign bailout on top of the €100-billion Spanish banking bailout, could send the euro swooning again. But only the bravest currency speculators would ramp up their euro short positions today. The euro could equally rise to $1.33 or higher.

German exporters will be the keenest euro watchers. The weak euro has been a godsend to them. German exports are near their all-time highs of May, 2012 while Japanese exports have plummeted in recent years, thanks to the enormous depreciation of the euro against the yen.

With the euro powering forward, you can bet that German exports will fall somewhat, and that Germany's jobless rate will not. You can also bet that Germany’s manufacturers and exporters will put pressure on chancellor Angela Merkel to keep the austerity campaign intact in the weakest countries, all the better to keep the currency tension intact. A de-stressed euro zone that sends the euro soaring might be good news for Japan, not so for its great export rival Germany.
There is much truth to this but the reality is that German political posturing has reached its limits and now threatens the global recovery, core European countries, including Germany itself.

David McWilliams of the Irish Independent warns, Prepare for titanic struggle as Draghi turns euro into lira:
Well that didn't last long, did it? The financial market euphoria, which greeted the announcement that the ECB would buy bonds in unlimited quantities, has melted away. In its place, the realisation that Europe's economy is weakening quickly is puncturing short-lived optimisms.

Yesterday, we had more evidence from Germany that business confidence is ebbing more quickly than anyone anticipated. The IFO index of businesspeople's expectations about the future has now fallen for the fifth consecutive month.

The rolling recession, which started with the collapse of Lehman, initially affected highly leveraged countries like Ireland, Iceland and Greece, then mutated into a slump in Spain and Italy and it is now moving in a crashing wave to the core of Europe. Affecting France at the beginning of this year, it is now being felt in the industrial powerhouse of Europe, Germany.

Until recently, China's demand for German exports -- particularly heavy machinery, which Germany excels at -- kept order books healthy. But now Chinese demand is not there any more as its exports and economy weaken. The real fear in China is that it will prove to be the mother of all property bubbles, which will burst.

This is its own fault because, as money flooded into China, the revenue from its exports should have caused the Chinese currency to rise. But the Chinese didn't allow this to happen and they allowed the local money supply to grow, providing cheap loans for speculation on property. Now the result isn't just ghost estates, but entire ghost cities of unsold apartments.

All this is having an impact on Germany. The economy that was once a powerhouse may well prove to be regular after all. The slowing in Germany will cause a renewed crisis in the eurozone because Germany, as well as being an exporter, is an importer and France and Italy are her main clients.

As always happens when there is a slowdown, the least competitive supplier loses. This will put the spotlight again on Italy and, for the first time in the crisis, on France.

If growth stumbles again, the inconsistencies in France will become more evident. France is a country which has been running a budget deficit for years, but in recent times it has also been running a current account deficit.
Of more concern is that France is a country that has proved itself incapable of even the most modest reforms to its labour market. This inflexibility will prove to be highly damaging if it has to seek ECB assistance (as Spain will definitely require and Italy is likely to need). In short, France is Europe's Achilles heel and, next year, we should expect more financial fireworks as the French bondmarket is sold by investors.

This cyclical slowdown is coming in a German election year when the hostility between the German Bundesbank and the ECB's Italian leadership will be difficult to conceal.

You know the world is in a strange phase when the Pope is a German and the head of the central bank is an Italian. But just how Italian, is now dawning on many in Germany. Make no mistake about it, Mario Draghi is turning the euro into the lira because he realises that in order to survive, the euro needs to look and feel much more like the lira than the Deutschemark.

Whatever the Germans were expecting when they reluctantly gave up their Deutschemark, they sure as hell weren't expecting the lira. But this is what they are getting.

As growth wanes, open war is likely to erupt between the Bundesbank and the ECB in a philosophical as well as economic confrontation.

The Germanic view of money, exemplified by the Bundesbank, sees money as a 'common good', protected by treaties and laws and it is a common good that no government or institution owns: the economy adapts to money, not the other way around.

The alternative school of thought, exemplified by Mario Draghi, views money as a tool: the state or institutions have a responsibility to use money to achieve desired outcomes, such as full employment, or economic growth, or saving the euro.

Thus we are set for a titanic struggle in Europe and the trigger for this struggle will be a crisis in France, where faltering growth will force it into an economic adjustment, which the country is simply incapable of effecting.

Europe's economic problems are: too much debt, too little growth and a lack of coherent political leadership.

None of these issues has been addressed by what is in effect monetary financing through the back door announced by the ECB two weeks ago. These problems will resurface in 2013 and, when they do, expect the next move from Draghi in 2013 to be printing of more money as the gradual but unambiguous "lira-isation" of the euro continues.

This is good for us because our major trading partners are Britain and the US, so anything that weakens the euro is good for Ireland. In addition, the bank debt deal will be supported by Draghi and we should play to this audience and for his affection in the months ahead.

But the question for the euro is how long Germans will tolerate the debasing of a currency that they intended to be as least as strong as the Deutschemark. In the past few days, the financial markets are suggesting that the Germans will not remain sanguine forever.

In the next few weeks, economists and analysts at large banks and pension funds will be locked in meetings trying to figure out what is likely to happen next year and how to position their funds accordingly.

Looking at the recent numbers, we are likely to see recessionary conditions in core Europe in 2013. Before the end of the year, Greece will need another bailout and Spain will be bounced into an IMF/EU programme.

But the big story for 2013 is likely to be France and the row, in a German election year, between Germany and the rest as the euro morphs from a mini-Deutschemark to a mini-lira under the eye of Mario Draghi.
Germany has little choice and will allow the "lira-isation" of the euro to continue as it will help bolster its exports (outside Europe) and loosen financial conditions in struggling periphery countries.

I'm actually part of a minority who think that Europe will eventually come out of this mess much stronger, but I do fear the current disjointed and piecemeal approach can easily devolve into further social unrest as unemployment soars to dangerous levels. At that point, we won't be discussing a Hobson's choice for Europe but a Hobbesian state of nature which will send Europe back to the Middle Ages, threatening global stability and prosperity.

Below, John Taylor, founder and chief executive officer of FX Concepts LLC, talks about the euro, the Swedish krona and the impact of central bank policies on the currency market. He speaks with Erik Schatzker and Stephanie Ruhle on Bloomberg Television's "Market Makers."