Europe’s Austerity Zombies                          

Joseph E. Stiglitz, 09/26/14

NEW YORK – “If the facts don’t fit the theory, change the theory,” goes the old adage. But too often it is easier to keep the theory and change the facts – or so German Chancellor Angela Merkel and other pro-austerity European leaders appear to believe. Though facts keep staring them in the face, they continue to deny reality.

Austerity has failed. But its defenders are willing to claim victory on the basis of the weakest possible evidence: the economy is no longer collapsing, so austerity must be working! But if that is the benchmark, we could say that jumping off a cliff is the best way to get down from a mountain; after all, the descent has been stopped.

But every downturn comes to an end. Success should not be measured by the fact that recovery eventually occurs, but by how quickly it takes hold and how extensive the damage caused by the slump.

Viewed in these terms, austerity has been an utter and unmitigated disaster, which has become increasingly apparent as European Union economies once again face stagnation, if not a triple-dip recession, with unemployment persisting at record highs and per capita real (inflation-adjusted) GDP in many countries remaining below pre-recession levels. In even the best-performing economies, such as Germany, growth since the 2008 crisis has been so slow that, in any other circumstance, it would be rated as dismal.

The most afflicted countries are in a depression. There is no other word to describe an economy like that of Spain or Greece, where nearly one in four people – and more than 50% of young people – cannot find work. To say that the medicine is working because the unemployment rate has decreased by a couple of percentage points, or because one can see a glimmer of meager growth, is akin to a medieval barber saying that a bloodletting is working, because the patient has not died yet.

Extrapolating Europe’s modest growth from 1980 onwards, my calculations show that output in the eurozone today is more than 15% below where it would have been had the 2008 financial crisis not occurred, implying a loss of some $1.6 trillion this year alone, and a cumulative loss of more than $6.5 trillion. Even more disturbing, the gap is widening, not closing (as one would expect following a downturn, when growth is typically faster than normal as the economy makes up lost ground).

Simply put, the long recession is lowering Europe’s potential growth. Young people who should be accumulating skills are not. There is overwhelming evidence that they face the prospect of significantly lower lifetime income than if they had come of age in a period of full employment.

Meanwhile, Germany is forcing other countries to follow policies that are weakening their economies – and their democracies. When citizens repeatedly vote for a change of policy – and few policies matter more to citizens than those that affect their standard of living – but are told that these matters are determined elsewhere or that they have no choice, both democracy and faith in the European project suffer.

France voted to change course three years ago. Instead, voters have been given another dose of pro-business austerity. One of the longest-standing propositions in economics is the balanced-budget multiplier – increasing taxes and expenditures in tandem stimulates the economy. And if taxes target the rich, and spending targets the poor, the multiplier can be especially high. But France’s so-called socialist government is lowering corporate taxes and cutting expenditures – a recipe almost guaranteed to weaken the economy, but one that wins accolades from Germany.

The hope is that lower corporate taxes will stimulate investment. This is sheer nonsense. What is holding back investment (both in the United States and Europe) is lack of demand, not high taxes. Indeed, given that most investment is financed by debt, and that interest payments are tax-deductible, the level of corporate taxation has little effect on investment.

Likewise, Italy is being encouraged to accelerate privatization. But Prime Minister Matteo Renzi has the good sense to recognize that selling national assets at fire-sale prices makes little sense. Long-run considerations, not short-run financial exigencies, should determine which activities occur in the private sector. The decision should be based on where activities are carried out most efficiently, serving the interests of most citizens the best.

Privatization of pensions, for example, has proved costly in those countries that have tried the experiment. America’s mostly private health-care system is the least efficient in the world. These are hard questions, but it is easy to show that selling state-owned assets at low prices is not a good way to improve long-run financial strength.

All of the suffering in Europe – inflicted in the service of a man-made artifice, the euro – is even more tragic for being unnecessary. Though the evidence that austerity is not working continues to mount, Germany and the other hawks have doubled down on it, betting Europe’s future on a long-discredited theory. Why provide economists with more facts to prove the point?

Joseph E. Stiglitz, a Nobel laureate in economics and University Professor at Columbia University, was Chairman of President Bill Clinton’s Council of Economic Advisers and served as Senior Vice President and Chief Economist of the World Bank.

So you think Europe's debt crisis is finally over? Time to think again

One of the factors underpinning renewed confidence in the UK economy is the belief that the crisis in Europe is now essentially over.

Jeremy Warner, The Telegraph, 08/12/13

One of the factors underpinning renewed confidence in the UK economy is the belief that the crisis in Europe is now essentially over. The immediate threat of banking and fiscal meltdown in the southern periphery has receded, and after one of the longest recessions on record – six successive quarters of economic contraction – there are even tentative signs of recovery.

Among eurozone policymakers, the relief is palpable. Mario Draghi, president of the European Central Bank, has waved his magic wand and apparently succeeded in calming the economic maelstrom. This is small thanks to the German core, which fought his actions tooth and nail but now seems more than happy to take credit. In any case, with the fear of financial Armageddon removed, European economies can begin the long march back to health. For Britain too, a key uncertainty for the banking and business sectors has been answered.

Or has it? For though it is true that some form of equilibrium seems slowly to be re-establishing itself in the European economy, it is at such a deeply impaired level that it can scarcely be regarded as cause for celebration. Unemployment, already at intolerable levels in some eurozone countries, is still rising and money growth remains exceptionally depressed.

Nor is there any end in sight to credit destruction, with deeply negative implications for SMEs and future jobs creation. According to a new report by Royal Bank of Scotland, Europe's banks need to shed a further €3.2 trillion (£2.7 trillion) of assets (roughly equal to annual German GDP) to comply with new international capital standards.

IMF research cited last week by the European Central Bank puts the eurozone's "structural unemployment" rate – that is the unemployment that won't go away even after the economy returns to normal – at a staggering 10.1pc, up from 7.4pc before the crisis. If correct, it means that any European recovery will be a largely jobless one.

Worse, barely a start has been made on the political, institutional and structural reform necessary to bring about a sustainable monetary union. The best that can be said for the eurozone crisis is that it is merely dormant. At any moment, it could re-erupt.

Contrary to the more upbeat economic forecasts that are beginning to emerge, both from official and outside sources, this is quite likely to happen at some stage over the next year, for Europe's crisis has always been as much political as economic and financial.

Where to begin? In Italy, government is only possible courtesy of support from Silvio Berlusconi's notoriously fluid Centre Right Coalition. All attempts at structural reform seem meanwhile to have run into the sand.

In Spain, prime minister Mariano Rajoy has taken to trying to deflect attention from allegations of personal impropriety by bizarrely making common cause with Argentina against British sovereign interests. Desperation indeed, seeing that many of his dispossessed army of unemployed seem to be over here in Britain, enthusiastically manning the counters at Pret a Manger and most other London-based fast food chains.

Portugal, where imposed austerity programmes have backfired spectacularly, looks in even worse shape. Nearly a quarter of sovereign debt has to be refinanced next year, with the government clinging to power only by the narrowest of majorities. Scarcely a week goes by without news of another ministerial resignation.

The one apparent bright spot amid all the economic misery is that current account deficits have narrowed, and in some cases even closed entirely, meaning that one-time deficit nations no longer have to finance their consumption externally. This has helped ease the debt crisis somewhat.

Yet, if destroying internal demand counts as success, as indeed it seems to at high command in Berlin, then it's even worse than I thought. Ask not what the euro can do for you, to misquote JFK; ask only what you can do for the euro.

One of the mistakes Anglo-Saxon commentators such as myself have made in forecasting the imminent demise of the euro is to focus only on its economic contradictions. If these were the sole determinants, then the euro would indeed already have lost a number of its original participants.

But for most, the single currency is built on political idealism – belief in common destiny and shared responsibility after the troubles of the past – and this has proved a far more resilient force than I appreciated. Unfortunately, it has also failed to generate the necessary resolve to do something about Europe's economic malaise, which won't, as policymakers seem to think, simply go away of its own accord given time, fiscal, and structural reform in afflicted nations.

However much Europe might wish to eliminate them, there will always be imbalances within the eurozone. With free floating currencies, these would normally be self correcting. Currency adjustment would both eradicate differences in competitiveness and provide a natural market mechanism for burden sharing.

Plainly, this cannot happen in a rigid, fixed exchange rate regime, where in the absence of debt mutualisation and fiscal transfers between nations, the adjustment has to be made through reductions in relative prices and wages. This latter process is proving both exceptionally painful, and in many respects counter-productive, since shrinking the economy as internal devaluation demands is further adding to the existing debt burden relative to GDP. Both the Merkel Government in Berlin and the European Commission in Brussels have softened their approach in recent months. Nations have been given more time to meet challenging deficit reduction targets. There will no doubt be more of that once Merkel is safely re-elected next month, especially if forced into another Grand Coalition with Peer Steinbruck's Social Democrats. There is only one thing that upsets Germans more than having to open their cheque books to bailout the feckless South, and that's being the most hated nation in Europe.

But the belief, still quite widely held in the financial community, that the German Chancellor will want to cement her legacy by going the whole hog and agreeing some form of debt mutualisation is just fantasy. Merkel is a small steps, evolutionary leader, not a revolutionary one.

What's more, the public mood in Europe is if anything becoming more nationalistic, not more integrationist. European elections next year are likely to given rise to the most eurosceptic parliament ever – a collection of highly nationalistic MEPs committed more to abolishing the European Commission than making it an alternative source of government. Power will therefore drift away from the Commission and towards the Council of Ministers.

This may suit David Cameron's campaign to win back powers from Europe, but it will be very bad for the further integration necessary to make monetary union a sustainable economic project. Already, Germany has dug its heels in over implementation of a fully functioning banking union, an absolute prerequisite for a successful single currency.

All this leads to the conclusion that Europe will remain economically depressed and crisis ridden for a long time to come.

http://www.telegraph.co.uk/finance/comment/jeremy-warner/10238631/So-you-think-Europes-debt-crisis-is-finally-over-Time-to-think-again.html

Eurozone crisis declared ‘over’ by French president as unemployment across the region soars

National Post Wire Services, 06/10/13

TOKYO — French President Francois Hollande told a group of Japanese business leaders Saturday that the eurozone debt crisis is ‘over’ but acknowledged that steps to boost the region’s growth and competitiveness need to be taken.

“What’s important for you here in Japan is to fully understand that the crisis of the eurozone is over,” Hollande said in the speech at the Imperial Hotel organized by The Nikkei, a major financial newspaper.

Although the eurozone debt crisis that erupted at the end of 2009 has eased, the region’s collective economy has shrunk for six straight quarters and unemployment has reached 12.2%, the highest since the euro was introduced in 1999. Joblessness remains particularly entrenched among Europe’s youth.

Hollande, on a two-day trip to Japan, said Europe now needs to put more emphasis on taking steps to promote growth and competitiveness “so that we can have a better presence in the world.”

“Europe has become more stable, but it must now be more oriented toward growth,” Hollande told the conference.

He also highlighted his proposal to create a common economic government for the eurozone that would set economic policy.

In a speech on the final day of his visit to Japan, Hollande said that the potentially destructive debt crisis has served to “reinforce” Europe and foster greater integration of the 17 member economies that use the euro currency.

He said authorities are developing tools to ensure greater stability and solidarity such as a Europe-wide “banking union” and budgetary rules.

Finance and labor ministers from Spain, Germany, Italy and France are scheduled to meet on June 14 in Rome to hammer out a European plan to directly address the 24% youth-unemployment rate. Merkel and Hollande met at the end of last month to discuss the issue, announcing an initial US$7.9-billion to fight joblessness.

European leaders won more potential reprieve after European Central Bank President Mario Draghi last week said the euro economy will return to growth by the end of the year.

Compiled from Associated Press and Bloomberg files

http://business.financialpost.com/2013/06/10/eurozone-crisis-hollande/

Just when you thought it was safe…

Bailing out Cyprus was always going to be tricky. But it didn’t have to be like this

The Economist, 03/23/13

EVEN by the standards of European policymaking, the past week has been a disaster. In the early hours of March 16th, nine months after Cyprus first requested a bail-out, euro-zone finance ministers, led by the Germans, offered a €10 billion ($13 billion) deal, well short of the €17 billion needed. Who ordered whom to do precisely what is not clear, but the Cypriots then said they would raise a further €5.8 billion by imposing a levy on depositors -- of 9.9% on savings above the €100,000 insurance-guarantee limit, and 6.75% for deposits below it. Chaos ensued, not least among the many Russians (reputable or not) who have parked their money in the lightly regulated island. On March 19th, with crowds in the streets and all the banks firmly shut, the Cypriot parliament rejected the bail-out package (see article). As The Economist went to press, the scene had shifted to Moscow, where the Cypriots were trying to persuade Vladimir Putin and his cronies to contribute some money in exchange, perhaps, for future gas revenues.

Cyprus is a Mediterranean midget, with a GDP of only $23 billion. But this crisis could have poisonous long-term consequences. Eight months after the European Central Bank appeared to have restored stability by promising to do whatever it took to save the currency, the risk of a euro member being thrown out has returned. It has increased the chances of deposit runs (if Cyprus can grab your money, why not Italy or Spain?). And it has revealed the lack of progress towards a durable solution to the euro’s troubles. Ideally, all this will prompt the Europeans to push ahead with reforms, but with a German election in the autumn that seems unlikely.

Towards Cyprussia?

Cyprus is broke. Its debt, if it took on its banks’ liabilities, would hit 145% of GDP. This newspaper suggested recapitalising Cypriot banks, on a case-by-case basis, directly through the European Stability Mechanism (ESM), thus breaking the vicious circle where weak sovereigns bail out weak banks. We also argued for depositors and senior bondholders to be spared -- not out of any particular love for rich Russians, but because of the fear of bank runs in larger weak euro economies. The Europeans instead decided to lend the money directly to the Cypriot government; and the Cypriots, perhaps bullied by some creditors, then decided to clobber all the banks’ depositors, even the insured ones.

This was ingeniously loopy. Cyprus is odd, because virtually all its banks’ liabilities are deposits (as opposed to longer-term bonds). Yet, of the 147 banking crises since 1970 tracked by the IMF, none inflicted losses on all depositors, irrespective of the amounts they held and the banks they were with. Now depositors in weak banks in weak countries have every reason to worry about sudden raids on their savings. Depositors in places like Italy have not panicked yet. But they will if the euro zone tries to “rescue” them too.

The blame for this should be shared between Cyprus and its creditors. Cyprus is guilty of a lot. It welcomed in the Russians and allowed its banks to get far too big: their assets reached 800% of GDP in 2011. The banks were in trouble even before the restructuring of Greek government bonds opened up a €4 billion hole in their accounts last year. As for the creditors, Angela Merkel’s priority seems to have been to appear stern before the German election, and the European Central Bank, whose job it is to protect financial stability, was party to a scheme that ended up jeopardising it.

What should Europe’s leaders do now? The worst outcome would be to allow the Cypriots to slide towards the exit. That would be disastrous for the island. And the euro zone would be wrong to imagine that Cyprus is tiny enough to let go safely. The currency’s credibility rests on the idea that it is irreversible.

Leaving it to the Russians to save Cyprus, by letting them recapitalise its banks and grab a slice of its gas, is an answer, but not the best one. However tricky the politics of using German taxpayers’ money to bail out Russian depositors, a deal that ends up entrenching Cyprus’s status as an offshore Russian satrapy would be a perverse outcome. A revised deal with the euro zone would be better.

The yoke of union

This newspaper would still prefer to recapitalise Cyprus’s banks directly through the ESM. That option is plainly not on the table. The best that can probably be done now is to spare the insured depositors, bail in other bank creditors and, given the economic damage caused in the past week, increase the amount of the bail-out. The financial assumptions in the rejected deal are already out of date. There will be capital flight when the shuttered banks eventually open; the island’s offshore-finance business plan is now bust. It needs to find new sources of prosperity, including faster exploitation of its recent Mediterranean gas finds -- although these can be overplayed (see article). The best long-term plan for its economy would be a deal with the Turkish-Cypriots to reunify the island, which would boost tourism and GDP.

More broadly, Cyprus’s tragicomedy should prompt Europe’s leaders to get a move on. Even if only uninsured deposits are hit, a line has been crossed. A formal European bail-in regime is needed as soon as possible, one that requires banks to hold a layer of loss-absorbing senior debt designed to spare depositors, both insured and uninsured, in all but the last resort. That promises a more predictable environment, but it will also entrench fragmentation, with borrowers in weak countries finding it harder and more expensive to gain access to credit. The only solution to such fragmentation is a proper banking union and limited mutualisation of sovereign debt.

The political consequences are toxic. Cyprus is the latest peripheral country to feel mistreated by creditor countries. For their part creditors resent the fact that their financial support is summarily discounted. The euro-zone economy is stagnant. Protest parties are gaining popularity. The euro was supposed to be the manifestation of a grand political project. It feels more like a loveless marriage, in which the cost of breaking up is the only thing keeping the partners together.

http://www.economist.com/news/leaders/21573972-bailing-out-cyprus-was-always-going-be-tricky-it-didnt-have-be-just-when-you

Six-Point Growth Plan Merkel Prepares to Strike Back Against Hollande

Der Spiegel Staff, 05/26/12

France's new president, François Hollande, has put the German chancellor on the defensive with his growth agenda. Now Angela Merkel is planning to strike back. She is calling for structural reforms to save the euro with a six-point plan aimed at harmonizing austerity and growth in Europe once again.

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The more European leaders talked at a dinner last Wednesday, the grimmer Angela Merkel looked. One after another, they spoke out in favor of the joint assumption of debt and against the strict austerity course Berlin is calling for. The chancellor stared silently at the man who was responsible for this change of mood -- France's new president, François Hollande, who noted with satisfaction that there was "an outlook for euro bonds in Europe."

Merkel disagreed, saying that euro bonds are not the right tool, but to no avail. Only a minority stood behind the German leader. Even European Council President Herman Van Rompuy said, at the end of the dinner, that there should be "no taboos," and that he would examine the idea of euro bonds. "Herman," Merkel blurted out, "you should at least say that some at this table are of a different opinion."

Merkel's world had been turned upside down. For the first time in years, the chancellor did not set the tone at an EU summit, nor did she and the French president agree on joint positions in a backroom before the meeting.

Much depends on whether Merkel and Hollande will be able to find common ground in the fight over Europe's common currency. They have been arguing for weeks over whether more austerity or more spending can save the euro. Now the dispute has reached a new level of escalation. After Hollande's statements on Wednesday, Merkel is now presenting her opposing concept. In a six-point plan, she calls for deep-seated structural reforms for Europe. Under the plan, government-owned businesses are to be sold off, protections against wrongful dismissal relaxed and obstructive regulations for companies removed. There is also talk of special economic zones and privatization agencies based on the model of Germany's Treuhand trust, created at the time of reunification to sell off most of former East Germany's state-owned enterprises. In short, the Mediterranean region is to become more like Germany, but with better weather.

Merkel and Hollande are presenting two contrasting programs for the planned EU growth summit at the end of June. A compromise will have to be reached in the end, but there are still considerable risks. If the two leaders manage to forge a joint concept for the currency zone out of their different plans, they could go down in history as the saviors of the euro. If they fail, the process that a growing number of experts believe is unavoidable will only be accelerated: the breakup of the monetary union.

Political Equilibrium At Stake

This week, Europe seemed to move a little closer to the abyss. The financial markets speculated on a Greek withdrawal from the euro, the exchange rate for the common currency plunged to new lows and economic imbalances worsened. While Germany was able to float a two-year bond with a zero interest rate on the markets for the first time, risk premiums for Spanish and Italian sovereign debt remained at crisis levels.

The euro zone is drifting apart, and the Franco-German dispute over how to tackle the problem is partly to blame. It isn't just a question of growth programs or the fiscal pact. Europe's political equilibrium, which has shifted since Hollande came into office, is also at stake.

A president has stepped onto the stage who wants to show his citizens and the rest of Europe that he will not submit to his more powerful German counterpart, Angela Merkel, because he believes that she is wrong. He doesn't want to agree to her conditions, but in fact dictate his own terms to her -- or at least he wants it to look that way.

In recent weeks, Hollande has come across as a man who was practically bursting with self-confidence. In response a conservative politician's critical remark that he behaves as if he could walk on water, he said jokingly to journalists at the recent G-8 summit in the United States: "The chances that I will attempt this are slim."

That was the most modest thing he said at the summit. Afterwards, the president bragged that he had placed the subject of "growth" on the agenda -- even if "growth" means something a little different to everyone else. His advisors let it be known that while Hollande and Obama got along very well, Merkel has been isolated with her austerity course.

Long before the EU special summit in Brussels on May 23, the French president made the impression that he wanted a showdown with the Germans. In the election campaign, he had consistently called for a renegotiation of the fiscal pact. After coming into office, he repeated that he would not ratify the pact unless it contained a "growth component." Although he has spoken out against the so-called communitization of debt in the past, since last week he is suddenly calling for real euro bonds, not just "project bonds" to pay for European infrastructure projects.

Last weekend, French Prime Minister Jean-Marc Ayrault made an additional demand, one that contradicts everything the Germans consider sacred: that the European Central Bank (ECB) should be able to lend money directly to countries in crisis.

A Vulnerable Merkel

It appears as if the French are trying to forge an alliance against the Germans, together with representatives of the European Commission, groups like the Organization for Economic Cooperation and Development (OECD), and the representatives of smaller and southern EU countries. Hollande's advisors have noted that Italian Prime Minister Mario Monti's ideas put him closer to the French than the Germans.

Has his successful start made Hollande overly confident? Or is he trying to lead Europe away from an erroneous course? Is he merely trying to expand his negotiating position to get as much as possible in the end? Or is it all just a big show for the domestic audience, which he hopes will provide him with a majority in parliamentary elections on June 10 and 17?

For the first time since the beginning of the debt crisis Merkel, once dubbed the "Queen of Europe," no longer seems invulnerable. Hollande, who she humiliated during the campaign by unconditionally siding with his predecessor, is now paying her back.

Nicolas Sarkozy, who sought his salvation by aligning himself with the chancellor, has been followed by a president who expects to achieve a greater political success by opposing German dominance in Europe. Hollande doesn't want a German-French directorate. Instead, he wants to open up Europe once again.

The French are convinced that what has to be done in the current crisis of confidence in the common currency is what Germany has sought to prevent until now: The euro-zone countries should issue joint bonds for at least a portion of their debt. They believe that euro bonds would establish the stability for investors in the crisis-ridden countries that is so urgently needed. Besides, Hollande said on Wednesday, it is unfair that Germany pays much lower interest rates than Spain, for example. The French argument is based on the view, shared by many economists, that a monetary union without a political union and debt sharing has never worked.

Hollande's ideas are not fundamentally different from those of his predecessor Sarkozy, who consistently held similar views. Sarkozy, however, worked out his differences with Merkel in back rooms, so as to bring calm to the markets. In contrast, President Hollande highlights the differences and seems convinced that it is up to him to put Germany on the right track.

A Judo Attack

But Merkel is an experienced opponent. She knows that she is now on the defensive in Europe, and she is planning her counter-attack. She believes that euro bonds would enable the crisis-ridden countries to lower their borrowing costs, and that the necessary structural reforms would be postponed. This is why she now wants to counter Hollande's proposals with a principle familiar to judo fighters: using your opponent's momentum for your own attack.

Merkel is determined to reject both Hollande's call for euro bonds and his proposal to allow direct lending by the ECB. The monetary watchdogs, she argues, would already do everything necessary to stabilize the euro, and thus preserve their high-paying jobs in Frankfurt's Euro Tower.

There is something to this. The ECB has signaled internally that, if it becomes necessary (if Greece withdraws from the euro, for example), it will buy up the bonds of other ailing countries once again. With a view toward Hollande's calls for more growth incentives, the Germans, for their part, are trying to seem more conciliatory. They are prepared to increase the capital of the European Investment Bank (EIB) to €10 billion, which would bring Germany's share to €1.6 billion.

They also want to yield to the French drive to use the money in the European Structural Funds in a more growth-friendly manner and float so-called project bonds. This would involve the EU countries and private investors raising funds together to pay for things like cross-border infrastructure projects. Merkel isn't hostile to the idea.

In Strasbourg, a day before the beginning of the EU special summit in Brussels last week, the European Parliament and European governments decided to try out such bonds, which was good news for Hollande. According to an internal European Commission priority list that SPIEGEL has obtained, some of the projects directly involve France. They include construction of the TGV high-speed rail line between Lyon and Turin, the Seine-Northern Europe canal in the corridor between Amsterdam and Marseilles and the expansion of travel routes between Dublin and Brussels.

When it comes to energy projects, the European Commission places special emphasis on projects such as connecting the wind farms in the North Sea and the cross-border power and gas lines among the Baltic countries, between Northern and Southern Europe and to North Africa. It also wants to promote international natural gas pipelines like Nabucco and expanding efficient internet connections. While Germany and France agree on the importance of these projects, their differences lie elsewhere. To stimulate growth throughout Europe, Merkel's advisors don't just want to implement measures that cost money. The Germans are convinced that growth can also be generated less expensively, using structural reforms that require nothing more than living with hardships.

Six-Point Plan

According to an internal document making the rounds at the Chancellery, German government experts have developed a six-point plan that is reminiscent of former Chancellor Gerhard Schröder's Agenda 2010 economic reforms, and seeks to harmonize austerity and growth in Europe once again. The document defines the position with which Merkel intends to enter into negotiations with Hollande and the other EU partners.

In the plan, the Germans focus primarily on measures that have been successful in Germany in the past, and that placed the country in the role of Europe's engine for growth. Accordingly, Merkel wants to launch Europe-wide programs to promote start-ups and small and mid-sized business, like the programs offered by the KfW development bank in Germany. Under the German programs, government agencies have to approve investments within a fixed time period, and the applications are considered automatically approved if they are not denied within that time period.

Merkel also wants EU countries with high unemployment to use Germany as a model in reforming their labor markets. This would mean relaxing protections against wrongful dismissal and introducing more limited employment circumstances, called "mini-jobs" in Germany, with lower tax and contribution burdens. And like Germany, these countries would also be expected to develop a dual education system, which combines a standardized practical education at a vocational school with an apprenticeship in the same field at a company in order to combat high youth unemployment.

Merkel's advisors have also noticed that southern EU countries still own many companies that enjoy special protections. Under their plan, privatization agencies or special funds would be established in these countries to privatize the state-owned businesses. Foreign investors could be attracted with tax benefits and less stringent regulations.

The advisors also recommend the establishment of so-called special economic zones, like the ones that once ushered in China's economic ascent. Finally, the Germans want Europe's southern countries to invest more in renewable energy, reduce tax barriers and promote worker mobility. All of this, they reason, strengthens Europe's competitiveness.

Hope in Hollande

Growth programs versus structural reforms: This is the conflict Europe is about to face, and for which Merkel and Hollande are now seeking allies. The French president has awakened the hope, especially in the southern European countries, that the German chancellor's austerity course could be softened. He already portrayed himself as something of a messiah for the southern countries during the campaign. "So many people in Europe long for our success! I don't want a Europe of austerity, where nations are forced on their knees," he told his supporters.

With remarks like that, Hollande became a shining light in Greece. In his resistance to Merkel's austerity policy, Alexis Tsipras, the leader of the leftist alliance Syriza, invokes a "new era" and says that the French socialist is "clearly a great white hope for us."

In Italy, where Prime Minister Monti's government of technocrats has not produced any growth so far, despite having implemented a few reforms, commentators maliciously referred to the G-8 summit as "Merkel's defeat" and raved about the "birth of a new alliance" between Monti and Hollande.

The former Berlusconi activist newspaper Il Giornale wrote that Germany, and not Greece, is Europe's real problem, "because it is bursting with health and, as a result, is also causing its neighbors to burst. Germany has to adjust to the rest of Europe, not the other way around."

So far, Merkel has shown little interest in publicly rebuking Hollande. At the EU special summit in Brussels, she merely noted pointedly: "Euro bonds do not create growth." She knows that she has to wait until after the parliamentary election in mid-June to begin dealing with a president who is no longer involved in an election campaign. What she doesn't yet know is whether he will be less adamant after that.

Uncertain Outcome

Although Merkel has lost allies, she is not completely isolated, not even in southern Europe. Portuguese Prime Minister Passos Coelho is competing with his Spanish counterpart Mariano Rajoy for the distinction of being Merkel's model student. Since the Spanish conservative came into power last December, hardly a week has passed in which he has not imposed a new austerity measure.

The Spanish media and the socialist opposition had hoped that Rajoy, in Hollande's wake, could apply more pressure to the German chancellor to spend more on growth measures. But the first upset happened even before Hollande and Rajoy met. Hollande said that it ought to be possible to recapitalize the Spanish banks from the European bailout fund. But this remark came at a very inconvenient time for Rajoy. "Hollande doesn't know what condition the Spanish banks are in," he said, rebuffing the French president's suggestion.

Instead, Rajoy cozied up to the chancellor during a group boat ride on the Chicago River after the NATO summit. He too takes no stock in a debate over euro bonds. "They're not the most important thing now," he repeated on Wednesday after meeting with Hollande in Paris. However, Rajoy agrees with Hollande's proposal to allow the ECB to actively buy government bonds, thus helping to lower interest rates.

Europe finds itself in the middle of a conflict with an uncertain outcome. The dispute over the growth pact could exacerbate the fiscal crisis if Hollande and Merkel block each other's proposals. But it could also turn out to be liberating if it leads to a workable consensus. The Germans have to accept that even more money has to flow from the north to the south, while all the Mediterranean countries must accept that they need additional reforms.

The fight has only just begun, and so it comes as no surprise that the roar of battle is drowning out everything else at the moment. But there are also signs of rapprochement. During his first official visit to Berlin, Pierre Moscovici, the new French minister of economics and finance, revealed some sympathy for the German line. He confirmed the new French government's intention to reduce the national deficit in the coming year to below the upper limit of 3 percent of GDP, and to eliminate all new borrowing starting in 2017. He also underscored how important healthy budgets are for growth and employment. Those who have too much debt become impoverished, he said. And those who are poor, he added, cannot invest.

BY FIONA EHLERS, JULIA AMALIA HEYER, CHRISTOPH PAULY, CHRISTIAN REIERMANN, MATHIEU VON ROHR, MICHAEL SAUGA, CHRISTOPH SCHULT, HELENE ZUBER

Translatedfrom the German by Christopher Sultan

http://www.spiegel.de/international/europe/merkel-preparing-to-strike-back-against-hollande-with-six-point-plan-a-835295.html

Post-Sovereign Europe?

Kori Schake, 02/01/12

There can be no "solidarity" without a loss of national greatness.

The crisis of the European monetary union has unfolded at roughly the same time as the Arab Spring, and their geneses illustrate a striking contrast in those societies’ views of government. Whereas people in the authoritarian countries of the Middle East and North Africa are insisting on governments more accountable to them, the people of Europe are agitating to reduce government sovereignty, replacing it with a commitment among governments. The juxtaposition demonstrates the extent to which nearly all European governments believe they no longer—or should no longer—have the power to act as sovereign governments.

David Cameron made a big bet that the other EU governments are mistaken in that view. Britain refused to agree that the EU should be allowed to supervise its choices on how much money to spend. Whipped by the turbulent financial markets and the public’s outrage at bailing out other Europeans, Europe’s creditor states demanded the right to establish limits on the amount of debt a country could accrue. The EU proposal, adopted without Britain, is that national budgets would be submitted for review by all other EU countries and, failing to gain their support, states would be fined for infractions of the rules.

Cameron thinks that Britain is likelier to prosper by setting its own rules than allowing a collective of countries—even those with similar interests—to set the rules. He points out that the structure of Britain’s economy gives it a greater reliance on financial services industries, something the governments of France and Germany would like taxed more heavily. He doubts that his fellow European governments will serve Britain’s interests better than Britain itself. He is surely right, although the argument depends fundamentally on whether states still have the capacity to chart their destinies.

In academic and policy circles, it is fashionable to conclude that globalization has radically reduced the autonomy of states. The free flow of commerce, information, and people, which defines globalization, is thought to prevent states from exercising the control of information, levers of economy, and monopoly on violence that previously characterized the role of the state.

As a result, states subject to currency crises blame not themselves, but predatory financial institutions that operate outside the reach of governments; the materials and know-how to produce nuclear weapons are described as slipping out of government hands; and the incapacity of governments to feed their people is ascribed to global warming. These are convenient and popular excuses, but they ignore the essential fact that states continue to control the vast majority of what occurs within their borders.

Do states still have the capacity to chart their own destinies?

As economist Jagdish Baghwati has demonstrated, famines are not caused by nature. It requires governments to turn scarcity into famine. And as Thomas Sowell has argued so persuasively about the subprime mortgage crisis in the United States, economics cannot create this problem; the involvement of politics was required.

States establish and exercise control through law. Through law, states regulate who can enter their territories, whether those people can work, how they will be cared for if they do not work, what responsibilities will be exacted from them, and what rights will be extended to them. And although the speed and ease of transit of information, commerce, and people has increased dramatically in the past decades, states still set legal frameworks that bind people within countries.

The financial crisis in the Euro zone has very often been ascribed to the forces of globalization, as though governments had no control over what was happening—as though the government of Greece didn’t choose to borrow money on Germany’s credit, or German financial regulators didn’t choose to count all debt denominated in Euros to be of equal credit risk.

The European Union has attempted to extend across its member states a “pooled sovereignty,” where states keep some authorities, but give others to a supranational body of their common creation. Some countries pooled their border control, removing all restrictions on movement between participating states. Some countries pooled their money, giving up their currencies for the Euro and their ability to set monetary policy. What is now proposed is that countries pool their debt, giving up the ability to use fiscal policies to manage their economies.

The financial crisis in Europe has been attributed to globalization. But this is wrong.

It sounds sensible enough: countries that use the same currency are all affected by the spending decisions others make. But such rules are only effective when two conditions are applied:

(1) there is a shared norm of compliance; and

(2) a credible enforcement mechanism is established.

In other words, laws are obeyed within communities both because we generally share beliefs about their merit (murder should be punished), and because they are punished.

For these reasons, “international law” is the recourse of those who consider norms inadequate. But even international law relies on enforcement—in fact, enforcement is even more important internationally because the common societal basis of norms does not provide a foundation of compliance. There is obviously not a shared norm of thriftiness among EU countries; so the creditor states are attempting to impose enforcement.

What they attempt is to replicate the norm of creditor government behavior in the debtor states. But the tools they have available are not strong enough for the task. Recall that the EU already had rules limiting the debt-to-GDP ratio for member states. This Stability Pact was insisted on by Germany, which was also the first EU country to be in violation of the rules. Germany brushed off condemnation, huffily insisting that its own circumstances (absorbing East Germany) were uniquely meritorious (as opposed to the circumstances of countries transitioning wholesale from communism or struggling out of poverty). Now that it is in a solid financial position, Germany would require stringent and immediate austerity from sinning governments as the price for their “solidarity.”

The countries of the EU have lost the sense that they're major world powers.

What is missing in Europe, which is being shouted from rooftops in Cairo and throughout the Arab world, is the belief that governments are in control. Continental Europe has become “post-sovereign,” no longer believing an individual state can take meaningful action alone. Greece’s financial crisis of course disproves the thesis—the choice of an individual state has made a huge difference. Germany’s answer is that the European Union should take away from states the ability to make their own choices.

How the member nations of the European Union view sovereignty affects their willingness to run risks to achieve aims that benefit their individual countries. Consider the situation with Iran. The Islamic Republic spends roughly $7 billion a year on its military whereas the European Union contains at least fifteen of the world’s most powerful militaries and spends more than forty times that amount. Still, none of the Europeans can imagine their governments undertaking to destroy Iran’s nuclear program. They wouldn’t even do it collectively, much less all alone. Despite their military might, the countries of the European Union have lost the sense that they’re major world powers.

The great defense lawyer Clarence Darrow famously said, “no man was ever convicted based on testimony he did not give.” And no government will be vulnerable to a market run that does not dig itself deeply into debt. Globalization isn’t yanking authority out of the hands of sovereign governments. Rather, sovereign governments are choosing to hand it to international institutions and international businesses.

There’s a wonderful passage in Tacitus, in which he describes the conquest of the British Isles less as a military victory for Rome than a voluntary submission by the British who wanted the advantages that that great civilization had to offer. “The unsuspecting Britons spoke of such novelties as ‘civilization,’ when in fact they were only a feature of their enslavement.” David Cameron has looked at ‘civilization’ in the form of EU solidarity, and chose to take his chances with sovereignty instead.

Kori Schake is a research fellow at the Hoover Institution. She is also the Bradley Professor of International Security Studies at the United States Military Academy at West Point, N.Y. Her areas of research interest are national security strategy, the effective use of military force, and European politics.

http://www.hoover.org/publications/defining-ideas/article/106936

How to Save the Euro

George Soros, 01/20/12

My new book, Financial Turmoil in Europe and the United States,1 tries to explain and, to the extent possible, predict the outcome of the euro crisis. It follows the same pattern as my other books: it contains an updated version of my conceptual approach and the application of that approach to a particular situation, and it presents a real-time experiment to test the validity of my interpretation. Its account is not complete because the crisis is still ongoing.

We remain in the acute phase of the crisis; the prospect of a meltdown of the global financial system has not been removed. In my book, I proposed a plan that would bring immediate relief to global financial markets but it has not been adopted.

My proposal is to use the European Financial Stability Facility (EFSF), and its successor the European Stability Mechanism (ESM), to insure the European Central Bank (ECB) against the solvency risk on any newly issued Italian or Spanish treasury bills they may buy from commercial banks.2 Banks could then hold those bills as the equivalent of cash, enabling Italy and Spain to refinance their debt at close to 1 percent. Italy, for instance, would see its average cost of borrowing decline rather than increase from the current 4.3 percent. This would put their debt on a sustainable course and protect them against the threat of an impending Greek default. I call this the Padoa-Schioppa plan, in memory of my friend who helped stabilize Italy’s finances in the 1990s and who inspired the proposal. The plan is rather complicated, but it is both legally and technically sound. I describe it in detail in my book.

The European financial authorities rejected this plan in favor of the Long-Term Refinancing Operation (LTRO) of the European Central Bank, which provides unlimited amounts of liquidity to European banks—not to states themselves—for up to three years. That allows Italian and Spanish banks to buy the bonds of their own country and engage in a very profitable “carry trade”—in which one borrows at low interest to buy something that will pay higher interest—in those bonds at practically no risk because if the country defaulted the banks would be insolvent anyhow.

The difference between the two schemes is that mine would provide an instant reduction in interest costs to governments while the one actually adopted has kept the countries and their banks hovering on the edge of a potential insolvency. I am not sure whether the authorities have deliberately prolonged the crisis atmosphere in order to maintain pressure on heavily indebted countries or whether they were driven to their course of action by divergent views that they could not reconcile in any other way. As a disciple of Karl Popper, I ought to opt for the second alternative. Which interpretation is correct is not inconsequential, because the Padoa-Schioppa plan is still available and could be implemented at any time as long as the remaining funds of the EFSF are not otherwise committed.

Either way, it is Germany that dictates European policy because at times of crisis the creditors are in the driver’s seat. The trouble is that the cuts in government expenditures that Germany wants to impose on other countries will push Europe into a deflationary debt trap. Reducing budget deficits will put both wages and profits under downward pressure, the economies will contract, and tax revenues will fall. So the debt burden, which is a ratio of the accumulated debt to the GDP, will actually rise, requiring further budget cuts, setting in motion a vicious circle.

To be sure, I am not accusing Germany of acting in bad faith. It genuinely believes in the policies it is advocating. Germany is the most successful economy in Europe. Why should not the rest of Europe be like it? But it is pursuing an impossibility. In a closed system like the euro clearing system, everybody cannot be a creditor at the same time. The fact that a counterproductive policy is being imposed by Germany creates a very dangerous political dynamic. Instead of bringing the member countries closer together it will drive them to mutual recriminations. There is a real danger that the euro will undermine the political cohesion of the European Union.

The evolution of the European Union is following a course that greatly resembles a sequence of boom and bust or a financial bubble. That is no accident. Both processes are “reflexive,” that is, as I have argued elsewhere, they are largely driven by mistakes and misconceptions.

In the boom phase the European Union was what the British psychologist David Tuckett calls a “fantastic object”—an unreal but attractive object of desire. To my mind, it represented the embodiment of an open society—another fantastic object. It was an association of nations founded on the principles of democracy, human rights, and the rule of law that is not dominated by any nation or nationality. Its creation was a feat of piecemeal social engineering led by a group of far-sighted statesmen who understood that the fantastic object itself was not within their reach. They set limited objectives and firm timelines and then mobilized the political will for a small step forward, knowing full well that when they accomplished it, its inadequacy would become apparent and require a further step.

That is how the European Coal and Steel Community was gradually transformed into the European Union, step by step. During the boom period Germany was the main driving force. When the Soviet empire started to fall apart, Germany’s leaders realized that reunification of their country was possible only in a more united Europe. They needed the political support of other European powers, and they were willing to make considerable sacrifices to obtain it. When it came to bargaining they were willing to contribute a little more and take a little less than the others, thereby facilitating agreement. At that time, German statesmen used to assert that Germany had no independent foreign policy, only a European policy. The process—the boom, if you will—culminated with the Maastricht Treaty in 1992 and the introduction of the euro in 2002. It was followed by a period of stagnation that turned into a process of disintegration after the crash of 2008.

The euro was an incomplete currency and its architects knew it. The Maastricht Treaty established a monetary union without a political union. The euro boasted a common central bank to provide liquidity, but it lacked a common treasury that would be able to deal with solvency risk in times of crisis. The architects had good reason to believe, however, that when the time came further steps would be taken toward a political union. But the euro also had some other defects of which the architects were unaware and that are not fully understood even today. These defects contributed to setting in motion a process of disintegration.

The fathers of the euro relied on an interpretation of financial markets that proved its inadequacy in the crash of 2008. They believed, in particular, that only the public sector is capable of producing unacceptable economic imbalances; the invisible hand of the market would correct the imbalances produced by markets. In addition, they believed that the safeguards they introduced against public sector imbalances were adequate. Consequently, they treated government bonds as riskless assets that banks could buy and hold without allocating any capital reserves against them.

When the euro was introduced, the ECB treated the government bonds of all member states as equal. This gave banks an incentive to gorge themselves on the bonds of the weaker countries in order to earn a few extra basis points, since the yields on those bonds were slightly higher. It also caused interest rates to converge. That, in turn, caused economic performance to diverge. Germany, struggling with the burdens of reunification, undertook structural reforms, principally in its labor markets, and became more competitive. Other countries, benefiting from lower interest rates, enjoyed a housing boom that made them less competitive. That is how the introduction of the euro caused the divergence in competitiveness that is now so difficult to correct. The banks were weighed down with the government bonds of less competitive countries that turned from riskless assets into the riskiest ones.

The tipping point was reached when a newly elected Greek government revealed that the previous government had cheated and the national deficit was much bigger than had been announced. The Greek crisis revealed the gravest defect in the Maastricht Treaty: it has no provisions for correcting errors in the euro’s design. There is neither a mechanism for enforcing payment by member states of the European debt nor an exit mechanism from the euro; and member countries cannot resort to printing money. The statutes of the ECB strictly prohibit it from lending to member states, although it lends to banks. So it was left to the other member states to come to Greece’s rescue.

Unfortunately the European authorities had little understanding of how financial markets really work. Far from combining all the available knowledge in the market’s movements, as economic theory claims, financial markets are ruled by impressions and emotions and they abhor uncertainty. To bring a financial crisis under control requires firm leadership and ample financial resources. But Germany did not want to become the deep pocket for bad debtors. Consequently Europe always did too little too late and the Greek crisis snowballed. The bonds of other heavily indebted countries such as Italy and Spain were hit by contagion—i.e., in view of the failure in Greece they had to pay higher yields. The European banks suffered losses that were not recognized on their balance sheets.

Germany aggravated the situation by imposing draconian conditions and insisting that Greece should pay penalty rates on the loans in the rescue package that Germany and other states provided. The Greek economy collapsed, capital fled, and Greece repeatedly failed to meet the conditions of the rescue package. Eventually Greece became patently insolvent. Germany then further destabilized the situation by insisting on private sector participation in the rescue. This pushed the risk premiums on Italian and Spanish bonds through the roof and endangered the solvency of the banking system. The authorities then ordered the European banking system to be recapitalized. This was the coup de grâce. It created a powerful incentive for the banks to shrink their balance sheets by calling in loans and getting rid of risky government bonds, rather than selling shares at a discount.

That is where we are today. The credit crunch started to make its effect felt on the real economy in the last quarter of 2011. The ECB then started to reduce interest rates and aggressively expand its balance sheet by buying government bonds in the open market. The ECB’s LTRO facility provided relief to the banking system but left Italian and Spanish bonds precariously balanced between the sustainable and the unsustainable.

What lies ahead? Economic deterioration and political and social disintegration will mutually reinforce each other. During the boom phase the political leadership was in the forefront of further integration; now the European leaders are trying to protect a status quo that is clearly untenable. Treaties and laws that were meant to be stepping stones have turned into immovable rocks. I have in mind Article 123 of the Lisbon Treaty, which prohibits the ECB from lending money directly to member states. The German authorities, notably the Constitutional Court and the Bundesbank, are dead set on enforcing rules that have proved to be unworkable. For instance, the Bundesbank’s narrow interpretation of Article 123 prevented Germany from contributing its Special Drawing Rights to a rescue effort by the G20. This is the path to disintegration. Those who find the status quo intolerable and are actively looking for change are driven to anti-European and xenophobic extremism. What is happening today in Hungary—where a far-right party is demanding that Hungary leave the EU—is a precursor of what is in store.

The outlook is truly dismal but there must be a way to avoid it. After all, history is not predetermined. I can see an alternative. It is to rediscover the European Union as the “fantastic object” that used to be so alluring when it was only an idea. That fantastic object was almost within reach until we lost our way. The authorities forgot that they are fallible and started to cling to the status quo as if it were sacrosanct. The European Union as a reality bears little resemblance to the fantastic object that used to be so alluring. It is undemocratic to the point where the electorate is disaffected and it is ungovernable to the point where it cannot deal with the crisis that it has created.

These are the defects that need to be fixed. That should not be impossible. All we need to do is to reassert the principles of open society and recognize that the prevailing order is not cast in stone and rules are in need of improvement. We need to find a European solution for the euro crisis because national solutions would lead to the dissolution of the European Union, and that would be catastrophic; but we must also change the status quo. That is the kind of program that could inspire the silent majority that is disaffected and disoriented but at heart still pro-European.

When I look around the world I see people aspiring to open society. I see it in the Arab Spring, in various African countries; I see stirrings in Russia, and as far away as Burma and Malayasia. Why not in Europe?

To be a little more specific, let me suggest the outlines of a European solution to the euro crisis. It involves a delicate two-phase maneuver, similar to the one that got us out of the crash of 2008. When a car is skidding, you first have to turn the steering wheel in the direction of the skid, and only after you have regained control can you correct your direction. In this case, you must first impose strict fiscal discipline on the deficit countries and encourage structural reforms; but then you must find some stimulus to get you out of the deflationary vicious circle—because structural reforms alone will not do it. The stimulus will have to come from the European Union and it will have to be guaranteed jointly and severally. It is likely to involve eurobonds in one guise or another. It is important, however, to spell out the solution in advance. Without a clear game plan Europe will remain mired in a larger vicious circle in which economic decline and political disintegration mutually reinforce each other.

1.     Public Affairs, 2012.

2.     The EFSF has been funded since May 2010 by the twenty-nine member states of the EU to deal with the problems of European debt. The European Central Bank was set up in 1998 to administer the monetary policy of the seventeen eurozone countries and to maintain price stability in Europe. Both the EFSF , which makes loans to countries, and the ECB , which makes loans to banks, are discussed in the interview with Klaus Regling, the director of the EFSF , in the February 23 issue of The New York Review.

http://www.nybooks.com/articles/archives/2012/feb/23/how-save-euro/

Thinking About the Euro in 2012

Jacob Funk Kirkegaard, 12/22/11

As the most anxious year in the history of the euro draws to a close, and with dire predictions about the euro’s fate in 2012, it is an irresistible option for this author to take stock in a more realistic way. Despite all this year’s drama, the value of the euro is almost exactly where it was at the beginning of 2011. Indeed it seems 2011 and its attendant turmoil might just as well not have happened. It was certainly no annus horribilis for the value of Europe’s currency. As Figure 1 shows, the real effective euro exchange rate today is above what it was in May–June 2010, when the crisis was only about Greece, and even slightly above what it was when the crisis spread to Ireland and Portugal in late 2010. After the prolonged decline in the real trade weighted value of euro1 following the revelation of the fraudulent Greek fiscal data in October 2009, it is almost as if investors actually stopped worrying, as it became clear by May–June 2010 that in the euro area (like everywhere else) the bailout that some doubted did happen.

(請至原網頁參考附圖)

Remarkably, the large increases in interest costs for systemically important and arguably too-big-to-bail-out Italy and Spain in July and August 2011 had next to no impact on the value of the euro. The common currency merely continued the slow decline that started several months earlier. Causality is always dangerous to allege. But Figure 1 suggests that the acknowledgement in April by the German finance minister, Wolfgang Schäuble, that Greece needed to restructure its government debts, with losses imposed on the private creditors of an Organization for Economic Cooperation and Development (OECD) country for the first time in decades, was more important than the rise of Italy’s borrowing costs to levels that would be unsustainable if maintained over many years. That "broken taboo" against debt write-downs, and the fear that it might spread to other euro area countries, stressed the euro more than Italy’s temporary funding costs and indeed more than anything else in 2011.  

The European Central Bank (ECB) and others that had warned against that haircut, known as the Private Sector Involvement (PSI), were proven right about its immediate contagious effects. This was true even though Greece’s debt sustainability required substantial debt write-downs. Although the likely imminent implementation of PSI provides political cover for continued official sector (especially euro area) financial support for Greece, euro area leaders must now convince markets that it will not be repeated. As European Council President Herman van Rumpoy said [pdf] in the early morning of December 9: "Our first approach to PSI, which had a very negative effect on the debt markets, is now officially over."

When you are in a hole, the cliché goes, it advisable to stop digging. But at least some shoveling by euro area leaders during 2011 will continue into 2012. That does not mean that no political response was undertaken this year. The main problem was one of policy coordination and sequencing for different parts of the responses.

The euro area crisis is multifaceted. It encompasses a fiscal crisis (Greece), a competitiveness crisis (the Southern periphery), a banking crisis (Ireland, Spain, Germany, and others), and a design crisis (the flawed initial design of euro area institutions). Coordinating these elements is critical. Too much austerity to deal with a fiscal crisis will depress economic growth, which might itself depress government revenues, although this is disputed by the ECB and the European Commission’s doctrinal oxymoron of "expansionary consolidation." The ECB president, Mario Draghi, at least made a welcome admission that there was a fallacy at work when he said in a recent Financial Times interview that "I would not dispute that fiscal consolidation leads to a contraction in the short run."

Policy coordination can be extremely difficult within a single government’s multiple political and administrative organs. The difficulties multiply among 17 or 27 countries with their own democratic processes. The biggest policy coordination obstacle in the euro area stems from its flawed initial institutional design, and its lack of critical common fiscal and banking regulatory institutions to help cope with the global financial crisis. The United States in late 2008 and early 2009 was hobbled by turf wars and legal constraints among the US Treasury, the Federal Reserve, and the Federal Deposit Insurance Corporation (FDIC). Euro area policymakers faced the infinitely harder challenge of coordinating among institutions that had to be created, staffed, funded, and given a democratic and legal mandate involving 17 or 27 members. Coordination between the embryonic European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) on the one hand and the ECB on the other is infinitely harder, especially when no one knows what the role of the EFSF/ESM will ultimately be. The ECB, meanwhile, is clearly trying to force governments to grant it a large mandate and large amount of funding. In this uncertain policy environment, financial markets can quickly lose confidence.

It is in the overlap between the euro area fiscal and banking crises that the lack of policy coordination has had the most devastating effect. Most euro members have banks that are not only too big to fail (TBTF), but possibly, as in Ireland, too big for national governments to rescue. At the same time, banks own a lot of government debt, so the linkages are symbiotic. In this situation, large and immediate spillovers between the sovereign/fiscal and banking crises are unavoidable, and close policy coordination is imperative. Obviously, euro area leaders failed abysmally in this task during 2011.

Wolfgang Schäuble, the German finance minister, may have articulated the obvious in April, when he said that Greece was insolvent and that it was not politically sustainable to transfer all these losses to the official sector. But raising this issue in a fairly open-ended manner at a time when euro area banks were severely undercapitalized and there was no credible financial backstop for most of them—something the expansion of the EFSF’s lending options to include bank recapitalizations only achieved by July 21—was a clear example of policy coordination failure. The fact that the EFSF/ESM were not big enough to deal with Spain and Italy was a further source of uncertainty.

A similar failure occurred when euro area policymakers set up the European Banking Authority (EBA) and understandably demanded that undercapitalized European banks accelerate their recapitalization process and achieve a Core Tier 1 capital ratio of 9 percent in order to build up a temporary capital buffer against sovereign debt exposures to reflect current market prices. The problem was that the sudden mark-to-market accounting of all bank sovereign debt holdings, combined with the reliance on an increased capital ratio, resulted in substantial deleveraging and dumping of non-national government debt by various euro area banks. These one-off attempts to address the banking crisis have almost certainly had a strongly pro-cyclical effect and worsened the situation in sovereign debt markets and hence the euro area fiscal crisis.

Primum non nocere, first do no harm, is the starting point for all emergency medical assistance. It is an axiom that euro area policymakers must embrace in 2012, as the European ship sails toward an iceberg in the form of hundreds of billions bond rollovers for sovereigns and banks. Two heavy political issues also loom:

Completion of the new Inter-Governmental Treaty on the new Euro Area Fiscal Compact. Up to 26 EU member governments have declared their interest in participating, although the final number of non-euro area members may be fewer than nine. Substantial political challenges will surround the implementation of the fiscal compact. Member states must amend their laws to incorporate the balanced budget principle and legislatures will have to approve the transfer of more fiscal sovereignty to the supra-national euro area level.

Completion of the new European Stability Mechanism (ESM) Treaty; the revised treaty without a PSI is to come into force in June; it might be increased in size in March in accordance with the December 9 summit agreement.

Meanwhile in the banking system, capital deficient European banks are supposed to hand in their plans to national regulators to reach their 9 percent Core Tier 1 capital target on January 20, after which the aggressive deleveraging of risk weighted assets is expected to subside.

The ECB has already begun its substantive 2012 policy agenda with the first of two planned 3-year longer-term refinancing operations (LTROs) on December 21. The demand for this first unlimited offer of liquidity was ?489 billion. The net increase in bank loans to 523 banks from the ECB was about ?210 billion. The bank’s loan offering thus suggests that there is now limited "stigma" attached to the reliance on ECB funding among European banks. The broad implication is that the risk of a euro area bank suddenly collapsing in 2012 has been reduced, especially since the banks have another opportunity to access ECB 3-year liquidity in late February.

How the banks plan to use this new long-term liquidity is not known. But the banks will have refinanced a lot of their existing maturing short-term debt with the new much longer-term loans, hopefully releasing capital for continued bank lending to euro area enterprises and easing the regional credit crunch. In a region where 80 percent of all credit is dispersed by banks, this should alleviate the risk of a deep recession.

Recent declines in interest rates for Spanish and Italian sovereign debt, especially for the shorter end of the yield curve—as well as comments by President Nicolas Sarkozy of France after the December 9 EU Summit—have suggested that banks will use some amount of the unlimited 1 percent ECB funding to purchase euro area sovereign debt. Given today’s high Spanish and Italian yields, this would result in a potentially sizable "carry-trade profit" for the purchasing bank.

Such strategies by struggling banks could even amount to a meaningful backdoor recapitalization, locking in profitable high coupon payments from their governments. Italy and Spain would in turn benefit from not having to undertake the extremely unpopular process of directly recapitalizing their banks ahead of the June 2012 deadline for addressing more than ?41 billion in shortfalls. One might also argue that the purchase of high yielding national sovereign debt by such banks would constitute a kind of national redistributive transfer from taxpayers footing the bill for elevated interest costs to shareholders and creditors of the banks. These bank stakeholders might or might not be domestic, but this transaction would fulfill the implicit state guarantee for Europe’s TBTF banks.

The new ECB 3-year funding option might further ease the detrimental financial effects of a major policy omission this year, the failure to agree on a pan-European term funding guarantee scheme for bank debt backed by the EFSF. Such an agreement is crucial for the reopening of the stalled term unsecured inter-bank funding market. Without it, euro area banks will have to make do with a set of national term funding guarantees, which for Italy would hardly assure other banks as counterparties. On the other hand, national bank bond guarantees will almost certainly make such bank bonds eligible as ECB collateral, irrespective of what the bonds are backed by. Collateral status for the bonds would allow Italian banks to repo any loan guaranteed by a national government to obtain a three-year loan from the ECB. Such a stratagem would clear the way for the Italian government to help banks offload government guaranteed bonds with the ECB so they can purchase new bonds to be issued by the Italian government in 2012. This option could be especially appealing as the second ECB allotment of unlimited 3-year loans occurs at the end of February, at the peak rollover season in early 2012.

At their last conference call in 2011 [pdf], EU finance ministers agreed to make ?150 billion available to the International Monetary Fund (IMF), helping to ensure that it has adequate resources to combat the global economic crisis. The United Kingdom has hedged its bets, and only committed to this effort in conjunction with broader global efforts supported by other major non-euro-area countries in the G-20. The challenge for euro area leaders (and IMF officials) will now be to ensure that sufficient parallel contributions will be forthcoming. Ideally, they must do so ahead of the next G-20 Finance Ministers and Central Bank Governors meeting in Mexico on February 25–26. Meeting that challenge will be difficult, despite the IMF’s status as a safer "counterparty" than the unappealing EFSF leveraging option. It will not be easy, for example, to convince China and other surplus countries to make sizable financial contributions. Certainly, the euro area must show its willingness to be flexible on other policy fronts. Beyond the issue of their own over-representation on the IMF Board and in the organization’s voting weight, Europeans must convince the rest of the world that they have done enough themselves to salvage the euro’s future prospects.

How big must a new additional IMF-led program be to bolster confidence in the sovereign bond markets of Spain and Italy? Earlier estimates for the size of the firewall suggested that perhaps ?1.5 trillion to 2 trillion was the minimum necessary. Europe has not been able to put together a single bazooka of such magnitude. But the EFSF/ESM will be ?500bn in 2012, which would meet the funding needs of the three small IMF program countries for the foreseeable future. In addition, the ECB has bought ?211 billion through the Securities Market Program and is providing another ?489 billion that could be used by euro area banks to purchase shorter term government bond s. Add to that the earlier bilateral euro area loans provided to Greece, and the sum begins to approach about ?800 billion to 900 billion committed to stabilizing the euro area.

On top of that comes the ?150 billion in new capital pledged to the IMF, which with politically feasible leverage from other new IMF contributions might amount to another ?600 billion. Added together, the entire committed official sector resources towards euro area stabilization in early 2012 come to roughly ?1.5 trillion, plus the value contributed by the essentially unlimited ECB liquidity provisions to the euro area banking system.

This is not a neat and rapidly implemented "single barrel bazooka" for sure. On the other hand, the euro area is inherently much more complex than single government entities and this is not chump change. Combined with continued progress on fiscal consolidation and pro-growth structural reforms, the totals are enough to restore confidence gradually in the euro area sovereign debt markets in 2012 and return the common currency to the "good equilibrium" of sustainable refinancing costs for the large peripheral economies.

Credit rating agencies do not see a "euro area comprehensive solution" and consequently they may go ahead with widespread downgrades of euro area sovereigns. That, however, is largely irrelevant. A downgrade would add no new information to the marketplace aside from some alarmist headlines for a few days. The agencies’ conduct merely underlines their limited ability to undertake the type of political economy analysis required for a highly complex hybrid entity like the euro area. A better approach for 2012 would be to quickly phase out the role of credit rating agency opinions in investment decisions embedded in various rules and regulations. Regrettably, though, an alternative would be hard to quickly come up with, as the banks’ in-house risk-models, for instance, are hardly an improvement.

In sum, 2012 will undoubtedly be yet another volatile year for the euro. But crisis management will likely improve and the catastrophic tail-end events will gradually disappear from the minds of most.

The major political challenge for the euro area in 2012 will thus not be to address the immediate crisis, but rather the longer-term direction of institutional reform. During 2012, the euro area is likely to see a new and considerably more credible set of fiscal rules and budget oversight regulation. This has been a clear and understandable demand from the ECB and Germany. But while the new fiscal compact will undoubtedly help stabilize the euro area, it must not serve as the end of the institutional reforms needed by the region. The movement toward further and symmetrical deepening of euro area fiscal integration must be maintained. There should consequently also be concrete steps taken on a reasonable timetable toward the introduction of eurobonds.

Note

1. Bilateral exchange rate relationships like the $-? are by definition affected by events in both countries, so that the euro might bilaterally weaken against the dollar because of chaos in the euro area or because of improved performance of the United States. Using trade-weighted (manufacturing goods) averages of the euro exchange rate against a number of trading partners instead captures how much foreign exchange can be acquired, on average, for ?1. This approach more accurately captures the effects of euro area specific events vs. the rest of the world

http://www.piie.com/realtime/?p=2601

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A Bridge to Nowhere

The Brussels plan is a decent stopgap. But if Europe's countries in crisis can't hold out long enough to start growing their economies again, it won't matter.

Barry Eichengreen, 12/16/11

The task of officials at last week's EU summit in Brussels can be likened to building a bridge. The fiscal and structural adjustments required of Europe's heavily indebted economies will take time to complete. Time will be needed in Italy to get parliamentary agreement on new taxes and even more time to begin collecting them. Rooting out tax evasion and privatizing public enterprise in Greece will take time. Whether pro-growth reforms actually succeed in producing growth similarly will take time to tell.

The problem is that the indebted and struggling European-periphery governments will not be able to fund their operations without official support in the meantime. With the outcome of the policy process uncertain, investors prefer to wait before buying bonds. They want to see not just good intentions but also good results.

So the crisis countries need help to get from here to there. They need the European Central Bank (ECB), the European Financial Stability Facility, the European Stability Mechanism, and IMF, in some combination, to step up and finance their governments while the requisite reforms are put in place.

The subtext of last week's negotiations concerned the terms on which this official support will be provided. The implicit question was whether the European Commission, the ECB, or the IMF would negotiate the conditions attached to the loans. The focus on legal reforms designed to strengthen fiscal discipline by giving the European Commission and the European Court of Justice roles in overseeing the fiscal conduct of member states was designed to make official creditors more comfortable about opening their pocketbooks.

Many details remain to be worked out, to make an understatement. But the outlines of the bridge can now be discerned. There will be strengthened fiscal rules and enforcement, whether through national legislation as a balanced-budget law or protocols to existing agreements. Consolidation and structural reform will proceed. And with governments doing their part, the ECB and its partners will provide the bridge finance needed to fund governments in the meantime.

But the danger is that the European Union and the international community are building a bridge to nowhere. Fiscal consolidation is needed, no doubt. Structural reform is well and good. Emergency financing is necessary to buy time. But none of this actually ensures the resumption of economic growth. And without growth there is no way that the eurozone crisis countries can make it to the other side.

It's a vicious cycle: Without growth, fiscal progress will be slower than promised. If economies stagnate, revenues will inevitably stagnate. Without growth, public support for policies of austerity will dissipate. And if pro-reform governments fall, there is no knowing what kind of governments will come next.

In addition to growing, Europe will have to rebalance internally. While the current account of the eurozone as a whole is roughly balanced, the Southern European countries are running chronic current account deficits with their northern neighbors. In some cases, like Portugal, it was the private sector that consumed more than it produced and became heavily indebted; in others, like Greece, it was mainly the public sector. Either way, now that debts have grown to unsustainable levels, rebalancing must take place. This will require not just slower growth of demand and spending in Southern Europe but concomitantly faster growth of demand and spending in Northern Europe. If Southern Europe is now to produce more than it consumes, then someone else has to do the opposite.

The solution is straightforward in principle.

First, fiscal stimulus in Northern Europe. German politicians may be loath to transfer resources to spendthrift southerners, but why not transfer them to their own households through tax cuts? More household spending in Northern Europe is essential if there is to be intra-European rebalancing.

Second, rates of fixed investment in Germany are strikingly low. A targeted investment tax credit would address this internal economic weakness while stimulating the demand for traded goods.

Germany's demographics point to the need for fiscal consolidation at some point, but not now when demand across Europe is collapsing.

Stronger demand from the rest of the world can also help Southern Europe rebalance. A weaker euro that prices European goods into international markets would make it easier for the crisis countries to export their way out of their bind. Although the ECB's recent rate cuts are a step in the right direction, additional rate cuts and U.S.-style quantitative easing that push the euro down on the foreign exchange market will be essential if Europe is to grow.

The financial bridge tentatively agreed to last week buys time to put in place a lasting solution. But a bridge makes sense only if there is something on the other side.

http://www.foreignpolicy.com/articles/2011/12/15/a_bridge_to_nowhere

Auf Wiedersehen to European Unity

In the aftermath of the Brussels summit, the continent is more divided than ever.

Russell A. Berman, 12/14/11

The conclusion of the Brussels summit seemed to bring the lingering crisis of the Euro and the European economies a big step closer toward a resolution. All the key players could declare victory: French President Nicolas Sarkozy has protected the large French banks from exposure to southern European sovereign debt; German Chancellor Angela Merkel has succeeded in establishing the expectation of disciplined budgeting; and even British Prime Minister David Cameron, whose principles or recalcitrance -- depending on your perspective -- has led to the United Kingdom’s isolation within Europe, was able to return to London to the applause of the many Euroskeptics in his party and the public at large.

Of course, in all countries, there are significant oppositional voices. The Brussels agreement has contributed to tensions within the German ruling coalition because of very realistic concerns that Germany will end up footing the bill for its spendthrift neighbors. The post-summit worries are surely most articulate in Britain, where critics fear that the UK is sliding out of the European community and toward international irrelevance.

Perhaps one should not make too much of those British worries: Anxieties about the strength of cross-channel ties are a long-standing part of British politics. Cameron’s refusal to sign on to the agreement is part of a tradition, which includes the refusal by his predecessor, Labor Prime Minister Gordon Brown, to support joining the Eurozone in 2008. Still, the dramatic divide that left Cameron alone in his opposition to the Brussels agreement has dominated the post-summit discussion. Is Britain genuinely moving out of Europe, and perhaps even toward a revised relationship with the United States? Only time will tell.

The summit also took on particular importance because of the financial turbulence in the lead-up to the gathering. It is worth reviewing the history of the current crisis to see how the fiscal issues have played out through competing visions of the shape of Europe. Debates over the European currency have been mediated by shifting perspectives on European geography.

The fall of the Berlin Wall in 1989, the adoption of the Maastricht Treaty in 1992, and the introduction of the euro in 2002 all pointed toward the establishment of a unified European space. Yet the ongoing fiscal crisis, beginning in 2008, has unleashed pressures that are eroding that European unity. The process began with the debt crisis in Greece, whose initial integration into the European Union had great symbolic value but whose economic health -- had it been fully aired -- would have probably disqualified it from joining the Eurozone.

Is the UK sliding out of the European community and toward international irrelevance?

Very quickly, similar concerns grew about the solvency of the southern European countries. Portugal, Italy, Greece, and Spain were attacked as corrupt and profligate spenders, and denounced with the unfortunate acronym, PIGS. Europe nearly split along north-south lines, and indeed one or more of the PIGS countries may yet leave the Euro and return to its devalued national currency.

Among the northern countries, the prospect that their strong economies might have to pick up the tab of the southern countries elicited opposition from budget hawks and from members of populist anti-tax parties in countries like Finland and Slovakia. But naturally, the key player was Germany, the continent’s largest economy. Under former Chancellor Gerhard Schröder, a member of the center-left Social Democratic Party, some significant reforms of the German welfare state had taken place, including reductions in unemployment benefits and a liberalization of the labor market, which made the German public even more reluctant to bankroll the generous welfare states in the south. That perceived parsimony in turn provoked anti-German hostility elsewhere. When the German Minister of the Economy, Phillip Rösler, visited Athens in October 2011 to firm up economic cooperation between the two countries, demonstrators greeted him carrying protest signs with Hitler images and swastikas on them.

Thus the initial contrast between northern and southern Europe gave way, in the course of 2011, to public concern about the emerging role of Germany. Merkel’s refusal to support proposals for “Eurobonds,” or other modalities to generalize southern European debt across Europe, encountered opposition, and not only in Greece. Commentators raised concerns about the growth of a German “hegemony,” responding to Merkel’s apparent tight-fistedness with references to World War II -- as if Berlin’s refusal to assume the burden of others’ debts was somehow part of a historical strategy to take over Europe.

It's important to understand what European leaders did not achieve at the summit.

Those history lessons, drawn from another era, were of course intended to put pressure on Berlin to use its resources to solve the Euro crisis. Within Germany, conflicting responses emerged. Fiscal hawks and economic nationalists resisted the call for Germany to bankroll Europe, and they could point out the absurdity of the insinuation that Germany wanted to dominate Europe precisely by refraining from getting involved in other nations’ budgets. At the same time, however, some politicians, including former Social Democratic Chancellor Helmut Schmidt, worried aloud that Germany had begun to appear as a threat to Europe and that Merkel, therefore, should take on more responsibility for Europe.

References to the dark German past provided a way, in the newspapers of London and Paris, to put pressure on Berlin to assume responsibility for solving the European debt crisis. Yet by late November, a new act began, marked by cooperation between Paris and Berlin, as Sarkozy and Merkel, acting in tandem as “Merkozy,” planned the Brussels summit on terms that, ultimately, engineered Cameron’s isolation. A process that began with the vilification of Greece and proceeded with angst over Germany ended with the exclusion of England. Was this the new shape of Europe? Perhaps, but it would be foolish to assume that the Euro crisis has come to an end simply due to the Brussels summit.

It’s important to understand what the European leaders did not achieve. There was no indication of a shared program to promote economic growth, ultimately the only way to get out of the crisis. There was no commitment to reduce expenditures. There was no clarification of the role that the European Central Bank should play. The main accomplishment in Brussels was a preliminary agreement to begin to pursue mechanisms to control debt. Yet these rules, including Merkel’s goal of an automatic Schuldenbremse -- a brake on debts -- have yet to be spelled out clearly and integrated into law. In most cases, they will be subject to review by national parliaments, and the approval process will not be quick, even though the sovereign debt crisis remains urgent and the viability of the Euro is by no means assured. Bond markets have signaled considerable doubt that the Brussels summit achieved much at all.

The viability of the Euro is by no means assured.

Moreover, the proposed rules on debt, like those that had been part of the original adoption of the Euro, will surely be susceptible to abuse. Even the proposed format, intergovernmental agreements, will probably be in a legal gray zone, standing outside of and to some extent at odds with Europe’s foundational treaty. An alternative process would have involved an amendment to the treaty, but that would have required unanimity, which was precluded by Cameron’s veto. Yet if the main upshot of Brussels is itself of questionable legality -- because the intergovernmental agreements have been specifically designed to circumvent an authentic ratification process -- it is hardly likely that legal restrictions will prevent member states of the European Union from continuing to accumulate debt, as they have in the past. Rules like these are made to be broken.

The combination of Schuldenbremse and the isolation of the UK is disheartening for another reason. Legal constructs to limit accumulation of sovereign debt -- akin to proposals for a balanced budget amendment in the United States -- can cut both ways: They may limit expenditures, but they are just as likely to lead to the pursuit of more revenues through greater taxation. To that end, Cameron has sought protection from the pending imposition of a Europe-wide tax on financial transactions. That tax would have had severe consequences for the financial industry in London, which represents 11 percent of the British GDP and employs 1.3 million workers.

The British Prime Minister was unwilling to see the British economy take a hit in order to participate in the inevitably forthcoming European regulatory regime with its high taxes. Was Cameron pursuing national self-interest? Perhaps, but so were Merkel and Sarkozy, in their own ways. Nonetheless, the English Channel continues to measure the distance between the neo-liberalism of the United Kingdom and the continental preference for regulation.

Russell A. Berman, the Walter A. Haas Professor in the Humanities at Stanford University, is a senior fellow at the Hoover Institution and a member of the Working Group on Islamism and the International Order.

Berman specializes in German culture and is a member of both the Department of German Studies and the Department of Comparative Literature at Stanford University. He is the author of numerous articles and books including Enlightenment or Empire: Colonial Discourse in German Culture (1998) and The Rise of the Modern German Novel: Crisis and Charisma (1986), both of which won the Outstanding Book Award of the German Studies Association. Other books include Anti-Americanism in Europe: A Cultural Problem (2004), Fiction Sets You Free: Literature, Liberty and Western Culture (2007), and, most recently, Freedom or Terror: Europe Faces Jihad (2010).

http://www.hoover.org/publications/defining-ideas/article/102756

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