Sado Monetarism & Fiscal Bondage

And here we go again! EconoTwist’s wish you all the very best in 2012, although the economic outlook are bleaker than ever. However, keep in mind that in between all the misery there is actually some great opportunities for the smart investors, and some rare possibilities for all hard-working people. Going forward, econoTwist’s will try to identify these, as well as expose the dangers and manipulative information coming from the establishment. And we’re gonna have some fun…

“Just as Margaret Thatcher favoured “sado monetarism” (a term coined by Denis Healey), the German plan for Europe is “fiscal B&D” (bondage and discipline).”

Satyajit Das

“Financially futile, economically erroneous, politically puzzling and socially irresponsible, the December 2011 European summit was a failure. Only the attending leaders and their acolytes believe otherwise,” analyst Satyajit Das writes in his first commentary of 2012.

Not that it matters much, but note that Mr. Das wrote and published this article before last weeks mass downgrade of European sovereigns by the US rating agency Standard & Poor’s.

In fact, the downgrades just makes his line of arguments even stronger.

Here’s the full post, as syndicated by eurointelligence,com:

German Chancellor Angela Merkel’s post-summit homilies about the “long run”, “running a marathon” and “more Europe” rang hollow. Europe is now firmly on the road to nowhere, with doubts whether there is enough money or political will to retrieve the position.

Fiscal Bondage…


The centrepiece of the new plan was a commitment to a new legally enforceable “fiscal compact” requiring government budgets to be balanced or in surplus, with the annual structural deficit not to exceed 0.5% of nominal Gross Domestic Product (“GDP”).

The language was Orwellian and incomprehensible in equal measure: “Member States shall converge towards their specific reference level, according to a calendar proposed by the Commission.”

The European Commission is to approve national budgets with, curiously, the European Court of Justice designated as final arbiter.

Whatever the long-term merit of greater budget discipline, the compact recycles previous Treaties, which have been honoured in the breach rather than observance.

Since 1999 or from the time of their entry, euro-zone member countries have recorded nearly 70 breaches of the existing Stability and Growth Pact, including nearly 30 occasions when budget deficits exceeding 3% of GDP were allowed because of recessions. Germany and France have been in breach on at least 6 occasions each.

Just as Margaret Thatcher favoured “sado monetarism” (a term coined by Denis Healey), the German plan for Europe is “fiscal B&D” (bondage and discipline).


The plan may result in a further slowdown in growth in Europe, worsening public finances and increasing pressure on credit ratings.

This is precisely the experience of Greece, Ireland, Portugal and Britain as they have tried to reduce budget deficits through austerity programs. This would make the existing debt burden even harder to sustain.

The rigidity of the rules also limits government policy flexibility, risking making economic downturns worse.

Fiscal controls may not prevent future problems.

Until 2008, Ireland, Spain and Italy boasted a better fiscal position and lower debt than Germany and France.

The weak economic fundamentals of these countries were exposed by the global financial crisis, leading to a rapid deterioration in public finances.

Irrespective of the treaty’s provisions, enforcement will be difficult. The Excessive Deficit Procedure call for “automatic consequences unless a qualified majority of euro area Member States is opposed”.

The provision defines how any breach and automatic sanction can be waived rather than the consequences of failure to comply.

It is difficult to see France and Germany voting to levy sanctions on each other.

In 2003, there was an ignominious episode where France and Germany each breached the deficit ceiling but voted against condemning each other.

Recalling John Maynard Keynes’ observation about the Treaty of Versailles, if actually implemented and strictly followed, the compact will skin Europe, especially those in the weaker economies, alive year by year.

The fiscal compact did not countenance any writedowns in existing debt. It also did not commit any new funding to support the beleaguered European periphery.

Germany specifically ruled out the prospect of jointly and severally guaranteed euro-zone bonds.

Instead, there were vague platitudes about working towards further fiscal integration.

Rebranding Bailouts…


Instead of dealing with the financial problems of the central bailout mechanism (the EFSF – European Financial Stability Fund), European leaders chose the re-branding option.

The EFSF will remain active until mid-2013 and then subsumed into the permanent European Stability Mechanism (“ESM”).

The ESM will be implemented by July 2012 once 90% of member countries have ratified it – “rapid deployment” in European terms.
Crucially, the overall ceiling of the EFSF/ESM remains at Euro 500 billion, but will be reviewed in March 2012.
To increase available funds, the EFSF leveraging rules will be implemented more quickly, using the European Central Bank (“ECB”) as an agent in transactions.

Given the indifference towards various leveraging proposals, especially from emerging nations like China, the ability to reach the target of at least Euro 1 billion in capacity remains in doubt.
Long-standing problems of the original EFSF structure remain unaddressed.

The creditworthiness of Italy and Spain (which make up around 30% of the EFSF’s supporting guarantees) remains questionable.

Pressure on the ratings of stronger guarantors (Germany, France, Netherlands, Finland and Luxembourg) complicates the ability of the EFSF to raise funds. Rating agencies have already warned of the risk of a rating downgrade.

Currently, the EFSF is only issuing short-term bills to finance its commitments (under the bailout packages agreed for Greece, Ireland and Portugal).

Its long-term funding costs are nearing the rate it is permitted to charge borrowers.

The EFSF was even forced to deny reports that it would need to include a health warning about the risk of a rating downgrade and also break-up of the Euro in documentation for any new fund-raising.
Given the problems of the EFSF especially the ratings threat, the acceleration of the ESM initiative is an attempt to reduce the reliance on the member nation guarantees.

The ESM will have paid-in capital (Euro 80 billion) which member countries can contribute.

Like its predecessor – the EFSF – is leveraged – Euro 80 billion supporting euro 500 billion, equivalent to 6 times leverage. Continuing the circularity, nations like Italy and Spain will borrow to contribute capital to the ESM to allow the ESM to buy Italian and Spanish bonds.

The ability of the ESM, like the EFSF, to raise the additional Euro 420 billion is also uncertain.

Calling in the Cavalry …


Euro-Zone nations and other EU members were asked to provide (up to) Euro 200 billion to the International Monetary Fund (“IMF”), to be lent, in turn, back to Euro-Zone countries.

As with the ESM, it is unclear how some countries will finance their contributions and the wisdom of countries de facto lending to themselves.

The curious arrangement was necessary to avoid breaching existing European Treaties.
The arrangement, most likely, will be an IMF administered account, with the full risk being taken solely by the providers of funding.

In the unlikely event that the IMF used its general resources, all members would have to bear the risk.
Full involvement of the IMF is difficult. A loan on the required scale represents a serious concentration risk for the fund.

In addition, the funding would be released in tranches subject to meeting IMF conditions. IMF loans also have seniority over other obligations.

So IMF involvement may reduce the relevant country’s access to commercial funding.

To date, European countries have only committed Euro 150 billion.

Britain is a notable absentee, having rejected the Treaty changes, refusing the invitation to join the Europeans on the maiden voyage of the Titanic.

The summit communique looked “forward to parallel contributions from the international community”.

The IMF (Influential Monied Friends) have proved reluctant, with the US and others unwilling to get involved. Only Russia has indicated a willingness to contribute (Euro 20 billion).

Bundesbank President Jens Weidmann observed that Germany would only release its contribution (Euro 45 billion) if: “there is a fair distribution of the burden amongst the IMF members. If these conditions are not fulfilled, then we can’t agree to a loan to the IMF.”

He noted that: “If large members, for example the USA, were to say ‘we’re not taking part,’ then from our point of view it is problematic.”

Don’t Bank On It…


Parallel to the Summit, The European Banking Authority (“EBA”) updated its stress tests, increasing the amount of capital that European banks need to raise to Euro 115 billion.

The increase was necessary to cover a fall in the value of sovereign bonds held by the banks.

As the data used was dated, further deterioration of the value of holdings may mean that more capital will ultimately be needed.

Italian, Spanish and Greek banks have the largest capital requirements. Italian banks need to raise Euro 15 billion. UniCredit, which holds around euro 40 billion in Italian government bonds, needs to raise euro 8 billion.

Spanish banks need Euro 26 billion with Santander needing Euro 15 billion.

German banks also need capital with Commerzbank, the country’s second largest bank, needing euro 5.3 billion.
With share prices down significantly (40-60% for the year) and the likelihood of weak profits driven by write-offs and lack of balance sheet growth, European banks face difficulties in raising capital.

Unlike US banks in 2008/2009, European banks are reluctant to cut significant dividend payouts.

Spanish bank Santander plans to pay shareholders euro 2 billion in cash and more in stock (over 15% of its stated capital requirements). They argue the need to preserve their brand, compensate investors for poor share price performance and a return to profitability.

Curiously, the EBA or the Bank of Spain has not intervened to force a suspension of dividends to husband capital.
The most likely source is national governments providing the capital, adding to their debt problems. Germany has already reactivated its bank bailout fund for this purpose.

Banks can also lift their capital levels by reducing the size of their balance sheets.

European banks could sell (up to) Euro 2 trillion in assets.

In addition to capital concerns, such a move is driven by liquidity factors with European banks having trouble raising dollars at acceptable cost.
Credit Agricole, the third largest French bank, is planning to reduce assets by around Euro 15-18 billion by the end of 2011 and by euro 60 billion by end 2013. This will improve the bank’s capital position and also reduce its funding needs by euro 50 billion.

If all banks undertake similar actions, selling foreign assets and shutting (mainly overseas) operations, then the effect on the broader economy will be significant.

The tighter credit conditions and lower economic activity may increase normal credit losses setting off a negative feedback loop.

Asset sales by European banks to improve capital are acceptable to the EU as long as they “do not lead to a reduced flow of lending to the EU’s real economy”. Withdrawal from foreign markets is already having a noticeable impact in Eastern Europe and Asia.

A slowdown in these economies will indirectly affect Europe, reducing demand for European exports.

Bad Road Ahead …

The proposed plan is fundamentally flawed. It made no attempt to tackle the real issues – the level of debt, how to reduce it, how to meet funding requirements or how to restore growth.

Most importantly there was no new funds committed to the exercise.

Over the next few months, the Euro-Zone faces a number of challenges including: the implementation of the new arrangements, possible downgrading of a number of nations, refinancing maturing debt and meeting required economic targets.

There will also be complex political and social pressures.

Implementation of the new fiscal compact may not be a fait accompli.

The lack of agreement by Britain makes the change more complex.

A number of treaties and protocols need to be amended. There are also doubts as to whether the “work around” will be legally effective.

At least four governments have indicated that agreement to the changes is contingent on the precise legal text.

One key area of concern is the precise form and extent of powers granted to the EU to police national budgets.

Another relates to the structure of the ESM, where a qualified majority of 85% will have the power to make emergency decisions.

Finland is currently opposed to the ESM act by super majority instead of unanimity. Others are also reluctant to pay in capital, which can be placed at risk without the right to a veto.

Given issues of national sovereignty, it is possible that there will delays in implementation. Changes cannot also be ruled out.

In the background, negotiations on the Greek package of July 2011 have also stalled.

There is a risk that a significant number of banks will refuse to participate in the complex debt restructuring, entailing a write-down of 50% of private debt.

"They're taking away our Triple C?"

The major agencies are reviewing the ratings of 15 euro zone members, including AAA-rated countries like Germany and France.

Retreating from an initial position that any downgrading would be catastrophic, the French President has already sought to reassure voters that it is relatively insignificant, suggesting one is likely.

A downgrade may increase the cost of funds for individual countries.

Depending on the extent, it may restrict the ability of the nations to issue debt, precluding purchases by certain investors.

If France, Germany and the other AAA guarantors lose their highest credit rating, the EFSF rescue fund will also be downgraded.

This would further weaken its already compromised ability to raise funds to meet existing commitments to Greece, Ireland and Portugal and to support the funding of other countries.

Wall of Debt…

A crucial issue is the ability of European sovereigns to meet maturing debt commitments and to keep borrowing costs at a sustainable level.

European sovereigns and banks need to find euro 1.9 trillion to refinance maturing debt in 2012, equivalent to around Euro 7.5 billion each business day.

Italy requires Euro 113 billion in the first quarter and around Euro 300 billion over the full year, equivalent to around Euro 1.5 billion per business day.

Italy, Spain, France, and Germany together will need to issue in excess of Euro 4.5 billion every working day of 2012.

European banks, whose fates are intertwined with the sovereigns, need Euro 500 billion in the first half of 2012 and Euro 275 billion in the second half. They need to raise Euro 230 billion per quarter in 2012 compared to Euro 132 billion per quarter in 2011.

Since June 2011, European banks have been only able to raise Euro 17 billion compared to Euro 120 billion for the same period in 2010.

Given that banks and investors have been steadily reducing their exposures to European countries and banks, the ability to finance this wall of debt is uncertain.

The bailout fund and the IMF with around euro 200-250 billion each cannot absorb this issuance. Europe will be forced to resort to “Sarko-nomics” to finance itself.

The ECB has reduced euro interest rates and lengthened the term of emergency funding of banks to three years with easier collateral rules (a lottery ticket is now acceptable as surety for borrowing).

The French President suggested that banks should buy government bonds, which could then be pledged as collateral to borrow unlimited funds from the ECB or national central banks.

Nicolas Sarkozy was unusually direct: “each state can turn to its banks, which will have liquidity at their disposal.” He pointed out that earning 6% on Italian bonds that could then be financed at 1% from central banks was a “no brainer”.

At the same, ECB President Mario Draghi is urging banks to reduce holdings of government securities and to use the funding provided to meet debt maturities.

Sarko-nomics perpetuates the circular flow of funds with governments supporting banks that are in turn supposed to bail out the government.

It does not address the unsustainable high cost of funds for countries like Italy. If its cost of debt stays around current market rates, then Italy’s interest costs will rise by about euro 30 billion over the next two years, from 4.2% of GDP currently to 5.1% next year and 5.6% in 2013.

In many countries, Sarko-nomics will be supplemented by “financial oppression” as government increasing coerce their citizens and institutions to purchase sovereign bonds.

Regulatory changes will require a proportion of individual retirement savings to be invested in government securities.

Banks and financial institutions will be required to hold increased amounts of government bonds to meet liquidity and other requirements.

There may be restrictions on foreign investments and capital transfers out of the country.

Financial oppression will complement traditional public finance strategies such as direct reduction in government spending, indirect reductions in the form of changing eligibility such as delaying retirement age, and higher taxes, including re-introduction of wealth and property taxes as well as estate or gift duties.

Debt reduction through restructuring remains off the agenda.

The adverse market reaction to the announcement of the 50% Greek write-down forced the EU to assure investors that it was a one-off and did not constitute a precedent.

Despite this, investors remain sceptical, limiting purchases of European sovereign debt.

Weaker euro-zone countries may meet their debt requirements through these measures but it will merely prolong the adjustment period.

It will also increase the size of the problem, locking Europe into a period of low growth and increasing debt levels.

Reality Check…

The prospects for the real economy in Europe are uncertain. European debt problems and slowing growth in emerging markets such as China, India and Brazil may lead to low or no growth.

For the nations that have received bailouts, the austerity measures imposed have not worked.

Growth, budget deficit and debt level targets have been missed.

Greece has an euro 14.4 billion bond maturing in March 2012.

Prime Minister Lucas Papademos must meet existing targets and agree the second Greek bailout worth euro 130 billion by end-January 2012 before scheduled elections to allow official funding to be available to re-finance this debt.

Even Ireland, the much-lauded poster child of bailout austerity, has experienced problems.

The country’s third quarter GDP fell 1.9% and its Gross National Product fell 2.2% (the later is a better measure of economic performance due to the country’s large export/ transhipment activity). Ireland must reduce its budget deficit from 32% of GDP in 2010 to 3% by 2015.

Despite spending cuts and tax increases, Ireland is spending Euro 57 billion euros including Euro 10 billion to support its five nationalised banks, against euro 34 billion in tax revenue.

Spain, which has voluntarily taken the austerity cure, is missing economic targets. Spain’s budget deficit is above forecast and the need for support of the Spanish banking system may strain public finances further. Spain’s economic outlook is poor and deteriorating.

Under Prime Minister Maria Monti, Italy has passed legislation and budget measures to stabilise debt. The actions focus on increasing taxes, especially the regressive value-added tax, rather than cutting expenditures.

Structural reforms to promote growth are still under consideration and the content and timing is unknown. It is also not clear whether the plans will be fully implemented or work.

If the pattern elsewhere in Europe continues, it is unlikely that Italy will be able to stabilise its public finances.

The sharp drop in demand from cuts in government spending and higher taxes will result in an economic slowdown, which will result in continuing deficits and increased debt.

In the third quarter of 2011, Italy’s economy contracted by 0.2%. The government forecast is for a further contraction of 0.4% in 2012. The government forecasts may be too optimistic.

Confindustria, the Italian business federation forecasts the economy will contract by 1.6% in 2012.

Consumption is especially weak in many of the problem economies, with Greece experiencing falls of around 30% and Italy also experiencing large falls.

Stronger countries within the euro-zone are also affected. Lack of demand for exports within Europe and from emerging markets combined with tighter credit conditions may slow growth.

German industrial production and export orders are slowing, reflecting the fact that the EU remains its largest export market, larger than demand from emerging countries. Germany exports to Italy and

Spain total around 9-10 per cent in 2010), higher than to either the US (6-7%) or China (4-5%).

As what happens in Europe will not stay in Europe, being transmitted via trade and investment channels, negative feedback loops will complicate the economic outlook.

One complication will be the Euro itself.

Following his American counterparts who insist that they favour a strong dollar inconsistent with the evidence, German Finance Minister Wolfgang Schaeuble stated that: “The Euro is a stable currency.”

In fact, the Euro has fallen around 12 % against the dollar.

Should the European debt crisis cause currency volatility, as seems likely, the effects will be widespread.

One unstated element of the calls for the ECB to engage in quantitative easing is to weaken the Euro, increasing the export competitiveness of weaker European nations boosting growth.

Such action risks setting off currency wars as both developed nations (US, Japan, Britain, Switzerland) and emerging countries retaliate.

The risk of capital controls, trade restrictions and currency intervention is high.

Voting Intentions…

The risks of political and social instability remain elevated.

Greece faces elections in April 2011. The polls indicate a fractious outcome, with the major parties unlikely to gain majorities with significant representation of minor parties.

An unstable government combined with a broad coalition against austerity may result in attempts to renegotiate the bailout package.

Failure could result in a disorderly default and Greece leaving the euro.

The French presidential elections, scheduled for May 2012, also create uncertain.

The principal opponents to incumbent Nicolas Sarkozy either oppose the Euro and the bailout (the National Front led by Marine Le Pen) or want to renegotiate the plan with the introduction of jointly guaranteed Euro-Zone bonds (the Socialists led by Francios Holland).

The European debt crisis is also creating political problems in Germany, Netherlands and Finland, especially among governing coalitions.

The risk of unexpected political instability is not insignificant.

In the weaker countries, austerity means high unemployment, reductions in social services, higher taxes and reduced living standards.

Social benefits increasingly below subsistence are widening income inequality and creating a “new poor”.

Protest movements are gaining ground, with growing social unrest.

In the stronger nations, increasing resentment at the burden of supporting weaker euro-zone members is evident.

Despite the tabloid headline, Germans have been relatively sanguine about the commitment of funds to the bailout, aided by limited disclosure of the extent of the commitment and a relatively strong economy.

A downgrade of Germany’s cherished AAA rating or any steps to undermine the sanctity of a hard currency (by printing money or other monetary techniques) will force increasing focus on the costs to Germans of the bailouts.

Germany’s commitment to date is Euro 211 billion in guarantees, euro 45 billion in advances to the IMF and Euro 500 billion owed to the Bundesbank by other national central banks – around 25% of GDP.

The increasing risk of losses may even divert attention away from the 2012 European Soccer Championship where Germany is drawn in the “Group of Death” with Netherlands, Portugal and Denmark.

Road to Nowhere…

In the short-term, Europe needs to restructure the debt of number of countries, recapitalize its banks and re-finance maturing debt at acceptable financing costs.

In the long-term, it needs to bring public finances and debt under control.

It also needs to work out a way to improve growth, probably by restructuring the Euro to increase the competitiveness of weaker nations other through internal deflation.

Such a program is difficult and not assured of success, but would provide some confidence. At the moment,

Europe does not have any credible policy or workable solution in place.

One persistent meme is that Europe has enough money to solve its problems.

This is based on the euro-zone members’ aggregate debt to GDP ratio of around 75%. There are several problems with this analysis.

The debt is concentrated in countries where growth, productivity and cost competitiveness is low, which is what caused the problems in the first place.

The relevant wealth is in the hands of a few countries like Germany that appear unwilling to bail out spendthrift and irresponsible neighbours.

A substantial portion of the savings is also invested in European government debt directly or in vulnerable banks, which have invested in the same securities.

The total debt of the PIIGS (Portugal, Ireland, Italy, Greece and Spain) plus Belgium is more than Euro 4 trillion.

A write-down of around euro 1 trillion in this debt is required to bring the debt levels down to sustainable levels (say 90% of GDP).

In the absence of structural reforms and a return to growth, the write-downs required are significantly larger.

This compares to the GDP of Germany and France respectively of euro 3 trillion and euro 2.2 trillion.

In addition, the stronger nations may have to bear the ongoing cost of financing the weaker countries budget and trade deficits.

Satyajit Das

This does not appear economically or politically feasible.

Europe now resembles a chronically ill patient, receiving sufficient treatment to keep it alive.

A full and complete recovery is unlikely on the present medical plan.

Europe resembles a zombie economy, which functions in an impaired manner with periodic severe economic health crises.

The risk of a sudden failure of vital organs is uncomfortably high.

In their song “Road to Nowhere”, David Byrne and the Talking Heads were on “a ride to nowhere”. Byrne sang about “where time is on our side”.

Europe’s time has just about run out.

A failure to properly diagnose the problems and act decisively has put Europe firmly on the road to nowhere.

It is journey that the global economy will be forced to share, at least in part.

By Satyajit Das

Satyajit Das is the author of Extreme Money: The Masters of the Universe and the Cult of Risk (2011).

This post is syndicated by www.eurointelligence.com.

(Cartoons provided by www.presseurop.de)

Earlier posts by Satyajit Das:

Related by the econoTwist’s:

7 Comments

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7 responses to “Sado Monetarism & Fiscal Bondage

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  5. Elvira Sortland

    An interesting discussion is worth comment. I think that you should write more on this topic, it might not be a taboo subject but generally people are not enough to speak on such topics. To the next. Cheers

  6. Pingback: “Euro Zone Crisis is Germany’s Fault” | EconoTwist's

  7. Pam Frasier

    Hello Twistedeconotwist,
    Very interesting, Paying for IncomeTax is probably the most least satisfying thing actually invented. We are going to see so much wastage of our personal taxes that it makes many of us cry out in anger.

    The theory with paying personal income tax is always to pay the very least amount as you can, don’t pay any more then you need to.. Income Tax Stinks however we can’t get away from paying it, so don’t fork out any more then you have to..
    Kindest Regards