Tag Archives: GDP

A Tombstone Treaty?

There is no doubt in this bloggers mind that the EU leaders eventually will agree on, and sign, a new fiscal Treaty for the euro zone. But the really interesting question is; will it actually work? Or will this be the document that buries the whole EU idea once and for all?

“The new Treaty provides little enhancement with respect to the Stability and Growth pact and includes measures that are either too vague or likely to be ineffective.”

Massimiliano Marcellino

Well, according to Professor Massimiliano Marcellino at the European University Institute it will not. “This is surely not the right moment to spend so much time in drafting a new treaty that does little to address the most pressing short-term problems of the euro area,” Professor Marcellino writes in a commentary, adding: “But let’s assume for a moment that the Treaty is approved, and without major modifications.”

It’s a perfectly timed commentary, and raises some of the really fundamental questions around the plans for a new fiscal Treaty amongst the euro zone members.

Here’s the rest of the article, published today at the www.eurointelligence.com:

Why We Don’t Need The New Fiscal Treaty

The first goal in the treaty is to “foster budgetary discipline” and Title III of the draft treaty introduces measures aimed at achieving this target.

The key economic indicators used in Title III are the structural balance of the general government, which is required to be balanced or in surplus, and the ratio of the general government debt to gross domestic product (GDP), which in the long run should not exceed 60%, and if it does it should be reduced by an average rate of one twentieth per year.

The problem of a target in terms of structural balance is that this variable is not observable. It must be constructed by cyclically adjusting the actual balance.

There is no consensus about how to measure the business cycle even among economists,  so it can be expected that member states will have very different opinions about the state of their business cycle and hence about the meaning and measurement of “structural balance”.

In addition, it is not obvious from an economic point of view that growth promoting expenditures, such as investment in education and research, should be included in the computations.

Equally problematic is the debt to GDP ratio, considered by many as the prince of fiscal indicators.

However, it is a strange indicator: in the numerator there is a stock variable, the total amount of government debt, and in the denumerator a flow variable, the gross domestic product in a given period.

The latter is considered as an indicator of the capability of the government to repay its debt. But to reflect fully the financial conditions of a government, it would also have to include a measure of the total government assets.

In addition, the value of 60% for the debt to GDP ratio, inherited by the Stability and Growth pact, does not have any serious economical basis. And there seems to be little awareness that reducing the debt to GDP ratio by one twentieth per year, it would require continuous tightening of fiscal policy with negative effects on GDP growth, which would make this policy ineffective while the economic conditions of the country worsen.

Much more preferable are thus targets defined in terms of actual deficits, ratios of debt not only to GDP but also to assets, and more gradual convergence criteria.

The main concern remains however, namely that the procedures in case of a breach of the rules remain very long and complicated, and that the penalty system is unclear and insufficient to prevent future misbehaviour, in particular in the case of a large country.

The second goal of the new Treaty is “to strengthen the coordination of economic policies“, article 9 states that “… the Contracting Parties undertake to work jointly towards a common economic policy fostering the smooth functioning of the Economic and Monetary Union and economic growth through enhanced convergence and competitiveness”.

To this aim, article 11 clarifies that “With a view to benchmarking best practices and working towards a common economic policy, the Contracting Parties ensure that all major economic policy reforms that they plan to undertake will be discussed ex-ante and, where appropriate, coordinated among themselves.”

Here there is quite a bold statement: to work jointly towards a common economic policy.

Taken literally, this has major implications.

But how can we expect that member states are ready to do this after they so utterly failed in the past?

And does this imply that national parliaments should partly give up their authority?

And what happens in case of disagreement on how to foster growth or convergence?

And what is the actual role of other European institutions such as the European Parliament?

Finally, in terms of governance of the euro area, the Euro Summits are welcome but, according to their description in Title V, they seem to be just discussion fora, and in this sense their value added with respect to other existing fora is not clear-cut.

Massimiliano Marcellino

The new Treaty provides little enhancement with respect to the Stability and Growth pact and includes measures that are either too vague or likely to be ineffective.

It also fails to address the current crisis.

Financial markets are more worried about short and medium term solvency than about the enhanced long-term sustainability and policy coordination.

Without bolder actions to prevent a break-up of the euro area this new Treaty is likely to become redundant.

Massimiliano Marcellino is professor at the European University Institute in Florence.

This article is syndicated by www.eurointelligence.com.

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Qou Vadis, QE?

Ever since the first rounds of quantitative easing (QE) by the US Federal Reserve, I’ve raised questions about how sound and sustainable this form of monetary policy is? How big is the risk that the greatest economic experiment in modern history may eventually fail? More than three years later, I’m still not sure. The only thing I’m sure of, is that the need for extreme measures is greater than ever.

“It doesn’t matter whether new investment is financed by more government borrowing, quantitative easing or redistribution. What matters is growth.”

George Irvin

(Photo by freakingnews.com)

While Mr. Ben Bernanke in the USA is trying to figure out new and more creative ways to flow the financial system with money in order to kick-start the nation’s economy, European politicians are obsessing over new and creative austerity measures in order to save money and regain the union’s financial balance. But nothing seems to work. 

In 2008 I called for the launch of a so-called “Keynesian war” – but with a twist:

Instead of increasing public spending the traditional way, by investing in infrastructure like transport and housing or by upgrading public institutions like the military, I suggested to aim the financial “guns” at research and education, closing  the gap between the rich and the poor, and developing clean energy.

The “Keynesian war” was launched, all  right. But the ammunition was poured into the banks and other financial institutions who barely manged to save their own asses, in addition to dump the problems on their respective  national governments.

The financial crisis is currently well beyond the stage I regarded as a “worst-case-scenario” only two years ago.

So, where do we go from here?

One thing ought to be clear: It’s no longer a question of method – the only thing that matters is the result.

Honorary professor George Irvin at University of London makes a pretty good summary in his latest blog post at the EUobserver.com.

The Debt Trap 

“Europe is obsessed with the growing stock of public sector debt; fiscal austerity has become the watchword of our time. Little does it seem to matter that fiscal austerity means reducing aggregate demand, thus leading to economic stagnation and recession throughout the EU as all the main forecasts are now suggesting,” Professor Irvin writes.

Even the credit rating agencies are worried, as S&P’s downgrading of France and eight other countries shows. Whether it’s Angela Merkel or David Cameron speaking, public debt is denounced as deplorable, and all are told to get used to hard times.

As Larry Elliot puts it:

“The notion that economic pain is the only route to pleasure was once the preserve of the British public school-educated elite, now it’s European economic policy”.

In Britain, immediately after the general election, the Tory-led coalition decreed that in light of the large government current deficit, harsh cuts were necessary to win the confidence of the financial markets.

But although the current deficit was high, the stock of debt (typically measured by the debt/GDP ratio) was relatively low and of long maturity, the real interest rate on debt was zero (and at times negative) and, crucially,

Britain had its own Central Bank and could devalue. As Harriet Harman argued in June 2010, Osborne’s cuts were ideologically motivated. The aim was to shrink the public sector, and the LibDems—fearing a new general election—chose to go along with the policy.

In the euro zone (EZ), where a balance of payments crisis at the periphery has turned into a sovereign debt crisis, the German public has been sold the idea that if only all EZ countries could be like Germany and adhere to strict fiscal discipline, all would be well.

The ultra-orthodox Stability and Growth Pact (SGP) has now been repackaged under the heading of ‘economic governance’ under which Germany and its allies will vet members’ fiscal policies and impose punitive fines on those failing to observe the deflationary budget rules to be adopted.

Never mind the fact that indebtedness in countries like Spain and Ireland was mainly private, or that the draconian fiscal measures imposed on Greece have, far from reducing public indebtedness, increased it.

Is debt always a bad thing?

In the private sector, obviously not since corporations regularly borrow money for expenditure they don’t want to meet out of retained earnings, while most households aim to hold long-term mortgages.

Public debt instruments like gilts in the UK or bunds in Germany are much sought after by the private sector, mainly because such instruments are thought to act as an excellent hedge against risk.

Remember, too, that when a pension fund buys a government bond, it is held as an asset which produces a future cash stream which benefits the private sector.

So ‘public debt’ is not a burden passed on from one generation to the next.

The stock of public debt is only a problem when its servicing (ie, payment of interest) is unaffordable; ie, in times of recession when growth is zero or negative and/or interest rates demanded by the financial market are soaring.

The question is when is debt sustainable?

Sustainability means keeping the ratio of debt to GDP stable in the longer term.

If GDP at the start of the year is €1,000bn and the government’s total stock of debt is €600bn, then the debt ratio is 60%; the fiscal deficit is the extra borrowing that the government makes in a year – so it adds to the stock of debt.

But although the stock of debt may be rising, as long as GDP is rising proportionately, the debt/GDP ratio can be kept constant or may even be falling.

Consider the following example. Suppose the real rate of interest on debt is 2% (say 5% nominal but with inflation at 3%, so 5 – 3 = 2). That means government must pay €12bn per annum of interest in real terms. But as long as real GDP, too, is rising—say at 2% per year—there’s no problem since real GDP at the year’s end will be €1020bn.

Even if the government were to pay none of the interest, the end-of-year debt/GDP ratio would be 612/1020 or 60%; ie, the debt ratio remains unchanged.

By contrast, if real GDP growth is zero, the ratio would be 612/1000 = 61.2; ie, the debt ratio rises only slightly. 

The rule is that as long as the real economy is growing by at least as much as the real rate of interest on debt, the debt/GDP ratio doesn’t rise.

Moreover, this holds true irrespective of whether the debt ratio is 60% or 600%.

But there’s a catch.

In a modern economy, the public sector accounts for about half the economy.

If a country panics about its debt ratio and cuts back sharply on public sector spending, this reduces aggregate demand and may lead to stagnation or even recession.

When a country stops growing, financial markets decide that its debt ratio may rise and so become more cautious about lending and demand a higher bond yield (ie, interest rate).

The gloomy prophecy of growing public indebtedness becomes self-fulfilling. This is exactly the sort of “debt trap” which faces much of the EU and other rich countries. The way out cannot be greater austerity.

What works for a single household or firm doesn’t work for the economy as a whole. A household can tighten its belt by spending less, saving more, and thus ‘balancing the books’, but an economy cannot.

If everybody saves more, national income falls.

Of course, Germany and some Nordic countries can balance the government books because an export surplus offsets domestic private saving. But the Club-Med countries cannot match them.

When no EZ country can devalue, to ask each EZ country to balance the books by running an export surplus is empirically and logically impossible.

Even if all could devalue, what would follow is 1930’s-style competitive devaluation.

The way out of the ‘debt trap’ is the same as the way out of recession: if the private sector won’t invest, the public sector must become investor of the last resort.

It doesn’t matter whether new investment is financed by more government borrowing, quantitative easing or redistribution (some combination of the three would be optimal).

What matters is growth.

By George Irvin

George Irvin is a retired professor of economics and for many years was at ISS in The Hague. He is now honorary Professorial Research Fellow in Development Studies at the University of London, SOAS.

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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:

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