So the European summit came and went. I am still struggling to see a credible transition plan from the Europe I see today to the new one that the “fiscal compact” speaks off. The imbalances in Europe exist today as they did yesterday and although I keep reading they have achieved a fiscal union-ship, the truth is what has been agreed to is anything but. There is certainly nothing resembling a usable mechanism to support re-balancing of differences in economic competitiveness.
It seems that the president of the Bundesbank agrees:
Bundesbank President and European Central Bank council member Jens Weidmann said decisions reached at the European summit in Brussels amount to a “fiscal pact, not a fiscal union,” Frankfurt Allgemeine Sonntagszeitung reported.
So, as far as I can tell what was announced on Friday night was nothing more than an agreement to push mass austerity into Europe while attempting to manage the servicing of the existing debts. The issue is, of course, that these two things are mutually exclusive.
Even if you believe that austerity will lead to higher production and stronger economies in the long run, even the most optimistic economist will tell you this will take years and will be deflationary in the medium term. So unless there was a solution delivered out of the summit as to how Europe was going to offset the Franco-German demand for deflationary austerity policies in such a way that these economies could still service their existing debts during the transition, then the summit was always going to be a failure in my eyes.
There were three credible options that would satisfy these circumstances, outside of a true fiscal union, and all have large side-effects.
- 1) write-down the debts to a sustainable level pushing the losses onto private sector creditors.
- 2) Allow the ECB to “print” and fund nations to pay down their exising debts with the new financial assets.
- 3) A mix of one 1) and 2).
It was obvious from the outset that many nations, including France, were already baulking at option 1) because of their banking system exposures. For that reason I discounted this as an option early. The farcical show that had gone on with the Greek PSI was proof enough to me that Europe was never going to take this path voluntarily. That assumption proved correct and you only need to read section 15 of the Euro leader’s statement to recognise that:
Concerning the involvement of the private sector, we will strictly adhere to the well established IMF principles and practices. This will be unambiguously reflected in the preamble of the treaty. We clearly reaffirm that the decisions taken on 21 July and 26/27 October concerning Greek debt are unique and exceptional; standardised and identical Collective Action Clauses will be included, in such a way as to preserve market liquidity, in the terms and conditions of all new euro government bonds.
So given that Europe has pre-decided in the lead up to the summit that option 1) was off the table, and therefore option 3), the only credible path available to make payment on the existing debts while implementing austerity was for the ECB to enter into a quantitative easing program and supplement falling national incomes during the transition.
You may be completely ideologically opposed to the idea, but that is irrelevant when it comes to economics. 1+1=2, so if European nations are going to drive austerity programs to a point where every single one of them is aiming for a balanced government budget (0.5% structural) then there is simply no other option. The latest proposals using the ESM/EFSF and the IMF are all well and good, and I am sure the some markets will confuse them with success in the short term, but realistically they are just more of the same loans that will come with the same deflationary demands.
For nations that are already insolvent they will do nothing more than give them yet another credit card to pay off a portion of their existing credit cards, all of which must be paid back. Once again I remind everyone that none of these institutions are a charity. It should also be noted that any IMF loan would make every other creditor sub-ordinate to the IMF, which in itself makes private sector involvement more difficult.
This is exactly what we have seen in Greece, and why I stated numerous times over the last 18 months that the periphery nations would inevitably need to receive ongoing bailouts while austerity was being implemented, even though every single one of them was the “last one they needed”. (See this post for more on this topic, even more here ). For nations that are still technically solvent but have issues with funding costs ie. Italy , then this would be a solution for short term funding while they made structural adjustments, however, the adverse effects of austerity which will be demanded either way will more than offset this positive effect.
It is for this reason I titled my post on Friday morning “Europe’s last hope collapses”. This is because the president of the ECB all but shut down the only creditable path left to Europe with some delusional talk about how an austerity based “fiscal compact” was going to provide confidence to the markets with such vigour that they would forget how to add two numbers together. The fact that Italian bond yields rose back towards unsustainable levels after the summit and required ECB intervention to bring them back down again, should be proof enough of the fantasy of this statement.
Let’s not even mention the talk about banks increasing lending to the private sector while requiring over 100 billion euros in new capital and attempting to implement Basel III.
So, as you can see from above as far as I am concerned Europe is now in an ideological vice. I am aware that many people believe that ultimately the ECB will be forced to do something, and I don’t totally disagree they will…eventually, but not before things get much, much worse. Mr Draghi’s press conference made it very clear that there is no “bazooka” on the way no matter how many times you ask the same question. The new plans with the IMF will not involve the ECB and I note that due to this the IMF and some other nations are beginning to show some resistance to the idea.
So while there is no credible counter-balance for the effects of supra-European austerity any attempt to implement the new “fiscal compact” will make Europe’s economic issues worse. The continent is already on the way to recession and unless we see some additional action from the ECB, or a huge swing against this new framework, the push to implement the outcomes of the summit will simply accelerate that outcome. My assumption is that, if Europe does ratify this framework (there are a few stragglers), after 12-24 months of trying the effect will be so disastrous that they will eventually give up. But until then my base case for Europe is a significantly worse economic outcome.
I could be somewhat more positive if I thought the rest of the world was going to be able to provide the sort of demand for European products and services of a magnitude that could offset internal European deleveraging. However, in the current global environment it isn’t going to occur and the inter-dependencies between Europe and the rest of the world guarantee that a slowing Europe means a slowing globe. We are already seeing a slowing in economic activity across Europe and some of the key components of the new agreement are only going to make that worse if they are actually enacted. Sections 4 and 5 of the new fiscal compact are quite specific:
4. We commit to establishing a new fiscal rule, containing the following elements:
- General government budgets shall be balanced or in surplus; this principle shall be deemed respected if, as a rule, the annual structural deficit does not exceed 0.5% of nominal GDP.
- Such a rule will also be introduced in Member States’ national legal systems at constitutional or equivalent level. The rule will contain an automatic correction mechanism that shall be triggered in the event of deviation. It will be defined by each Member State on the basis of principles proposed by the Commission. We recognise the jurisdiction of the Court of Justice to verify the transposition of this rule at national level.
- Member States shall converge towards their specific reference level, according to a calendar proposed by the Commission.
- Member States in Excessive Deficit Procedure shall submit to the Commission and the Council for endorsement, an economic partnership programme detailing the necessary structural reforms to ensure an effectively durable correction of excessive deficits. The implementation of the programme, and the yearly budgetary plans consistent with it, will be monitored by the Commission and the Council.
- A mechanism will be put in place for the ex ante reporting by Member States of their national debt issuance plans.
5. The rules governing the Excessive Deficit Procedure (Article 126 of the TFEU) will be reinforced for euro area Member States. As soon as a Member State is recognised to be in breach of the 3% ceiling by the Commission, there will be automatic consequences unless a qualified majority of euro area Member States is opposed. Steps and sanctions proposed or recommended by the Commission will be adopted unless a qualified majority of the euro area Member States is opposed. The specification of the debt criterion in terms of a numerical benchmark for debt reduction (1/20 rule) for Member States with a government debt in excess of 60% needs to be enshrined in the new provisions.
I have explained previously that not even Germany has government spending or existing nation debt within the current treaty thresholds, and a look at some historic data shows just how unrealistic these new measures are:
The basis issue I have with the entire plan is that for some odd reason, against ever mounting evidence, European economic policy is still being implemented on the basis of an ideology that using bailout loans and “expansionary fiscal contraction” is a workable economic recovery strategy for Eurozone nations that are bound to a non-deflatable currency. The periphery continue to prove this point wrong and even the IMF, and more recently the OECD, have admitted that the policy is failing in Greece. Yet despite this, all I can see that has come out of this latest summit is even more plans based on this same underlying premise.
One lesson that the world has learned since the financial crisis of 2008 is that a contractionary fiscal policy means what it says: contraction. Since 2010, a Europe-wide experiment has conclusively falsified the idea that fiscal contractions are expansionary. August 2011 saw the largest monthly decrease in eurozone industrial production since September 2009, German exports fell sharply in October, and now-casting.com is predicting declines in eurozone GDP for late 2011 and early 2012.
A second, related lesson is that it is difficult to cut nominal wages, and that they are certainly not flexible enough to eliminate unemployment. That is true even in a country as flexible, small, and open as Ireland, where unemployment increased last month to 14.5%, emigration notwithstanding, and where tax revenues in November ran 1.6% below target as a result. If the nineteenth-century “internal devaluation” strategy to promote growth by cutting domestic wages and prices is proving so difficult in Ireland, how does the EU expect it to work across the entire eurozone periphery?
The world nowadays looks very much like the theoretical world that economists have traditionally used to examine the costs and benefits of monetary unions. The eurozone members’ loss of ability to devalue their exchange rates is a major cost. Governments’ efforts to promote wage cuts, or to engineer them by driving their countries into recession, cannot substitute for exchange-rate devaluation. Placing the entire burden of adjustment on deficit countries is a recipe for disaster.
Yes it is. But it is now the recipe Europe is using. Another “summit to end all summits” is guaranteed.