Europe’s suicide pact

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.

noted yesterday that Paul Krugam had linked an article discussing this exact point in the context of Ireland:

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 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.

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  1. +1

    The first step has been taken, but the solution is not in sight …yet. Now there is a run on SwedBank in Latvia even though it had a credit upgrade last week….panic is setting in. When will the ECB print?

  2. If the ECB prints, then the pain and adjustments that have so far taken place, small they may be, will have been entirely wasted. How would you like to be Ireland; having done’ the right thing’ to have your efforts inflated away? One way or another the accummulated debsts have to be repaid or borne by the private sector. It’s either now, or later – when they are nominally much larger, if the ECB prints. We have spent 3 or 4 years setting the scene for what has to be done. Deflationary it may be, but what has to be done, will be done. Let’s hope the ECB, or is that just Germany?, stands firm.

  3. While France may oppose default due to its banks, Germany opposes printing as the memory of Weimar is ever-present.

    That rules out all sensible options, and leads to what we have now. Ultimately, as you have said, this is an EU suicide pact.

    At some point outright default or default-via-printing will have to occur regardless of what the EU and its leaders think.

  4. DE, I love your work! I thought the new fiscal rule they are moving to was sarcasm or farce until I remembered the doltish politicians who have run the world show for the lat 20 years.

    FWIW re: politicians; I think the Germans want to run the show and be the prefects who enforce the rules. The French just want everyone else’s money handed to their banks. The Brits want the trade with the rest of Europe but to still maintain their sovereignty and own tax systems. The PIIGs just want to live in the sun on someone else’s dollar, whilst the Yanks are so scared of their own banks they will risk dystopia with their endless money printing. The Aussies want photo opportunities with anyone who will stand still for 5 minutes. The Japanese have retreated into a hell of their own and the Chinese are waiting to see of there are any crumbs worth picking up. Only the Icelanders had the guts to discipline their pollies to get them to stand up to the banks.

  5. The BIS say “Nearly $2 trillion of bank debt is due to be repaid by the end of 2014”

    The EU banks are in a death spiral, and no one really want to lend to them given their sovereign exposure. Sometime in 2012 this is going to be the key issue, and if you look at Italy alone it might start there …around 320B needed in 2012 alone for on country.

    Fiscal rules now don’t sole past sins.

  6. DE,

    As Mish Shedlock recently brought to my attention, the ECB is already “printing” via stealth.

    Behind all their “flap” about not printing, they are committing to buying Euro 20 Billion PER WEEK in sovereigns. That’s Euro 1 TRILLION+ per year.

    They are taking on paper at par of which the market value is well below par. That is printing by any measure, is it not? It certainly is a scale of issuance that even makes the US look pretty tame.

    Of course there is a chance that the ECB will get all those loans repaid in full I guess – but what chance would you give that? If there are haircuts the ECB will find itself sitting on a pile of toilet paper and will have effectively monetized a great chunk of it.

  7. This is step 1 towards fiscal union.

    1. Germans want to see proof that money won’t be wasted – hence new enforcement of rules around budgets.
    2. Once that is shown to be effective, Germany will allow Eurobonds
    3. Sovereigns will issue Eurobonds to ECB (e.g. print money). Step 1 will ensure that printing won’t be excessive and inflationary.

    But Merkel seems to think that Europe has a few years to go from step 1 to step 2. As a63 says above, there’s too much debt to be repaid in that period. This meeting was a huge miscalculation. I wonder how long it will take for the market to realise that…

    • I understand the idea of EMU countries agreeing to new budget rules & restrictions, even though the idea is wrong. But I don’t see why non-EMU would agree. What is in it for them – why should the Swedish or Czeck governments sent their budgets to a Brusselcrat for approval?

  8. Is there a strategy Merkel has in mind to help get the PIIGS back on their feet again? Simply put: No, and it’s not something most Germans care about either, so convinced are they that the lazy Greeks deserve their terrible fate. (For this Merkel, too, is responsible.) Europe-wide, Keynesian deficit spending is not only frowned upon, it is now being outlawed and subject to sanctions. No one’s talking about investment in the deficit-strapped countries to relaunch growth and employment, or upping wages or other measures in the north that would reduce trade surpluses and give the south a fighting chance.

    Personally I am now less concerned about the economic consequences of this policy than I am about the political ones. My worries about there being no jobs in the City for me next year have given way to being more concerned about tanks parked at the entrance to the Chunnel…

  9. Good post, DE.
    Does anyone know how the latest “Agreement” has affected the pricing of EU debt, particularly CDS’s?

  10. Its not as bad as you paint it.The ECB will print once moral hazard is reduced and inflation risk is very low. The first condition will be satisfied by the new pact(ECB will however need to see ratification process going well) and the second is arguably already in place given the speed of the EZ contraction. The ink will be flowing by end of Q1.Relax.

    • I believe you’ve got it right, with just a couple of problems.

      Unfortunately the ratification isn’t scheduled until May. And then I’m pretty sure that Germany will want to see a track record of the PIGS meeting the new restrictions (which will be impossible) before the printing begins. So we’re talking a year or two before printing (in the event that the impossible actually happens).

      Unless they can significantly calm the bond market over the next couple of months, then they don’t have time. I don’t think the latest “agreement” will calm the market.

  11. Good work DE. Makes no sense to me either.

    How does this work out?

    It seems to me the Bundesbank are saying in effect “You wanted us to give up the DeutschMark and create the Euro in its likeness. Well, we have, what are you lot complaining about?”

    So the French Imperial Bureaucratic Dream is dying. Now that Germany is whole again (the reason for giving up the DeutschMark in the first place) and cannot so easily be dominated by hyper intelligent French Bureaucrats.

    I don’t get the feeling the Germans want to have to run Europe, they just want an orderly society and a currency they can trust.

    So, when do the rating agencies demote France? When do the French try to introduce austerity in order to get a loan from the IMF? When does the Paris mob rise up once more?

    There will be riots and buildings will burn. Hopefully no politicians will be lynched, but don’t bet on it, it is a French tradition after all.

  12. What a great article DE!
    It is unbelievable they don’t even mention trade imbalances as part of the problem. And relying on IMF for help seems flimsy, given how that went a few months ago. Since the option of ECB printing is still not used, the markets must be getting impatient and the underlying banking crisis close to reaching a boiling point?
    I still think they’ll have to do a combo of 1 & 2. But how much QE? In particular, how much QE are the markets now demanding? ECB to bail out all private sovereign debt holders? How many funds would have taken that bet?

    Rodzone’s take is brilliant too!

    • Interesting however, your first solution is an outcome and a lot would need to happen in between to get there (pain and calamity).

      And your second solution: Printing money is never a long term solution.

  13. Okay DE, I have a question for you. It’s a bit vague but I will do my best to put it into words.

    Am I right in thinking that behind the smoke and mirrors the ECB is actually engaged in QE by another name as we speak?

    As I see it (or think I see it, peering through the fog of war) the ECB has basically said to the key Euro banks that they can borrow as much as they like at 1% provided they use the money to buy Italian, Spanish and French bonds. They can use any collateral they like, including promissory notes from their dead Uncle Herbert.

    So, given that the key banks in question are way over leveraged they are selling their worldwide loan book as fast as their micro second trading computers allow and buying this guaranteed trade.

    So, effectively the banking crisis in France and Germany is resolved, bar a bit of sweeping and tidying.

    The Europeans still have their economic mess to sort out but they have instigated an internal carry trade guaranteed by the ECB to allow their banks to make guaranteed profits. The banks can then write off their insolvent loans at a time of their choosing.

    Am I wrong? Or has that actually happened in the background behind the drama and distraction of the latest summit?


    The agreement to “push mass austerity into Europe” and the intention to “manage the servicing of the existing debts” are not “mutually exclusive” if the “austerity” takes the form of a holding tax on the values of indestructible, immobile, irreplaceable assets, such as sites (land). The holding tax forces the asset into productive use, because the owner must either generate income from the asset in order to cover the tax, or sell the asset to someone who will.

    In the short term, however, the easiest course for indebted EU members is to scrap the social security tax (payroll tax) and replace the revenue by raising or extending the VAT. Because payroll tax and VAT are similarly regressive, the redistributive effects of such a reform would be minimal. The point is that, whereas a payroll tax has a production/origin base, a VAT has a consumption/destination base. Hence, whereas the suppression of production due to one country’s payroll tax is concentrated within that country, the effect of a VAT on production is shared with the country’s trading partners and is therefore less detrimental to that country’s ability to generate income and pay its debts.