Mario Draghi – boiling the German frog!

The anecdotal boiling frog story holds that if you throw a frog into a pot of boiling water it will immediately jump out, but if you place it in a pot of cold water and slowly boil the water, it will not perceive the danger and will be cooked to death. The recent announcement by Mario Draghi, the President of the ECB, of how the ECB believes it can bring the Eurozone crisis under control, smacks of these tactics.

By the end of July, as many of Europe’s leaders had set off for their holidays, Spanish bond yields hit critical levels, which if maintained would shortly leave Spain unable to raise money in the financial markets and requiring a full-scale bailout from the other governments. Spain is however too big for the other Eurozone countries to bail out without considerable help from the ECB in the form of printing money.

Mr Draghi has carefully constructed a plan of action that garners just enough political support to be workable. First, a country must ask for assistance from its fellow Eurozone governments, which must be approved (thus achieving full political buy-in) unanimously. They and the ECB will then set out the conditions for such assistance (achieving the strict conditionality criterion demanded in particular by Germany) and the ECB will then be free to buy short and medium-dated debt in any amount in the secondary market.  That should, in theory bring down yields and enable the country to continue to fund itself in markets. Draghi has promised that he would also deal with the issue of ECB priority in the repayment of debt which bedevilled the Greek bailouts.

As an idea this has the support of the “moderates” within the Eurozone, essentially most of the political leaders and Central Bankers with the sole exception of the Bundesbank, which firmly opposes any Central Bank buying of government debt. The Bundesbank though is a greatly weakened institution today. On the ECB it has only vote out of 17, and only has influence to the extent that the German government agrees. In this case, both Merkel and Schaeuble have come out in favour of the Draghi plan – the Bundesbank is therefore rather isolated. Draghi has successfully driven a wedge between the Bundesbank and the German government

The realpolitik logic of such a plan however is where the boiling frog appears. Once one starts buying up the debt of credit-challenged countries, one begins to incur a large cost should it cease. Since the ECB can create money at will, the cost to it of buying more debt (if conditions do not improve) is zero, but the cost of stopping buying more debt will be considerable if the country defaults on the debt already owned. The German politicians may choose to believe that by imposing conditionality on a country before the ECB starts buying its debt, they are not creating an inflationary problem, but they are the frog being placed into tepid water. Every successive purchase of debt will be the equivalent, in the eyes of the Bundesbank, of raising the water temperature another notch.  

Europe continues to march ever closer to a denouement to its crisis, but the ultimate choice to be made is still the same. Germany has to decide very soon between the lesser of two very large evils.  Should it maintain its foreign policy objective to be a good European and keep the euro together, it will have to accept massive money printing to bail out the sovereign debts of the other countries, and suffer the consequent inflation. Alternatively, should it maintain its key economic policy objective of a sound currency with tight control of the money supply, it will have to accept the break-up of the euro and possibly of Europe as other countries find themselves politically unable to cope with the resultant economic depression..

 

Spain – sliding down the Greece-y pole

A condensed version of the Greek tragedy in recent years: 1) A new government comes to power and finds that the true state of the public finances is much worse than the previous government admitted to. 2) They want to stay in the Eurozone because their people finally have a currency they trust, and so they solemnly promise their European partners that they will do whatever it takes to ensure this occurs. 3) An eye-wateringly aggressive fiscal austerity package is announced by the new government. 4) The sharp fall in expected public sector demand in the economy leads to a significant recession, unemployment rises sharply, welfare spending rises more than expected, tax revenues come in lower than expected and the fiscal deficit does not improve. 5) The government finds that foreigners no longer want to buy the debt it needs to sell in order to finance the deficit, so it forces its bank and insurance companies to buy the debt. 6) They are not keen despite high yields and so will only buy short-dated Treasury Bills of less than one year rather than bonds with longer maturities. 7) Yields on government bonds rise to levels at which it becomes impossible for the government to issue any more bonds and the deteriorating creditworthiness of the government debt means that the sovereign debt crisis is now also an existential crisis for the domestic banking sector. 8) The rest of Europe provides funds for a bailout, not to help out the distressed sovereign but to help out their own banking sectors who have massive exposures to both government and banks of the affected country. 9) This bailout from Europe comes with a price of even greater and more immediate austerity. 10) Youth unemployment soars to tragic levels as recession bites even deeper. 11) The country is bust.

Spain’s recent history is putting it on the same road to misery that Greece has travelled in recent years. 1, 2, 3 and 4 have already occurred and 5 is coming into sight, although Spain has taken advantage of the recent period of positive sentiment surrounding the ECB’s LTRO announcements to raise a good part of this year’s debt requirements. However 10-year yields of over 6% for an economy that is likely to show barely any nominal economic growth in the next few years, are not sustainable for very long, and foreign investors are likely not to want to commit more funds to Spain. The LTROs did however facilitate a move towards 6 as the 3-year fixed-rate financing allowed the Spanish banks to make arbitrage profits by buying debt with less than 3 years to maturity – the data suggest many Spanish banks did this.

Spain’s problems are different to Greece in two ways. First, whilst the initial Greek problem was a massive under-estimate of how much debt was owed by the government due to creative accounting, Spain’s problem is that the regional governments in the country have been busily running up debts which are seen effectively as debts of the national government, even though the national government has little political or financial control over the regions. Secondly much of the Spanish banking system has urgent solvency problems following the boom and bust in Spanish house prices over the last decade – the banks need more external capital and it probably has to be the government which has to supply it. The worse the austerity-induced recession, the lower house prices will fall, the worse is the solvency position of the Spanish banking system, and it becomes even more impossible for the Spanish economy to grow its way out of its problems. A move to 7 in Spain could happen faster than many think.

Moving to 8 – a bailout for Spain would be the critical moment for Europe. Greece, Ireland and Portugal together account for about 6% of the Eurozone economy, but Spain accounts for about 12%, so the scale of bailout assistance would triple. For Northern European countries this could well be a bailout too far.

As has always been the case since the crisis started, the solution depends on which of the 3 bad options Germany decides to opt for – either a full political and fiscal union, or inflation caused by the ECB printing money or Germany leaves the euro.

Elections and political transitions in 2012 – January 2012

This year brings elections or organised transitions in political leadership in Russia, the US, China and France. Such periods can lead to unpredictability in economic policy ahead of these transitions as current leaders seek to avoid bad news in order either to win the election or to go out on a high. Similarly the period immediately after an election or leadership transition is usually one where the leader has most political capital and will generally seek to execute his or her most vital or most cherished policies. These may not necessarily be those policies which are most appropriate in an economic sense but are the most appropriate in a political sense. With so many transitions in such important nations this year, the scope for good politics to triumph over good economics is very large.

The US election is now underway with the Republican primaries firing the starting gun. The two parties are ideologically further apart than at any time in living memory (the phrase “class warfare” is being used a lot), and the Democrat President is unable to get the Republican Congress to agree to anything he wants to do. This year policy is in limbo, US politicians are unlikely to agree on doing anything  with regard to economic policy – this is understood and to some extent accepted by the markets, but action must be taken in 2013 to start reducing the fiscal deficit and the candidates are unlikely to reveal to the electorate just how bad things will need to be in terms of spending cuts or tax increases. In addition, upcoming elections require all candidates to stand up very strongly for American interests in any international dispute – in trade matters this can easily spill over into protectionist policies to “safeguard American jobs”.

In China, a new generation of leaders will come to power just before the US election – at the top level there will be no shocks but there is much manoeuvring still going on for the next level down, who will form the leadership team in five years time. Chinese officials will struggle to allow or tolerate “bad” economic news, and any further weakness of the type seen in recent months may well generate another dramatic stimulus response of the sort seen in early 2009. In foreign and trade policy also, it will be important for the Chinese to be seen to be stoutly defending their interests to safeguard Chinese jobs.

France is the most interesting story with its May Presidential elections. First it means that Sarkozy cannot allow anyone to leave the euro before the elections, because all his efforts over the last two years to “save the euro” would have visibly failed – therefore more summits and buying of time with new initiatives is very likely. However were he to remain President (unlikely from the current opinion polls), he would never have to face the French voters again – he could afford to try to be a European statesman and actually may be prepared to adopt a more German solution to the euro crisis, even at the expense of traditional French interests. By contrast markets might get a nasty shock were his main challenger Francois Hollande to win the Presidency. He is a fairly unreconstructed socialist, and would have few political soulmates in Europe, and has already declared that the current policies of austerity and institutional change to force countries into more restrictive fiscal policies are unacceptable to him. It is difficult to see Angela Merkel willing to give much of the ground that Hollande would require in order for France and Germany to continue to lead the efforts to save the euro. Either way the French election looks likely to be absolutely pivotal in determining which way the euro crisis gets resolved.

Amidst all this, the UK looks to be a rather stable place. The coalition looks set to soldier on – the Liberals cannot afford to leave since the ensuing election would see them almost wiped out, whilst Cameron benefits from pursuing the economic policies that he believes is necessary but seeing the blame laid on the Liberals. The economic policy of steady austerity has been set for the next few years and no change will be considered until much closer to the planned 2015 election. For Cameron, current economic policy is both economically and politically appropriate and he stands in a place that many of his fellow world leaders would wish to be.