The German dilemma

Within the Eurozone, Germany is coming under increasing pressure to approve and adopt policies designed to stimulate the Eurozone economy. This is because (i) Germany is the largest economy in the Eurozone, (ii) since the global financial crisis, Germany has enjoyed the strongest performance within the Eurozone based mainly on exports, which has led to a very substantial trade surplus, (iii) German public finances are in a very healthy state compared with most in the Eurozone and (iv) they are rich and have the policy flexibility to act.

Many in the rest of Europe are calling on the German government to launch a large debt-financed fiscal boost through public investment spending, creating, it is hoped, jobs and demand throughout the Eurozone. The Germans are resisting this strongly because they have worked very hard in recent years to get their government finances back onto a solid footing, and are expected to get close to a balanced budget in 2014. German politicians are stoutly resisting European calls for them to spend more and move back into deficit.

It is though in monetary policy where the greater controversy is being generated. Through his public utterances over the last six months, Mario Draghi has sought, to maintain market confidence by positioning the ECB as about to introduce a US- or UK-style QE programme in its efforts to boost demand and inflation. However the actual policy steps agreed at ECB meetings have not lived up his words – QE is always just a few months away. It is clear that, behind the scenes, the Bundesbank and several ECB members are fiercely opposed to such a policy, with many in Germany believing it to be illegal. They are angry at the way that Draghi has sought to bounce them into such a policy by his public statements.

To many in Europe (and indeed the world), the Germans are the bad guys, doggedly blocking any moves to boost the moribund Eurozone economy due to their particular economic ideological fixations around sound government finances, conservative monetary policy and a strong currency. Being so out of step with their Western allies is not a position in which post-war German governments have wished to find themselves, and in any other field than economic policy, they would have made adjustments to their position and found a compromise.

It should however be recalled that Germany never asked for the single currency, and when it became inevitable, did their best to restrict membership only to those economies that were happy to embrace German economic orthodoxies, for precisely the reasons that are now being played out within the Eurozone.

In 1990, Mitterand’s price for accepting the re-unification of Germany was monetary union. In permitting Germany to become a much larger, and thus more powerful nation, he sought to maintain France’s significance by sharing the all-powerful Deutschemark. Kohl accepted this provided that all those involved in monetary union were prepared to manage their economies according to German orthodoxy. Thus the ECB’s mandate was constructed along very similar lines to that of the Bundesbank – very independent of politicians, with a mandate of low inflation delivered through conservative monetary policy. Similarly, the Maastricht Treaty constrained the size of government deficits and public debt that individual countries would be permitted. With these in place, the only economic solution for countries finding themselves in economic difficulties is for export-led growth, with the private sector becoming more competitive in global markets through cost control, innovation and structural reform. There would be no room for short-tem fixes generated by lower interest rates, weaker currencies and debt-financed government spending.

The criteria for membership of the euro were deliberately designed to exclude what are now known as the peripheral economies. Only the “core” European economies were expected to qualify, who understood and were prepared to accept German economic thinking. However everyone wanted to qualify and through a combination of the long economic boom of the 1990s and some very creative accounting, the euro began life both with many more members than Germany had ever intended, and with much weaker (though disguised) public finances than Germany would have countenanced.

Since 2008, the Germans have continued to espouse the policies that they believe were written into the monetary union. Thus they expect countries to embrace public sector austerity to reduce budget deficits and bring their giddy debt levels back under control, they expect their Central Bank to adhere to policies of sound money by control of money supply growth and they have a particular fear of Central Banks who buy government debt with newly-printed money. This is the economic and monetary union Germany insisted on, signed up to and has always believed that others had agreed to.

To date they have not relented on these principles, but it is leading to great pain and bad will across Europe, where the peripheral economies which previously resorted to policies of devaluation and government spending to boost their economies in times of trouble, cannot understand why these should not be adopted now. Germany now faces its greatest dilemma – whether to abandon the economic principles which have been the foundation of its economic success since 1945 and remain on good terms with the rest of Europe, or, remain true to its economic ideals and be the cause of the break-up of the monetary union as weaker economies are forced to leave.

In 2012, Angela Merkel opted to bail out Greece rather than risk the break-up of the euro, though by all accounts the decision was close and arrived at only after months of consideration. When the ECB finally votes to adopt QE (almost certainly sometime in early 2015), there will be vigorous opposition within Germany including legal challenges. Once again Mrs Merkel’s leadership will be key in determining the future for Germany and for Europe.

Eurocalm before the Eurostorm

That the Eurozone ends 2012 in an apparently stable condition is mainly down to the work of two people. The first is Mario Draghi with his promise of potentially unlimited intervention in sovereign bond markets.  The second is Angela Merkel’s with her summer policy decision that forcing Greece from the Eurozone would be more damaging than keeping it in.

Mrs Merkel over-ruled the Bundesbank on both of these issues, and her steady approach to crisis management leaves her as one of the most popular European leaders within her own party and country.  She has now clearly grasped that, for the Eurozone to survive in the long term, it is necessary to have a much deeper integration of Eurozone countries, which extends ultimately to national government finances, common banking supervision and control, and joint liability for debt. In short banking, fiscal and political union is required to complete the economic and monetary union.  These are not particularly popular positions to adopt, either with the German people or with the other European nations, but they are the logical steps required to ensure the long term existence of the single currency.

She understands that for this to happen, Germany will have to dip into its pockets and provide substantial assistance to the poorer countries in the transition. However, she has not been as explicit with the German people that the financial costs of such policies to them will be very great.  The German people are not in favour of lending more money in bailouts to their Southern neighbours, and they are not in favour of accepting losses on previous bailout monies already granted.  Next autumn there is a Federal election in Germany in which Mrs Merkel would like to be re-elected as Chancellor.  So ideally, from her perspective, there would not be any more Eurozone bailouts before the German elections.

The recent agreement on the next tranche of Greek aid was farcical.  Everyone (Greece, the IMF, the EU and the ECB) is pretending that Greece is not insolvent, merely illiquid and that (based on optimistic assumptions) all will be well a decade from now.  Significantly, Germany has agreed that should Greece be doing well by 2015 in delivering on its budget deficit targets, then they would be prepared to forgive some of their debt.  The truth is that if Greece does not achieve its targets the Germans will be forced to forgive the debt because it cannot be repaid.  The point though is that any debt forgiveness happens after the German elections, when European priorities may once again be more important than domestic German ones..

Southern Europe is now very close to the limits of its tolerance for austerity. The Greek, Spanish and Portugese governments have all told their people that they are on the last round of austerity measures.  With youth unemployment close to 50% in these countries, anti-euro, anti-austerity political ideas are beginning to gain ground.  German leaders still consistently state that austerity in these economies will be necessary if further bailout funds are to be provided, and this rhetoric will not be watered down ahead of the elections.

The other major Eurozone election due by April 2013 is in Italy.  Mr Berlusconi’s withdrawal of support for the technocratic Monti government and his announcement that he will fight the elections on an anti-austerity, anti-German platform are not helpful for the euro. However, it is the honest debate to be having.

The Eurozone begins 2013 in recession, and fiscal policy is being tightened further, except in Germany.  A weak European economy will mean larger budget deficits than planned, and more pressure from the southern economies for bailouts.  This will produce more demands for austerity from the northern economies, with the rapidly fading ability to deliver either.

The stability of current financial markets in the Eurozone will not survive very long into 2013 without a dramatic improvement in economic growth, which is very hard to envisage.  Ultimately, the only solution for the weaker economies is inflation. This can come about either through leaving the single currency or through overturning the Germanic culture, which controls Eurozone economic policy. The former is the more likely solution, and the investment conclusion is to remain very wary of all euro-denominated investments until a more sustainable monetary system is in place in Europe.


“Zombie” companies: – Why corporate bankruptcies have to increase to spur recovery

Corporate bankruptcy plays a very important role within a competitive, free-market economy. Enterprises that fail were either providing a good or service that was not in sufficient demand from the rest of the economy or were providing a good or service that was not competitive with other providers in the marketplace.  Bankruptcy provides a means for the resources that were being used by the unsuccessful company to be taken from inefficient use to a more efficient use.  If this is continually occurring throughout the economy, then the use or resources will be efficient and the level of economic activity will be greater.

The US economy has generally been very good at this.  As the fortunes of industries wax and wane, both capital and workers can be seen moving from the struggling parts of the economy to the newly growing and profitable parts.  Private sector capital will always be highly mobile, but with relatively poor welfare benefits and the advantages of a common language and laws, the US workforce is also very mobile and ready to change geography and sector of work.

The above is fine in theory.   However, for politicians, elected by voters who want secure jobs, the concept of long term resource efficiency will often play second fiddle to protecting companies from going bankrupt and making their workforce unemployed.  If too many bankruptcies (that should have occurred) are avoided, then there will be adverse economic consequences.

Japan’s long period of very slow growth since 1990 can be at least partially attributed to the reluctance of their banks to foreclose on companies and force them into bankruptcy.  The alternative was to reduce the interest rates due on the loans to very low levels, even though there was little prospect of ever repaying the principal amount – in Japan they are known as “zombie” companies.  This reluctance was for two reasons. Firstly, the banks themselves were critically short of capital, and forcing companies into bankruptcy would mean that they would have to acknowledge losses, which would reduce their capital base and weaken the perception of their capital strength in the market.  Secondly the culture of Japanese society, which like many Asian cultures, places a large emphasis of maintaining “face” and avoiding “shame”.   Going bankrupt and formally not making good on your responsibilities to creditors is seen as very shameful, and many will go to great lengths to avoid it.  In the US by contrast, having a company go bankrupt is seen as part of the learning process to becoming a successful entrepreneur.

Recent data on European bankruptcies by Creditreform Research , is very illuminating.  When ranking European countries by the number of corporate insolvencies per 10,000 businesses in 2011, the four countries with the lowest rates of insolvency are Greece (5), Spain(18), Italy (26) and Portugal (57).  These are the Eurozone peripheral countries with the poorest economic performance.  The countries with the highest rates of insolvency are Austria (152), Denmark (182) and Luxembourg (316), which have all been relatively successful European economies.   The differences in this data between countries strongly supports the idea that an insolvency process that allows bankruptcies to occur easily, works to the benefit if the economy as a whole.

After the 2008 Crash, one of the surprises in the UK economic data in the face of weak economic performance, has been the rate of corporate insolvencies.  In the 1990s, business liquidations averaged about 160 per 10,000 companies, but during and since this crisis the number has not even reached 100.  There is a general sense that, as in Japan in the 1990s, banks are not foreclosing on companies.  This is (i) to avoid even more bad publicity than they have been receiving already, (ii) to avoid selling off whatever assets there are at knock-down prices and so realise larger losses than might be warranted, and (iii) to avoid write-offs from their capital bases at a time when their regulatory capital requirements are rising sharply.  Thus, as in Japan, they are content to roll over existing debt at low interest rates, even though they know that their collateral is worth far less than the loans against it.

The UK therefore probably now has a fair share of “zombie” companies. In the longer term, this will tend to inhibit recovery and growth in the UK economy, but in the shorter term it may well explain why the UK unemployment data has been consistently better than expected.  The other conclusion is that considerable, unrecognised bad debts still exist within the UK and European banking systems.  This underpins our concern that there will not be a return to stronger growth in the UK and Europe for several years ahead, which will limit returns from financial markets.

Mario’s Magic

Mario Draghi, the ECB President, can look back over his first twelve months in office with a great deal of satisfaction with what he has managed to achieve.  What he has done has been necessary, but it is not sufficient to maintain the integrity, and indeed the existence of the Euro.

Mr Draghi took over from Jean-Claude Trichet with the peripheral Eurozone bond markets in crisis.  At his first meeting of the ECB last November, he reversed the ill-timed interest rate increase made by his predecessor in July.  At his second meeting, he cut interest rates again and announced a Long Term Repurchase Operation (LTRO), which allowed any Eurozone bank to borrow as much money as it wished (subject to collateral rules) at a rate of 1% for 3 years.  In February, he announced a second LTRO.  For banks in Italy and Spain in particular, this was a lifeline as the money enabled them to buy into bonds issued by their governments which were then yielding much more than 1%, and so locking in a profit stream.  These two LTROs injected over one trillion euros of new liquidity into the banking system and eased the escalating liquidity crisis in the Spanish and Italian banking systems.  Though providing liquidity to markets in times of great stress is part of the job description of any Central Banker, Draghi, was seen to be very bold by opting for 3 year LTROs, much longer than anything else that had been previously done by the ECB and in unlimited size, which restored confidence to the system.

Unfortunately, the Eurozone’s problems were much worse than a banking liquidity crisis.  As 2012 progressed, it became clear that the Spanish banking system had a major issue of solvency.  In July, the Eurozone countries appeared to agree that the new bail-out mechanism, the ESM, would be able to lend directly to the Spanish banks, without the funds becoming a liability of the Spanish government and thus increasing the sovereign debt.  This was conditional on obtaining agreement to the setting up of a European Banking Union.  Within a few weeks however, Germany, Finland and Holland reneged on this agreement and Spanish bond yields rose as fears of a Spanish bailout and debt restructuring returned.

At a speech in London, just before the Olympics, Mr. Draghi made a dramatic comment: – “Within our mandate, the ECB is ready to do whatever it takes to preserve the Euro.  And believe me, it will be enough”.  In placing the preservation of the Euro as its highest priority, it effectively downgraded the importance of its previous prime priority, the control of inflation – the only acceptable target for German Central Bankers.  He quickly gained the support of all the political leaders and all the other ECB members apart from the Head of the Bundesbank, Jens Weidmann.

Draghi’s plan was that once a country had requested a bailout from its Eurozone partners, which had been approved by the other member states (unanimously, but with conditions), then the ECB would be prepared to purchase unlimited amounts of that country’s bonds to ensure that the interest rates in that economy would be aligned with what the ECB regarded as reasonable.  To Draghi, this would ensure that the ECB’s policy on interest rates was not sabotaged by the markets pricing in a Euro-exit risk premium that should not exist.  For Mrs Merkel and other Northern European leaders, the power to decide on a bailout still remained with them, but the ECB was doing the hard work of putting up the money.  Draghi’s manoeuvrings had isolated the Bundesbank, which was the only dissenting voice within the ECB.

Over the last twelve months, Draghi’s boldness and creativity have kept the Eurozone with a functioning monetary system.  The financial markets have understood and applauded his moves, sharply bringing down the cost of borrowing for the peripheral governments.  For his actions to continue to be successful in keeping the Euro together, however, he needs the politicians to make some difficult decisions.  The Northern European creditors must be prepared to (i) take losses on their Greek bailout loans, (ii) lend Greece more money to get it back on its feet, and (iii) when Spain and possibly other countries come to request bailouts, then the conditionality they impose needs to be politically bearable within the debtor countries.  In turn, the Southern European debtors must be prepared to adopt structural reforms and spending cuts that are painful but necessary for their countries to live within their means.  German and Italian elections next year will bring confusing political rhetoric, but it will be their politicians’ actions rather than their words that will determine whether Mr Draghi will go down in history as the man who saved the Euro.


The single currency – making Germany more European or Europe more German?

Following the fall of the Berlin Wall when Kohl wanted to press ahead with the reunification of Germany, the price of Mitterand’s acceptance of this was to demand that Germany share the power of its currency with the rest of Europe (or more particularly France) in a monetary union. Germany agreed provided that the guardian of the currency, the ECB, was made in the image of the Bundesbank, with its rigorous implementation of policies to control inflation. Both were happy because Mitterand believed he was making Germany more European, Kohl believed he was making Europe more German and the Bundesbank believed that it had the right to criticise and have a special influence over the policies of the ECB.

Until last year, the ECB did indeed operate in much the same way as the Bundesbank would have done, tending to be quick to raise interest rates and rather slow to cut them. After a Dutchman and a Frenchman, it was to have been a German, Axel Weber, who was expected to take over the ECB Presidency. However, he resigned following the introduction of the ECB policy of limited buying of the bonds of troubled peripheral governments, which in retrospect was a fairly minor breach of Bundesbank monetary orthodoxy. The man selected to take over the Presidency was Mario Draghi, an Italian and a former investment banker.

By the time Draghi took over as President in November, Europe was in deep crisis, and the ability of the politicians to respond with bailout money funded by the other governments was almost nil. If the Euro were to survive it would require extraordinary monetary policy measures. Draghi understood this and introduced two Long Term Repurchase Operations, lending unlimited money to any Eurozone bank at 1% for 3 years. Much of this was used by the Spanish and Italian banks to buy their own government bonds trading at much higher yields. For the Bundesbank this was pretty close to the direct funding of government deficits, which is illegal – they were unhappy but did not oppose it.

The crisis has worsened during this year and Spain has become close to joining the ranks of those on the bailout list. Doing so would use up most the capacity of the bailout funds (which were designed to be so big that they would never need to be used). Over the summer, Draghi has come out with a new bond-buying plan for which he has garnered substantial support. Under the plan, if the politicians agree to a sovereign bail-out with conditions, and use some of the bail-out funds set up for the purpose, then the ECB will buy bonds of those countries to maintain their deficit financing costs at a reasonable level, in potentially unlimited amounts.

Rather neatly, everyone, except the Bundesbank is happy with this. The German politicians can claim that any bail-out requires German approval and will be subject to strict conditions, thus making Europeans more German, whilst the rest of Europe sees the ECB being publicly prepared to print large quantities of money to support the weaker European economies even though this creates the risk of inflation in Germany, making Germany more European! The Bundesbank reject it because the ECB is now no longer operating in the Bundesbank’s image.

The history of the crisis in Europe is that at each step Germany talks tough and finally gives in and pays up to keep the Euro alive. It has reached the end of contributing to bail-out funds with taxpayer funds and future bail-outs need the money to be printed by the ECB. Draghi’s plan allows this to happen, once the politicians agree to a bail-out. Despite their talk, German politicians always do seem to agree to them, and so, ineluctably, the Germans are giving up on the sound money orthodoxy, which has served them so well over the last 50 years. It is the Germans who are becoming more European rather than the Europeans becoming more German.

The implication for markets is that the pattern of markets is set to continue on a loop: creating crises in the bond markets of weaker countries, followed by those counties requesting assistance from Germany and Germany demanding more austerity from them before acquiescing, leading to a rally in markets before the cycle starts again. Draghi’s plan is a good solution for today but doesn’t solve the fundamental problems. However, if German politicians continue to become more European, the clearest market implication is to sell German government bonds, because Germany will either take on the debts of the rest of Europe in some way or the money printed by the ECB will create inflation in Germany.

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.

Just what do you get for a trillion euros?

A trillion is a seriously large number. Counting E500 notes at the rate of one per second, it takes a lifetime (63 1/2 years to be more exact) to get to one trillion euros.  In two operations over 10 weeks, under the new leadership of Mario Draghi,  the ECB lent this much to the European banking system at a fixed rate of 1% for a term of 3 years and backed by much weaker collateral requirements than it has historically permitted.

The net new liquidity provided to the banking system is about half of this, the other half reflecting the expiry of other ECB lending facilities which these operations have replaced. Balances held at the ECB by the banking system have risen by about E500bn over the same time period. So for now the ECB has lent money to the banks at 1% and the banks have re-deposited it with the ECB at 0.25%. The banks however have about E750bn of bond issues maturing in 2012, and so they now have a far less pressing need to borrow in the financial markets to refinance these maturing bonds – it was this huge refinancing requirement which, at the end of last year, had brought fear to the markets of another 2008 event in which the banking system froze and plunged the world into  a savage recession.

So Mr Draghi is credited with finding a solution to the eurozone’s banking liquidity crisis which threatened markets last November and December. In response the bonds and equities of banks have risen sharply and pushed up the prices of securities all over the world in 2012. In particular sovereign bond yields in Italy and Spain have fallen sharply as investors expected that many eurozone banks would use the new liquidity at 1% to buy these sovereign bonds offering much higher yields. The numbers suggests that this has not actually happened, or at least not yet, but the prevention of a crisis has pushed prices higher anyway as confidence has returned.

A full 3 cheers for Mr Draghi is not appropriate though. First, financial markets have read this operation as the European equivalent of Quantitative Easing and this together with the stated desire of Central Banks in the US, the UK, Japan and Switzerland to print more of their own currencies, has sent the gold price rising sharply as well. This has terrified the German Bundesbank which has also realised that in effect these operations have meant that the ECB has acted as lender of last resort, a role it has historically not seen as part of its remit. Further the ECB’s willingness to accept much less secure forms of collateral for this lending, because some of the weaker banks were running out of secure collateral means that the ECB itself could become theoretically insolvent in a further crisis. German support for monetary union as a result of the recent steps, is clearly weakening both amongst the people and politicians and within the Bundesbank.

Secondly, this may not do much to boost the public sentiment towards banks because it seems unlikely that much, if any, of this money will find its way into the real economy via higher lending. Instead it is likely that banks will use it to make an arbitrage profit – some UK banks have already announced that they will not be paying bonuses to their staff based on such profits, indicating that this is the strategy they will adopt for this money.. In addition, in 3 years time, this huge amount of money is due to be repaid – this could create liquidity problems for the banking system all over again. Although the ECB will be likely to be able to manage this over time, withdrawing liquidity from the system nearly always has negative effects on the real economy.

The most serious concern is that although dealing with bank liquidity issues these operations do very little for the bank solvency problems that beset so many banks within the eurozone. Lending them new money is not the same thing as providing the much-needed new capital which can then be used to offset the substantial bad losses that still need to be written off. In fact, this trillion euros has merely created even more debt in an effort to solve the problems caused by too much debt, and since this new money is owed to the ECB who demand priority over all other creditors, all other creditors have implicitly been diluted!

Both Osborne and Cameron can count themselves a little unlucky- December 2011

As with football managers, the ability of politicians to keep their jobs can be defined by the formula – Success = Outcome minus Expectations.

A year ago, George Osborne set out his plans for getting the UK public finances onto a more secure footing. To counteract the Treasury’s longstanding record of over-optimism in forecasting trends in the UK economy, he set up the Office of Budget Responsibility, as an independent body to give greater credibility to his plans, believing that they would adopt a less rosy view of the world. Then he went further and gave himself a target of eliminating the structural budget deficit in 5 years, but his actual plans were forecast to achieve this in 4 years. His aim in all this was to maximise the expectation of the pain required in his deficit reduction plan and so minimise his chances of his plan not achieving their goals by the time of the next election. He was trying very hard to ensure that the economy and the reduction in the budget deficit actually came in better than expected in the later years of this Parliament, leaving him some scope for reining back on spending cuts or cutting taxes just before the May 2015 election.

The last year has not been kind to him. First the performance of the global economy has been much worse than was expected a year ago – this is not just the result of the mess in Europe, but also much weaker growth in the US and high food price inflation in many developing economies forcing them to slow their economies by raising interest rates – and this has contributed to a weaker than expected UK economy, making the job of reducing the deficit even m ore difficult. Secondly, the OBR made some key assumptions in its work that in hindsight were still too optimistic – they took the view that much of the reduction in tax revenues suffered in 2009 and 2010 was cyclical and thus short term rather than structural and so long term. Thus, they had tax revenues recovering quite sharply once growth got going again. This year’s deficit forecast is close to target, because there was little growth expected but the deficit forecasts for the next few years have had to be increased to account for weaker world growth and the OBR’s recognition that tax revenues from the banking system will not bounce back as fast due to the ongoing crisis and that weak productivity growth is likely to mean a slower rate of reduction in the unemployment rate.

In his first year then, Mr Osborne has not been seen as a success because he has had to reset expectations to an even lower level. From here though, it might just work out well for him. First, both he and Mervyn King have explicitly stated that all forecasts are dependent on the eurozone crisis being resolved fairly quickly, which is not unreasonable, and secondly that this time round it could well be that the OBR’s assumptions are too pessimistic in that they now assume that the loss of tax revenues were structural and long term and not at all cyclical and short term. Mr Osborne now has more pessimistic forecasts, for which he is criticised today, but which give him a greater capacity to produce a positive surprise, for which he can take credit, in a few years time.

For David Cameron, the bad luck may not be so easy to turn around. A successful resolution of the eurozone crisis requires much greater co-ordination of fiscal policy across the Eurozone. This will require tighter rules and international bodies with real power – in other words deeper political union amongst the Eurozone as Mrs Merkel has been saying for some time. The UK’s economic interests are clearly best served by a resolution of the crisis, but such a resolution is not, from a Conservative perspective, in the UK’s foreign policy interests. A deeper political union amongst the eurozone members, will lead to far larger and more powerful area, which will make policies affecting the UK but over which the UK will have little influence. It re-opens the European faultline within the Conservative Party, which Mr Cameron has worked so hard to paper over. The UK will have to make a fundamental reassessment of its policy towards Europe if the euro survives and a deeper, political union results. Such a debate has always proved to be very damaging for the Conservative Party.

Germany cheerfully leads the Eurozone towards misery – November 2011

At the previous G20 meeting, European leaders were sent away with the message to agree a solution to the debt problems of the Eurozone which were hitting the economies of the rest of the world. The Brussels agreement on the latest round of measures to be adopted by the Eurozone was a triumph for Mrs Merkel but does nothing to resolve Europe’s economic problems despite the initial positive reaction from markets. In the agreement, Germany commits no more money to the Eurozone bailout programme than it had previously agreed to, it has not given any guarantee of the debts of any other country, it has kept down the amount of recapitalisation required of the banking system to a level that its banks should be able to raise from the private sector alone and so avoid another unpopular state bailout of banks and it has blocked French attempts to get the ECB to intervene massively to support the Spanish and Italian bond markets. On top of that, all Eurozone countries are now committed to balanced budget constitutional amendments and Italy was forced to bring to the summit, in an almost schoolboy-like manner, a detailed plan as to how it would take further steps to reduce its spending. On Greece, the inevitable default is acknowledged but only for private sector lenders, and not public sector lenders such as the ECB, the IMF and the EU, who remain favoured creditors.

Unfortunately, what the Germans believe to be a good plan is terrible news for the near term health of the Eurozone economy. Greece will still owe a very high 120% of its GDP by 2020 (on optimistic assumptions) – this is double the old Maastricht Treaty maximum of 60% and leaves the capacity of the Greek economy to grow its way out of its problems severely hampered. For the other Eurozone countries the ability ever again to use fiscal policy as a tool to boost their economies in future times of trouble will disappear, leaving the ECB and monetary policy as the only route to stimulate economies. Germany is securing an economic straitjacket around its Eurozone partners, at the exact moment when their economies have become hugely uncompetitive compared with Germany.  Their only path back to economic growth is for prices and private sector wages to fall by about 25% and thus re-establish competitiveness – that path means several years of a real economic Depression.

The German misunderstanding is in taking what have been sound long term economic policies for a relatively small open economy (where exports and imports are high proportions of the economy), and which have delivered a strong and stable economy for Germany since the war and more particularly since the Euro started, and assuming that they must therefore be the best policies for the Eurozone as a whole. However the Eurozone is not a small, open economy – rather it is a large and relatively closed economy (once intra-Eurozone trade is stripped out), very similar to the US economy. If the entire Eurozone is cutting back on its spending, then domestic demand within the Eurozone will be anaemic and exports outside the Eurozone are not a significant enough force to lead the whole economy back towards growth.

It is ironic that the British Conservative Party, which has always sought to avoid being drawn into European attempts at greater integration, is now one of the loudest voices calling on the Eurozone to become more integrated and adopt a pan-Eurozone approach to its problems rather than the national approach that has been adopted by Germany and France today. Their economic analysis is right though, the sum of the individual Eurozone economies is very different from any one of them. Helmut Kohl and Jacques Delors had the truly European perspective in the 1990s that is now required of, but sadly lacking in, Angela Merkel and Nicolas Sarkozy.

Sadly this latest package will merely buy a little time before the next crisis (ignoring the mini-crisis generated by the on/off Greek referendum). Worryingly, each crisis in this saga is bigger and more serious. The next problem to occur will be in Italy, where despite buying of its bonds by the ECB, yields are already over 5% for 2 year bonds and over 6% for 10 year bonds. There is little scope for these to move higher before the market comes to the conclusion that they are unsustainable and will refuse to fund them, as they have with Greece, Ireland and Portugal already. Italy is too big to save.