Thursday, 12 July 2012

Eurocrisis: Analysis of where we stand today

Contributed To Hellasfrappe By Protesilaos Stavrou
PS Protesilaos Stavrou

There have been several events in the eurozone ever since the latest European Council meeting in the end of June, which will eventually force upon European leaders the kind of conditions that will make reforms and further integration the only way to salvation. As I noted in my assessment of the outcomes of the last EU summit, certain breakthroughs were achieved especially towards the creation of a banking union over the medium term, which is essential to break the negative feedback loop between hardly-pressed states and quasi-bankrupt banks.

However there were many lacunae in the last deal, as several important parameters were not discussed, while some other aspects of the broader issue remained open for broad interpretations and speculation. One such unknown variable was the actual content of the agreement over the joint supervision of banks; and another was the role of the ECB which eventually decided to cut its benchmark rate to 0.75% and its deposit rate to 0%.

Concerning the first issue of bank supervision and recapitalizations, it is crystal clear that political leaders have been willing to obfuscate the fact that they made a first agreement on partial debt mutualization and shared responsibility. Given that such a view is quite unpopular in core eurozone countries and after taking into account the legitimate claim that there can be no sharing of burdens without political checks and balances (which practically means loss of sovereignty over banking affairs); I can fully understand the emphasis that has initially been given on the "supervision" aspect of the deal.

Yet we must not be fooled into thinking that this is solving any problem, since the persistent economic issue is how to remove the pressure from member-states who are now forced to recapitalize their banks at the cost of the sustainability of their fiscal position. Sooner rather than later there has to be some sort of debt sharing on this issue that will pave the way for a genuine banking union. If this incrementalist, "frog boiling" approach is the best way to do it, fair enough, but the point is that it must be done before the eurozone deteriorates further. In short, we must all know that without a banking union the euro will not survive the pressures and will eventually disintegrate.

On the role of the ECB and its decision to lower both benchmark rates and deposit rates, I may say that this is a rather clumsy move. It only compounds the series of egregious errors that the ECB has done, perhaps because it is also trapped in the "one step forward - two step backward" decision-making of EU leaders. At first the ECB decided to pump a trillion of euro in the European banking system via its 3-year LTRO loans at a mere 1% rate, only for the sake of indirectly propping up Spanish, Italian (and eventually German) sovereign bonds. A trillion of euro circulated through the banking system and ended up either in ECB overnight deposits or in government bonds so that governments could have money to pay back their older debts (to banks).

All that this ocean of liquidity did, was to make things worse, litanies to the opposite notwithstanding; as domestic banks, such as Spanish, increased their holdings of sovereign bonds, which means that they further strengthened the vicious cycle with their respective near-bankrupt states; and second the ECB was essentially forced ex ante to decrease its deposit rate to zero so as to push banks to channel even more money into the bonds market. But if money is to go into government bonds, amid this environment of great uncertainty, it will only to go the perceived safe havens, like Germany and the Netherlands - the extent of this rather perverse web of causes is made clear in the fact that even France managed to sell short term bonds at negative interest rates.

So in effect, the ECB, through the mumbo jumbo of bad monetary policy measures, managed to set up a supply line of cheap liquidity into core eurozone countries; which understandably does not arrest the crisis at its current epicenter in Spain and Italy, while it reduces the incentives on the politicians of core countries to push for collective action and speedier procedures.

As such it is no surprise that Spanish Prime Minister Rajoy has announced a new package of austerity measures, which features tax hikes and drastic cuts on social benefits. The decision of the Spanish government will have deleterious effects on the domestic economy, because it has mistakenly placed the burden of adjustment on the lower and middle parts of the income distribution, while it has not emphasized on the need for a thoroughgoing reformation of the Spanish banking system which is replete with toxic debt that has to be liquidated. In effect the kind of austerity that Mr Rajoy has called for, will depress production and will protect bankers from the failure they deserve, by paying for their bad debts.

Concerning the cuts on social benefits, there is one quite plausible argument in favor of reducing such payments, which suggests that it will diminish or extinguish the perverse incentives that people have by making unemployment and inaction less favorable; and will consequently force individuals to become more entrepreneurial or to search for work more actively, even if that implies migrating. Theoretically this argument can stand and in fact this is what the apologists of Mr Rajoy will be saying in one way or another. However it must always be clear that this argument may only hold in the context of a completely free market with flexible wages, minimal taxes, no state-imposed impediments to trade etc. As we all know Spain, just like most European economies is far away from such a system; thus it must be born in mind that under the given conditions even the free market (or pro-market reformist) approach needs to align with the facts and understand the need for avoiding asymmetric policies that harm consumers and producers to the favor of bankers (we shall clarify the misconceptions about the free market account and the views in favor of corporatism in a future post in light of the Libor scandal).

Given that the confidence crisis has not been addressed and no solution to it will come during this summer, I expect that the pressure on the weakest parts of the eurozone will actually increase. This might mean higher yields on Spanish and Italian bonds; a renewed round of uncertainty in Greece, or even a renegotiation of the bailout terms in Portugal. Also one cannot rule out the possibility of yet another ECB intervention of some sort that will most probably provide an initial relief at the cost of longer-term trouble and distortions. Finally we must also take into account the possibility of increased anti-euro oratory in core countries, on the grounds that voters/taxpayers in these countries can no longer tolerate any more funding to the periphery.

There are many obstacles and challenges ahead, and as the eurocrisis continues to deteriorate further, European leaders will gradually see the scope of their available choices diminishing. The months ahead are essential and will largely determine the future of the euro, with further (genuine) integration actually being the only path forward. The crisis will be solved only when European leaders prove their commitment to the idea of a unified Europe, by putting aside all ambiguities and dithering and by making audacious steps towards the establishment of a banking union, a fiscal union and a political union. The alternative now is a disorderly breakup of the eurozone and the Hobbesian "war of all against all" such a human-made calamity will engender.

Ps. I think you noticed in the video the mention that was made to high quality collateral. If you are interested for more on that issue, I wrote about it more than a month ago in my article titled "German interest rates: That which is seen and that which is not seen".

 Hellas Frappe 

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