Bailout Fund Ratings And Snake Oil Don't Mix

The response to the downgrade of the Eurozone bailout funds from Aaa has yielded a fascinating political response from the head of the fund. 

Moody's, the ratings agency, says the €700bn European Stability Mechanism (and the the EFSF it replaces) is now a riskier proposition since France lost its Aaa rating earlier this month. It considers that, if the full fund were needed, France would have to stump up 20%. The whole purpose of the fund is to invest in the debt of weaker Eurozone member states whose creditworthiness is highly correlated. So, if one runs into economic trouble, they all do. That also makes for a "highly concentrated credit portfolio." And if push came to shove, Moody's doesn't think France would prioritise it's ESM contributions above its own debt payments. Similarly, in that event it would be unlikely that other member states would make up France's shortfall.

Both the chairman and managing director of the ESM were keen to claim political support for the fund. The ESM's chairman said:

"The 17 euro area Member States are fully committed to ESM [and EFSF] in political and financial terms and stand firmly behind both institutions."

And the ESM's managing director said:

“Moody's rating decision is difficult to understand. We disagree with the rating agency's approach which does not sufficiently acknowledge ESM's exceptionally strong institutional framework, political commitment and capital structure."

Of course, the political reality is actually the flaw in the single market and Euro fantasy: there's no credible plan to discipline profligate states, as the continuing Greek tragedy demonstrates. Those who negotiated the Maastricht Treaty foolishly believed such states would ultimately behave in the interests of the Zerozone, just as Alan Greenspan thought the boards of Lehman Brothers and others would refrain from driving their firms into a wall out of concern for the interests of shareholders and taxpayers... snake oil. 

The only real disciplinary option is for creditor states to 'send the boys around' to the debtor states. In that event all political solutions will have been exhausted, and the 'European Union' long gone. 

So Moody's is right to discount the politics - and the ESM's credit rating.

If the politics is not to further undermine the ESM, politicians have to demonstrate that the disintegration of the Euro zone is survivable. 

The ECB Won't Really Do "Whatever It Takes"

I can't understand why 'stock markets soared' 2% on yesterday's announcement by the European Central Bank (if there really was a causal link). 

Mario Draghi's threat/promise in late July that the European Central Bank would to do 'whatever it takes' to save the Euro always rang hollow. And yesterday's long-promised follow-up announcement on (some) of the detail only confirmed the lack of substance.

Doing 'whatever it takes' would involve the ECB buying the bonds of troubled Eurozone Zerozone countries unconditionally - regardless of whether those countries operate their economies responsibly. Of course that's a crazy notion, and a long way from what the ECB is really offering to do. Draghi added yesterday that troubled countries would actually have to formally request such purchases and accept "strict and effective conditionality", which roughly translates into all European languages as "austerity". 

Of course that's something Greece and Spain have shown a marked reluctance to accept - understandably. And there seems no real way to force them to do so without sending the boys around, which would shatter the single European fantasy ideal. As Graham Bishop has explained, this has always been the flaw in Zerozone monetary 'union'. There's no credible plan to discipline profligate states. Those who negotiated the Maastricht Treaty believed such states would ultimately behave in the interests of the Zerozone, just as Alan Greenspan thought the boards of Lehman Brothers and others would ultimately refrain from driving their firm into a wall in the interests of shareholders and taxpayers...

So it seems the giant EU foot is intent on kicking this particular urn down the road until it breaks. In the meantime, hopefully Greece and anyone else who is genuinely unable to cope will grasp the opportunity for an amicable parting to recover on their own terms.

Image from JMK Advisors.

We Need A Lot More Little Things To Go Wrong

As Nietzsche said (I always wanted to begin a post that way), "That which does not kill us only makes us stronger."  Or as my first boss was fond of saying, "We only learn when things go wrong."

Both are right. But implicit in both sayings is survival and survivability. 

Survival of the fittest, building strength through adversity - this is how species evolve. It's what makes Kipling's poem "If" so stirring. It's the difference between all those 'best practice' presentations at corporate off-sites (let's be honest, they're about rescued screw-ups) and the whirring of shredders at Arthur Andersen. It's what turns complaints into fixes, features and products instead of fines.

Yet all the research suggests it's impossible to 'pick winners'. In fact almost all significant events in our history are Black Swans - surprise events that have a huge impact and which we rationalise by hindsight. We have no real idea which ventures will succeed and which will not until the facts and figures emerge. And even then we don't know how sustained that success will be. Indeed, sometimes we don't even know what success looks like, expecially with not-for-profit projects or organisations (including government departments - and the European Commission). In his book "Adapt" (a veritable bible on the importance of survivable failure) Tim Harford explains the need for built-in feedback to distinguish success from failure in such contexts. 

But, hey, the Euro had built-in entry criteria, and they were ignored because the politicians refused to countenance failure as an option.

And there you have it. Above all, as Harford emphasises, the critical thing is to accept the risk of failure, but to ensure that such failure is survivable.

Our political and economic leaders don't grasp this any more today than their forbears did when negotiating the Maastricht Treaty. Because they see it as their job to protect 'the system'. But by continuing to back the same institutions, the same systems, and essentially replicating and deepening the same old regulatory regime, they're merely resisting the tide of evolution. Rather than cutting their losses, they're busy hurling the big dice again, and again, and again like so many casino junkies.

It's impossible to mix too many metaphors in a situation like this. So here's another: if Necessity really is the mother of Invention, then we have to get her to a fertility clinic.

We need more trials and more errors of the survivable variety. In other words, we need a hell of a lot more little things to go wrong before the big things start going right.

Maybe we should make it our leaders' job to promote innovation instead of protecting the system?

One Simple Way To Stop Kicking The Can Down The Road

We all know with calm certainty that it each European economy functioned without the Euro. 

We can argue that Germany has done much better under the single currency, and that Greece has always been a basket case whatever the currency. But these economies functioned. 

Whereas the sovereign debt crisis is driven by complete uncertainty about whether the 'Eurozone' economic union will ever be sustainable, and the conviction that some economies are definitely doomed without their own national currency.

In this situation one might have thought the ultimate route to relative economic stability would be to set a date by which the Euro will be withdrawn. Everyone would then unite to deal with that fundamental economic fact. 

Some might argue that the decision to form the Eurozone also encouraged unity and stability, as should efforts to maintain it. Yet it's obvious that including weak economies in the drive towards monetary union created moral hazhard, driving national fiscal and banking sector irresponsibility to the point of fraud. And there's plenty of evidence on the streets and in the polls to demonstrate that the maintenance efforts are divisive rather than unifying. It's difficult to see how a decision to return to national currencies would drive the same behaviour - in fact it may eliminate it entirely, or at least reduce it to manageable, local levels where the national politicians and their banks would be stuck with the consequences of their fiscal profligacy rather than everyone else. That may explain why some resist, while it's in the job description of European officials to support the Euro in service of the single market fantasy policy.

At any rate, there's one simple way to stop the politicians 'kicking the can down the road'. 

Remove the can. 

Image from JMK Advisors.

When in Doubt, Stay Out

I’m with the Tories on the EU treaty veto. There are just too many unanswered questions for anyone not already implicated to sign up. Even other EU leaders are now saying they'll struggle to sell the treaty nationally. 

Key among those questions is how the EU can democratically enforce its fiscal rules. I say ‘democratically’, because the whole point of the European Union is to avoid the diplomatic equivalent of ‘sending the boys around’.

Graham Bishop tries to address this in his short book, "The EU Fiscal Crisis: Forcing Eurozone Political Union in 2011?".

Perhaps the best place to start is Graham's point that “Wrong behaviour in misleading investors is still wrong even if the motive is patriotism, rather than personal greed.” During the Maastricht Treaty negotiations in the early ‘90s, Graham wrote some papers that “doubted the willingness of finance ministers to discipline profligate states”. The issue was ignored at that time on the basis that member states assumed it would always be in a profligate state's interest to want to do the right thing - a version of the efficient markets hypothesis, royally debunked first by Lehman Bros et al and now Greece. Even Alan Greenspan has had to admit that, left to itself, when any organisation is in trouble it is likely to behave in a way that suits those in 'control', which is why a taxpayers' guarantee constitutes a moral hazhard.

After gamefully attempting to explain the alphabet soup that comprises the EU financial bandaid stability aparatus, Graham recommends four principles of more effective fiscal supervision:

1.       Recognise there is nominal credit risk in the debt issued by a state that can’t print its own money – traditionally, there is assumed to be no nominal credit risk on loans to central governments held to maturity, since it's assumed that if the government needs more money it will simply print it (even though this may create other problems) - this is clearly wrong for Greece, for example;

2.       Make it progressively harder for EU banks to finance the excesses of an EU member state;

3.  Insurers, pension funds and other caretakers of peoples’ savings should be similarly disincentivised from concentrating on risky public debt;

4.      “Develop necessary flanking measures".

Funnily enough, non-Eurozone investors seem to be playing by these rules, even if the Eurozone isn't.

Little wonder private investors are working hard on contingency plans for Eurozone break-up.