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.

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.

Sweat The Small Stuff

I enjoyed a great conversation with the Renegade Economist on Thursday. On the humorous side, it reminded me that:

"Among the maxims on Lord Naoshige's wall, there was this one: "Matters of great concern should be treated lightly." Master Ittei commented, "Matters of small concern should be treated seriously." Ghost Dog (previously cited here).

But, seriously, it's stunning how little of the detail is really understood by our institutions. Instead, they are obsessed with erecting grand schemes that are shaped most by surprise events beyond our control - 'black swans'. These grand schemes, like the 'single market' and the Euro, are brittle political constructs that neither minimise our exposure to the downside of surprise events nor maximise our exposure to the upside. Worse, they distract us from coping with structures that emerge organically outside the artificial regulated sphere as well as day-to-day outcomes that we might otherwise have avoided within it. It was typically five years too late before any financial regulator demonstrated any understanding of the shadow banking system lurking outside the walls, for example. And our regulated financial system has suffered from within due to poor due diligence on sub-prime debt, lack of scepticism amongst auditors, analysts who rarely say 'sell', banks who are fined millions for lax controls, and tax incentives that concentrate investors' risk and fail to deliver finance to creditworthy people and businesses.

Retail is detail, they say, but so is everything else. We need to align our tax and regulatory system with our actual or desired end-to-end activities, bottom-up, rather than with artificial, paternalistic institutional visions for the future.


Image from Core77.

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.

Euro Withers While Rome Turns

Giuseppe Lami/Ansa/REUTERS Hat tip: National Post

Too good a headline to miss - Italian politicians turn on each other on the eve of EU summit aimed at resolving the Euro crisis. The Euro slid against the dollar by the end of the day.

Let Go Of The Rising Balloon

I recall being told the terrible story of some military personnel grabbing the ties on a hot air balloon that was threatening to leave the ground prematurely, only to be hauled into the air. One by one they faced the decision whether to drop off as it continued to rise, and some held on too long... I'm tempted to search for an accompanying YouTube clip. But you get the point, and Winnie the Pooh provides a more fitting illustration for the Eurozone politicians who face the same dilemma.

The latest proposal is that a €440bn European Financial Stability Fund be somehow swelled to €1 trillion, which in turn would be leveraged to €4 trillion using "distressed sovereign debt, and equity in distressed banks exposed to the very same sovereigns, as security".

That this is the equivalent of a rising balloon is not in doubt. Nor is it a surprise. Gillian Tett explained two years ago why sovereign debt could be "the new subprime". And the IMF's report on the subprime crisis has explained the problem with allowing the same $1 trillion in assets to be rehypothecated or 'churned' to 'secure' $4 trillion in borrowing by US banks in the lead up to the Lehman collapse... Noting the "surreal" circularity involved in the latest EU proposal, Satyajit Das also recently pointed out that the proposed structure is also flawed because it fails to recognise that the underlying bonds could lose 75% of their face value.

Martin Woolf discusses this process in terms of "How to keep the euro on the road" but I prefer the rising balloon analogy - as did Danny, the dealer in Withnail and I, when referring to the end of the '60s:

"Politics, man. If you're hanging onto a rising balloon, you're presented with a difficult decision - let go before it's too late or hang on and keep getting higher, posing the question: how long can you keep a grip on the rope? They're selling hippie wigs in Woolworths, man. The greatest decade in the history of mankind is over. And as Presuming Ed here has so consistently pointed out, we have failed to paint it black."

Time to let go. Greece first.

In Brussels It's Always 3 Years Ago

Yesterday's speech from the European Commission President perfectly underscores Brussels' feeble grip on reality. 

Now is not the time, amidst multiple sovereign insolvencies - "a burning building with no exit" - to be debating (yet again) the need for a 'Tobin Tax' that might take effect in 2014. 

Now is not the time to be recommending legislation that might one day deliver greater centralised control. Nor is it timely - or wise, given the confessed lack of central control - to assert that solutions cannot be achieved by negotiations between governments. 

Surely, the EC President's role in such troubled times, if he ever really had one, was to do all he could with the structure he'd been given. Which would have included locking governments in a room until they did what was necessary.

Alas, that opportunity slipped by in 2008, if not before. "Europe" is an ex-parrot.

Even the news that German MPs have backed moves to bolster the Zerozone rescue fund is beside the point, as Satyajit Das explains in an excellent article today. The Zerozone central banking system simply does not have the capital to leverage itself, CDO-style, to the point at which the rescue mechanisms need to stretch:

"A 20 per cent first loss position may be too low. Unlike typical diversified CDO portfolios, the highly concentrated nature of the underlying investments (distressed sovereign debt and equity in distressed banks exposed to the very same sovereigns) and the high default correlation (reflecting the interrelated nature of the exposures) means potential losses could be much higher. Actual losses in sovereign debt restructuring are also variable and could be as high as 75 per cent of the face value of bonds."

We must get our heads around the fact that Europe's building will inevitably burn down.

So where will you be in 2014, Mr Barroso?

Images from Crisisboom and The Nation.

Okay, So How About A Mutual Europe?

Putting harsh economic reality aside for a minute, those who've always suspected that the Euro was a political Trojan horse for full fiscal European union must be highly amused by the current rhetoric.

The self-congratulatory political engineers of the European Union, like Jacques Delors, are lambasting their successors for ruining the grand plan. In their minds, monetary union and the Euro should have naturally led to complete union by now. That having failed, suddenly an enormous shared debt is suggested as the new political vehicle for the single market vision:

"To avoid falling, the choice looks straightforward to me: either member states accept the robust economic partnership I always demanded, or they transfer more powers to the Union."

Delors said Merkel and Sarkozy were playing games by arguing for "a minimum amount of cooperation designed to limit any transfer of sovereignty" to Brussels.

Taken on that basis, the ideas for eurozone reform they put forward on Wednesday after a head-to-head in Paris "won't amount to a hill of beans...

[Delors] instead called for a part-mutualisation of eurozone member states' debts, "up to 60 percent of GDP," saying the pooling of guarantees on that basis would "put out the fire" on money markets." 

Or, as Hunter S. Thompson once put it: 

"when the going gets tough, the weird turn pro."

"Fear and Loathing at the Super Bowl" 
(Rolling Stone #155, Feb. 28, 1974)

All very reminiscent of the following scene:

Wither The Zerozone?

I'm no Eurosceptic, but after all the dithering over the options open to the Eurozone it seems only the default option, as it were, will transpire: break-up. 

It remains to be seen whether we need to go through the farce of country-by-country downgrades and bank-by-bank recapitalisation. I guess we do, since avoiding or pre-empting that would take some kind of decision which the Zerozone politicians are incapable of making and for which they probably have no electoral mandate anyway.

But why stop there? I wouldn't weep for all those European Commission officials having to lodge their final excessive expenses claim and head home to defend their huge pensions from rioting neighbours. 

Flowers will grow through the cracks in Brussels' streets, and we can forget Strasbourg again.

We could certainly use the money more wisely.

Image from Crisisboom.

More Tea, Wolfgang?

The "Tea Party" may be getting it in the neck for its bumbling brand of brinkmanship over the US debt ceiling, but, as Schumpeter points out, it's the European finance leaders who seem not to realise the gravity of the current financial situation:

"Italy sold €8 billion ($11.4 billion) of ten-year bonds on July 28th but had to pay a yield of 5.77% to do so, the highest level at auction for 11 years. Making matters worse, European politicans have gone back to making unsettling comments after their brief show of discipline at the summit: Wolfgang Schäuble, Germany’s finance minister, said this week that he would not be writing any blank cheques to the euro area’s bail-out fund, the size of which is inadequate to ringfence Spain and Italy."

Cut Greece Loose

Cutting the Gordian knot

Talk about Zeitgeist - last Saturday morning I was in Porto, reading about the Greek crisis in The Economist. It was my first trip to Portugal, which I guess was good timing for them, economically speaking. Next month, Spain receives some of the Pragmatic Pound. And I'd like to think I'm doing my bit for Ireland, albeit on the meter, by assisting a financial start-up there (sorry, still in stealth).

But I won't be bailing out Greece.

Tax-dodging, low productivity and overly generous pensions aside, The Economist reckons the key to that country's dismal plight is political patronage. "Greece needs transparent and impartial rules, but politicians are not keen to limit the scope for dishing out favours." Everything from railways to medical budgets leaks cash to powerful lobby groups.

And, reading on, it seemed to me that in this sense the Greek rioters have more in common with the proponents of the "Arab Spring" than their EU colleagues. As the ebbing economic tide exposes the littered wrecks of corrupt schemes and relationships, the have-nots are descending in droves on the survivors and what's left of their loot. In Syria, the crowds are putting the "squeeze on Assad" by demanding a "civil democracy" that comprises free elections, freedom of speech and assembly, protection of minorities and an end to repression. The longer the government resists, the more citizens withhold labour, and capital flees. In return, the regime dishes out more favours, stokes inflation and the country edges further toward meltdown. Egypt is clearly further along. Libya perhaps further still.

This chaos is vital for renewal - though bloodshed is not essential. Back in June '09 I suggested that the UK's constitutional reform must be a messy process, and it's proving just that, but riot-free (you can ignore the photo calls). A dynamic, open, democratic process that encourages broad engagement by all stakeholders cannot realistically be neat and linear.

Though in May 2010 I also suggested going short EU banks and long riot shields. And if things do turn nasty it's perhaps worth bearing in mind Mathias Koenig-Archibugi's reminder to The Economist of the lines from "The Third Man":

“In Italy for 30 years under the Borgias they had warfare, terror, murder, and bloodshed, but they produced Michelangelo, Leonardo da Vinci and the Renaissance. In Switzerland they had brotherly love, they had 500 years of democracy and peace, and what did that produce? The cuckoo clock.”

The point is, we do the Greeks no favours by bailing out their system of political patronage. The bureaucratic emperors must be shown to have no clothes.

So cut Greece loose, I say. Only then will the Greeks have their Renaissance.

Could An EU Contract Law Catalyse A Single Market?

Not content with the dog's breakfast of European consumer and retail finance directives, the European Commission now wants to harmonise all contract law in the European Union.

The latest fry-up is yet another futile attempt by the EC to catalyse cross-border retail markets of the same scale as national markets within the EU. This is spawned partly by a dogmatic interpretation of single market policy. But it also reflects the difference between the common law view of the world (do anything until the government says 'stop') with the civil law view (wait for the government to tell you how it can be done).

I'm an avid fan of cross-border markets, but long experience and the EC's own research has shown that they can't simply be mandated. Regulation is the least significant of the numerous barriers to cross-border retailing. Cooking up a bunch of extra regulation that doesn't solve a real problem merely adds legal costs for everybody to no end. Or worse: it's ironic that the EC's changes to VAT on electronic services from 2015 actually removed a significant driver for firms to structure their activities in a way that boosted cross-border e-commerce in the first place.

When will this expensive, Quixotic tinkering end?

Well, economic reality may be pointing away from a single European market of the scale envisaged by the EC. Some describe the north-south divergence in the EU and others herald a return to national currencies, or at least regional versions of the Euro.

But if, as I suspect, this latest Green Paper is intended as a frantic signal that the single market is not dead, there'll be plenty more such concoctions before the whole thing finally comes apart at the seams.