Überfordert in der Ecke

As I argued in Sunday’s Business Post, the best solutions to Ireland’s problems are Europe-wide. On the other hand, Wolfgang Münchau believes that Europe’s political class are simply not up to the job. A growing number of commentators are arguing for a ‘big bang’ solution to the Eurozone crisis; and yet last night’s Eurogroup meeting had nothing new to announce.

It is not surprising that Europe’s finance ministers are finding it difficult to agree on a way out of the Eurozone crisis. They have boxed themselves into a corner in which this is almost inevitable.

The Eurozone is suffering from several major problems right now. The first is the lack of nominal exchange rate flexibility, but let’s leave that aside for now. A second major problem is that the solvency of its banking system is currently guaranteed by a series of stress tests that Ken Rogoff described yesterday as ‘pathetic’.

Let us assume that less pathetic stress tests were to reveal that there were holes in the European banking system that needed to be filled. The question then would be how to fill these holes. Assume that private investors will not fill the holes on their own until they are confident that the underlying problems of the banking system have been solved. That leaves three options. The holes could be filled by the ECB. The holes could be filled by existing bondholders, with their claims on the banks being converted into equity. Or the holes could be filled by European taxpayers. My guess is that the optimal solution would be an interior one, involving a little bit of each. But Europe’s politicians are determined to force us into a corner solution, one senses out of timidity as much as anything else.

If we rule out the ECB option on political and legal grounds, that leaves bondholders and taxpayers. If Europe’s political class rules out the bondholder option, then taxpayers will be stuck with the entire bill.

In such a situation, the only relevant political question is: whose taxpayers should pay, either explicitly, or implicitly via some sort of Eurobond arrangement? This is an inherently divisive question, and it is hardly surprising that Europe’s finance ministers are finding it difficult to achieve consensus in such circumstances. The prospect of the major cleavage in European politics in the years ahead being one between furious core taxpayers, and equally furious periphery taxpayers, is a good reason to be pessimistic about the future survival of the Eurozone.

If bondholders were brought back into the picture, the politics would be less poisonous: European taxpayer interests on one side, bondholders on the other. Exclude that option and you are setting up a slow-burning confrontation with potentially disastrous consequences.

History is littered with examples of international economic institutions that were intended by their architects to last forever, but which failed. This is typically because while the economics of the situation demand particular solutions, political constraints rule these out. By unnecessarily ruling out the bondholder option, Europe’s politicians are making it more likely that the Euro will one day be added to the list of failed institutions.

On the upside, we would then regain our exchange rate flexibility, which would be a very good thing. But it’s a gain that would come at a pretty steep cost.

Update: I just saw this article in the FT, on the growing political gap between Northern and Southern Eurozone countries. Expect to see more of the same…

19 thoughts on “Überfordert in der Ecke”

  1. Probably not the best place for this but anyone got any idea why Anglo are offering to buy back covered bonds at face value? Probably has something to do with the restructuring but bound to be politicaly toxic.

  2. Sadly, the EU institutions are not up to the job and the generation of politicians that were willing to work for the European ideal, however imperfectly, has passed from the stage.

    Merkel’s cack-handedness in the recent crisis has been incredible, although Ireland itself through its IFSC adventures played a major role in trimming back her options. If the EU fails, Germany will be left beached like a whale in the middle of Europe.

    Worse than the technical details of the crisis is its emotional impact on electorates and its impression on the expectations of current and future European political leaders about what they can expect and gain from the EU.

    A new constitution for the ECB is needed but is impossible to achieve in a reasonable timeframe; would Trichet not quickly get the printing presses going if the ECB mandate permitted it?

    EU failure has the potential to be a political disaster of incalculable proportions.

  3. @Kevin O’Rourke

    +1 on all links, including your own.

    3rd option on EuroIntelligence is way to go: E-Bond + Restructure Bank Bonds + a lesser hit on Jacques and Marleine European citizens – if new Treaty so be it – Massive Political Battle which will be incredibly difficult to win – on positive side putting e-Bond on table a good move ….

    on the negative side Überfordert at the mo reigns supreme …

    Someone might need to start a ‘short war’ to get it moving ……….. are you familiar with the history of the Goths?

  4. What would Willi Brandt do? Or Jesus ? Someone has to knock a few heads together and spell out some consequences to the Bildleser and Leserinnen. If the EZ collapses it isn’t going to be good for “investors” either. Capital has too much power nowadays anyway.

    I saw an interesting piece in the Norman Davies book about Breslau/Wroclaw – a train in spring 1945 was stopped and the occupants of one carriage were thrown out into the cold. The occupants were prostitutes, war profiteers and speculators.

  5. @seafóid

    ‘What would …. Jesus do?

    He would weep. Then action to restructure the bust money lenders in the temple of course (-; So would Willi …..

  6. @seafoid:

    Someone has to knock a few heads together and spell out some consequences to the Bildleser and Leserinnen.

    From the German commentariat’s perspective, there is no point in lending any more money to Ireland since it is no longer in a position to pay back what it has already borrowed — the country has reached its repayment frontier and is now behaving like a rational (though sociopathic) debtor who has nothing left to lose and is simply maxing out on its credit line by duping the few outstanding lenders.

    The more sophisticated commenters are of course aware that Germany’s ‘going it alone’ would have potentially disastrous consequences, but believe that the policy of ‘hanging on in’ will be more disastrous still. They have a powerful argument.

  7. CG

    It sounds a bit like the 1944 attempt on Hitler. If he had been killed everything could have been so much better for Germany. But he wasn’t killed, was he? It had to go all the way to the Götterdämmerung.

  8. @K O’R,

    Very brave to start a thread parallel to the big Dail set-piece, but, in contast to the sound and fury there that will likely fizzle out like a damp squib, you are getting to the heart of the matter. The EU and its previous manifestations have always been developed by an elite who were and are guided by the best of intentions but they rarely engaged voters directly and relied on the executive dominance of national governments in their parliaments to give legal force to their initiatives. The EU Constitution saga and the development of EMU provide the most recent and pointed examples.

    Having generally ignored, browbeat or manipulated their voters the EU political elites are really struggling to muster the courage to engage directly with them and to confront them the failings of the projects, in particular EMU, that they pushed through without their voters’ freely given consent.

    And it is clear that the international capital markets are not minded to give them the time to engage with their voters, to convince them about where their long term interests lie and to persuade them to accept what is required to secure their interests. A full and frank exchange could reveal serious political failings and an arrogance towards voters that would damage whatever credibility the politicians retain. This would make it even more difficult to persuade voters to accept what is required.

    Jean-Claude Juncker, the chair of Ecofin is reported to have said: “We know what we have to do, but we don’t know how to be re-elected if we do it.”

    The long term solution is increased democratic control of EU governance, but in the short to medium term the likelihood is some tinkering with existing institutional and procedural arrangements to share the economic pain among voters in the core, voters in the periphery and the stupid bond investors, but the biggest share is likely to fall on voters in the periphery. It would be wonderful if this were to act as a goad to prod them to reform the political governance (or misgovernance) that exposed them to this pain, but the resistance of those who thrive in the current system is probably too strong.

  9. It is rare that those that favour federalism or some variant also present analysis built on cold and realistic analysis of the facts rather than wishful thinking. Nice analysis and good to see an economist acknowledging the role of politics in all this.

    Don’t underestimate Germany. They will not be kicked into a federation, in my view.

  10. @Kevin
    It would be helpful if when you post links like this:
    “Update: I just saw this in the FT”..you would give the title of the FT article. Not all of us have the readies for an FT subscription.

  11. I don’t blame the Euro for the creation of the crisis – The great modernation; securistisation; and US:Chinese fiscal bearhug all played a more direct role.

    However, where the Euro has failed is in its responce to the crisis.

    Agressive QE (i.e. non debt backed money creation being spread whereever its required to geneate liquidy) combined with Debt (Public and Personal) restructuring seems to point the way forward.

    I’m a fan of the Euro in that I believe that regionalisation is the best protection against globalisation, however there has to come a point where the pain of membership outweights the benifits.

    Read the excellant Paul Gillespie

    http://www.irishtimes.com/newspaper/opinion/2010/1204/1224284774362.html

  12. The markets, imo, look like they will push the politicians in the core to face the real issues. If there is one default – or partial default the game will be up and the problems in German and french banks will have to be addressed. I am afraid that that is our only hope of getting to a point where we can begin to see a resolution. It won’t be pretty, but at least we will know the fever has broken. The only problem is can the patient survive that long.

  13. @Ko’R

    On the update:

    This is absolutely dreadful and hugely damaging to our reputation as European citizens. VOTE THIS OUT RIGHT NOW.

    Appreciation to the social democrats in Germany and Holland who crossed the floor to support the so called ‘Irish Bail-Out’.

  14. One of the benefits of instability at the perimeter is that it is weakening the Euro wrt to major trading partners. The manufacturing powerhouses with Germany in the lead are benefiting enormously. Should Germany retreat to well fortified bunker Deutsche Mark its value would increase immediately to a level that would seriously weaken exports. The rest of Europe would have an immediate depreciation on a world market basis which would double Germany’s problems. Strategic thinking is widely practiced in Germany outside of political circles. Helmut Schmidt ex Chancellor is giving interviews again. While Frau Doktor Merkel is catering to her party base and the wider public with a short term view to being re-elected she is also receiving advice on how to ensure Germany prospers for the next quarter century ( the 1000 year Reich is out). The vision is not one of hungry countries not buying German goods and competing with Germany in foreign markets. Europe is a complex state of mind which has had many fixations over the centuries, “the balance”, “domination”, “competitiveness”, “sound currency”, the saga continues.

  15. The core countries would likely continue with the Euro; its due to get its 17th member in a few weeks and not all countries associate devaluation with prosperity.

    There is the political challenge of the lack of support for bailouts of the misgoverned countries and it’s not only in Germany.

    Josef Pröll, Austrian vice chancellor and finance minister, said on Monday that he was “very critical” of the concept of issuing euro bonds.

    “I don’t know the exact model, but it can’t be that countries like Austria, with the disciplined economy that we have, must carry additional payments,” Pröll said in Brussels.

    This sums up the attitude of the well-run Eurozone countries to the issue of an E-bond, which would raise borrowing costs in core Eurozone countries.

    In the peripheral countries, it has taken the intervention of the IMF to provide a serious prospect of reform both in Greece and Ireland.

    In Ireland, the symptoms of a rotten system system get a lot more attention than the long-term systemic failures of public governance.

    @ seafóid

    Harking back to WWII is hardly going to shed much light on the issues.

    Do you think German tax rates are currently too low?

    Pay rises have been very moderate over the past decade.

    It’s easy to say European politicians should show leadership but it’s only now that reality is striking home in Ireland that the bubble party is actually over.

    It is also likely that the introduction of an E-bond would require an amendment to the Lisbon Treaty.

  16. Exchange rate flexibility is *not* a good thing, and has never been. Guess what, all European countries had it and exchanged it against the Euro with enthusiasm.

    Lets detail that :

    – devaluation *is* an hair cut on debt, and long term investors *hate* it. Who here keeps forgetting many major European economies, France, Italy, have been borrowing at more than 10% rates in the early 90s ?

    – devaluation sounds like an easy way out of many problems.
    Great, you just won’t have to take those unpopular, harsh measures to restore your countries competitiveness and make your industry more efficient. But that doesn’t work.
    You devaluate, have a short boost of competitiveness, get all sorts of bad effects in exchange, and two years later you’re back at the exact same point. It doesn’t help you more than cocaine does, a short positive boost, but all sorts of permanent bad effects.
    So 2 years later, either you devaluate again, and get even worth of a reputation as a borrower and even worth deals when you need to borrow, or you take the harsh measure you wanted to avoid two years ago.

    People obviously need a history lesson, so let’s give it.

    France has gone this devaluation cycle all over the XXth century, with the period between two devaluation getting shorter and shorter in the early 80, the effect less and less convincing, the difference with Germany more and more obvious.
    It ended up looking with envy at Germany that had always avoided devaluation after WWII and was the living demonstration not devaluating just worked better. That wasn’t just France; Italy, etc. had similar feelings.

    So it ended with all European countries taking real harsh measure, accepting recession induced by the spending cuts instead of trying to avoid it with devaluation, actually making the industry more competitive instead of trying to cheat with devaluation, and then getting better rates on borrowings, but *not* the rates Germany was getting. They were being even better pupils than Germany, but the markets were still wary.

    Then the Euro came, everybody got almost the same rate as Germany and everybody was greatly happy ever after … not !

    So the story went bad again. Most European countries, getting great deals on debt with the euro, just stopped making the efforts they had in the 90s. And there apparently was no consequence. The rates were still almost just as good as Germany, even for Greece who everybody knew was not just making less effort, but was cheating on it’s published debt level.

    There was no problem because there was no stress in the market, so investors were not too careful. Also the level of borrowing wasn’t high WRT what investors could provide. But then the real estate crisis, and all it’s various consequences, came, stress has been back on the market, governement have had to borrow huge amount, and the situation has gone critical, at once.

    What is the solution ? Go back at step 1 with separate currencies and devaluation ? It doesn’t work. The only solution is to go back at the steps of the 90s, and cut spendings, take harsh measure, even if yes it’s the worst possible moment and will hurt the economy.

  17. There’s a second part of the story that better explained separately.

    I talked about European countries falling back in their old fallacies, letting public debt go up, making no effort since the rates were low and financing that debt was easy.

    Ireland didn’t do any of that. Ireland had a perfectly sane public debt, one of the best in the world, definitively better than Germany.
    So what went wrong ?

    Well Irish banks had a huge level of investments that were junk. But we know it was junk in retrospect. They were denying it was junk all the time, and were is the *objective* factor that allows to say that was junk ?

    The thing is, the huge investments of banks actually materialized in huge private and enterprise debt. And there lies the problem. The level of private and enterprise debt was insane. At one point, it just stopped being redeemable. So that private debt suddenly became a huge financing problem for bank. Next step is the state guarantying that debt, so it becomes public debt. And suddenly good pupil Ireland has a huge public debt. One could think the government could have stopped the spiral by not accepting that debt, that’s not true since we see that Island’s government ended up in the same situation, it didn’t want at all to guarantee it’s private national bank debt, but had no choice at the end, whatever the price.

    That’s the new lesson. For decades, all we cared about was public debt, and private, enterprise debt was on nobody’s screen. But the recent events demonstrate that huge private debt results in just the same situation as if you had let public debt go up. It’s time for a change of paradigm. You can not just ignore that private debt, pretend the debtor are rational, pretend it won’t become a huge public problem. Private debt of 300% is just as bad a situation as is a public debt of 100%.

    And that’s how Ireland finds itself in almost the same situation as Greece, even though it appeared as the complete opposite initially, very low public debt, very honest public accounts.

  18. @ Michael h

    Someone has to clean up the mess the Euro banks left behind. Either the politicians stand up to the bondholders or other taxpayers pick up the tab. Ireland is maxed out.

    The German solution of hoping it will all boil over isn’t working.
    Yes German workers are very efficient but German banking regulation was poor.

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