The eurozone’s third comprehensive package in 2011 will make matters worse, and continues the 17 little Indians saga.
This failure was totally predictable. Firstly the latest so-called comprehensive package was based on three supposed major initiatives. Each fell way short of achieving their objectives. In very simple terms here’s why:
1. The agreement to write down Greek debt by 50% didn’t. Of the €340 billion total Greek government debt, only about €200 billion are covered in the agreement. (The rest is held by the ECB, IMF, and other institutions who are taking no write-down.) This means the write- down, which is voluntary, will at most be 30%. The correct write-down figure is 30% minus. Just about all experts agree that that is not enough, and another write-down will be required, so the objective of making Greek public finances stable was not achieved. This ensures continued pressure on Greek and eurozone banks, sovereign debt, and therefore economies, and so the inability to withstand even the threat of a Greek referendum. The 17 little Indians saga [explained below] continues.
2. The European bank recapitalisation of €106 billion is mythical and inadequate. In contrast to the US and the UK, European governments are not injecting funds directly into banks. The banks have been given until June 2012 to raise the relevant funds, which they can do by using retained profits, selling assets and only as a last resort raising external funds either from private sources, sovereign wealth funds, foreign governments, or as a further last resort EU institutions. In simple terms getting capital from the state means significant control of executive remuneration etc so this will be avoided at all costs. The result will mean banks shrinking their balance sheets, in other words selling assets and minimising lending. The Economist correctly describes this, as follows: “That would be a terrible outcome: by depriving Europe’s economy of credit, it would worsen the downturn.” (Europe’s rescue plan, the Economist, 29 October 2011). Latest estimates, and they can only be estimates, are that approximately €25 billion will be raised through this recapitalisation. The IMF a month ago estimated that European banks needed €200 billion. Others put the figure at €300 billion. This exercise is a joke in essence, ensuring that the one thing European banks will not be focusing on for the next year is lending to business-this guarantees a recession in Europe. In the meantime doubts will continue over European banks, which means doubts on their sovereign states, so again the 17 little Indians saga continues.
3. The firewall, the EFSF rescue fund of €1 trillion, will not work, and is already not working. This firewall is to protect heavily indebted yet solvent borrowers. The maximum value of the fund under this agreement is €1 trillion, which is inadequate to withstand a run on Italy and Spain. For that reason pressure immediately mounted on Italy. [Italy alone has nearly €2 trillion in debt. It is the fourth largest borrower in the world after the US, Japan and Germany.]
However even raising the inadequate €1 trillion is in doubt. Two schemes are supposed to help achieve this funding. The first is insurance of sovereign bonds. As this involves guarantees by countries that would themselves be vulnerable if their over-indebted neighbours got into trouble, no one expects too much to be raised this way. The second scheme is a set of special-purpose vehicles (much used by banks in the madness years) to raise funds from China and sovereign-wealth funds. Each vehicle is targeted at one country only-so risk is not spread but maximised. Why would China or Brazil invest in them when Germany will not do so? The EFSF bears first losses, which could hit the French AAA rating. This would most likely undermine the rescue fund just when it was needed. So nothing done here to stop the 17 little Indians saga-in fact by designing the scheme as they did, EU leaders ensured that Italy would be targeted. It immediately was.
Taking the three measures together, each is a failure, but each failure magnifies the failure of the other. As an example, by keeping banks weak, each related country is kept weak, and the continued failure to once and for all sort out the situation in Greece, means that European banks and the related countries stay under pressure. The game of 17 little Indians continues, but the outcome of this “game”, continued austerity, lack of growth, continued market turbulence, and crucially declining confidence means that the cost is anything but a joke.
This raises the interesting question: who is fooling whom? Are the Eurozone leaders completely out of their depth? Or are France and Germany (the latter particularly) playing games?
“It’s not a solution to the crisis”, said Nicolas Veron, a senior fellow at Bruegel, a research organisation in Brussels. “It doesn’t address the weak links in the banking system.”
This was all predictable. Here’s why.
Banks in Europe have extraordinary economic and financial clout (much greater than that in the US), have made some extraordinarily poor investment decisions (particularly in Germany), which have severely weakened them, and for these and other reasons have too much political control.
In 2008 when Angela Merkel, in response to the then financial/banking crisis, decided that there would be no joint EU guarantees for European banks (with the objective of maintaining political control of German banks rather than handing such control over to EU authorities) this was a massive change in the rules of the game and completely contrary to the way European banks and the ECB had financed and managed their operations until then. Instead of Europe standing together, each country stood alone. A problem in any one bank, because of the extraordinary importance and weakness in each country’s banks, meant that the problem would immediately extend to the country, the sovereign, itself. This was the beginning of the Euro crisis – in essence a modern-day version of the game of “17 Little Indians”. No one set out to play this game, but by not understanding fully the economic and financial environment, that is the game we see playing out in front of us today. The weakest banks in Europe get hit first, and then the related sovereign or country. Then the next weakest bank and sovereign, and so on until the strongest Indian (Germany) will eventually be hit.
In simple terms, by changing the rules of the game midstream, banks (which played by the rules set out by the ECB with respect to sovereign bonds always being 100% secure and the safety of short-term funding), were caught with too much debt (and too much of it short-term), many investments in sovereigns which now conceptually could go bad, and the wrong type of funding. This had to lead to massive pressure on banks, which logically had to lead to huge pressure on each country itself. The logic of the markets in this case is and was only too accurate.
The solution clearly requires the reversion, in whatever detailed fashion is appropriate, to the rules of the game where all eurozone countries stand together. In effecting such the mindset of Germany is critical. There is no doubt in my mind that for a whole variety of reasons the German mindset, generally, and particularly with respect to this matter, is today not what many in Europe and the world think.
A recent interview with Helmut Kohl, former chancellor of Germany, in the leading German foreign affairs journalInternationale Politik1 is a good indicator of a Germany that is adrift from its three core moorings of the past (multilateralism, the EU, and the relationship with the US) and in search of a new identity/role in the world. The same magazine, in the September/October edition, published a survey showing that although 33% of those surveyed think Germany should maintain its political co-operation with the West, 31% think it should favour relations with Russia, China and India over the West.
Until Germany has clarified its own role in the world, and therefore in the EU and the eurozone, any solution to the current crises is likely to be piecemeal, inadequate, and therefore a failure.
Any solution can therefore be assessed very simply: it will succeed only if the two following criteria are met-
1. The solution is an EU one overall (most likely based on the ECB actually acting as a lender of last resort to all the countries in the eurozone), not one involving national governments or private or other entities mainly.
2. Germany decides that maintaining political control of its banks has become too costly, and agrees to them and all other European banks being placed under the control of EU institutions.
The latest EU “comprehensive package” did not even try to address these issues. Therefore it will fail and is clearly doing so ready.
When Germany in 2008 decided for political reasons to maintain political control of its banks (to give it time to consider whether it wished to continue its entanglement with the EU, or break out of that straight jacket and go it alone in Europe, developing independent relationships with China, India, Russia and other states) it inadvertently started a game of 17 little Indians in the eurozone. Little did it understand that as this game goes on its own position grows increasingly weaker. No country in Europe, including Germany, can stand alone against market investigation. Standing together Europe can do so. As an example of this the threat of a referendum in Greece, and the impact that has had in Europe and on world markets, shows the extent to which the game of 17 little Indians can snowball out of control when politics intrudes unduly into banking, finance and economics.
Unfortunately, Germany’s unwillingness to see the downside of its attitude to this matter is both very deep and very dangerous. The independent International Institute for Strategic Studies (which has significant German membership) had a particularly pointed comment in a recent analysis of the eurozone crisis about this German attitude. Having analysed recent (September 2011) comments by Wolfgang Schauble, German finance minister, it commented: “His moralising tone – implying that people needed to suffer through recession, however deep or long, to pay for past excesses-echoes the zeal of Tea-Party Republicans in the United States, who seek dramatically to reduce US government spending, whatever the costs”. [Economic storm gathers over Europe, Strategic Comments, 13 September 2011, The International Institute for Strategic Studies.)