Say It Again, Sam

I tweeted, early this morning, a piece by Samuel Brittan in today's FT. I quoted:

No so-called banking union will suffice while these imbalances remain

 Which chimes with my own scepticism that banking union is neither necessary nor sufficient to deal with the Eurozone's problems. Now I am fully awake I have second thoughts. Did I fall into a rhetorical trap? Here is what he meant by "these imbalances":

Since the euro was inaugurated in 1999, German unit labour costs have risen by less than a cumulative 13 per cent. During this time, Greek, Spanish and Portuguese labour costs have risen by 20 to 30 per cent, and Italian ones by even more.

Of course, banking union is not meant to deal with the problem of competitiveness diverging between Eurozone countries. You see the trap. It reminds me of a recent article by Ken Rogoff where he argued that Keynesian stimulus to demand would not work in the Eurozone; what was needed was to fix the banks. So fixing the banks will not resolve the competitiveness problem and boosting demand will not fix the banks and, I suppose, sorting competitiveness will not boost demand.

There are in fact three problems in the Eurozone:

• a financial crisis, in which many banks' solvency is questionable;
• a recession caused by a lack of demand; and
• imbalances in competitiveness (by which I mean misaligned real exchange rates).

A solution for one is not the solution to all. Banking union is intended to deal with the financial crisis, not the competitiveness crisis, and boosting demand is meant to deal with the recession. Where Sir Samuel and Mr Rogoff are correct is that solving only one problem is not sufficient as the three issues interact. So we need to stimulate demand and fix the banks and somehow deal with the effects of different rates of inflation in the Eurozone.

In the heading of this blog, I say that Equals, as in equations, will not fear algebra. I actually have in mind an equation to explain each of the problems. When I find the time I will blog on each.

Exit By Accident

As Mr Cameron loses control of his party, the country is once again heading towards leaving the EU by accident. It is evident that Brexit is supported by a minority of the country's political class. None of the leaders of the main political parties favours the idea, nevertheless we could find ourselves on the outside before the end of the decade.

Mr Miliband has been too astute to fall into the trap of matching the Conservative pledge of a referendum. Not only would that increase the risk of exit by accident, it would legitimise the Tory right and embroil Labour in an issue which is best left to the fanatics, rather than keeping the focus on jobs and growth.

Labour needs a line on Europe that allows us to watch from the sidelines while the other lot tear themselves to pieces. The line should remain that Europe is changing and we should not make a decision until the Eurozone crisis is finally resolved.

We could add that the Euro may not survive another five years. Mr Kai Konrad, who chairs the advisory panel of the German finance ministry, recently declared that

I would only give the euro a limited chance of survival.

The break up of the Eurozone would be immensely disruptive and costly, not just to its members but also to its trading partners. At the same time it would present Britain with a new challenge to help rebuild Europe in a different form.

A European Union after the Euro would be a very different proposition from the present set up. The key lesson of the failure of the single currency would be that integration needs a more cautious and pragmatic approach.

Which is very much what Britain wants from the EU; a sharing of power where there is a clear benefit while avoiding grand schemes driven by dreams of unification for its own sake.

Now is not the time to talk of leaving the EU. It might be worth thinking about how to help the EU backtrack on its single currency.

Umm... Well... Uh... Bye then.

"An Approach We Should Take"

To answer my own question, I don't think that Britain will go the way of Cyprus. My argument is that Cyprus and its tragedy is a better pointer to the real problem than Greece and its troubles. While I wonder how much Russian money there is spinning through British banks, the real worry is the instability of the finance sector.

Not so long ago some commentators were proclaiming the end of the eurozone crisis. I was sceptical; the crisis was in remission, not cured. My opinion was based, not so much on the capacity of eurozone leaders for policy errors, but my awareness that the fundamental problems in the banking and finance sector have not been resolved.

There had been a plan for a European fund to recapitalise failing banks. When the time came for the fund to act in Cyprus, it didn't happen.  So when Mr Dijsselbloem, the Dutch chair of the Eurogroup committee said that the Cyprus solution "is an approach that we should take," he was right.

The shareholders and bondholders of failing banks should be the ones to take the loss, not the taxpayer. This is the approach that should have been taken when Ireland's banks got into trouble. Instead the ECB forced the Irish government to underwrite the banks turning the banking crisis into a public debt crisis.

The fear back then was that losses in Irish banks would undermine banks in other places whose failure in turn would lead to more failures with a cascade of banks collapsing like a line of dominoes. It could happen like that. The problems in Cyprus's banks were triggered by the losses on Greek bonds included in Greece's bail out package.

That is where my question could becomes serious. How are the dominoes set up and where does Britain's banking sector stand in the line up?


Mr Dijsselbloem implies that each country will be responsible for its own banks if they fail. While he has been forced to "clarify" his comments, we should still ask how big is the banking sector compared to a country's national income? I have found some ECB figures for the aggregated assets of banks and compared them to Eurostat figures for GDP.



Source: ECB, Eurostat

As you can see, Luxembourg and Malta are ahead of us in the queue.

Double Dutch

Only a few days of excited anticipation remain before the prime minister descends the chimney to deliver his carefully wrapped speech in the Netherlands. It is risky to offer a comment so close to the point when the ribbons come off and we all see what Mr C has for us. All the same, there is one point I think will be worth watching out for.

In all the build up to The Speech, it has been presented as focusing on the relationship between Britain and the EU. If that is its subject matter then I think the prime minister has already fallen into the trap of seeing the UK as external to the EU.

The alternative would be a speech on reforming the EU.  It is not just Britain who might seek a return of powers from Brussels. In the last two decades the French, the Dutch, the Irish (twice) and the Danish have all said no to some part of EU integration. Nor is the issue of a tighter eurozone group a concern only for the UK. Ten of the 27 EU member states (soon 11 of the 28) remain outside and risk losing influence if the inner core starts to dominate policymaking.

Comparisons with  the Bruges speech will be unavoidable. In that speech a previous prime minister set out an alternative vision for Europe, one in which sovereign states cooperated to their mutual benefit. In contrast the spinning of Friday's speech has prepared us for the opening bid in a Dutch auction.

Mr Cameron does not want to lead Britain out of the EU, but if his text really is as limited as we have been led to expect then exit by accident will become ever more possible.

The Decline of Europe - Not

From time to time over the last few years I have heard serious pundits bemoan the relative decline of Europe. It is a sentiment which infuriates me.

It is true that Europe commands a declining share of global GDP. That is a fact we should welcome not fear. For at least 50 years the rich countries of Europe have promoted the development of the poor countries in other continents. The fact that so many are now making progress is a cause for celebration not anxiety.

The thought is prompted by an execrable book I picked up in Waterstones while Christmas shopping. For Europe is a federalist manifesto which declares on page one that:

We are being overtaken by the emerging economies at lightning speed.

The first problem with this perspective is that it is morally and politically wrong. The fact that poor countries are catching up is a major human achievement.

Source: IMF

The second problem is that the statement is factually wrong. Per capita GDP in the EU is double that in Russia, 4 times that in China and 8 times that in India. Even fast growing China will need decades to catch up.

Don't get me started on this one:

...we are still required to compete against economic and political powerhouses of the calibre of China, India, Brazil, Russia or the United States.

There is so much nonsense in that phrase I don't know where to begin. I'll just point out that the rise of poorer countries does not harm us and indeed holds many opportunities for developed countries.

The authors of this terrible book are serious politicians: Guy Verhofstadt, leader of the Liberal faction in the European parliament and former prime minister of Belgium and Daniel Cohn-Bendit, leader of the Green faction in the same parliament and former soixante-huitard.

Angela's Ashes (and Sackcloth)

My nomination for scariest comment of the year is by Angela Merkel in an interview with the Financial Times:

“All of us have to stop spending more than we earn every year.”

Who does she mean by we? If it is countries then the comment is nonsense. As I mentioned recently, countries can sustain a stable debt level while spending more than their income. So long as the deficit is less than the nominal growth rate multiplied by the debt ratio, the debt will not increase as a proportion of GDP. For example keeping the debt below 60% of GDP in a country with 5% nominal growth means keeping the deficit on average below 3%.

If she means businesses then how are they to finance investment? A small business with an opportunity to expand typically borrows from a bank. A large firm may borrow by issuing bonds. Without "spending more than they earn", businesses would have trouble to grow, modernise or innovate.

If she means households, then it is sensible not to spend more than you earn, but only measured over a lifetime. In youth, people borrow to fund education, buy a house, etc. In middle years people may save to fund retirement when spending is based on past income.

Even stranger was her claim that East Germany failed due to a lack of competitiveness:

“We witnessed in the GDR and in the entire socialist system that an economy which was no longer competitive was denying people prosperity and ultimately leading to great instability.”

I can think of many reasons why the GDR economy collapsed, but wrapping them up in one portmanteau word is a feat beyond even Humpty Dumpty.

Finally, Mrs Merkel hinted at even scarier ideas to come:

Although Ms Merkel stopped short of suggesting that a ceiling on social spending might be one yardstick for measuring competitiveness, she hinted as much in the light of soaring social spending in the face of an ageing population.

The right is out to cut the welfare state and Mrs Merkel is aiming to cut social spending in pursuit of the chimera of competitiveness.

Fix the Banks 2

I know I am not alone in arguing that fixing the broken banking system is the essential prerequisite to recovery. I want to share a thought on how to move on fixing Europe's banks which might just be politically feasible.

The problem we have is that for countries to deal with the problem by nationalising, refinancing or recapitalising their banks is massively expensive. At a time when Euroland politicians have persuaded themselves that the problem is government debt, it is politically impossible for countries to borrow to cover the cost.

My thought is that a banking resolution regime could be organised at the European level and financed by the issue of Eurobonds. A new institution would be needed to issue the bonds and hold the shares of the rescued banks. In time the assets could be sold and the money used to buy back the bonds.

Germany has objected to the issue of Eurobonds in the past, but this was in the context of pooling sovereign debt. Germany fears  creating "moral hazard" where profligate southerners would lose the incentives to borrow less. However issuing Eurobonds for a limited purpose, especially where the assets would be jointly owned is different. In fact Eurobonds already exist on a small scale as the European Investment Bank raises money this way.

ECB's Dangerous Game?

Here is an odd thing. The EU summit failed to produce a credible plan for fiscal union. The ECB did not become the "lender of last resort" as economist's believe is necessary to end the crisis. Yet, the roof did not fall in and the panic has ebbed. With no political or monetary intervention to calm the markets, the Euro has muddled on through another week.

What has happened? Perhaps Mr Draghi has not been as invisible as I previously thought. The ECB did inject liquidity into Europe's struggling banks. That seemed to be a response to the freezing up of interbank lending which could have led to a new credit crunch. It seems to have done something else. The liquidity has found its way to the bond markets easing the pressure on Italy and other peripheral governments.

Coincidence? Or conspiracy? There is a fascinating analysis of ECB policy on Vox, published before the summit. It claims that, far from being a weak central bank unable to do what its peers can by guaranteeing government debt, the ECB is using its political independence to play a very political game.

The ECB is a full-blooded political actor engaging in a strategy aimed at forcing EU political leaders to embrace fiscal rectitude and a quantum leap forward in European integration.

The allegation is that Mario Draghi is using the crisis to force reform on reluctant governments. The ECB is doing just enough to keep their economies from collapse but not enough to get the market off their backs. In fact it wants the markets to keep the pressure on. Comparing the ECB approach to military strategy the article claims:

Its philosophy is that you never offer your opponent certainty (by pre-committing to buy all Italian debt at 5% yields, for example). Rather, you constantly seek the dislocation of your opponent’s mind until this dislocation (10-year interest rates above 6-7%) renders the delivery of a decisive blow practicable.

Indeed the article alleges that the ECB played a part in the ejection of Mr Berlusconi from office.

The implications of this analysis are profound. Are democratic governments being undermined? What legitimacy has the ECB for acting as a political player? Who decides on the policy agenda of the ECB and who can hold it to account?

Apart from legitimacy, is its policy correct? By backing a particular theory which puts supply side reform above addressing the deficiency in demand, is the ECB pursuing the wrong policy? That is one danger if the ECB is playing a political game: that it may be pursuing a disastrous policy.

Another danger of the ECB's alleged political role lies in the implementation of the policy. Could the ECB make the fine judgements necessary to keep the bond markets on edge without starting a bank run that would ruin us all?

Source: Jacob Funk Kirkegaard, The next strategic target: De Gaulle’s EU legacy, Vox, 30/11/2011

Getting Fiscal

Flash, I love you but we only have three days to save the Euro.

The depressing part of this week's narrative is that fiscal union is completely irrelevant to resolving the Euro crisis.

Would fiscal union have prevented the current crisis? A moment's recollection is enough to see that it wouldn't. Spain ran a budget surplus in the three years before the crisis and brought its debt ratio down to 32%. Ireland too ran a surplus and at 25% was well below the Maastricht limits until it took on the debt of its failing banks. Even Italy had its debt on a declining path from around 120% in 1996 to 103% before the crisis.

OK there was Greece, but Greece was prepared to lie and cheat on its national accounts. Ordinary rules cannot catch a determined cheat.

There are two aspects of a fiscal union which could help. One is transfers from stronger countries to weaker ones. The second is a common treasury issuing common bonds. That is why fiscal union works in the US; but both are off the table in the Eurozone.

So why is there a buzz of hope around the Merkozy proposal? The answer is that Signor Draghi dropped a hint that, with a fiscal compact agreed, the ECB might do something. What the ECB needs to do is massive. It has to underwrite the bonds of all Eurozone governments without limit. A suggestion of a possible undefined move doesn't quite fill me with confidence.

Fix the Banks to Fix the Crisis

While conventional wisdom says that Europe is embroiled in a debt crisis, I keep pointing out that it is still a financial crisis. The problem is not government debt; it is the solvency of the banks. Fixing the crisis should start with fixing the banks.

Martin Wolf in the FT has a nice illustration of the problem. He shows a chart of the exposure of banks to debt of Greece, Ireland and Portugal. German banks holding such debt  could lose as much as 60% of their capital. France is a little better with exposure worth a bit more than 30%. Even British banks are as risk to around 20% of their capital. Add in Spain and the picture is much worse. German banks' exposure is almost 100% of their capital and French banks have risks up to 60%.

This explains why Eurozone governments are so keen to avoid a default. If soverign debt had to be writen down, bank losses would push them to the brink of bankruptcy, meaning new bail outs. If Greece defaulted on its debt, German banks would need to be rescued by German taxpayers, in effect turning Greek government debt into German government debt.

This also explains why there is now talk of "reprofiling" rather than "restructuring" Greek debt. Which means simply extending the payback period of loans rather than cutting the face value of debt.

The truth almost came out in yesterday's Today programme. A Greek economist explained that the difference is  one of accounting. Reprofiling means that the loan remains unchanged as an asset on a bank's balance sheet. Restructuring forces a bank to regonise the loss and so face up to its solvency problem. ( Adam Shaw jumped in before he could complete the point to press his own view that the language was just "politics".)

Of course, reprofiling doesn't make the banks any more solvent. It just delays the day of reckoning.

Competitiveness Pitch

So the Franco-German plan for a "competitiveness pact" ran into opposition at the summit last week. The plan which is meant to cover the eurozone, includes ideas like harmonising corporate tax rates and pushing up retirement ages, which do not seem to me to have much to do with competitiveness.

Leaving aside the issue of how meaningful it is to focus on competitiveness. I thought to check whether there is any evidence that the Eurozone is failing in international competition.

The latest figures show a current accout deficit of 0.4% of GDP. Over the last 4 quarters the current account has varied between a surplus of 0.5% and a deficit of 0.9%. In other words the Eurozone is selling pretty well as much as it buys.

Competitiveness Patch

According to press reports, tomorrow's EU summit will discuss a "competitiveness pact".

My questions remains: is competitiveness Europe's problem?

I don't mean: is Europe uncompetitive? As Paul Krugman argued a long time ago, countries and major economic blocs do not compete economically with each other. Companies seek competitive advantage, countries seek comparative advantage.

My question means: is chasing competitiveness the problem? Pursuing the wrong goal will lead to adopting the wrong policies, and allocating funds to the wrong places. Which is why Krugman described "competitiveness" as a dangerous obsession.

A Picture Tells Another Story

This chart appeared in The Economist last week to show how strongly Germany has emerged from the recession.

It is clear that GDP growth in Germany has recovered ahead of the 5 other countries. Looking at the early part of the chart tells another story. In 2002 and 2003 Spain, Ireland and Greece were growing much faster than Germany, France and Italy. While Germany struggled to get growth up to 2%, the three peripheral states were touching as much as 6%.

Think about interest rates. Germany, France and Italy needed low rates to stimulate their economies. Ireland and Spain need higher rates to stop their rapid growth leading to inflation. In fact, inflation in Spain and Ireland was around 4% at the time and house price inflation even higher.

All six countries are in the Euro zone and so had the same interest rate - one more attunued to the needs of the three larger economies than the smaller ones.

Higher inflation, makes countries less "competitive". (Yes, I am still on my quest.) If costs have risen then the price of exports are higher and the price of imports lower; another meaning of the word competitivness.

So when this week's EU summit talks about the competitiveness of peripheral countries in the Euro zone, there is an explanation in terms of the problem of controling inflation when monetary policy is not available to help.

Spain on the Naughty Chair

Gavin Hewitt came over all censorious in his BBC blog last week:

To an extent Spain's problem is Europe's problem. For a decade many of the eurozone countries used the cover of the single currency to borrow and expand their welfare states. In fact they were living way beyond their means. Putting that right is not just a financial dilemma - it challenges what many Europeans see as their way of life.

You could forgive him for talking bollocks because
a) he is a European correspondent not an economist
b) he is just parroting the conventional wisdom.

What does it mean for a country to live beyond its means? I don't know, but did the Spanish government live beyond its means, did it borrow to expand its welfare state?

No, until the crisis struck Spain had a fiscal surplus not a deficit. Here are the figures from Eurostat for Spain's public balance (-ve means a deficit):

2001  -0.6
2002  -0.5
2003  -0.2
2004  -0.3
2005   1.0
2006   2.0
2007   1.9
2008  -4.1

In 2007, Spain's government debt was 36.2% of GDP compared with 64% in France, 65% in Germany and 66% in the eurozone as a whole. Unemployment had fallen to 8% from over 15% a decade earlier, which I suppose would make the welfare state somewhat more affordable.

Were those profligate Spaniards loading up on government handouts? Not if you look at the data instead of relying on uninformed prejudice.

What really happened in Spain is that it joined the Euro. The ECB's job is to set interest rates for the eurozone as a whole and in the naughties big eurozone economies like Germany needed low interest rates. Peripheral states like Spain and Ireland found themselves with monetary policy which was too loose. Their economies were running too hot with fast growth but rising inflation. In Spain, inflating property prices fed a construction boom. As part of the eurozone Spain could not adapt its policy to restrain the boom or choke off inflation.

When the downturn came, Spanish prices and wages had risen out of step with other eurozone economies. Higher costs put Spanish firms at a competitive disadvantage compared to other producers. So now we have a slump in which tax receipts fall and benefit claimants increase, which is why Spain now has a large government deficit.


The target here is not Gavin Hewitt, who is a competent and entertaining journalist, it is the conventional view that the Euro crisis has been brought on by feckless Mediterranean types shirking their responsibilities. Spain gives the lie to that popular narrative.

Another Euro Crisis

We may all breath easier. The crisis is over. In Brussels yesterday the leaders of the 27 agreed to save Greece from the jaws of the bond market.

On the other hand the real Euro crisis is only just beginning. Germany has signalled its price for the Greek rescue: the EU must be able to expel errant members from the Eurozone. A way is sought to revoke the irrevocable union.

A new treaty will be needed and there is little appetite for that in European capitals. Still, Ms Merkel is pushing for it and the compromise language in the summit conclusions opens the door to treaty revision.

The root of the next euro crisis lies in the change made to the German constitution last year which requires a balanced budget. While Greece and Spain and Portugal are pushed to deflate their way to German levels of competitiveness, Germany will be deflating its way to a budget balance. That is why Germany wants to make an emergency exit available.

Until now we expected the borders of the Eurozone to extend to the east. It seems more likely that the southern border will retreat northwards.

Is the UK the Free Rider?

Britain was the first European country to move on fiscal stimulus. As other countries fell into line there was a fear that Germany might take the benefit of the boost to demand in other European countries while spending little of its own money on boosting demand in Germany. In time Ms Merkel came through and Germany has been pulling its weight.

Now Britain is going to be the first to withdraw the stimulus. From January the VAT rate will return to its old level and government spending will come under pressure. Of course the "automatic" stimulus of more benefit payments and lower tax take will still be there, and the government deficit will be as huge as anywhere in Europe. Which is the reason why the chancellor is reluctant to let the stimulus continue.

When Britain moved aggressively with monetary and fiscal stimulus the pound fell against the euro, potentially boosting demand from net exports. At the time I thought that this was fair as it gave the British economy some compensation for the demand which would leak to countries not making the same efforts to counteract the recession.

Now however, Britain is beginning to look like the free rider, and the low pound could be seen as a beggar-my-neighbour policy. (I remember Paul Krugmann using that expression when he visited Britain earlier this year.) I doubt that the pound will rise much. Monetary easing is continuing and interest rates are lower in the UK than Euroland.

Are we now going to gamble on other countries' fiscal expansion to get us out of recession?