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To help understand where we are and how we got here I found the article below very enlightening. It was sent to me in John Mauldin’s ‘Outside the Box’ newsletter.
A big part of the problem in Europe, as you will see, is an increasing public sector that is devouring the productive sector. Or as they put it, the triumph “of the rentier over the entrepreneur.”
Sorting Out the Euro Mess
By Anatole Kaletsky, Charles Gave, Francois Chauchat – GaveKal
Starting With the Bad News…
Although the usual post-summit rally should not be too hard to orchestrate in the thin markets around Christmas, there was more bad news than good for the dwindling band of bureaucrats and politicians who are determined to save the Euro, regardless of the costs to the democracies and economies of Europe. We will begin with the “bad” news–partly because our bias is to treat bad news for the Euro as good news for the world and Europe, but mainly because this so-called comprehensive and final “fiscal compact” was no more comprehensive and final than any of the previous failed deals. As in all the previous summits, the only truly definitive decision on Friday was to have another meeting in three months’ time, when a new agreement would supposedly be cooked up to resolve all the controversial issues left undecided on Friday. Once the holiday season is over and investors start to think seriously about this “fiscal compact,” the economic and political uncertainties are bound to intensify, building to another crisis ahead of the next summit in March.
The summit failed to satisfy the first (and maybe not the second?) of even the minimum necessary conditions to give the Euro a chance of medium-term survival. These are (i) creation of a fiscal union, which will take at least one to two years to set up, and (ii) unlimited ECB lending to bridge the gap between this multi-year political timetable and a market timescale measured in weeks or months. While the ECB may still end up being more pro-active than Mario Draghi suggested last week (see next page), the summit’s most obvious failure was on the fiscal front. Despite the self-
congratulation among EU politicians about their “fiscal compact,” the fact is that Germany vetoed the most important characteristic of a true fiscal union, which is some degree of joint responsibility for sovereign debts. Since Germany refused even to discus Eurobonds or a vastly expanded jointly-guaranteed European Stability Mechanism, the summit did nothing to reassure the savers and investors in Club Med countries that their money will be protected from either devaluation or default.
Secondly, the summit raises huge political uncertainties. With the UK failing to climb on board, an intra-governmental deal will need to be arranged outside the EU legal framework. Will all 17 countries in the EMU ratify the new treaty and how long will this take? Will Ireland be able to avoid a referendum in a period when Europe is viewed by the public as a hostile colonial power? Will all 17 members insert German-style debt-brakes into their constitutions to the satisfaction of the German courts? If a country fails to legislate or implement an adequate debt-reduction programme, will it be expelled from the Euro? If so, can the Euro be described as “irrevocable” any longer and does it really differ from any previous fixed currency peg? Worst of all, perhaps, how will this deal affect French politics? If Marine Le Pen and Francois Hollande denounce Merkozy’s “fiscal compact” as a betrayal of French sovereignty and democracy, then this agreement will be worthless until after the French presidential election on May 6.
Thirdly, and most decisive in the long run, is the economic and political incoherence of what Merkozy are trying to do. Even if the fiscal compact could be immediately put into practice, even if it contained provisions for joint-liability debts and even if the ECB backed it with unlimited monetary support, it would aggravate the Club Med’s economic nightmare of unemployment and economic stagnation. Small open economies such as Ireland and Sweden may be able to deflate their way out of a debt crisis, but for large continental economies in the Eurozone this is arithmetically impossible. In this respect at least, Keynes’s key insight of the 1930s—that workers and taxpayers are also customers—remains as relevant today as it was then. By imposing permanent austerity, the fiscal compact guarantees permanent depression—and that in turn guarantees that the citizens of Europe will eventually turn against Merkozy and the Eurocrat elites.
…And Now for the Good News
Now let us turn to the good news, at least for the Eurocrats and perhaps, in the short-term, for the European markets. The potential support from the ECB is the one part of the summit deal that could turn out to be much stronger than it seemed at first sight. While Mario Draghi’s public statements were less than helpful, they were presumably directed at a German audience, as was Bundesbank president Jens Weidman’s astonishing decision on Thursday to vote against even a -25bp rate cut. This seemed to confirm our longstanding view that, whatever the preferences of Angela Merkel and other politicians, the Bundesbank would like to sabotage the Euro if it can. Behind this macho posturing, however, the ECB may be moving towards a programme of sovereign debt monetisation and quantitative easing on a scale that even Ben Bernanke and Mervyn King would never contemplate.
The three-year unlimited liquidity operations announced last Thursday could provide infinite monetary support for European banks and through them, their sovereign debt markets. Once these three-year repos get started, banks in the Club Med countries will be able to borrow as much as they want from the ECB at 1% and use this money to buy government bonds now yielding 6% or more. Because of the unprecedented maturity of these repo-operations, banks will now be able to theoretically acquire unlimited government bond portfolios without exposing themselves to rollover or maturity risks. Banks will therefore be able to pick up 500bp of carry, with zero risk-weightings, by hoovering up all the debt their governments can throw at the markets. Of course there would be risks—we cannot say banks will want to jump on this deal, but in theory they can.
This Ponzi scheme could potentially result in an even bigger money-printing operation than anything the US, British and Swiss central banks have done on their own accounts. It would allow the banks to rebuild their equity with no dilution to shareholders. And if the banks in Italy or Greece became too “profitable” by using cheap ECB funding to buy up their entire sovereign debt markets, then the Italian or Greek governments could always recover the “excess” profits with special taxes. The governments could thus effectively reduce their own cost of funds to the 1% rate offered to banks by the ECB. Of course if the Italian government defaulted on its debts, Italian banks would go spectacularly bust. But these banks would go bust anyway if the Italian government ever defaulted. All the incentives for Italian bank management will therefore be to go for broke in their sovereign debt markets, making maximum use of the new ECB credit lines.
That said, however, the European Banking Authority’s recent stress tests forced banks to assume mark-to-market losses in the stressed scenarios. These demands from the EBA may inhibit banks from adding more sovereign risk—unless the EBA uses the “fiscal compact” as an excuse to ease up on the stress tests.
And it is crucial to remember that banks are likely to use the ECB credit lines only to buy the bonds of their own national governments, partly in response to political pressures but also for prudential reasons. If the Euro were ever to break up, Unicredit would not want to own any Greek or Spanish debt, since this would entail unpredictable currency risks. An Italian bond, by contrast, would be redenominated into the new Lira and would be matched perfectly against Unicredit’s borrowings from the Bank of Italy, which would also be redenominated into Lira.
Thus, the result of the ECB’s covert QE via the banks will be gradually to re-nationalise the banking systems and the sovereign debt structures in Europe. This process will help Club Med countries avoid sovereign debt defaults, but it will make eventual breakup of the euro much less painful– and therefore more likely.
The Long March of the Euro Communist Economies
As we look forward to the coming year, we can bet our bottom drachmas that French and Italian trade deficits are going to continue to crater. Industrial production in most European countries will continue falling (who will invest given the uncertainty and the constant changing rules?). Unemployment is going to go ballistic.
This is because Europe’s problem is fundamentally not one of excess debt (look at how Japan, the UK or the US are dealing with debt). The true problem is that half of Europe is uncompetitive and falling into debt traps (see page 5). As a result, budget deficits are going to explode. Remember that Greece after the first fix was supposed to grow in 2011?With hindsight, this looks like quite a joke. Though not a very funny one.
Nearly a decade ago, in the ad hoc Communist France vs Capitalist France (or in French the book Des Lions menes par des Anes), I wrote about the growing weight of government sectors (and employment) in the economy of France. It seems to me that everything that happened in the latest EU summit was about saving the “communist economy” (by guaranteeing its financing at a low rate); even if that meant sacrificing the “capitalist economy”.
It is also hard for me to imagine that much in the way of reform will actually take place—why should one reform if money is readily available from one’s domestic banks? Because we have signed on to a tougher, tighter fiscal treaty? We did not even manage to respect the previous, easier, treaty. Why assume that it will be any different this time? Fool me once, shame on you; fool me twice…
The media all over the world, but especially in France, are presenting the crisis as a financial one, as if the governments and the politicians have no responsibility. This crisis is in fact very typical of a communist system arriving at the end of its ability to borrow and make the productive system service the debt it has accumulated, simply because the productive sector is going bust.
And nowhere is it more visible than in France. The “communist sectors”—which I define as the sectors in which there are no market prices and lifetime employment—have grown remorselessly since 1980. The market sectors are falling by the wayside one after the other as everybody can see:
This is not a banking crisis but a political crisis, and as Toynbee wrote, political crises always occur when the elites have betrayed. For reasons that I have never really understood, such crises tend to end either with reforms (in countries where people drink beer) or in revolutions (where people drink wine). As far as France is concerned, it seems to me that we drink both, but with a marked preference for wine.
Have Southern Europeans Bought Too Many BMWs?
We are often being told that the first decade of the Euro led to artificially low rates in the South, which provoked a credit-led consumption boom that allowed the poor guys in Valencia or Lecce to buy a BMW. This story is supposed to provide a colorful illustration of the intra-Eurozone imbalances accumulated over the last decade. Yet, as we show below, the deterioration of the Southern European trade balances with Germany has accounted for a relatively modest part of the rise of their trade deficits. More importantly, the story misses the essential point about the main cause of these deficits.
Take the example of Italy. Italy had a €25bn trade surplus when the Euro was introduced in January 1999, and has a €35bn trade deficit now—that is a €60bn swing. Germany has accounted for €13bn, or 22% of the total deterioration, and this was in part caused by declining German imports during the first half of the last decade. But as the chart below illustrates, the bulk of the deterioration of Italy’s trade deficit came from oil first (€60bn since 1999), and China second (€20bn). Excluding China and oil, Italy today runs a comfortable trade surplus that is almost twice as high as it was in 1999 in nominal terms, and that has remained roughly stable as % of GDP (3% to 4%).
Thus, the idea that the rise of Southern European trade deficits was essentially due to (or reflected in) intra-Eurozone trade imbalances is largely a myth. The additional consumption of Italian and Spanish households benefitted oil-producing countries, China and other Asian countries first and foremost. And viewed from the German side of the equation, only 13% of the rise of German exports of the last decade went to Southern Europe.
Most observers and analysts now tend to interpret everything that has happened in the Euro area during the last decade as a consequence of the Euro experiment. But they hugely underestimate the fact that the rise of China during this same decade, and the accompanying explosion of commodity prices, has had even more impact on the Eurozone economies than the monetary union. This is especially true of trade development in Southern Europe.
Looking at the trade deficits in Italy and Spain, we can see that their main challenge is not to regain competiveness against German producers, but to reduce their dependency on oil imports (through the development of solar energy, for example). This will obviously take its time, and in the meantime the deleveraging Southern European countries will begin (Italy) or continue (Spain, Portugal, Greece) to improve their current account balance through lower import volumes. This would have to take place even if they left the Euro and devalued. We doubt, however, that BMW will prove to be the main victim of this inevitable development.
The Triumph of Southern Italy over Northern Italy
On the previous page, my colleague argues that Italy’s balance of payments problem is not caused by the Euro, but instead by the China factor and rising commodities prices. Besides the fact that Italy would have better adjusted to the pressures of a rising China and higher commodities prices were it not for its artificially high foreign exchange rate under the Euro, this theory fails to explain Italy’s disappearing industrial sector.
As the chart below shows, up to 2000 Italy’s industrial production and GDP grew roughly at the same rate. Then the Euro was invented, and Italian GDP growth has basically flat-lined. But the situation was far worse for the country’s industrialists as these days IP is some -15% lower than 2000 levels:
This dichotomy reveals a very sad reality—that the relative stability of GDP in Italy is thanks only to the relentless growth of the public sector:
The industrial production index gives thus a perfectly good representation of the state of the private sector in Italy—it is going out of business. Meanwhile, the free loaders’ economy of southern Italy has won the day. Unfortunately, the bill will have to fall on Northern Italy. And needless to say, if you tax Northern Italy a little more every year for the primary surplus to remain a surplus, Northern Italy grows even less, which means that the following year, you need to tax Northern Italy a little more…eventually Rocco and his brothers in the South will also find themselves in trouble.
So the Euro has in fact led to the triumph of Rome and Southern Italy over Northern Italy and of course of the rentier over the entrepreneur. Is it sustainable? No more than the Soviet Union was…
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Good post Mark – though it’ll take time to digest.
This bit caught my eye though:
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Thus, the result of the ECB’s covert QE via the banks will be gradually to re-nationalise the banking systems and the sovereign debt structures in Europe. This process will help Club Med countries avoid sovereign debt defaults, but it will make eventual breakup of the euro much less painful– and therefore more likely.
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That’s a great piece Mark. I agree with it’s conclusions.
Anyone who has lived in France well understands the imbalance between the public and private sectors. There is a feeling that entrepreneurship is tainted and not quite a respectable endeavour. Public sector is seen as worthy and good for society. Sadly they are the jobs everyone qualified wants.
Most French people just cannot understand that it’s the private sector which creates wealth, public sector simply spent it.
It’s like having a profligate wife. You go out to work and use all your energy to make a living and all the while back at home the wife is leaking it on shoes and clothes. Eventually under that scenario something has to give. Usually divorce.
I have been waiting for that to happen in France for years. Sarkozy came to power promising change. He has failed to even scratch the surface.
Now France will return in May after the elections to it’s socialist/communist leanings and the status-quo will resume.
All this may not have much relevance to readers interested in Spain. However the French model of socialism runs deep in the European Union. With ever deepening ties Spain will get sucked into that philosophy. Every treaty it signs is a step closer and once on that road there’s no turning back.
Merkle today reiterated her opposition to increasing the level of the ESM. Germany seems determined to undermine the accord they signed last week. I believe none Eurozone countries and a couple inside it will have great difficulty agreeing it on the current basis.
It’s a lame treaty anyway because it cannot have any legal backing without the UK’s agreement.
The Maastricht Treaty laid down voluntary budget borrowing principals of 3% of GDP which everyone has ignored. The French were among the first to breach it.
I do now think because of the continued complete failure of Europe’s politicians to deal with this crisis, the demise of the Euro is inevitable. -
I’ve come to the conclusion that it is more likely than not that key countries will drop out of the Eurozone. The Euro might survive as a northern European currency, but not as it is.
Might take years for it all to shake out though.
The new “treaty” will get swept away by events. And anyway, what was it really about? Here’s an interesting take that echoes the article this thread started with:
http://www.efinancialnews.com/story/2011-12-14/secret-glee-sarkozy?mod=promos -
Good article Mark.
Like you, I’ve now come to the conclusion that the Euro as we know it simply won’t survive. This saddens me somewhat as I consider myself pro-European and have always been in favour of the currency.
Saving the currency was always going to be a political decision. If decisive action had been taken a couple of years ago, we wouldn’t now have this problem. The European leaders have shown themselves to be both spineless and incompetent.
The markets will tear the euro apart sooner or later. My guess is sooner.
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I think there is some truth in the story Sarkozy was spoiling for a fight with Britain. A bit of public Brit. bashing is always popular in France and Sarko needs every bit of help he can get. However he’s doomed unless there’s a major political upset.
The Franco/German axis will be even stronger under the inexperienced socialist Hollande. The ineptitude of politicians to solve the crisis will continue until Germany relents and a new treaty is agreed allowing the ECB to print money and lend directly to the Eurozone states.
In my view the markets know that is the only real solution which will work.
They will continue to weaken Europe’s financial standing until that realisation dawns on Merkle and Germany as a whole. -
I am always troubled when so-called experts exploit a crisis to push their ideology and agenda.
I far from being an expert in European economies. However the same “public sector is the root of all our problems” chant can be heard here in the States. As someone who has about 15 years in the private sector, including major companies such as Deloitte, and 23 years in the ‘public sector’ I can say that there is little difference. It is the management and size of the organization, not its governance, that makes the difference.
All of a sudden, my government job looks good to others. I remember my friends laughing at me because when I accepted this job, the salary was so low compared to the same type of work in the private sector. But the benefits were great. Now that the private sector has dried up (due to the global economic meltdown and not because of government jobs) my job looks good and people are saying ‘that is not fair.’
There needs to be reform in all organizations, including government entities. And societies have to make decisions about privatization, recognizing that if something is not profitable but deemed necessary, it needs to remain a function of government, because businesses cannot exist without profit.
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Germans, however are absolutely convinced that what they are doing is right and there is no chance of euro break up.
(German businessmen)
A full 90 percent said they believed austerity measures for crisis-plagued countries like Greece and Italy are the correct policy, even if it threatens to slow German economic growth. Meanwhile, 95 percent said they viewed the leadership role Merkel has taken together with French President Nicolas Sarkozy in the euro zone as positive. In recent weeks, the media have taken to calling the political pair “Merkozy.”
Only 11 Percent Believe Euro Zone Will Break Up
On the downside, however, 92 percent agreed that government bonds would become more difficult to float in euro-zone countries. But only 11 percent said they thought the euro zone would break up as a result of the crisis.
http://www.spiegel.de/international/germany/0,1518,803751,00.html
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@GarySFBCN wrote:
And societies have to make decisions about privatization, recognizing that if something is not profitable but deemed necessary, it needs to remain a function of government, because businesses cannot exist without profit.
I have heard that excuse so often, especially in France. If something is not profitable then that’s a structural management problem.
If the demand for the product does not exist why then should the public sector be burdened with supporting something nobody really wants.Most state owned entities in France do not make a profit. SNCF (Railways) is an example. They cannot make a profit because their staff have lifetime contracts, are overpaid, over manned. Train drivers can retire at 55 on final salary pension, it used to be 50! Nothing can be changed because the unions would bring France to a halt.
There are many other similar examples.I don’t think you can compare the US public sector with that of France. I recall President Regan sacking the entire air traffic control work force when they went on strike. If they tried that in France a bloody revolution would take place.
One of the principal reasons Greece is in such a mess is that for the last decade they created a top heavy public sector with generous staff benefits, high incomes and early retirement on ludicrous pensions.
The Greeks paid for all that from borrowing or more accurately the proceeds from the sale of their sovereign bonds. Millions of Euros poured into the country and bloated the public sector. They totally neglected private enterprise and the crumbling infrastructure with the noted exception of the Olympic Stadium, now a white elephant.
Socialist governments in every democratic EU country always inflate the public sector, burdening tax payers with useless and expensive schemes, quangos and overbearing regulation. Some of it, as in Spain, is political patronage and the repayment of favours buying loyalty. -
The problem is when the state gets too big it devours the productive economy and in the long-run undermines itself.
People on the left should recognise this. The state has to be paid for, which means allowing the wealth-creating sector to thrive. If they cherish the state they should never let it get too big for it’s own sake. (You can use the same self-interest argument against income inequality. Who wants to be super-rich in a wretched society? It’s in the interests of the wealthy elite not to let income inequality get so big they end up living in a miserable country.)
The other problem with the state is it’s very difficult to roll back once it’s gown to big. Too many vested interests, powerful unions, and spineless politicians. It becomes one big gravy-train.
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@mark wrote:
The problem is when the state gets too big it devours the productive economy and in the long-run undermines itself.
People on the left should recognise this. The state has to be paid for, which means allowing the wealth-creating sector to thrive. If they cherish the state they should never let it get too big for it’s own sake. (You can use the same self-interest argument against income inequality. Who wants to be super-rich in a wretched society? It’s in the interests of the wealthy elite not to let income inequality get so big they end up living in a miserable country.)
The other problem with the state is it’s very difficult to roll back once it’s gown to big. Too many vested interests, powerful unions, and spineless politicians. It becomes one big gravy-train.
Not only all that, people still have the mistaken belief that public sector or state sector workers are taxpayers. They are not.
Only way a country can improve is to increase the tax base from the private/corporate sector.
This is what happened to the UK — they forgot all this and Blair/Brown made the public sector and housing market ‘the economy’ and ruined the UK in the process.
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One of the principal reasons Greece is in such a mess is that for the last decade they created a top heavy public sector with generous staff benefits, high incomes and early retirement on ludicrous pensions.
In my university economics class, Greece was used as a case study because 70% of its economy was ‘off the books.’ This was shorty before joining the EU. Were reforms put into place to fix this? If not, their economy was unsustainable, with or without public sector workers.
The problem is when the state gets too big it devours the productive economy and in the long-run undermines itself.
People on the left should recognise this. The state has to be paid for, which means allowing the wealth-creating sector to thrive.
I agree. As a social progressive and fiscal conservative, I embrace this. But the right needs to recognize the unchecked, unregulated capitalism is just as bad as communism. The only difference is who is controlling the finances, the media, etc. I do wince at the word ‘wealth’ – is the the responsibility of the State to create wealth or jobs? To create wealth or reduce the ‘misery index’?
I once worked for a very wealthy lady. And she taught me that with wealth comes responsibilities. And those wealthy people who do not embrace those responsibilities will be rightfully despised.
As for pensions, retirement, etc. yes there need to be reforms, but I would ask, is it reasonable to expect that all people can work until the age of 67? And I’m guessing that more money is wasted in graft, corruption, favoritism, etc, than in a pension system that allows people to retire at age 62.
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While Rome burns…
America’s top bosses enjoyed pay hikes of between 27 and 40% last year, according to the largest survey of US CEO pay. The dramatic bounceback comes as the latest government figures show wages for the majority of Americans are failing to keep up with inflation.
America’s highest paid executive took home more than $145.2m, and as stock prices recovered across the board, the median value of bosses’ profits on stock options rose 70% in 2010, from $950,400 to $1.3m. The news comes against the backdrop of an Occupy Wall Street movement that has focused Washington’s attention on the pay packages of America’s highest paid.
http://www.guardian.co.uk/business/2011/dec/14/executive-pay-increase-america-ceos?newsfeed=true
And that explains all of the ‘Eat the Rich’ placards and bumper-stickers that are seen here in the US. With workers being asked to make sacrifice after sacrifice, with workers feeling ‘blamed’ when executives and Republicans talk about pensions and a retirement age of 62 as if that is the root of all economic problems, the 1% continues to fleece and be unconcerned.
Yes, I understand the Europe is not the US. But some of the underlying dynamics are identical.
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@mark wrote:
The other problem with the state is it’s very difficult to roll back once it’s gown to big. Too many vested interests, powerful unions, and spineless politicians. It becomes one big gravy-train.
Perfect description of France Mark. 🙁
At the last French Presidential election there was a significant debate about reducing the size of government and state control, not quite ‘rolling back the state’ but it was a start. Sarkozy was elected to at least give it a try and change France. In the last five years he has in fact done very little and his only real achievement was increasing the state retirement age to 62 in about eight years time.
Even that caused immense disruption, civil unrest and months of strikes.
It’s unlikely that debate will return next year since the majority of French are comfortable with the state running everything. Capitalism, competition and the free market is unpopular and distrusted.
The financial crisis will not change that either. Rather it has increased the French faith and belief in big government.
That helps to understand why Sarkozy behaved the way he did towards Cameron at the EU summit.
He has in fact managed to achieve great unpopularity on both sides of the political divide and is politically doomed. -
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