Sunday, 16 May 2010

Deliver us From Evil

The Malta Independent on Sunday - 16 05 2010

If your house was on fire, would you continue to behave according to the routine rules and rituals that apply when things are normal? That is exactly what Jean Claude Trichet, the president of the European Central Bank (ECB), tried to do on Thursday, 6 May when addressing the international press at a conference following the ECB decision in Lisbon to keep interest rates steady at one per cent.

A banker’s currency is credibility. If he loses it, his balance sheet, strong as it may be if underpinned by credibility, gets tattered. Bankers, especially central bankers, should beware of over-promising and under-delivering. By nature they are extremely cautious, to the point of being boring. In a fiat currency economy, the credibility of the central bank is all we have to preserve our faith in the value of money. If the credibility of the central bank is questioned, the currency is heading for trouble.

The euro is a very particular currency. It is not underpinned by a single treasury. It shares a common monetary policy operated by the ECB for all euro member countries but each country has its own national treasury and is responsible for its own fiscal policy. No currency can outsmart any degree of stability if monetary policy and fiscal policy operate in conflict rather in harmony. So the euro was launched with a potentially fatal flaw. Its monetary policy was centrally decided in a supra-national manner, whereas fiscal policy was decentralised at national level.

Euro member states defended their fiscal sovereignty with the gluttony of those who like to have their cake and eat it too. Euro membership gave credibility for members to borrow easily and cheaply with little restriction on their fiscal latitude to ensure they operated prudent fiscal policy in support of the common currency.

It was not meant to be that way. The Stability and Growth Pact (SGP) was meant as a discipline for euro member countries to aim for a neutral budgetary position with maximum deficits to stay within three per cent of GDP at the bottom of the economic cycle. Accumulated national debts were also supposed to be kept within 60 per cent of the GDP or to move determinedly towards that level if countries were above it at the point of joining the monetary union. The SGP was, however, a loose expression of intent without real measures of discipline to enforce it. In theory, countries could have been fined for transgression but no country ever paid a cent in fines. It also depended on the goodwill of member states to report faithfully their fiscal position rather than embark on political games to hide the deficit through delayed payments, anticipating revenues, and the use of strange financial derivatives which magically convert present debts into a future stream of payment obligations, thus helping to push the can down the road rather than do what’s necessary here and now.

The financial crisis of 2007-2009 brought the chickens home to roost for many euro countries who were either over-exposed to the property and financial sector (Ireland and Spain), or who were reckless in their fiscal rectitude, most especially Greece. A new incoming Greek government, following a landslide election win last October, brought the shocking revelation that the Greek deficit had blown out to 13 per cent of GDP, if figures are properly reported, and that the debt level was some 115 per cent of GDP, mostly owned to foreign banks and investors and with maturities that constrained the Greek government to have a regular presence on the international financial markets to roll over existing loans and borrow new money to cover the recurrent deficit.

International investors were horrified by the EU’s and ECB’s inability to enforce the SGP and to look beyond the reported figure. What was the governor of the central bank of Greece doing at the ECB table if he could not warn about the bomb building under his own feet, with borrowings far greater than the reported deficit and with such huge exposure to short term external debt` In the end it is not only the level of the debt that matters but also how it is financed. Japan handles much larger debt to GDP ratios, but all its debt is financed internally – the private sector lending to the public sector, (much as we do here in Malta), without any resort to external borrowing. That is much more manageable.

International investors had always worked under the unspoken assumption that no euro country would be allowed to default and that co-members would come to the rescue of any member in trouble. This assumption started being questioned as stronger euro countries initially tried to pretend that this was a domestic Greek problem that the new government could solve by itself through fiscal adjustment without any external help. Politicians seeking to shift blame for their own deficiencies often refer to international investors as speculators, vultures, locusts, and similar derogatory terms. In reality, investors are in the market to make money and when they see increased risk they start pricing it.

If doubt was created that Greece would be left on its own to sort out its fiscal mess, investors would start demanding much higher yields on Greek debt to take account of the increased default risk. When the yield on Greek debt in comparison to the benchmark German version widened beyond belief (the effective yield on a two-year Greek Bond reached some 18 per cent pa), and when the Greek disease started infecting other Mediterranean countries, particularly Portugal and Spain, the EU realised that not only could Greece not reform on its own (who can reform while paying 18 per cent pa interest on its debt`), but the EU needed the expertise of the IMF to apply the proper medicine and provide political cover from the ire of the Greek population at large that has been short-changed by its political class. But as weeks rolled by, with endless negotiations extracting round after round of Greek concessions on fiscal austerity, investors’ doubt on the sustainability of such inhuman austerity measures increased, especially as street protests in Athens turned into riots that claimed the innocent lives of three bank employees. By 6 May, when the IMF/EU package for Greece was ready and simply awaiting the approval of the German Parliament the next day, the market continued to price Greek bonds to default and Portugal and Spain’s bonds with an increased risk of default.

It was clear to anyone experienced in this field that the markets were ready to take on Portugal as the next weakest link as soon as the Greek package was approved in such a laborious manner. In simple terms, the European debt markets were on fire and were earnestly awaiting soothing reassurance from the ECB that what was done for Greece would be done without hesitation for any other euro country that needed assistance. Instead, Trichet totally fumbled and tried to pretend that the house was not on fire and all was bright and sunny.

His emphatic assertion that the ECB governors had not even discussed taking any extraordinary measures to reassure the markets was interpreted as a challenge to the bond market to test the resolve of EU member states to stand behind those of their own that had run into financial trouble. Friday, 7 May shaped the European sovereign default nuclear version equivalent of the financial devastation from Lehman Brothers bankruptcy in the US in September 2008. Trichet’s misjudgement had some benefits. From across the pond, President Obama and Treasury Secretary Geithner warned their counterparts in Europe that panic needed strong action (a bazooka) not nonchalance (a water pistol).

Over the weekend, the EU leaders and the ECB did what it had taken months to do in much smaller proportions for Greece. Faced with the imminent prospect of a total freeze of international banking system unless extreme measures were announced before Asian markets opened for business on Sunday night European time, the EU leaders responded with atypical vigour. Crisis forced fiscal harmonisation through the back door.

While on the face of it fiscal sovereignty remains with the individual state, once their debts are now notionally or formally guaranteed by the Stability Fund put together in co-ordination with the IMF, it is obvious that borrowings will be under strict scrutiny of the Stability Fund. For all I know, Trichet’s fumbling could have given the euro system the fiscal pillar it was missing to sit stably on a tripod of common monetary policy, low inflation and controlled borrowings. That’s until some brainy investment banker comes up with some colourful financial derivative through which a country can spend without instant borrowing. Like a securitisation proposal for our Citigate project. God deliver us from evil.

No comments:

Post a Comment