Monday, 27 October 2014

After the Asset Quality Review and Stress Tests, now what?

Hats off to our two main domestic banks, Bank of Valletta and HSBC Bank (Malta) for passing the Asset Quality Review (AQR) and Stress Tests (ST) with a lot of margin to spare even though the tests were very rigorous assuming a scenario as if our national economy was going to fall off a cliff.
Victor Costancio - Vice President

The stiffer the better one may argue as the Maltese saying goes "ahseb il-hazin biex it-tajjeb ma jonqosx". ( assume the worst so that the better will not fail to materialise)

In essence however the whole European Banking sector performed well. Less than Euro 10 billion required as new equity ( after adjustments) on an aggregate Balance Sheet of Euro 28 trillion i.e. 0.035%, is clearly not a significant game-changer.

This means that there are two ways to interpret the broad results of the AQR/ST conducted by the ECB and EBA:

                              the tests are not credible

                              the tests are credible but the banks are not the problem behind the flat            growth and  lack of credit demand across Europe.

The ECB seems in no doubt that whilst addressing problems about the supply of credit is a necessary step to fix the European economy, on its own it is not sufficient.   In fact Vice-President Victor Constancio was very measured in his words:

"the economic recovery will not be hampered by credit supply restrictions coming from the banking sector, provided there is enough aggregate demand"

As ECB President Draghi pointed out in his August Jackson Hole speech and repeatedly since then, monetary policy cannot carry the whole responsibility for economic revival in the Eurozone - it needs to be re-enforced by growth friendly structural reforms ( Italy Greece Spain and France please listen) and more flexible fiscal policy ( Germany please note).

To avoid a protracted recession Europe needs all three arrows: loose monetary policy and strong banking sector to deliver it where it matters, supportive fiscal policy and growth oriented structural reforms.

The ECB is doing its bit to provide time for politicians to get together and fire the other two arrows.   But there is not much time left if we are to keep Europe from falling into a deflationary debt trap from where it will be almost impossible to climb back.

Sunday, 19 October 2014

History must not repeat itself

This article was published in The Malta Independent on Sunday - 19th October 2014

The fear of history repeating itself forced me to re-read the story of Germany between 1928 and 1933. By 1928, Germany was recovering well from the shattering experience of the First World War and the heavy reparation costs imposed on it by the 1918 Treaty of Versailles. Then, in 1929, disaster struck.
The Wall Street crash exported depression around the world and Germany was hit, as international trade collapsed, unemployment shot up and austerity was forced on people who were practically destitute. Fiscal and monetary policy tools had not yet been 'invented' to counter the economic cycle and, in any event, when a depression becomes global there is very little that a single country can do to avoid the fallout.
In this context, the Nazi movement was transformed from insignificance to the largest political party, with about one-third of the vote in the election of 1932, as it promised a better life to the 5.5 million unemployed. In 1933, Hitler was elected Chancellor, the Reichstag was burnt down during a fresh election campaign and, as public perception considered this an attempted coup by the 'communists', the Nazi party gained a sufficiently large electoral mandate to pass the Enactment law. Hitler began ruling by decree until he became a total dictator on the death of the German President in 1934. And the rest, as they say, is history.
Why is this relevant in today's circumstances? Europe is trapped in a never-ending recession and certain countries are now in outright depression. The argument as to whether this is best addressed by austerity (euphemistically often referred to as 'economic restructuring') or by demand stimulating growth policies continues and seems as fruitful as a dialogue between the deaf.
The German block, as the beneficiary of the crisis, keeps insisting that austerity is the best medicine. It expects countries in distress to regain their competitiveness by undergoing harrowing internal devaluation as the countries in surplus continue to reap the benefits of monetary union without making structural adjustment to address the disequilibrium from the surplus side as much as from the deficit side.
Countries in distress, particularly Italy, Spain and Greece but now joined by France, seem to have had enough of dictating by the Merkel clique and are insisting that fiscal flexibility must accompany economic restructuring as otherwise they will never escape the deflationary trap that will ultimately lead to default and collapse. All these countries will, in the next few years, face election campaigns (in Greece it could be as early as next year) and an electorate hurt and poisoned by austerity without a sign of redemption may well make the same decision as the one made by the German electorate in 1932-33. Parties of extremes - left, right or with no ideology apart from destroying democratic institutions - are not missing in all these countries.
Let me try to explain in language as plain as possible, both sides of the argument. The monetary union has rules about budget deficit and debt levels. These rules were recently (and very inappropriately) made more stringent to ensure that countries have no fiscal space for counter-cyclical demand management. Keynes must be turning in his grave. Germany insists on adopting a balanced budget, even though its seven per cent of GDP balance of payments surplus would indicate the need for stimulating internal demand to address this chronic surplus disequilibrium. It must be understood that surpluses and deficits are the opposite side of the same coin and no deficit can be successfully addressed unless surplus countries agree to share responsibility in the adjustment process.
When countries are in control of their own currencies, the rate of exchange operates as a self-correcting mechanism. If Germany still had its Deutsche Mark, this would have hardened so much on the international foreign exchange markets as to make Germany less competitive and thus adjust its surplus. Also, the strength of the Deutsche Mark would have forced the relocation of investment to the lower cost environment of deficit countries. However, as Germany's currency is now the euro - which is shared by countries whose economies are in distress - the euro does not re-value the way the Deutsche Mark would have done and therefore the self-correcting mechanism is distorted. Germany can continue to have a free lunch on the back of the countries in distress.
On the other hand, the countries in distress would have regained their competitiveness by a fall in their currency exchange if they still had their lira, franc, peseta or drachma. But as they now share the euro with Germany, the euro exchange cannot fall enough to offer a self-adjusting mechanism and these countries will have to work harder to regain their competiveness.
And herein lies the dialogue between the deaf. Germany is insisting that these countries regain their competiveness by means of economic restructuring, another word for internal devaluation, which essentially means outright cuts in wage levels and social entitlements and a reduction in government expenditure. According to the German doctrine, if these countries stick long enough with such painful austerity they will ultimately come out of the austerity tunnel in good shape, just as Ireland has managed to. The Germans have the audacity to state that deflation is a sanitary exercise to restore competitiveness and these countries should grind their teeth and keep inflicting pain on their population.
The Irish example is totally misleading. Even at the peak of the crisis, Ireland never lost its competitiveness and continued to attract foreign direct investment on a grand scale, given their US connections, their English speaking and their favourable tax environment. The Irish problem was caused through a property bubble that bankrupted its banking sector and the Irish government was forced to bail out its banks to ensure they honoured their obligations to other European banks. Basically, the Irish taxpayers had to bail out not just Irish banks but other international banks too!
Furthermore, the German logic does not take into consideration whether or not democratic institutions in problem countries have enough staying power to remain operative as they pass their electorate through the austerity sausage machine. Eventually, of course, if wages and entitlements fall enough to render the country competitive again, the economy will start to grow again. But could the electorate - in the painful process - be lured by the siren calls of the extremists, as happened in Germany in 1932-33 and from which there will be no point of return?
The argument from Valls and Renzi ('Vallenzi' has been coined by The Economist) is that whilst they will continue to restructure their economy to lubricate the rigidities and monopolies that have accumulated over a long period of time (Renzi is imposing, against foe and friendly resistance, a bold programme to restore flexibility to the labour market and make the judicial system more effective) this cannot be done in the context of fiscal austerity. They plead to be allowed space to stimulate the economy so that the restructuring can be carried out in the context of economic growth if they are to maintain their political constituency.
To this Chancellor Merkel has gone to the German parliament to emphasise that:
"All member states must accept in full the strengthened rules of the Euro......In Europe we have to look first and foremost at mobilising private capital."
The two sides are entrenching themselves without room for compromise. Efforts to mobilise investment through the Europe Investment Bank for infrastructure can only be viewed as a long-term solution, with little or no immediate impact. Such infrastructure projects, even if defined as shovel-ready, would require a long lead time to organise, finance and obtain all regulatory and environmental approval, so their impact for instant impetus to render 2015 growth would be next to negligible.
Germany seems determined to stick to the stern defence of their orthodoxy and surpluses, even as their own economy is being hit by lower demand from export markets. Italy and France have had enough of German diktats and very soon something will have to give. Hopefully, good sense will prevail to ensure that history does not repeat itself.

Monday, 6 October 2014

Europe must learn from the US

This article was published in The Malta Independent on Sunday - 05 10 2014

Europe has again defeated the US in the Ryder Cup.   In golf there is nothing we need to learn from the US.   But in the handling of the economic crisis there is much that Europe needs to learn, and fast.

Six years after the financial crisis of 2008 that nearly brought the total collapse of the international financial system as credit froze and banks were losing the trust of their depositors, the US is now flying high again.   

This week we had figures showing that the US economy has continued to add employment at a fast pace bringing the unemployment rate below 6% for the first time since the crisis.   The US dollar rate of exchange index is soaring as America becomes the world’s leading producer of energy and is in a position to start exporting it, in the process pushing down energy prices.   

The only blot on the US economic performance is that economic growth is not well distributed, with the top echelons of society grabbing most of the fruit of economic revival whilst workers’ wages remain stuck at pre-crisis levels.   But this is a process which will sort-out  itself if economic growth proceeds unabated as shortage of labour will eventually inevitably translate into higher wages without pushing up inflation, given the productivity gains accompanying economy growth and falling commodity and energy prices.

Europe, especially the Euro area, is a complete antithesis of the US success. Unemployment remains stubbornly high and a generation of youth is being lost as they cannot participate at all, or at least not to the best of their abilities, in an economy stuck in a crisis. Countries that were most hit by the crisis due to their deficit and debt levels at the point of crisis entry have undergone several rounds of crushing austerity measures but they have not much to show for it.  They are stuck in an economy that has all characteristics of deflation, with falling prices, high unemployment, lack of investment, gummed bank credit and their burden of debt is getting heavier as they are caught in a deflationary debt trap.

From Malta this view seems unreal as thank God our economy has continued to perform and indeed accelerate more in US style rather than European style.  But we are the exception to the European rule and let us not kid ourselves:  if the European crisis prolongs our economic performance will be hit too as demand for our exports of goods and services is mainly sourced from the EU.

The obvious question is what has caused this difference in results between the US and the EU, particularly the Euro area.   The problem was largely the same so why in a such an economically inter-connected world the youth in Pennsylvania are finding work, even if not well paid, whereas the youth in Portugal have no jobs?

Clearly this has been due to the different response to the crisis between the US and Europe.  

The US as a single Federal State with a Federal Congress, an elected Federal Executive and a single Treasury and Central Bank could respond more forcefully and punctually to the crisis.    Although not to the degree desired by Keynesian economists like Paul Krugman, Larry Summers  and Joseph Stiglitz, fiscal policy was complementary to the aggressive monetary policy which brought interest rates down to zero. When that was not enough the Federal Reserve made three rounds of quantitative easing buying long term government bonds and mortgage backed securities to bring down long term interest rates, giving banks space to entertain fresh credit demands and in the process stabilising and reviving the housing market.  More than anything else the US immediately addressed the capital deficiency problems of its banks, resulting from losses they suffered in the crisis, using fiscal policy to re-capitalise banks so that they could immediately become active players in the revival of economy.

The US recipe which is proving so successful was based on three pillars:
  •  Immediate re-capitalisation of Banks through TARP funds approved during the last days of the Bush administration.
  •  Fiscal stimulus given by the Obama administration soon after executive takeover.
  •   Ultra-loose monetary policy consistently operated by the Federal Reserve.

The European response was piecemeal, uncoordinated and altogether insufficient.

There was and still there is no adequate reply to the capital deficiency of European banks.   Bank stress tests undertaken in various rounds were too soft and failed to serve any purpose.   Even the current process of Asset Quality Review to be followed by aggressive stress tests is half baked.    Without a ready fund which can be used to fill up any capital deficiency holes, it is like risking starting a fire without having an extinguisher at the ready.    As in the US,  Europe needed to use fiscal policy to create such a TARP like capitalisation fund.   And the burden for such funds should have been pan-European.  No use expecting countries struggling with excessive fiscal deficits, within a currency bloc they do not control, to use more fiscal funding for  their banks’ capital deficiency.

Instead of fiscal stimulus Europe imposed harsh austerity programmes.   The word austerity was not in the US lexicon for handling the crisis.  Austerity crushes demand leading to economic contractions, larger deficits and yet more austerity.  It is a spiral which like a slippery slope is hard to break. Europe needed restructuring of the disequilibria in countries like Ireland, Portugal and Greece but this had to be compensated by creation of compensating demand in surplus countries.  Instead surplus countries like Germany also adopted austerity and balanced budgets when their excessive balance of payments surplus needed a totally opposite approach.

And lastly the only institution in the EU which has autonomous authority to work in a Federal-like manner, the ECB, was not forceful enough with loosening monetary conditions.  One can mention the interest rate increases in 2011 which were a heresy in the context they were applied and had to be immediately reversed.    When the zero-interest bound was reached the ECB could not move into quantitative easing as fast as the US Fed and only now that inflation in the Euro area overall has fallen to 0.3% (meaning that problem countries are effectively in deflation) the ECB is finding the courage to do some altogether inadequate quantitative easing.   In the process it is finding harsh criticism from German quarters who only respect the independence of the Central Bank when it suits them.

The stasis in the EU organisational structure is becoming a serious threat to its own existence.    Democracy cannot take endless rounds of austerity without at least a credible light at the end of the long and dark economic tunnel.     Inevitably such dissatisfaction will become easy prey for extremist demagogues of the left or right who promise easy solutions which will challenge the whole EU structure and stability.    Papendreou and Berlusconi were practically forced out of power from Berlin but they were losing support in their home ground in any case.   What would happen if Marine Le Pen will be the next democratically elected President of France with a popular mandate to break all the EU and Euro rules?

If the EU and the Euro are to be saved there is not much time left to revise our response to the crisis and build on the model of the US measures that proved effective.  Obviously institutional arrangements are difference and a direct copy is impossible.  But the general message is that the ECB as the only pan European institution with autonomous power that give it the flexibility to move fast and effectively, have to deliver through its monetary policy and macro-prudential mandates solutions that carry the load  that fiscal policy cannot shoulder within the current EU institutional framework.  It can be done if countries respect the ECB independence all the time not just when it suits them.

Thursday, 2 October 2014

Deflation leads to debt trap

My Letter featured in today's  (2nd October, 2014) FT

Deflation leads to a debt trap, not competitiveness
   Sir, Hans-Werner Sinn (“Merkel has a duty to stop Draghi’s illegal fiscal meddling”, September 30) contends that “deflation is not a danger for southern Europe but an essential precondition for restoring competitiveness”. I had to read this more than once to believe my eyes. Dr Sinn needs to read some history books to be reminded of where the deflation of the 1930s led us.
   His assertion flies in the face of all economic data, which prove that deflation leads to a debt trap and more deflation, not to competitiveness. Mario Draghi has been a superhero as the head of the only institution that can keep the monetary union together, taking measures to give political leaders time to do what needs to be done so that the effectiveness of monetary policy is reinforced by fiscal policy action. Angela Merkel’s support for Mr Draghi, sometimes even overruling the German central bank, shows the pragmatism that has made her the longest-serving and most successful European political leader.
   As to the German constitutional court, it is worth remembering, as the current president of the European Commission once quipped, that Germany is not the only country with a parliament, to which I would add: nor the only one with a constitutional court. If Mr Draghi’s efforts to keep the monetary union together are obstructed by beggar-thy-neighbour policies among eurozone members, the major losers would be those that have benefited most from the single currency.
   Alfred Mifsud
   Balzan, Malta


This in answer to the following Opinion published in the FT on 30th September 2014:

Merkel has a duty to stop Draghi’s illegal fiscal meddling
Hans-Werner Sinn
   Despite the Bundesbank’s protests, the European Central Bank is giving Europe’s banks a leg-up. To make them fit enough for the proposed banking union, the ECB proposes to relieve them of some of the potentially toxic loans they have extended to the private sector, which will be bundled into asset-backed securities and taken on to the central bank’s balance sheet. The ECB’s preference is to purchase the better tranches of these securities and leave the junk for the European Investment Bank. But since politicians are not playing along, the ECB will have to hold its nose – and complete its conversion into a bailout agency.
   The ECB began as a central bank that carried out monetary policy, providing liquidity for domestic uses. But when the financial crisis hit in 2008, banks in Ireland and southern Europe faced a dearth of foreign loans, on which they had come to depend. The ECB allowed national central banks in these countries to end the drought by lending even more money against ever-weaker collateral. This exercise in money creation went beyond what was needed to ensure domestic liquidity; €1tn in central bank credit was created out of thin air to settle foreign bills. The citizens of the six countries that were indulged in this way used the money to pay off their foreign debts and to purchase foreign goods.
   The ECB went on to instruct national central banks to grant crisis-afflicted states credit totalling €223bn under the so-called Securities Markets Programme. Mario Draghi, the ECB president, moreover offered unlimited protection for their government bonds, formalising his vow to do “whatever it takes” to save the euro under the rubric of “outright monetary transactions”. This lowered the interest rates at which overstretched eurozone members could obtain credit and reversed the losses of their foreign creditors, triggering another borrowing binge.
   As comprehensive as these measures seemed, they may pale in comparison to what is now being considered. By directly granting credit to the private sector the ECB will enter a far larger arena. Mr Draghi has said that, as a first step, he intends to expand the ECB’s balance sheet by €1tn. The end of the property boom has left many private borrowers in southern Europe close to bankruptcy. The ECB’s plan to purchase their debt could end up transferring dozens if not hundreds of billions of euros from eurozone taxpayers to the creditors of these hapless individuals and companies. As UBS chief executive and former Bundesbank president Axel Weber has noted, the ECB is turning into a bad bank.
   The ECB says these unorthodox measures are needed to combat looming deflation. Given that prices are still rising (albeit slowly – core inflation stands at 0.9 per cent) this seems little more than a fig leaf. Anyway, deflation is not a danger for southern Europe but an essential precondition for restoring competitiveness. This is nothing less than a fiscal bailout – something the ECB has no right to undertake, as the German constitutional court implied when it declared OMT unlawful.
   Yet politicians may again keep their mouths shut about the ECB’s transgressions. Eurozone governments might even be thankful that the ECB is doing by stealth something for which they would otherwise have to seek permission from tight-fisted parliaments. Mr Draghi would never have dared to promise to do “whatever it takes” without the backing of the government heads of the day, and especially of German chancellor Angela Merkel. Mario Monti, Italy’s former prime minister, said as much this month.
   But Germany’s constitutional court has expressly prohibited the German government from sitting back while the ECB oversteps its mandate. If politicians do nothing, any German citizen can petition the court and force them to act.
   The writer is president of the Ifo Institute for Economic Research