Breaking a Circular Problem

9^th October 2011

The Malta Independent on Sunday

Finally push has come to shove! As the Italians say: “Il nodo è arrivato al pettine”.

The financial crisis of 2008 and consequential recession was (is) not a normal recession – it was a balance sheet recession, not a cyclical one. In a cyclical recession, the financial sector remains strong and acts as the transmission mechanism for fiscal and monetary stimuli to pump prime the economy back to health.

This time, it is the financial sector that has caused the recession. Banks lost their capital through bad investments in overpriced property and property-related financial assets and, following the Lehman Bros. collapse, the US and UK governments had to intervene to recapitalise their banks to keep them afloat. The European Central Bank (ECB) is having to provide unlimited liquidity to EU banks to replace sources of wholesale inter-bank funding which are drying up.

After an initial stabilisation and some sort of recovery between mid-2009 and early 2011, it became evident that rather than having been resolved, the financial problem was transferred from the banks to the sovereigns. Governments had to incur huge debt burdens to support banks at the same time as fiscal revenues were experiencing severe reductions, resulting from reduced economic activities: lower taxable profits by banks and less revenue from property sales, as the real estate market collapsed.

Unable or wary of taking on more debt, the expiry of government stimuli support showed that, without such support, the economy started to stutter. This happened at a time when banks were coming under renewed stress due to ‘hidden losses’ on their balance sheets caused by their investments in government bonds, formerly considered “gilt-edged” but now turning doubtful as governments are having difficulty managing their debts.

So we now have a circular problem. Banks came under stress because of bad investments in property and property-related investment products. Governments came under stress when they had to save their banks. Banks came under stress again when the value of their government bonds turned doubtful.

Unless we break this vicious circle, the world will fall into a depression the like of which we have not seen in post-war history. And unless we break this circle, the Ricardian/Austrian economic school – which brought us to the source problem in the first place, with their laissez-faire policies of no, or light touch, regulation of banks and financial institutions – will be having both the first and the last laugh. They will have proved that government intervention has been ineffective in avoiding the recession and a great deal of resources would have been saved, had the market been allowed to bankrupt errant banks and errant investors.

In the eye of the storm there is the euro area. The recession has exposed the design flaws in the euro structure. Countries in depression are locked into a monetary union with a currency that is hugely overvalued for their domestic realities and consequently forced to go for internal devaluation (reductions in wages and entitlements) by austerity bone-shaking measures which, in their immediate impact, tend to crush the economy rather than strengthen it.

I sometimes wonder whether these design flaws were purposely meant to arrive at the point of crisis that we are at today. At times of acute crisis such as the present, the unthinkable becomes the choice of the lesser evil. Formerly, no go areas such as fiscal union, eurobonds, economic government and the like, which transfer a huge slice of sovereignty from individual states to a central government dominated by Germany and France, suddenly become not only possible but, for some countries in acute despair, a welcome solution.

Be what it is, the circular problem must be broken. Until we have restored health to EU banks, credit will not flow where it is needed for economic growth, and without an effective transmission mechanism, policy measures – be they monetary or fiscal – will prove ineffective. This means that banks have to be cleaned up. They have to market all their holdings of sovereign bonds and if that leaves them short of capital, they will have to be recapitalised. Once banks have enough capital, and once the value of their assets is no longer under suspicion by the market, then they can start being banks again, taking money from depositors and lending it to borrowers whose investments will help the economy grow sustainably.

Most EU governments have been hiding away from the inescapable need to recapitalise their banks by fooling themselves that they can restore confidence in the system by fiat rather than by sensible decisive measures. Isn’t it funny how, when she was the French Finance Minister, Mme Lagarde always insisted that French banks were generously capitalised and then no sooner had she put on her hat as managing director of the IMF, she changed course, stressing that it was imperative for European banks to be adequately recapitalised .

A perfect example of how politicians are often caught in a position where they cannot tell the truth – either because the truth would expose their nakedness or because they genuinely believe that people cannot handle the truth and that admitting the truth would depress optimism and enthusiasm for a solution.

Now that push has come to shove – with the forced rescue of Dexia by the French and Belgian government – everybody finally agrees on the need to recapitalise EU banks. Pretty soon, they will also agree that banks have to mark their sovereign debt holdings to market to establish the quantum of recapitalisation required and then, as part of the rescue of Greece and other countries in distress, the EU will also agree to debt exchange schemes offering banks a small profit on the written-down value of their sovereign holdings and sovereign borrowers, a substantial haircut on their debt obligations without going through the dirtiness of a forced default.

What the EU is continuing to shilly-shally about is who is going to fund the necessary recapitalisations. The general thinking is that this would be the European Financial Stability Facility, whose €400 billion resources could be leveraged to offer fire-power close to €2 trillion. This is a crazy idea. Leveraging at the centre to solve leverage problems at the periphery does not address risks, it concentrates them.

A solution has to be found through the mechanism of the ECB which is the only pan-EU institution that can operate autonomously with a speed that matches the market without having to depend on the slow democratic process of 17 member states each holding a veto. It would have been much more sensible for the EFSF funds to be used as capitalisation of the ECB to give it the fire-power to create an ECB-owned rescue/recapitalisation agency that could replicate the US TARP programme of 2008. The resources of such a fund would have been augmented by a 1:1 monetisation and by inviting contributions from other countries that have every interest in saving the euro, including the US, Japan, Switzerland, oil surplus countries and BRIC (Brazil, Russian, India and China) countries. This would have produced a genuine €2 trillion fund without crazy and dangerous leverage.

This week, Merkel and Sarkozy finally woke up to the fact that they cannot continue biting at the edges of the problem and must attack it at source in order to break the circle. Let us pray that they break it in the right way, as otherwise the circle will break them – and us.

Alfred Mifsud

Start of the Silly Season

25^th September 2011

The Malta Independent on Sunday

Minister Austin Gatt has kicked off the silly season leading to the next election. This being the penultimate PN organised Independence Day festivities before the next election, the opportunity could not be missed to start the election campaign with arrogance, eternal gratitude and expectations asserting that the PN would stay in government for another 20 years!

Why 20, not 15 or 25, is hard to fathom but really it is meaningless as what matters in politics, where a week could be a long time (ask Mubarak, Ben Ali and Gaddafi) is whether the local electorate, which was forced to resist political change in the last two elections by the EU/ Alfred Sant factor, will still reserve inhibitions to go for the change it is naturally hoping for, now that the EU/Alfred Sant factor is no longer there.

In political campaigning, as in war, truth is the first victim. And the truth is that Minister Gatt has no predictive power to say who will win the next election let alone the three after that.

In truth, the PN campaign had started softly quite a few months ago when in tandem with its allies, it started a campaign to try to force Labour leader to move on from pure criticism and to be more forthcoming with detailed policies on how Labour proposes to carry this country forward if it should become the next tenant of Castille post 2012.

Cell after cell in the power network that prefer to have Castille permanently inhabited by the PN leader, have been putting pressure on Muscat to show his hand even though he is not expected to start playing the game for the next 21 months.

Muscat has learnt from the mistakes of his predecessor, who used to delight the PN with detailed policy formulations that could be exploited and turned to their political advantages by a well-equipped PN strategy team. While generic policies have universal application, detailed measures for policy execution invariably have negative effects on certain sectors that can be exploited by political adversaries.

If Alfred Sant had simply said that under his leadership it would be a priority to render the country more competitive internationally, that would not have been controversial and would have carried no political risk. However, explaining that in the pursuit of such objective measures to devalue the national currency (since subsumed into the euro) were to be contemplated opened up a whole plethora of contentious argumentation.

Muscat’s tact in keeping to the general objectives without exposing his hand on particular measures is clearly unnerving the PN strategists who are short of issues to kick up in order to hide the general disappointment of the electorate with their overstay in office.

It is concentrated arrogance to expect the Opposition to explain its policies in detail, which they can only implement in 21 months’ time when the situation could be hugely different from what it presently is, and then government gives no detailed explanation of its here and now policies.

Take the Moody’s credit downgrade. It is clear that the government was not expecting it. The problem is that the government believes its own propaganda and that is very dangerous. Moody’s downgrade is a wakeup call for government to look reality in the face and take measures to address our weaknesses immediately rather than continue to feed the electorate with illusions and distractions.

The government wants us to believe that the budget deficit is nicely floating downwards to 2.88 per cent of GDP this year and public debt is 68.80 per cent of GDP. It seems to believe that itself even though there is manifest evidence that both these figures are unreal, that they are fabricated to hide the unpleasant reality.

Let me start with the annual deficit. Out of the budget we provide about € 17 million Contribution to Treasury Clearance Fund (TCF) Advances. Vote number 7189 for those who want to check it. This means that in the past expenditure was incurred and suspended in the TCF and now this is being amortised annually through the Consolidated Fund. No information on the balance left in the TCF is available anywhere, though the Auditors General Report for 2009 lists €117 million loans to the shipyards which will have to be repaid from the Consolidated Fund. But there are other advances that will never be repaid, such as loans to Freeport, loans to various employees’ foundation and, hold your breath, loans to the Hellenic Republic of Greece under the euro rescue fund agreement. I suspect that other expenditure is going through which is being suspended in the TCF e.g. Air Malta rescue funding. So basically, the deficit in the Consolidated Fund is a managed figure not a real figure. If you take €117 million shipyards loans written off and probably at least another €60 million Air Malta loans that have to be written off plus other exposure, making a total of at least €200 million loans in the TCF to be written off through the consolidated fund, that is three per cent of GDP.

Take the public debt. At 68.8 per cent, it is above the Maastricht 60 per cent criteria, but not worryingly so, and with good housekeeping it could be gradually brought down. But is it real?

According to the latest Auditor General Report for 2009, there are €893 million in bank loans to various public entities which are guaranteed by government. This is up from €774 million in 2008 and €673 million in 2007. The upward trend is indicative that government, in an attempt to keep the official national debt low, has resorted to funding through commercial credit channels against government guarantees. When John Dalli was Minister of Finance, he had declared in a budget speech that this would no longer be tolerated. €893 million is 14 per cent of GDP.

So the figure of 68.8 per cent public debt to GDP is a manufactured figure. Eighty-five per cent would be closer to the truth and we still have to account for expenditure still going on, like the City Gate project, which is not funded through the Consolidated Fund.

You cannot solve a problem unless you admit its existence. We have to accept that the true level of our national debt is more like 85 per cent of GDP and that there is a huge amount exceeding one billion euros (that is one thousand millions) that sooner or later will have to be passed through the Consolidated Fund and reflected in the official national debt.

Taking this reasoning, which a government in denial cannot see but which Moody’s can easily account for, the downgrade should have come as a surprise to no one and the negative watch is a clear warning that unless we are going to take measures to increase the growth potential of our economy, further downgrades are to be expected.

So before indulging in the silly season and before expecting the Opposition to do the government’s job and expose itself to unpopularity with the electorate, who cannot be expected to vote for austerity when the government has been duping itself that all is fine, it would be much better for it to forget the election and do the job it has a duty to do here and now. The election campaign should be no more than five weeks, and that’s a long way away.

Alfred Mifsud

Whither euro? Whither EU?

16^th September 2011

The Malta Independent on Sunday

The euro system is under severe stress. This weekend the EU finance ministers will meet in Poland and they will have a special guest in the person of US Treasury Secretary Tim Geithner. The topic will be whether to continue bailing out Greece or to cut it loose. The cost of bailing out Greece is pretty clear and given its size, quite affordable

The cost of cutting Greece loose is much less certain and Mr Geithner will no doubt sound a stern warning about taking such risks, having been burnt by the Lehman collapse just three years ago; an event that unleashed a financial crisis of global proportions.

Many economists warn that a dirty default of Greece on its sovereign debts will unleash a financial turmoil which will make Lehman look like a walk in the park.

A lot is at stake this weekend. The existence of the euro, the sustainability of the EU in its current format and the endowment of 60 post-war years of free trade, political cooperation and economic well-being in peace and prosperity is what is at stake. If politicians stick to their introspection and forego their wider pan-EU responsibilities, we are doomed. Markets will not wait and will take cover wherever they can seek it if they perceive that EU leaders and national politicians cannot agree how to put out the fire inside the Euro house. Investors will stampede to run out of the small door and consequences would be unpleasant, possibly disastrous.

I have been writing about this for two-and-a-half years now. On 13 February 2009, I wrote in my erstwhile Friday Column an op-ed titled ‘Will the euro survive?’. Many thought I had lost it, asking questions that should not be asked. On 10 June 2010, I wrote a piece titled ‘Plan C for the euro’.

I asked: “So what future is in store for the euro? Plan A, built on hope rather than realistic expectations, sees austerity in errant countries bringing order for the euro to continue as it did during its first decade of existence. Plan B is just to muddle through somehow from crisis to crisis as the austerity measures cause instability and greater disharmony within the euro club. The ECB had better think of a Plan C!”

We have tried Plan A. It has not worked. Democracy has a limit on how many rounds of austerity it can accept without blowing up before it delivers the intended benefits. The risk starts taking shape that under crushing sequential rounds of austerity, democracy elects demagogues bent on sowing anarchy.

Plan B is also not working. Only last 21 July the terms of the second Greece bailout were approved and here we are again. Not only the market judged that what was agreed then was insufficient but the EU has severe problems even to implement what was agreed. Netherlands wants the creation of an EU budget Tsar as a condition to approve the deal. Finland wants collateral security which if given would force default on Greece through infringement of negative pledge clauses in its sovereign bonds. The German constitutional court insists that each disbursement has to be approved by parliament. The Slovakia government coalition will table a deal for parliamentary approval only after all others have approved it in the clear hope that someone else will abort it before as it is doubtful whether the Slovak government coalition can stay together to vote the deal through. Greece itself is falling behind in its privatisation schedule and tax collection plan on which the deal is conditional.

Faced with this indecision, the markets are solidifying their opinion that in the EU there are many leaders but really no one is in charge. The markets are demanding catharsis and they are demanding it now. Chancellor Merkel can fool herself thinking that she will not be bullied by the markets but she would be well advised to consult James Carville, President Clinton’s advisor, who famously articulated how he was stunned by the power the bond market had over governments: “I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everyone.”

So what Plan C can the EU leaders put together over the next weekend to give the market the catharsis it is demanding?

Before answering this crucial question it is worth considering what the default position would be if no Plan C is reached. A dirty Greek default on its sovereign debt will set in motion a chain reaction which could force many EU banks into bankruptcy leading to their nationalisation. Investors hurt by Greece’s default will shun sovereign exposure to other EU governments perceived in distress, including Italy, Spain and maybe France. These countries would find it difficult or prohibitively expensive to borrow to recapitalise their banks so that financial confusion will be the norm, leading to gummed up financial markets and to breakdown of the euro as the problems would be too big for the ECB to handle. When a tsunami hits, even solid buildings cannot stand in its way.

The break-up of the euro will force countries back to their domestic currencies, or to much smaller currency groupings (e.g. Germany, Austria, Finland and Netherlands). Such currencies will shoot up in value rendering exports uncompetitive just as most of the markets of countries in distress disappear through devaluation of their domestic currencies, trade barriers or outright reduction in demand caused by the financial collapse. Unemployment and consequent social unrest will bring back memories of the great depression of the 30s.

Can the EU survive in such a scenario? I doubt it. The risk of 60 years of post-war cooperation being flushed down the drain should not be under-estimated. Wars will re-enter the European dictionary. From trade wars, to economic wars, to cold wars and God forbid military wars. Countries in distress will inevitably form alliances with existing or upcoming super-powers. China and/or Russia will forge strategic alliance with some countries in distress putting Europe back to a cold war scenario.

This stark reality must be borne in mind by European leaders as they make their choices this weekend. Chancellor Merkel in particular would do well to read a research published this week by UBS top economists where they estimate that the cost of bailing out Greece, Ireland and Portugal together would amount to a little over €1,000 per person in a single hit, whereas the break-up of the euro will cost a single hit of between €9,500 to €11,500 per person and an annual hit of between €3,000 to €4,000 per person.

So what Plan C can EU leaders put together? Given the problem in getting any fiscal measure approved by 27 or 17 national parliaments, in order to remain within the realms of practicality, the solution will have to be spearheaded by the ECB as a monetary measure. The ECB is the only pan-EU organisation that can act autonomously with a speed to match the market.

The ECB has these choices:

•       Continue acting as the bond buyer of the last resort for countries in distress. This is okay as a temporary measure but it offers no long-term solution as persistence will render the ECB, supposedly an anchor of solidity, as a mega bad bank where sovereigns borrow cheaply to avoid market discipline. This apart, even this temporary measure has already created deep divisions inside the ECB with resignation of two prominent German exponents from the governing council. It is not healthy to have an ECB divorced so drastically from the old Bundesbank tradition.

•       Fund a substantial bank rescue operation on the basis of the US TARP programme, to recapitalise the EU banks which take a hit on their capital by marking sovereign bonds to market.

•       Concurrently with such bank rescue, organise a voluntary debt exchange mechanism to offer deep haircuts to sovereigns in distress on their debt exposure to give an incentive of light at the end of the tunnel for persisting with the austerity of adjustment policies to restore their competitiveness.

•       Loosen monetary policy, if necessary through quantitative easing measures, to keep markets liquid as well as to reduce the overvaluation of the euro on the foreign exchange markets in order to render EU products more competitive with the rest of the world, especially the US and China.

•       Renegotiate the euro rules to create the EU Budget tsar that will give substance to enhanced discipline of the Stability and Growth Pact.

•       Start a political process for an EU treaty change leading to an EU Treasury, co-ordinated fiscal policy and eventually the launch of eurobonds to replace separate sovereign borrowings.

This might not be a perfect recipe but any real lasting solution cannot wander too far from it.

Alfred Mifsud