The Great Debate UK

Geithner’s fudge won’t kill the euro zone debt Ouroboros

The frosty reception given to US Treasury Secretary Timothy Geithner at the ECOFIN meeting in Poland last week tells you all you need to know about what is wrong with the EU. The hostility was directed not at the feebleness of the advice he had to give, but at the right of an American passport-holder to offer any advice at all to the policymaking elite of Europe, who are so obviously capable of handling the crisis themselves without any outside assistance.

As far as I can tell, Geithner’s proposal amounts to leveraging the EFSF so that it can be inflated to a level sufficient to assure the markets that it has the resources to do the enormous job it has been given: bailing out Greece, Ireland, Portugal,  Spain, probably Italy and maybe even France at some point.

So, as ever, the American solution to the problem of excess leverage is… even more leverage. Financial wizardry is what Europe needs now – after all, it worked so well last time around… Risks? What risks? The additional borrowing will be guaranteed by the ECB, whose credit is cast-iron, so problem solved. Why did it take them so long to come up with an answer? If only it were so easy. Ask yourself: why is the ECB so creditworthy in the first place?

Not, in the final analysis, because its borrowing is backed by the governments of Greece or Portugal or Spain or Italy, nor even because it is backed by the Netherlands or Finland – however fiscally responsible they may be, they are simply too small to stand behind Europe’s central bank. In a crunch (and if we ever doubted that crunches happen, we know now that they do) even French support could be inadequate, given that it is currently running a sizeable budget deficit and faces a presidential election in a few months.

No: there are two meaningful levels of support that give the ECB its pristine credit status.

Firstly, the backing of the German government was, until recently, enough to preserve the ECB’s status as Son of Bundesbank. The trouble is that Germany itself has a debt-to-GDP ratio comparable to that of Britain, and the ratio would be a lot higher if it included commitments already made and about to be made to support weaker euro zone member governments. Moreover, even if they still have the capacity to do so, it is hard to see why the Germans would want to shoulder the bailout burden in this barely-camouflaged form when they are apparently so wary of entering into a more explicit transfer union (as they call the nightmare scenario of a Europe in which they are doomed to subsidise everyone else in perpetuity).

There is a second-level backstop for the ECB, and it is the one which I suspect will be called upon in the end. Although it is subject to all sorts of nominal restrictions on its freedom of action to reflect its multinational character, which have served to prevent it ever being free to behave like the Fed, the ECB is ultimately a central bank and, as such, it can always be given the green light to print Euros in whatever quantity is required to pay its debts or simply to cover the cost of more loans. The Geithner proposal amounts essentially to freeing the ECB from some of its existing constraints and preparing it to monetise Europe’s fiscal deficits, a policy similar to that which the Obama Administration itself has pursued vigorously so as to fund massive bailouts of Fannie Mae, Freddie Mac and other basket cases, with results that have been at best extremely mixed.

Ben Bernanke could teach the EU a thing or two

By Kathleen Brooks. The opinions expressed are her own.

Markets thrive on certainty. Anything that smacks of uncertainty, fence-sitting or indecision will lead to market turbulence, as investors punish those who don’t tell them how it is.

This is exactly what we are seeing in Europe right now. The markets are losing patience with the EU’s inability to come up with a credible plan to fight the sovereign debt crisis and that is why it is escalating at an alarming rate.

In general, investors in credit markets are a canny bunch. Bond spreads between Germany and Greece, Ireland, Portugal, Spain and Italy have already blown out, but in recent days spreads between Germany and France, Belgium and even Austria have increased to their widest level for more than two years.

So what does this all mean? In short it suggests that bond investors are going off Europe, even those members who were previously considered safe are no longer out of harm’s way. The credit markets are turning against the political make-up of the currency bloc and until concrete changes are made to the structure of the euro zone the pressure on European credit markets is unlikely to abate.

The various branches of authority in the Eurozone seem to lurch from one crisis to another. Because there is no central voice or authority you end up with a cacophony of voices talking at odds to each other that confuses the markets.

For example, Germany and the ECB continue to play out their differences in public on whether private investors in Greek debt should take a loss. A new low was when the EU President confirmed an emergency summit would be held last Friday, which some member states didn’t even know about.

Trichet’s United States of Europe?

By Kathleen Brooks. The opinions expressed are her own.

Another week another round of EU officials proposing solutions to the Greek insolvency problem.

First there was the President of the European Council Jean Claude Juncker who suggested that bond holders could be tempted into rolling over their maturing debt and buying more Greek bonds as long as a few sweeteners like higher coupon or interest rates were thrown in.

But while this will plug short-term financing needs it is still only adding more debt to Greece’s enormous debt pile and not dealing with the core problem:  the financial malaise at the heart of the euro zone that allowed Greece to get away with a flagrant breach of fiscal rules for years.

It came down to Jean-Claude Trichet, whose tenure as President of the European Central Bank (ECB) comes to an end in October, to suggest a long-term solution that would hopefully avoid another debt crisis, but would also require a degree of economic centrality never imagined by the euro zone’s founding fathers.

His idea is for a euro zone-wide Ministry of Finance that would have three critical powers. Firstly, it would be in charge of ensuring adherence to fiscal and competitiveness policies, secondly, it would control the region’s financial sector and thirdly it would centralise representation of the currency bloc in international financial institutions like the International Monetary Fund (IMF). “Would it be too bold?” the Frenchman shrugged as he spoke of his dream at a ceremony in Germany where he picked up the highly coveted Karlspreis.

While Trichet didn’t go as far as to suggest his ministry should control state budgets or issue debt, it is still an extremely interesting idea that – if implemented – could re-invigorate the currency bloc.  Firstly, fiscal integration is often considered the missing piece of the united Europe puzzle. Without actually controlling states’ revenues and expenditure directly, Trichet’s plan would give the EU direct powers to alter the course of national economic policy. For example the central ministry would have if it thought they could jeopardise the financial health of the member.

Bernanke steps up to scrutiny

-Kathleen Brooks is research director at forex.com. The opinions expressed are her own.-

While ECB head Jean Claude Trichet is nearing his final post-policy decision press conferences – he retires in October – on the 27 April the Fed’s Ben Bernanke will be stepping up to the podium for his first.

This is a massive shift in dynamic for arguably the world’s most important central bank. In the past we have only had the minutes to pore over alongside Fed speeches. But now we get a regular post-policy update along with a Q&A session where journalists can pick the head of the Fed’s brains about one of the most important events for financial markets this year: will the Federal Reserve start to normalise rates.

But investors shouldn’t get too excited. If it is anything like the ECB’s monthly press conference or the Bank of England’s quarterly Inflation Report then it won’t be any more candid than the Fed minutes.

Trichet’s speech is fairly opaque, complete with phrases and signals that hint at what the ECB is thinking, but don’t pin anything down. Likewise, Trichet takes no nonsense during his Q&A sessions. A question from a journalist that requires too direct an answer like: “Is the ECB on a tightening cycle?” is swiftly dismissed with a flick of the President’s hand.

We don’t know how tightly stage-managed Bernanke’s press conferences will be, but due to the importance of the Fed to global financial markets, one can assume the Fed Governor won’t adopt too candid a tone and his opening remarks will be along the lines of the current Fed minutes.

The Fed has to tread carefully. After all, former Fed Governor Alan Greenspan could move the markets based on how full his brief case looked before a meeting.

from MacroScope:

Axel who? ECB gets tough without hardman Weber

When it decided the time was right to crack down on inflation, the European Central Bank did so without the man who is often regarded as its toughest inflation hawk: Bundesbank chief Axel Weber.  The ECB took financial markets by surprise by announcing on Thursday it could raise rates as soon as April -- a decision its policymakers reached without Weber even in the room.

The German, who has appeared isolated at times over the last year because of his staunch commitment to price stability above all else, was absent without leave and did not attend the meeting.

"He's tied up today," a spokesman for the Bundesbank said of Weber, who last month announced he would step down from the central bank a year before his term ended and that he was no longer a candidate to head the ECB when Trichet's term expires in October. Weber said his hardline views were not well received by other decision makers.

The ECB's decision to flag a rate hike took markets completely unawares.

"The position of the Governing Council is that an increase in interest rates at the next meeting is possible," Trichet said in his matter-of-fact style, sending the euro soaring.

Weber made a splash last May when the lone ranger came out swinging against the ECB's decision to start buying government bonds - seen as a breach of protocol in the sanguine central bank which prides itself on unanimity in its decisions.

A new paradigm for inflation

-Kathleen Brooks is research director at forex.com. The opinions expressed are her own.-

Looking through the minutes of the Bank of England’s policy meetings for the past year, there are a couple of patterns that you see emerge. Firstly, that rates are on hold, and secondly, that the UK’s elevated inflation rate is temporary. Now the European Central Bank has joined the chorus. ECB President Trichet recently sounded confident that prices will moderate, even though consumer prices rose above the ECB’s target rate of 2 per cent in December.

But how long will citizens of Europe and the UK accept rising prices and how long can central bankers continue to stand by while inflation smashes their target rates? To answer this we need to find out two things: firstly, is this rise in inflation really that bad? Secondly, why are central bankers willing to let inflation pass them by without exercising monetary control?

Inflation is a tricky thing to get right. A little is good since it helps growth, but not enough is bad as it can stunt an economy and leave it in a deflationary spiral. There is also another benefit to inflation: it helps to erode debt levels in real terms. When many developed economies are struggling with unsustainable debt loads, a little inflation helps to lower the size of the mountain.

But prices are rising at a 3.3 per cent annualised rate in the UK. While the Bank of England rightly points out that this is due to commodity prices, but its assertion that inflation will prove temporary has been incorrect for more than a year.

Commodity super-cycle:

We are in a super-cycle for commodities. Burgeoning demand for food and raw materials from the fast-growing emerging world is set to dominate demand for commodities for the next few years, possibly even for the next generation. This means that people in the west who were used to low prices for most of the last decade will have to get used to coughing up at the supermarket and at the petrol pump for a while yet.

Why we have to support Ireland

– Laurence Copeland is a professor of finance at Cardiff University Business School. The opinions expressed are his own. –

Supporting Ireland to the tune of a few billion quid must look like a no-brainer to the British Government. We should not make the same mistake as the Germans, who managed to get the worst of both worlds over Greece – forced by the scale of their bank exposure to support Greece, but providing the money with ill will, causing bitterness rather than gratitude – and now repeating the error in the Irish case.

Our wonderful British banks are more exposed than those of any euro zone member to the Irish debacle, with, at the front of the queue, the usual suspects: RBS and Lloyds-HBOS, the two big nationalised banks. So the answer to those who ask why we are contributing to the rescue package is that it is nothing more than the latest (and probably not the last) instalment of the cost of the bank bailout.

This is something to remember next time you hear one of the banking sector’s apologists crowing about how little the bailout is actually costing and how great a killing we taxpayers are ultimately going to make on our bank shares – and don’t forget to add in the cost borne by us all as bank customers, with the gap between borrowing and lending rates at their highest level in history.

There are of course other economic reasons for supporting Ireland. As we have been repeatedly reminded in recent days, Ireland is a major market for UK exports, three times as important as China and five times as important as India, so we stand to benefit considerably from a revival in its economy.

But economics is by no means the whole of this story. I have no idea what the Great British Public thinks about the support, though I suspect that, given the deep-rooted links between UK and Ireland, it is moderately sympathetic. But whatever the mood, it does no harm at all in terms of the battle for hearts and minds in Britain to see our PM playing the benefactor to a stricken neighbour, serving at one and the same time to exaggerate the difference between us and Ireland (which, as I have argued in previous blogs, is smaller than most people realise) while simultaneously warning that we ourselves would have been the ones holding out the begging bowl, if the overwhelming majority of the chattering classes, including my professional colleagues, had been able to drag us into the euro zone.

What happens next? Portugal, if it has to be taken into intensive care too, is small enough to be manageable. The nightmare is Spain, which is far too big for anything like the same treatment, or even Italy, which is not far behind and, just to make matters worse, could be facing a period of political instability over the next few months.

Too soon to predict that EMU will wobble

-Jane Foley is research director at Forex.com. The opinions expressed are her own.-

The budget crisis facing the Greek government has drawn an array of comments and responses from various parts of the European Central Bank, the European Commission, the International Monetary Fund and the financial markets.

Academics and economists are also keen to get their pennies worth pointing out that in effect the Greek budget was an accident waiting to happen.  During the early years of the Economic and Monetary Union it was no secret that some members of the system “fudged” their numbers to comply with the budgetary criteria of the Maastricht Treaty.

Such countries should have used the good growth years to initiate structural reform and fiscal restraint which would have promoted a healthy budget.  In the event that they did not it would only take a recession to uncover the cracks that had been papered over.

The opponents of EMU now have their moment.  The recession arrived and countries such as Greece, Spain, Portugal and Ireland found themselves to be in deep water.

The Irish appear to be swallowing the bitter pill of austerity but remarks by the Greek PM last month that Greece was plagued by tax evasion have heightened scepticism over whether Greece can achieve its aim of cutting the budget deficit to 3 percent of GDP by 2012 (from 12.7 percent currently).

So great are the issues in Greece that talk is emerging that the country may have little practical option but to leave EMU.  From an economic point of view there is validity in these arguments.

from Commentaries:

Trichet points to possible double-dip recession in Europe

In his cautious Franglais central-bank speak, Jean-Claude Trichet has pointed to the strong possibility that the euro zone may face a double-dip or W-shaped recession.

Of course, that's not exactly what the European Central Bank president said. But how else are we to interpret his repeated references to a "bumpy road" ahead, and his comment that we are likely to see quarters with positive growth and other quarters with "less flattering" figures? All this was illustrated with a hand gesture that drew a W (or a corrugated iron washboard) rather than a V or a U.

True, he also said a significant contraction in economic activity has come to an end, and may be followed by a very gradual recovery. The ECB staff have lifted their economic forecasts for the 16-nation euro area after Germany and France surprised markets by exiting recession in Q2. The bank is now forecasting 2010 growth in a range from -0.5 to +0.9 percent, compared to its June prediction of -1.0 to +0.4 percent. But Trichet made clear there remains a high degree of uncertainty.

Furthermore, the ECB's only significant policy announcement -- that it will offer banks yet more 12-month liquidity at its basement 1.0 percent refi rate later this month -- was a strong indication that rates are on hold for the next year, coupled with another clear signal that ultra-loose monetary policy would not be withdrawn any time soon. "Today is no time to exit."

Even the ECB's most outspoken inflation hawk, Juergen Stark, is cautioning against any early withdrawal of the monetary stimulus.

The latest growth figures may indeed flatter to deceive. Germany probably only grew in Q2 because the government's cash-for-clunkers handout boosted the auto sector. That scheme ran out at the end of August.

Private consumption in France and Germany has been buoyant because of state-subsidised short-time work programmes that have kept people in jobs despite the collapse in orders. Those schemes expire late this year or early in 2010. In some cases, order books have filled and workers have gone back to full-time jobs. But unemployment is bound to rise over the next year to over 10 percent. That will likely depress consumer spending leaving the euro area's two biggest economies reliant on exports for growth.

Wrong, wrong and wrong again – a response to “Latvia: let the lat go”

- Morten Hansen is a guest columnist, the views expressed are his own. He is head of the economics department at the Stockholm School of Economics in Riga -

The debate for or against a Latvian fixed exchange rate rages on. There are good pieces of analyses on both sides of the debate, there are less good ones, there are mediocre ones – and then there is Jonathan Ford’s “Latvia: let the lat go” from 29 July.

The article does not argue why the lat should be devalued –- fair enough, the arguments have been heard before. Neither does it mention all the potential risks of devaluation such as a currency collapse but I can live with that, too. But an 804-word article that contains no less than 10 – 10! – inaccuracies or outright wrong statements is highly objectionable.

For those who have read Mr. Ford’s article allow me to make comments on these 10 points.

“The central bank has been obliged to raise interest rates” –- no it lowered its refinancing rate from six percent to five percent on 24 March 2009 and to four percent on 24 May. And lat rates are not that important anyway for Latvians as most loans are in euro.

“… a host of non-Latvians … have urged the small Baltic state to cleave to its currency board system”. Latvia operates a fixed exchange rate system that allows the lat to fluctuate at +/- one percent around a parity of 0.702804 LVL/EUR; it is not a currency board. More importantly a host of non-Latvians have recommended devaluation (Nouriel Roubini and Kenneth Rogoff among others), arguing that maintaining the peg is a foreign plot is just plain wrong –- it is actually the Latvian authorities that have demanded this.

“…which pegs the lat at the wildly uncompetitive rate of 0.702804 to the euro”. Proof? I believe myself that the lat is overvalued but I haven’t seen any analysis pointing at it being “wildly uncompetitive”.