MacroScope

A change of tack

Today sees the release of the European Commission’s annual review of its members’ economic and debt-cutting policies. It’s a big moment.

This is the point at which we get confirmation that France, Spain, Slovenia and others will be given more time to get their budget deficits down to target. We already know that France will get an extra two years, while Spain will get another two extra years (to 2016) to bring back its deficit below 3 percent. That comes on top of the 1-year leeway given last year.

This is the austerity versus growth debate in action. But let’s be clear, whatever the rhetoric, this is anything but an end to austerity. What it is, is an invitation to cut more slowly for longer. And in return, there will be extra pressure to press ahead with structural reforms to make economies more competitive and help create jobs. Spain already has, France has barely started and it is there that a lot of the concern rests. If Europe’s second largest economy fails to revitalize itself it will be a big blow to the EU project and further erode France’s political ability to drive it in tandem with Germany.

The European Commission is likely to ask France to tackle its labour laws which makes it difficult to fire someone on a permanent contract, making employers reluctant to hire. It also has the highest minimum wage in Europe and will be asked to open up closed professions like taxi drivers, the legal professions and the health sector, and allow competition into railways and electricity. Paris is under internal pressure too. Yesterday its central bank governor, Christian Noyer, said it must cut public spending after Standard & Poor’s declared that a further rating downgrade was probable absent further deficit-cutting measures – this at a time when the economy has just slid back into recession. Noyer also said it was inevitable that the French would have to work longer. That adds up to something of a perfect storm for a Socialist government already facing stiff opposition from its allies.

Outside the euro zone, Brussels could announce that Hungary can exit its excessive deficit procedure, which would be another political coup for Prime Minister Viktor Orban and his unorthodox policy approach. Budapest is working on a standback on the apparent success of Orbanomics, defying all expectations. The man he appointed to run the  central bank will hold a news conference on his plans to boost growth. Yesterday, he and his colleagues cut interest rates for the 10th consecutive month and flagged more to come.

Why a German exit from the euro zone would be disastrous – even for Germany

Let’s face it: “Gerxit” doesn’t roll of the tongue nearly as smoothly as a “Grexit” did. While Europe continues to struggle economically, fears of a euro zone break-up have receded rapidly following bailouts of Greece and Cyprus linked to their troubled banking sectors.

Mounting anti-integration sentiment in some of region’s largest economies, raise concerns about whether the divisive monetary union will hold together in the long run. Indeed, the rise of an anti-Europe party in Germany begs the question of what would happen if one of the continent’s richer nations decided to abandon the 14-year old common currency. Never mind that, viewed broadly, the continent’s banking debacle has actual saved Germans money so far.

Billionaire financier George Soros, has argued that Germany should either accept a closer fiscal union with its peers, including so-called debt mutualization – the issuance of a common Eurobond – or give up on the euro. Hans-Werner Sinn, head of Germany’s influential Ifo Institute, strongly disagrees, blaming the crisis on southern Europe’s “loss of competitiveness.”

Greek bond rebound masks stark economic reality

Ten-year Greek government bond yields tumbled to their lowest in nearly three years one day after Fitch upgraded the country’s sovereign credit ratings.

Borrowing costs fell to 8.21 percent – the lowest since June 2010, just after Greece received a bailout from the International Monetary Fund and European Union. The difference between 10- and 30-year yields was also at its least negative since that time.

The move comes after Fitch Ratings raised Greece to B-minus from CCC citing a rebalancing of the economy and progress in eliminating its fiscal and current account deficits that have reduced the risk of a euro zone exit.

There is no sovereign debt crisis in Europe

Evidence that Europe’s austerity policies are not working was in ample supply this morning. The euro zone as a whole is now in its longest recession since the start of monetary union. France has succumbed to the region’s retrenchment. Italy’s GDP slump is now the lengthiest on record. And Greece, still in depression, shrank another 5.3 percent in the first quarter.

To understand why this is happening, Brown University professor Mark Blyth says it is necessary to forget everything you think you know about the euro zone crisis. The monetary union’s troubles are not, as often depicted, the result of runaway spending by bloated, profligate states that are finally being forced to pay the piper. Instead, argues Blyth, it is merely a sequel to the U.S. financial meltdown that started, like its American counterpart, with dangerously-indebted risk-taking on the part of a super-sized banking sector.

In a new book entitled “Austerity: The history of a dangerous idea,” Blythe writes that sovereign budgets have come under strain primarily because taxpayers of various nations have been forced to shoulder the burden of failed banking systems.

Finally, an Italian government

A weekend packed with action to reflect on with more to come.

Top of the list was the formation (finally) of an Italian coalition government. Market reaction is likely to be positive, although Italian assets rallied last week, and today’s auction of up to 6 billion euros of five- and 10-year bonds should continue this year’s trend of being snapped up by investors. Italian bond futures have opened about a third of a point higher.

Prime Minister Enrico Letto will seek a vote of confidence in parliament at 1300 GMT, which presumably should go without a hitch. But a coalition with the centre-left and Silvio Berlusconi does not necessarily look like a recipe for smooth government. It is quite possible that the leftward part of the centre-left will find it too hard to stomach, eventually leading to a split. Letta is expected to try to pass at least a few basic reforms quickly including a change to Italy’s much criticised electoral laws and a cut in the size of parliament

As far as the markets are concerned, there shouldn’t be any nerve-jangling economic policy shocks although Letta has said debt-cutting is self-defeating. New economy minister Fabrizio Saccomanni said on Sunday he plans to cut taxes and public spending and lower borrowing costs. The rhetoric may have shifted but the reality for the euro zone’s high debtors is many more years of pain to come. But it’s probably true that more emphasis will now be placed on structural reforms.

German ghost of inflations past haunting European stability: Posen

“Reality is sticky.” That was the core of Adam Posen’s message to German policymakers on their home turf, at a recent conference in Berlin.

What did the former UK Monetary Policy Committee member mean? Quite simply, that the types of structural economic changes that Germany has been pushing on the euro zone are not only destructive but also bound to fail, at least if history is any guide.

Posen, who now heads the Peterson Institute for International Economics in Washington, argued Germany’s imposition of austerity on Europe’s battered periphery is the product of an instinctive but misguided fear of an inflation “ghost” that has haunted the country since the hyperinflationary spurt of the Weimar Republic in the 1920s and 1930s. However, Posen offers a convincing account of modern economic history that shows inflation episodes are rather rare events associated with major political and institutional meltdown — and not always around the corner.

from The Great Debate:

The year ahead in the euro zone: Lower risks, same problems

Financial conditions in the euro zone have significantly improved since the summer, when euro zone risks peaked because of German policymakers’ open consideration of a Greek exit, and the sovereign spreads of Italy and Spain reached new heights. The day before European Central Bank President Mario Draghi’s famous speech in London in which he announced that the ECB would do “whatever it takes” to save the euro, bond yields in Spain and Italy were at 7.75 percent and 6.75 percent, respectively, and rising. When the ECB announced its outright monetary transactions (OMT) bond-buying program, the euro zone was at risk of a collapse.

Since then, risks have abated significantly, thanks to a number of factors:

    The ECB’s OMT has been incredibly successful in reducing the risks of breakup, redenomination and a liquidity/rollover crisis in the public debt markets of Spain and Italy. Although the ECB has yet to spend a single additional euro to buy the bonds of Spain and Italy, both short-term and longer-term sovereign spreads against German bonds have fallen substantially. Following a number of political and legal hurdles, the successful operational start of the European Stability Mechanism (ESM) rescue fund provides the euro zone with another €500 billion of official resources to backstop banks and sovereigns in the euro zone periphery, on top of the leftover funds of its predecessor, the European Financial Stability Facility (EFSF). Realizing that a monetary union is not viable without deeper integration, euro zone leaders have proposed a banking union, a fiscal union, an economic union and, eventually, a political union. The last is necessary to resolve any issue of democratic legitimacy that might result from national states transferring power from national governments to EU- or euro zone-wide institutions. This transfer of power also would have to involve the creation of such institutions to ensure solidarity and risk-sharing are developed in the banking, fiscal and economic unions. The open talk in the summer by some German authorities about an exit option for Greece has turned into a tentative willingness to prevent and postpone such an exit. There are several reasons for this. First, Greece has done some austerity and reforms in spite of a deepening recession, and the current coalition is holding up. Second, an orderly exit of Greece is impossible until Spain and Italy are successfully isolated. Such an exit would lead to massive contagion, which would hurt not only the euro zone periphery but also the core, given extensive trade and financial links. Third, an economic disaster in Greece would be damaging to the CDU Party’s chances of winning the German elections. Thus, even when Greece inevitably underperforms on its policy commitments, Germany and the troika (the IMF, EU and ECB) will hold their noses and keep the funds flowing as long as the current coalition holds up.

Given these developments, the risk of a Greek exit in 2013 has been significantly reduced, even if the risk of an eventual Greek exit from the euro zone is still high, close to 50 percent by my estimation. Meanwhile, the narrowing of Spanish and Italian sovereign spreads has significantly diminished the risk that either country will fully lose market access and be forced to undergo a full troika bailout like Greece, Portugal and Ireland. Both Spain and Italy may in 2013 opt for a memorandum of understanding (MoU) that opens the taps of ESM and OMT support, but such official financing would inspire confidence as it would not be associated with rising, unsustainable spreads and a loss of market access.

While there is a much lower likelihood of disorderly events in the euro zone, there are still significant obstacles to deeper integration, as well as country-specific economic and political vulnerabilities. The biggest obstacle to the formation of a banking, fiscal, economic and political union is that Germany is pushing back against the time line for action, with the initial skirmish on ECB supervision of euro zone banks. This backpedaling reflects deep German skepticism on whether the resolution of the euro zone crisis requires a move toward greater union. Without a more credible commitment to austerity and reforms from euro zone periphery countries, lurching forward would imply that risk-sharing will turn into a large, long-term transfer union, which is unacceptable to Germany and the core. Thus, Germany will do whatever is necessary to delay the integration process, at least until after elections in fall 2013.

Mario and Angela — the euro zone’s pivotal pair

European Central Bank chief Mario Draghi and Germany’s Angela Merkel – the two most important people in the euro zone debt crisis response – take to the stage today, the former giving lengthy testimony in the European Parliament, the latter holding a news conference with foreign journalists.

With Greece sorted out for now, Spain and Italy fully funded for the year and markets simmering down, the crisis is in abeyance, in no small part thanks to these two. Draghi provided the game changer with the ECB’s bond-buying plan late in the summer but Merkel has shifted profoundly too during the course of the year – most crucially from considering a Greek euro exit might be a good thing “pour encourager les autres” to realizing it would be a disaster and acting to rule it out and also in backing Draghi’s bold move and ignoring a large measure of German disquiet.

Germany continues to go-slow on future steps, at least in part largely for domestic political reasons, but look where we are now – with an ECB prepared to act in a way that horrifies the Bundesbank, a permanent euro zone rescue fund, a banking union in progress and multiple bailouts agreed and help for Spain likely to come soon – and it’s remarkable to see how far Berlin has moved.

Greek bailout deal tantalisingly close

The Greek bond buyback has fallen a little short, leaving Athens and its lenders to plug a 450 million euro hole. The euro zone and IMF had given Greece 10 billion euros to buy back enough debt at a sharp discount so that it could retire 20 billion euros worth of bonds and knock that amount off its debt pile. Without that, the deal to start bailout loans flowing to Athens again would fall through.

Due to the discount working out slightly more generously than expected, Greece fell slightly short but it’s impossible to believe the currency bloc will throw itself back into turmoil over a few hundred million euros. Athens will confirm the state of play this morning. One source said German “bad banks” had not tendered most of their holdings and could be tapped again. A solution will be found and probably in time for the EU leaders’ summit on Thursday and Friday. IMF chief Christine Lagarde came close to saying as much last night, welcoming the bond buyback and leaving the loose ends to the Europeans.

More preparatory work for the summit gets underway today with EU finance ministers meeting to try and bridge a gap over plans to regulate euro zone banks cross-border – part one of building a banking union. The European Central Bank is set to be the overarching regulator but Germany wants its scope severely constrained, while others want it to be able to intervene in any euro zone bank, at least in theory. This does not have the power of Greece or Italy to move markets but an inability to agree on the least contentious part of a banking union would not send a good signal.

Italy gives new bite to euro zone crisis

Don’t start putting out the tinsel yet. Just when we thought we had a smooth glide path into Christmas the euro zone has bitten back.

Over the weekend, Italy’s Mario Monti called Silvio Berlusconi’s bluff and said he was pulling the government down which will mean early elections in February. The budget bill will be passed and then the country will be in a potentially precarious state of limbo as parliament is dissolved. Italian bond futures have opened more than a point lower, which denotes a reasonable measure of alarm, although the safe haven Bund future has only edged up so we’re far from panic mode.

The big question is whether a government results that will stick to Monti’s agenda and whether he himself will have a prominent role to play in the administration. There are constitutional difficulties to keeping Monti as prime minister since he has said he would not stand at the election, though he has also said he would be prepared to step in again if no stable government is formed. Most likely, presuming a government is elected that supports his reforms, is that he will play a key role but not take the top job.