JPMorgan Explains Why There Is No Deus (gr)Ex Machina For Europe
Just because there aren't enough traumatizing events in the next week to look forward to, the market has already set its sights on the next "big" (let down) event in Europe - the EU summit on June 28/29, which will only benefit just one class - Belgian caterers. But for some odd reason there is hope that Europe will, miraculously and magically, after years of failing at this, come to some understanding over either Eurobonds, a fiscal union, a deposit insurance, banking union, or some or all of the above (expect many daily rumors regarding any of the above to incite small but violent EUR and ES short covering rallies). However, as we have been observing for the past 3 years, and as David Einhorn summarized visually, nothing will come out of this latest summit. JPM explains why the one thing that can save Europe is a non-starter, and will be for years.
From JPM's David Mackie:
Consider Eurobonds as an example. In theory, it would be possible to create a system whereby a centralised debt management agency issued joint and severally guaranteed debt and then allocated funding to national governments. The size of the allocation and the interest rate would depend on an agreed path of fiscal and structural reform. To the extent that sovereigns deviated from the agreed path, the borrowing cost would go up. So far, so easy. But, there are a myriad of practical problems, in addition to the key issue of how the debt management agency would make its decisions. Government deficits and debt are a reflection of many things:
- the size of the public sector,
- the generosity of public sector remuneration,
- the efficiency of public administration,
- the generosity of the welfare system
- and the extent of tax evasion.
The differences across Euro area countries regarding all of these things are huge. How they are dealt with is a monumental task.
And so on. Good luck to all those hopeful that absent a full-blown market collapse, and EURUSD trading sub parity, both of which are precisely what Germany wants, needs and will get, European countries will hand over their sovereignty to Germany.
Ironically, only by crashing and burning, can the market be fixed.
Ful JPM note:
Starting to think about the EU summit on June 28/29
One way of framing the Euro area debate ahead of the EU summit on June 28/29 is to consider the trade-off between national sovereignty and burden sharing. Sovereignty relates to fiscal, banking and structural policies. Burden sharing, meanwhile, can be either explicit (fiscal transfers, debt forgiveness, areawide bank recapitalisation) or contingent (Eurobonds, areawide bank deposit insurance).
The original Maastricht vision put the region at almost one extreme of this trade off: significant national sovereignty in all areas except monetary policy, but no burden sharing. For non program countries, the past two years has seen little movement along this trade off. Sovereigns are still expected to reduce their debt to 60% of GDP—what might be viewed as an equilibrium level of leverage for sovereign debt with credit risk—via national austerity at market rates, and the burden of bank losses is still contained within the nation state. For program countries, there has been more movement along the trade off, albeit on a temporary basis: adjustments are being cushioned by long term loans at concessional interest rates, which represent a limited form of burden sharing, and there has been some decline in national sovereignty for the duration of the programs. Meanwhile, the internal current account adjustments remain the responsibility of individual countries, albeit cushioned for both program and non program countries by low cost ECB loans to banks and Target 2.
It now seems clear to pretty much everyone that the approach of the past two years has run into a dead end. This is not because the region is unable to buy enough time. Although fiscally based liquidity hospitals (EFSF/ESM) are limited by the market’s appetite for their debt, and monetary based liquidity hospitals (SMP) are limited by concerns about subordination, the region could build a huge hybrid liquidity hospital if the ECB were willing to fund the ESM. Rather the dead end is because the burden of adjustment—the combined impact of sovereign and bank deleveraging and real exchange rate adjustment—is too much for some individual sovereigns to bear.
Given recent developments, it is not surprising that is it now widely agreed that the region needs to move towards greater burden sharing. The real disagreements regard the quid pro quo in terms of national sovereignty—how much sovereignty has to be given up—and what is the sequencing. Germany thinks that a lot of sovereignty has to be conceded over time with burden sharing coming at the end of the process. German concerns about sequencing are not just about who bears the burden, but also about the fact that premature burden sharing tends to impede fiscal, banking and structural adjustments rather than facilitate them. Other countries in the region have different views.
The challenge for the EU summit on June 28/29 is to agree on a path to a significantly different position in the trade off between national sovereignty and burden sharing, in a manner which ensures that the right incentives for appropriate fiscal, banking and structural adjustments remain in place. This is not going to be easy.
Consider Eurobonds as an example. In theory, it would be possible to create a system whereby a centralised debt management agency issued joint and severally guaranteed debt and then allocated funding to national governments. The size of the allocation and the interest rate would depend on an agreed path of fiscal and structural reform. To the extent that sovereigns deviated from the agreed path, the borrowing cost would go up. So far, so easy. But, there are a myriad of practical problems, in addition to the key issue of how the debt management agency would make its decisions. Government deficits and debt are a reflection of many things: the size of the public sector, the generosity of public sector remuneration, the efficiency of public administration, the generosity of the welfare system and the extent of tax evasion. The differences across Euro area countries regarding all of these things are huge. How they are dealt with is a monumental task. Also, there is the issue of how lower levels of government try and avoid hard budget constraints created by higher levels of government: borrowing by entities outside the general government sector, borrowing from local banks, forms of financial engineering, the build up of arrears, the provision of explicit or implicit guarantees. Again, there are many differences across the Euro area. Another key issue is whether a move to Eurobonds also requires a much bigger system of fiscal transfers. State governments in the US face a hard budget constraint which seems to work. But this is not only due to the credibility of the no bailout threat from the federal government, and the political sanctions regarding the balanced budget rules in state constitutions, but also the much more extensive system of fiscal transfers from the federal level.
But, agreeing on a path to burden sharing in the form of a fiscal and banking union is not enough to change the region's growth trajectory over the coming years. The challenge of getting sovereign debt to 60% of GDP is not only about the sovereign’s marginal borrowing cost. It is also about the size of fiscal deficits and the level of outstanding debt. In our view, the benefit of a move to Eurobonds is not just about lowering the marginal borrowing cost for peripheral sovereigns. It is also about increasing the equilibrium level of leverage for peripheral sovereigns, which would enable a less aggressive fiscal objective to be adopted. Confidence would surely be lifted by an agreement on a credible path, but if the region sticks with the current fiscal objective of getting debt down to 60% of GDP, then growth is likely to be lacklustre over the coming years even with the prospect of greater burden sharing down the road, unless monetary policy is able to deliver a significant and sustained boost to growth.