Last week, Zero Hedge first brought to readers the infamous UBS report, which has since made the global rounds, and which essentially laid out the binomial tree for Eurozone survival as follows: either the EUR survives, or we get Civil war. In keeping with the schizophrenia of the TBTF banks whose number one goal is to cover their ass by predicting the two opposite possible outcomes, so as to avoid being sued by sovereigns once the dominos start falling, here is the firm's much respected economist George Magnus, who in his latest release of "By George", does a comprehensive framing of the agenda in the Eurozone. His conclusions: don't believe the European bureaucrat PhDs - there is much more here than meets the eye. To wit: "The dilemma over where to draw the lines between integration and sovereignty lies at the core of the fiscal union debate. The policy agenda has to recognise this, and not assume that fiscal union, one way or another, is eventually a ‘gimme’, even though logic would say it should be. Parallel to the logic are the politics and vested interests, the German Constitutional Court notwithstanding, which say fiscal union only one theoretical outcome, and maybe a long shot. Most likely, the political limits to fiscal integration have not yet been reached, but if there are further moves towards but not reaching this goal, they will most certainly be on German, and therefore, limited, terms. We may conclude that while the Euro system is not about to break up, its viability as it stands is far from assured." Maybe not "about" - give it a few weeks though...
From George Magnus:
Framing the agenda in the Eurozone: bank recapitalisation, and sovereignty issues
In the Eurozone, it is hard to keep track of the moving parts, which include:
- faltering economic growth in the core and recession in the periphery
- stressed bank liquidity and funding markets, and total reliance on a reluctant and split ECB to purchase sovereign bonds so as to prevent contagion
- parliamentary approval of the redesign of the EFSF, and possible changes to economic governance allowing existing institutions to play a stronger crisis management role
- the terms of the IMF’s next loan tranche to a non-compliant Greece, the Finns’ demands for adequate collateral, the implementation of the Greek debt swap terms, and how and when a Greek default might be managed.
Agreement to address any of these issues satisfactorily will likely influence the chances of success in others. And vice versa. In the event of the former, Eurodenominated asset markets would undoubtedly squeeze sharply higher, and yield spreads lower.
But, as before, these rallies will fade unless Eurozone policy makers reformulate the policy agenda. The tools and techniques of sovereign debt crisis management, whether by the ECB, the EFSF or any other institution won’t substitute for the failure to see the crisis for what it is.
The immediate problem, which policy makers have been unable or unwilling to address successfully, is the negative feedback loop between diminishing sovereign creditworthiness and weak, undercapitalised banks. Improving sovereign credit through austerity is a long process, and, in any case, hard to pull off in recessionary conditions and when all one’s major economic partners are also in austerity mode. It is also accepted now, if grudgingly, that debt relief and restructuring are essential to that improvement process. But that emphasises the circuit breaker even more forcefully.
To break the loop, significant and mandatory bank re-capitalisation is required, as recently stated by Christine Lagarde, and in short order. Ideally, the EFSF would perform this task, as envisaged by Heads of State at their summit on 21st July. Even if the EFSF redesign is approved by all 17 parliaments by the end of September, its limited financial capacity is widely acknowledged, and boosting this would become the next urgent task.
Several proposals are circulating as to how this might be done without having to ask all the sovereign shareholders to cough up more money or collateral up front, though most involve further complex negotiations to redesign the EFSF further. Assuming there is time to do it, one of the more interesting is based on turning the EFSF into a bank, with access to the ECB, and the ability to leverage up its resources considerably (see, August 2011: What to do when the euro crisis reaches the core, Daniel Gros and Thomas Mayer, Centre for European Policy Studies, 18th August 2011).
But if, for one reason or another, bank recapitalisation doesn’t happen or is inadequate, it is hard to see how the negative feedback loop can be broken. And if European policy makers prove unable or unwilling in this regard, and the Eurozone debt crisis becomes more intense and damaging, what then? In a thoughtful piece, published recently in the Financial Times, it was suggested that the US, the IMF and China would all have strong vested interests to come to the rescue of the Eurozone, embarrassing as it would be for its leaders (It is Time for outsiders to save the single currency, Barry Eichengreen et al, Financial Times, 5th September 2011).
Bank recapitalisation is the most important tool/technique that needs to be implemented, but this still leaves open the related but more structural problem, which is to how to provide a lasting solution that fills the chasm between the interconnected financing needs of sovereigns and banks, and the inadequate amounts available from private lenders. As an example, the reason Italy has found itself in trouble this year is not only because of contagion shock, but also because its current account deficit has been widening steadily all year (4% GDP, and 7% GDP annualised over the last 6 months), creating the demand for larger capital inflows, at a time when lenders are backing away from the periphery of Europe.
It’s a small part of Europe’s imbalances problem, and policy makers find it hard to talk about systemic problems, not least because a smoothly functioning Euro system now requires even higher levels of economic and fiscal integration, which intrude uncomfortably into the sovereignty of both creditors and debtors. Creditors are becoming increasingly powerful and assertive and debtors too are at serious risk of becoming austerity-weary, while already anxious about ceding more sovereignty to creditors and European institutions. Germany’s dominance in the Eurozone as the biggest economy and strongest creditor, makes last week’s strong judgement issued by the German Constitutional Court last week, all the more telling. The ruling, which dismissed the plaintiffs’ case, insisted, nevertheless that the sovereignty of the German state cannot be subsumed by or handed over to any third party, permanent institution, such as the EFSF’s successor from 2013, the European Stability Mechanism, or, for that matter to the proposed issuing authority of any future E-bond scheme.
The dilemma over where to draw the lines between integration and sovereignty lies at the core of the fiscal union debate. The policy agenda has to recognise this, and not assume that fiscal union, one way or another, is eventually a ‘gimme’, even though logic would say it should be. Parallel to the logic are the politics and vested interests, the German Constitutional Court notwithstanding, which say fiscal union only one theoretical outcome, and maybe a long shot. Most likely, the political limits to fiscal integration have not yet been reached, but if there are further moves towards but not reaching this goal, they will most certainly be on German, and therefore, limited, terms. We may conclude that while the Euro system is not about to break up, its viability as it stands is far from assured.