Where Does Sovereign Credibility Come From? The European Sitaution

As usual, when Bob Barro of Harvard writes something it usually contains some provocative ideas.  In the Monday morning Wall Street Journal, Barro writes about how Europe might get out of the Euro. (http://professional.wsj.com/article/SB10001424052970203462304577134722056867022.html?mod=ITP_opinion_0&mg=reno-secaucus-wsj)

What interested me most in Barro’s piece was the emphasis he placed on the credibility of the organizations that issue a currency. 

In essence, as I read the article, Barro argues that the credibility of the Euro comes from those within the eurozone that are fiscally sound and carry those that are not fiscally sound, the “free riders”, along with them. 

This credibility is maintained for as long as the “free riders” conduct their irresponsibility within limits.   In fact, this is what the original charter of the eurozone called for…limits to how irresponsible the “free riders” could be.

But, the limits must be enforced.

“Greece…has been increasingly out of control fiscally since the 1970s.  But instead of expulsion, the EU reaction has been to provide a sufficient bailout to deter the country from leaving.” 

The bailouts have become serial, as bailouts have also been given to Portugal, Ireland, Italy, and Spain. 

Thus, the only way credibility can be maintained is for Germany to continue to be fiscally strong while the union continues to provide bailout packages that will carry the “free riders” along for as long as possible.

Meanwhile, the internal effort of the members of the eurozone has been to create a stronger “fiscal” bond within the zone itself…ultimately moving to a “centralized political entity” that will oversee the fiscal and currency policy of the whole eurozone. 

Europe, to achieve such a “centralized political entity”, would have to overcome many, many issues that have existed on the continent for a long time.  For one, the internal rivalries that have existed for centuries would have to be overcome.  Already the resentment against Germany has grown as Germany has become a more demanding partner within the union.  Even statements like “Germany is achieving through economics what it could not achieve militarily at an earlier date” demonstrate some of the underlying emotions that exist on the continent.  Then you have the cultures, languages, and other hurdles to overcome to achieve the needed unity.

Even so, Barro continues, in the shorter run, the credibility of the nations is vitally important because of the sovereign debt that has already been issued by the governments of Europe and that rest on the balance sheets of the banks within the eurozone.  This is the reason there is rush to achieve the near term austerity in the budgets of Italy, Spain,…and France…among others. 

Greek debt is now yielding more than 34 percent on its ten-year bonds.   Portuguese bonds are yielding more than 13 percent.  The debt of Italy is yielding more than 7 percent.  And Spanish bonds are above 5.5 percent.  These rates are unsustainable!

French debt is yielding around 3.5 percent and the rating agencies are soon expected to remove their AAA rating.

The status of this debt is important because, “the issue that has prompted ever-growing official intervention in recent months has been actual and potential losses of value of government bonds of Greece, Italy and so on.  Governments and financial markets worry that these depreciations would lead to bank failures and financial crises in France, Germany, and elsewhere.”

Credibility is lacking because “it is unclear whether Italy and other weak members will be able and willing to meet their long-term euro obligations.” 

Not only is the banking system threatened by this lack of confidence, the uncertainty that exists surrounding the future structure and performance of this area does not contribute to the achievement of stronger economic growth.  If anything, this uncertainty works to reduce growth.

Only as independent nations with their own currencies would these countries be able to meet their own obligations and achieve the credibility a nation needs to function within the global economy.  “This credibility underlay the pre-1999 system in which the bonds of Italy and other eurozone countries were denominated in their own currencies.  The old system was imperfect, but it’s become clear that it was better than the current setup.”

The issue is one of credibility. 

Right now, Germany seems to possess credibility.  But this credibility is based on its maintaining the position of fiscal responsibility it has already achieved.  And, this is just what the Germans seem to be doing. (“Germany Resists Europe’s Plea to Spend More,” http://www.nytimes.com/2012/01/09/business/global/germany-resists-europes-pleas-to-spend-more.html?_r=1&ref=business)  

As long as the current economic structure exists for the eurozone, the credibility of the eurozone will depend upon it’s ability to provide sufficient “band aides” to piggy-back on the credibility of Germany.   My guess is that it will become harder and harder for financial markets to buy-into this piggy-back arrangement. 

Credibility requires the provision of actions that backup promises.  Barro is suggesting that the only way that the fiscally irresponsible will become credible is for them to be “out-on-their-own” again where they will have to be totally responsible for their own actions.  Unless this happens, there is too much historical baggage carried by the eurozone that will not be overcome.      

Italy is the Key in Europe

It seems to be boiling down to this.  Italy and its prime minister Silvio Berlusconi are the evolving focus of any acceptable solution to the European sovereign debt crisis. 

There are, I believe, two reasons for this focus.  First, Italy is the third largest economy in the European Union.  Thus, moving it into the spotlight leapfrogs the problems of Spain and Portugal and others in terms of impact.  If Italy can be “tamed” then Spain, Portugal, and others will have to fall in line.

Second, Italy, within the European Union, is most like Greece in terms of fiscal irresponsibility, governmental patronization, and lackluster economy.  If both Greece and Italy take steps to correct their situations, then other troubled countries can justify stronger efforts to straighten out their problems as well. 

Another factor is that Silvio Berlusconi has become a characterization of European leadership…or the lack thereof…given his personal as well as his public tribulations.  And, this does not include his recent disputes with others, like that with French president Nicolas Sarkozy, over the makeup of the board of the European Central Bank.  Berlusconi, it seems, must be brought into line...even though he is just barely hanging onto power now.  

By focusing on Italy, the European Union is, in a sense, attempting to “get its arms around” the problem.  The EU efforts of the past have started with the smaller countries with the idea of working up the ladder as the need arose to deal with larger and larger countries.

By bringing Italy in at this time, the EU seems to be admitting that the problem is more fundamental than it had assumed in the past and that the problem is one of solvency and not the liquidity of the sovereign debt.  

Furthermore, the EU seems to be saying that more fiscal coordination needs to be achieved within the European Union itself and to gain this coordination, even the larger countries, like Italy, must submit to greater oversight and community discipline than had originally been built into the organization.    

With the crisis, it has become more and more obvious that for the countries of the European Union to really benefit from the creation of a common currency, greater fiscal union must be achieved as well.  Painful as it may be to some to accept this reality, I don’t believe that there is really much support anywhere for the breaking up of the currency union.

The European Union may finally be getting someplace, although I don’t want to be too optimistic.  Up to this point, the EU has just been “kicking the can” down the road.  It has continually avoided the seriousness of the situation; it has not accepted the reality of the solvency issue; and it has attempted to deal with problems piecemeal. 

As a consequence, many analysts have claimed that it would be better for some nations to leave the currency union or for the Euro to be eliminated all together. 

The fact is, the benefits of the currency union have been sufficiently great that the members of the EU really don’t want to see it go away. 

The “big bump in the road”, however, has been the need for sovereign nations to give up some of their sovereignty on the fiscal front, something they have, understandably, been reluctant to give up.  As a consequence, the path to greater fiscal union has been winding and painful.  No one, willingly, wants to look like the pansy.

By putting the pressure on Italy, the European Union is accepting the seriousness of the situation; it is accepting that the primary issue is one of solvency and not liquidity; and it is finally trying to encircle the problems that exist, not deal with them one-by-one.

This does not mean that the crisis in Europe is over.  There are still many “bumps in the road” that must be smoothed over. 

However, to me, putting Italy into the spotlight raises some hope that the officials in Europe (I am not willing to call them “leaders” yet) may finally be moving in the right direction.

Now Back to Europe

Silvio Berlusconi, Italy’s prime minister spoke to the Italian Parliament yesterday about the economic and financial situation facing Italy. 

Mr. Berlusconi “pointed the finger at speculators, global economic weakness and general problems in the eurozone.” (http://www.ft.com/intl/cms/s/0/088747fc-bdf5-11e0-ab9f-00144feabdc0.html#axzz1TyUqwXts) 

These words were an almost exact copy of those issued by the Greek government, the Irish government, and many others from within the eurozone over the past year or two. 

Gotta stay on message…the problem is “out there”!

Now that we have a modest pause in the news coming from the United States concerning sovereign debt and all that, we can return to the European sovereign debt situation…which is far from resolved.

When are people in Europe (remember that there are no leaders in Europe, “In Europe the Issue is Leadership”, http://seekingalpha.com/article/280658-in-europe-the-issue-is-leadership) going to realize that “kicking the can down the road” is not going to get them out of the situation they are in. 

In fact, as southern Europe continues to burn, the banking system in Europe is having to endure greater and greater stress. (See, for example major articles in the New York Times, http://www.nytimes.com/2011/08/04/business/global/europes-banks-struggle-with-weak-bonds.html?ref=business, and the Wall Street Journal, http://professional.wsj.com/article/SB10001424053111903885604576486671709242408.html?mod=ITP_moneyandinvesting_0&mg=reno-secaucus-wsj.) Only very short term loans seem to be available between banks but even these loans require borrowers to pay a premium over similar borrowing costs in the United States. 

The cost of borrowing 10-year money in Italy has now risen above the “crisis” level of 6 percent this week and Spain is now borrowing at interest rates not seen since the creation of the Euro.  Even Belgium and France are facing near term highs in borrowing costs.

As I wrote yesterday, the problem is that there is too much debt outstanding in Europe (and America) both in the private as well as the public sectors.  We, in the Western world, have lived off of the debt idol for too many years (See http://seekingalpha.com/article/284276-the-problem-too-much-debt).    

 How do we determine whether or not there is “too much debt outstanding”? 

In my opinion, an exact answer cannot be given.  We try and measure this by using statistics like government debt to GDP ratios, or, government deficit to GDP ratios, and the like.  But, we are dealing with human beings and ratios like these can only provide hints at debt loads and clues to times when debt burdens become excessive and unsustainable.

When do people start to realize that they have to make decisions about how they allocate their income rather than just keep spending on everything they want?  When do governments realize that they can’t fund every good social cause presented to them?  When do businesses realize that they just can’t continue to raise their return on equity by adding more financial leverage to the balance sheet?

There is no exact answer to these questions.  Economics is not an exact science no matter how much economists like to project this image to the world. 

And, the Keynesians argue that added spending stimulus will cause consumption expenditures to increase and this will get the economy going again, or, incentive for businesses to increase capital investment will get the economy going again.

Keynesian models have never adequately handled the issue of debt and financial leverage.  One reason is that debt levels and financial leverage are not always limiting factors in consumer and business spending.  In fact, during the early stages of a period of credit inflation, the greater availability of debt and financial leverage may have a positive influence on consumer and business spending. 

That is, debt levels and financial leverage may be positive influences on economic activity…before they become a negative influence. 

This is one of the problems in trying to understand human behavior.

But, back to the situation in Europe.  The world has changed.  The old models are not working and new ideas must be introduced into the efforts being made to get control over the crisis. 

Maybe this is not going to happen until the “old guard” of top government officials is replaced by someone new.  Continuing to try and govern using the assumption that the problem is “out there” is not going to work. 

The problem is with the governments and their officials and until this is recognized I don’t see Europe getting its act together. 

And, the longer it takes for the eurozone to get its act together the greater the opportunity for the BRICS and other emerging nations to prosper and overtake the “ancient regime” now governing Europe.

The United States cannot ignore this dilemma for it faces similar problems.  And, the government of the United States is emulating Europe by claiming that the cause of its problems is “out there” and by postponing any real solutions until a later date. 

The world has changed.  As the West went through a philosophical and social change after the Second World War, we are now going through another sizeable and traumatic change.  But, to stick with existing models of the world and, consequently, say that the problems are “out there” will just “kick the can further down the road”.  It will solve little or nothing.

The Focus is on Europe

The recent events in Europe have captured the attention of the world and taken the heat off of China and the value of its currency, the United States and the value of its currency, and financial reform in its various forms.

The focus, in my mind, is going to stay on Europe for a while because that is where the greatest amount of disruption to world financial markets and damage to world economic recovery can take place.

How long will this disruption and damage last?

I continue to recall a piece of advice given several years ago that has never let me down. The advice is this: If you say the problem is ‘out there’, that is the problem! That is, if you blame your problems on everyone else or everything else, your outward facing focus is the problem. Maybe you had better look at what you are doing before you start blaming someone else.

I have found this true in individuals, families, organizations, communities, businesses, and governments.

Right now, Europe is over-run with self-pity blaming speculators and the ‘irrationality’ of markets.

As a consequence, Europe has responded to the difficulties it faces with a grudging move to maintain the liquidity of its financial markets while preserving as much as it can the ‘integrity’ of its economic model. Its leaders are still trying to hold onto their model of the world.

Hence, the blame must be aimed at someone else!

And, that is precisely the problem.

The fundamental problem is that the economic model used by most of Europe is faulty and the current financial problem is one of solvency and not liquidity.

The three primary perpetrators of these fallacies are President Nicolas Sarkozy of France, Jean-Claude Trichet the head of the European Central Bank (French), and Dominique Strauss-Kahn the Managing Director of the International Monetary Fund (also French).

So far, these French leaders have been the winners of the political battles for the heart of the
European Union. So far, international financial markets have given these leaders at least a D- in terms of the plan they have devised to save union.

Where can we find this grade?

The value of the Euro has declined 18% from the middle of December 2009 to this morning.

The German Parliament has voted to support the current ‘bailout’ but throughout Germany discontent is rising concerning the leadership shown by the German Chancellor Angela Merkel. She, more than any other leader within the European Union, seems to be losing her clout.

Chancellor Merkel cannot afford to follow the French leadership.

Germany has established its position within the European Union through its strong economic growth fueled by a very robust export sector. It has also been fiscally prudent and plans to reduce its budget deficit to zero by 2016. The yield on German bonds attests to the belief the international investment community has in the intent and discipline inherent in Germany to sustain these outcomes.

It is these factors, carried over to the whole EU, that have benefitted other nations within the community to the extent that they could live beyond their means and feast off of their association with the Germans.

This, as we have seen, is an unsustainable relationship. Either Germany has to give in and accept fundamental reforms to the European Union that would seriously damage German competitiveness. Or, it has to maintain its discipline and continue to adhere to its fundamental world view.

There is no question as to what I think Germany should do!

Yet, if Germany continues to encourage its competitiveness in European and world markets and maintains its fiscal discipline, others within the European community will either have to emulate them or will have to remove themselves from this union. It seems as if we are at the juncture where there are no other choices. A wishy-washy response at this time will just postpone the outcome.

Of course, the critics of Germany see such a German policy as disastrous. Following the German model of reigning in wages and social benefits and achieving real control over fiscal budgets would result in further dislocation of economic resources in Europe accompanied by social and political upheaval.

The problem is that these other European nations have put themselves into a position where there are no ‘good’ solutions! Years-and-years of profligate living eventually lead to a situation where nothing they can do provides happy answers.

The only thing these loose-living nations can hope for is for time, cause “things will get better in the future!” Yeh, sure!

I don’t know how many times I have heard this response in business and elsewhere. “The market doesn’t understand us!” “All we need is some time and things will work themselves out!” “It’s just that there are some ‘greedy bastards’ out there that want to make money off of our misfortune!”

Europe, your economic model of the world doesn’t work! The only way you are going to really get out of this mess is to change your economic model. Deficits and a lack of social discipline don’t contribute to economic health. But, it is so much easier to blame someone else and following Germany would be a disaster.

There remains a lot to work out in Europe. These issues are not going to go away overnight. How long things remain unsettled there depends upon how quickly people realize that the problems are internal and not a result of “irrational markets” and the greed of speculators. It is very difficult, however, to realize that your model of the world requires modification. Perhaps such change is generational…but, can we wait that long?

Is Germany resisting the "Race to the Bottom" in Europe?

Germany, and Angela Merkel the German Chancellor, clearly lost the battle over the bailout package and the European Central Bank’s move to buy bonds. (See “Where’s the Leadership in Europe, http://seekingalpha.com/article/204702-where-s-the-leadership-in-europe.)


Is Germany and Merkel now trying to stage a “comeback”?

There are certainly signs that Berlin is attempting to re-asset itself in the moves it made on short selling and other complex bond transactions. Furthermore, Merkel is asserting herself into the financial reform debate. At a meeting of the G-20 Thursday: “German Chancellor Angela Merkel said Thursday she will push her Group of 20 counterparts to accelerate steps to tighten political control over financial markets and add new taxes on banks. Ms. Merkel also said she will push G20 leaders to coordinate their strategies as they look to withdraw stimulus measures enacted during the financial crisis.“ (http://online.wsj.com/article/SB10001424052748703559004575256051573932296.html?mod=WSJ_hps_MIDDLEThirdNews.)

Politically, in the German state itself, Merkel needs to exert herself to defend Germany and Germany’s support of a sound fiscal and monetary stance within the European Union. The political feedback to the Chancellor’s position on the bailout was immediate and dramatic. She and her party lost seats. To maintain her coalition, it seems as if she must place herself in a stronger position.

Within the broader picture, however, someone needs to step up in Europe and show some real courage, something that will not be easy. That leadership has been sorely missing and the decline in the Euro to a four-year low just underscores how the market is ‘grading’ the response of the European Union to their current financial crisis. The immediate reaction to the German actions was disappointment in the response of the rest of the Union. There obviously is no unity within the European community.

Yet, the German movement is not without reason.

Someone has to step up to the plate.

Unfortunately, the European Union has tolerated the lack of discipline and incompetence in its member nations for years. As a consequence, there has been a “race to the bottom”; a movement to the lowest common denominator and the recent financial crisis is the result. And, now all members of the European Union are suffering.

Nature does not allow a vacuum to exist for very long in any human association. If the association allows the undisciplined or incapable to dominate, then the performance of the association comes to reflect this bias. Need I present a sports analogy?

The other alternative is for the members of the association to have standards set by the disciplined and capable where a situation can be achieved in which the rising performance of the community is shared by all.

A successful union has enough benefits for all to share. In an unsuccessful union no one is really happy!

In the European Union it seems as if there is no one else to turn to but the Germans for this leadership. It is certainly not going to come from France. France is the epitome of the acceptance of the mediocre. France’s leadership has guided the European Union into the state it is now in. It is not the future.

Will other nations listen to Germany? Will new leadership be established in the European Union?

I’m not sure that the rest of Europe is ready to get ‘disciplined’. There is a lot of ‘mouthing’ of the need for discipline, but are the nations doing this talking ready to change things for the longer term or will they revert to old habits once the immediate crisis is over? Can governments that really ‘tighten up’ be able to be re-elected in Greece, and Spain, and Portugal, and other places? Will other nations in the European Union really stand for German discipline and leadership?

Watch the hips, not the lips!!!

If the nations in the European Union other than Germany fail to get their acts together, will Germany and the German people be able to drop their standards of performance to the level of the ‘bottom’?

My guess is that the Germans do not want to be mediocre.

Therefore, disunity and disgruntlement will continue to rule in Europe. And, this will not be good for the Euro.

What might change attitudes in Europe?

The answer might be years of falling further behind the United States, China, India, Brazil, Russia, and other emerging nations. The European model, as it now stands, cannot compete in this world of the future. Competition is going to be fierce and nations that thrive on low performance and undisciplined behavior will fall further and further behind. But, this is a message to all nations, including some that are in the list just presented.

Unfortunately, Europe stands in a position to cause a lot of disruption to others. It is still important enough to let its failures cause dislocations in the world economy.

The United States should applaud the behavior of the Europeans. The behavior of the Europeans and the decline in the value of the Euro takes a lot of attention off of the value of the United States dollar and the weakness it has experienced due to the undisciplined behavior of the United States government with respect to its fiscal and monetary policies.

Still, I would like to see Germany and Angela Merkel succeed. I would like to see a strong Europe and a strong Euro. But, maybe I am just being sentimental.

The European Union: It's a Question of Leadership

The dust is clearing around the recent negotiations in Europe concerning the “bailout” bill and what we are seeing, at least to me, is unnerving.

“France has won!” (“Paris seen as trumping Berlin at EU table” at http://www.ft.com/cms/s/0/4fbef0b4-5d5e-11df-8373-00144feab49a.html)

“The French government yesterday vowed to ‘reinvent the European model.” (“Sarkozy triumphs in his bid to rewrite the rules” at http://www.ft.com/cms/s/0/f2666c76-5d5d-11df-8373-00144feab49a.html)

The press has predominantly been following German Chancellor Angela Merkel over the past month or so as she struggled to achieve a “German” twist to the negotiations concerning the fate of Greece and the bailout package that was needed to keep the EU together.

Many in Germany did not like what her leadership has achieved as people voted against her party last Sunday making it ever so much more difficult for her to lead her nation.

Sarkozy, the president of France, kept a very low profile…for him.

And, who seems to have come out on top? France!

France’s intent? To build a new structure with greater budgetary policy co-ordination and more effective fiscal rules. In essence, to follow the French model, allowing the spenders to spend and the savers to pay for what the spenders are spending on.

The start is a vast loan facility to distribute cash quickly to “a stricken member” without prior approval from other national governments…especially Berlin! (However, the current effort is to last only three years, but once begun…)

Also, Sarkozy is said to be very happy with the decision of the European Central Bank to start buying euro-zone government debt. This is a massive step toward “Quantitative Easing” something the ECB had been constantly resisting.

The ECB has been “Bernankied”!

This shift in policy direction is seen by Sarkozy as “irreversible” and puts France in the driver’s seat.

In my mind, this “victory” just exacerbates the “race to the bottom” (See “How the euro-zone set off a race to the bottom” at http://www.ft.com/cms/s/0/5d666d5a-5c69-11df-93f6-00144feab49a.html.)

The feeling in Germany? The newspaper Bild Zeitung puts is very simply: "The 'safety parachute' for the euro is the ultimate crime for Europe. We Germans have made sacrifices for a stable euro for the last 10 years, with wage restraint and sacrificing pension rises. We have paid the price while others have been partying at our expense . . . Europe's path to a transfer union is simply a road to its ruin."

And, what direction are you betting the euro will go?

This whole muddle returns to the question of leadership and in Europe.

Unfortunately, I don’t see anyone there that I would call a real leader.

In terms of the leadership at central banks, the head of a central bank can only go so far in achieving a monetary policy independent of the party that rules a nation.

NOTE: Check out what recently happened to the head of the central bank in Argentina!

Ben Bernanke and the Federal Reserve System have never acted independently of the presidential administration in Washington, D. C. whether it was the Bush 43 administration or the Obama administration.

The only show of independence that Bernanke and the Fed has made is to keep the Congress from conducting an audit of them.

Alan Greenspan was the lackey of whoever was in the White House.

This is why the financial markets expect that sooner or later massive governmental deficits will be monetized. Central banks cannot forever “hold out” against a government that wants to continue to live way beyond its means.

And, because of this Jean-Claude Trichet should not be judged too harshly. The “profligates” are in charge and a central banker can only fight back so hard. At least if they want to keep their high profile position.

So, we go back to the victory that France has achieved. If people were uncertain over the future of the European Union and the future of the euro, in my mind a lot of that uncertainty has been removed.

The major uncertainties now relate to when the periodic financial upheavals are going to take place, how severe they will be, and how long it will take for a European leadership to arise that will have had enough of the “race to the bottom”?

Weak leadership always caves in to the popular short run viewpoint!