“The global manufacturing sector continued to record belowtrend growth at the start of 2012. At 51.2 in January, the JPMorgan Global Manufacturing PMI™ rose to a sevenmonth high, but remained below its long-run average (51.8). Manufacturing output expanded for the second successive month in January, as new orders rose for the first time since last August”.

“The cyclically sensitive new orders-to-inventory ratio also moved higher, reaching a ten-month peak. Although rates of expansion for both output and new orders were the fastest since last June, they were still only modest at best. Growth of production was recorded in the US, Japan, Germany, the UK, India, Eastern-Europe, the Netherlands, Austria, Canada, Switzerland, Turkey, Brazil, South Africa and Denmark”.

“International trade volumes improved for the first time in six months during January. Growth of new export orders was led by India, the US and Turkey. China, Japan and the UK all reported modest increases, in contrast to the declines seen in the Eurozone, Russia, Canada, South Korea, Taiwan and Brazil”.

“The first NCB PMI of 2012 has got a familiar feel to it; domestic demand continues to drag and export orders continue to expand. The headline composite index contracted for the third month running (48.3 from 48.6), with output contracting more sharply than last month (47.3 from 48.7). New orders overall continued to contract (46.8), but export orders expanded once again (50.9). 2012 is going to be the fifth year in a row in which domestic demand will contract and if GDP is to expand, Ireland will need an improvement in the euro area economy in H2 2012.”

And I think this is the whole point all along the periphery, the excessive debt overhang makes their economies almost entirely export dependent, yet after years of credit-driven consumption-abuse their economies are totally distorted and their manufacturing industries are just not big enough to do the work. Ireland`s industrial base is in better shape than many, but even in this case expanding exports coupled with falling domestic demand simply means the economy flatlines.  Ireland’s central bank now expects GDP to grow just 0.5% this year, while the fiscal deficit target is still a hefty 8.6% of GDP, so not much in the way of “bang for the buck” there. The country’s debt will now surely peak above the 118% currently anticipated by the IMF due to the lower growth expectation, and it is hard to see the country achieving debt sustainability without the kind of debt assistance being given to Greece, and which markets increasingly expect will be offered to Portugal.

Germany Not As Strong As It Might Be

“The increase in the headline index was primarily driven by a robust rebound in output growth at the start of 2012. Production levels rose for the first time in four months and at the fastest pace since June 2011, led by an upturn in both intermediate and investment goods output. Higher output volumes were supported in part by greater work on unfinished business in the manufacturing sector. This was highlighted by backlogs of work falling in January for the fifth month in a row”.

“Meanwhile, new orders continued to decline at the start of the year, although the rate of contraction was relatively modest and the slowest in the current seven-month period of reduction. Latest data indicated that the decline was driven by a marked fall in new work received in the consumer goods sector”.

“A further solid drop in export sales contributed to the overall fall in new business levels in January. Lower levels of new work from abroad have been seen in each of the past seven months, largely reflecting weaker global demand and uncertainty about the economic outlook. In line with recent trends, lower new export orders were recorded across all three market groups monitored by the survey”.

“Anecdotal evidence from survey respondents indicates that much of the improvement appears to be based on business and consumer confidence reviving, in the belief that the worst of the region’s debt problems are behind us and that a new credit squeeze may be averted. As such, the outlook remains very much dependent upon further progress in resolving the crisis.” 

Chris Williamson is absolutely right  the situation is extraordinarily fragile, and much depends on how the Euro debt crisis evolves. The ECB’s 3 year LTRO has stuck a finger in the dyke for the time being, but without more decisive moves to reform the Euro Area’s institutional architecture for how long will it last?

Booming EMs

Among emerging markets the situation is very different, and Brazil and India are now both showing real signs of recovery. The recovery in maufacturing is significant, but the composite indexes (which cover both services and manufacturing) show a really strong surge in activity.

Curiously, only this week the Columbian central bank started intervening in the currency markets again, buying dollars in an attempt to stem the rise in the peso which is starting to crimp export competitiveness.

Emerging market nations such as Colombia have faced a flood of cheap money in recent months as near-zero interest rates in developed markets prompt investors to seek higher yields, pushing up their currencies and strengthening their economies. The peso has firmed almost 7 percent this year, making it one of the best performing currencies among the world’s 36 most-traded, partly thanks to strong foreign direct investment inflows. The dollar purchase program, which previously ran through September 2011, would re-start on Monday, the bank said in a statement.

The Euro As A Global Funding Currency?

So as core European banks ramp up their deposits at the ECB, and credit conditions on the periphery continue to worsen, a lot of the extra liquidity being generated either at the ECB or the Fed is simply seeping out and fuelling demand in emerging markets, which is a plus for exports, as long as your manufacturing industry is big enough and competitive enough for this to matter. As I say, much of the European periphery is facing an outright credit crunch as banks tighten their credit standards. The FT’s John Dizard put it this way:

There was a lot of earnest chitchat last week about the ECB’s Euro Area Bank Lending Survey, which reported a tightening of lending standards and a decline in the demand for credit. The results, in the bureaucratic tradition of false precision, were reported to accuracies of one percentage point. So, for example, the report tells you that credit conditions were tightened on 42 per cent of long-term loans in the last quarter of 2011, compared to 20 per cent in the preceding quarter.

What the ECB’s survey did not tell you was what is meant by “tightening”, and exactly where in the euro area this undefined tightening occurred, and, where it did not occur. Let me put it this way: if you are a German machinery exporter, your bank just cut the cost of your receivables financing. If you are a Spanish commodities trader or Italian aircraft lessor who had a line of dollar credit from a French bank, you are probably out of luck.

In an article entitled “ECB ‘saves’ banks as economies sink” Edward Chancellor makes similar points:

Over the past couple of months, the cost of Italian two-year debt has fallen from 7 per cent to around 3 per cent. As investors’ fears abated, the share prices of European banks rebounded. The vicious cycle that gripped Europe’s financial system appears to have ground to a halt.

Unlimited access to ECB money means Europe’s banks will have cash on hand to repay any loans that become due this year. Since deposit outflows can quickly be replaced with ECB funds, the periphery is less vulnerable to bank runs. Now that the liability side of their balance sheets has stabilised, European banks will not be in such a rush to dispose of assets.

At around 1 per cent, LTRO money is also very cheap. Barclays estimates that lower funding costs will boost the earnings of eurozone banks by 4 per cent. Clever bankers may do even better – Italy’s Unicredit, for instance, is using money from the ECB to repurchase its own hybrid bonds at a large discount. Increased profits reduce the amount of equity capital that the banks will need to raise. More stable share prices diminish the risk of dilution for bank shareholders.

Mr Draghi’s largesse, however, cannot cure all of Europe’s woes. Within the eurozone, banks have becomes increasingly reluctant to lend across borders. Banks in the core of Europe are reportedly still looking to reduce exposure to the more spendthrift members of the currency union. On its own the LTRO is unlikely to reverse this financial Balkanisation. European banks remain massively leveraged. They will continue to shrink their balance sheets, albeit at a more measured pace.

Nor can a wave of Mr Draghi’s monetary wand remove the eurozone’s macroeconomic imbalances. Much of the periphery remains uncompetitive relative to Germany.

The latest Euro Area Bank Lending Survey reports that 35 per cent of banks tightened lending conditions to European non-financial corporations. The money supply in the periphery contracted by 4 per cent in the year to November. Spanish industrial production fell by 7 per cent over the same period. The dire economic prospects for the periphery are exacerbated by Germany’s insistence on fiscal austerity.

The ECB’s action has brought a liquidity crisis to an end. But it is unlikely to spur lending in the real economy. Until the economies of Europe’s periphery start to grow, concerns about their solvency will continue.

So what is happening? Well the massive liquidity easing engaged in by the Federal Reserve in the US and the Wall of Money sent out by the ECB has loosened credit conditions, but not in the intended economies. We have been here before during QE1 and QE2, but if you look at the first chart in this blog (the global manufacturing one) you will see that we are hardly getting a “mountain” of growth, indeed at this moment what we have is little more than a bump in the road (on aggregate).

Confidence is back globally, as fears of an imminent Euro unwind recede,  and “risk” is “on again”. Cheap liquidity available for tapping in over-indebted developed economies is flowing into rapidly growing emerging markets again, risking yet more distortions in their developing economies. One sign of this is the Columbian iattempt to stem the rise in the peso which would furher crimp export competitiveness. In general “carry is king” once more, and the Euro has even becoming the funding currency of reference. To cite William Kemble-Diaz in the WSJ:

Canny foreign-exchange investors are increasingly tempted to borrow euros to fund bets in higher-yielding currencies, even though it is a lot cheaper to borrow dollars.

The combination of low European Central Bank interest rates that are likely to fall further, and growing confidence that the euro is set for a big slide this year, lines the currency up as a good bet to sell in search of juicier bets elsewhere. In the market’s parlance, that makes it a funding currency, equivalent to nailing a “for sale” sign on its fence.

It is an unusual role for the common currency, and one normally grabbed by the dollar and yen. While low, ECB interest rates at 1% are still four times higher than, say, the U.S. Federal Reserve’s, so when investors feel broadly confident the euro usually rises as traders are drawn to its higher returns. Now, though, a poor outlook for the currency’s value and quirks in the interbank borrowing market mean typical trading patterns are being turned on their head.
The three-month euro-dollar basis swap, which is a function of spot and forward foreign-exchange prices and prevailing interest rates as well as a bellwether for dollar funding stress, has improved to minus 86 basis points from as low as minus 165 basis points in late November, when worries about “another Lehman” filled the air.

But that figure remains deep in the red when, if all were well, it would be closer to zero. For market participants seeking a funding currency, that, combined with the euro’s weak outlook and slowing euro-zone economy, makes for an increasingly tantalizing combination.

(See Bloomberg’s Masaki Kondo and Hiroko Komiya on the same topic here).

China The Odd Man Out?

But even here we find yet another anomaly. While many emerging markets are beginning to boom, China (oddly) failed to spring back,. This suggests the country may really be feeling the housing slowdown/bust pinch.

This is a possibility that Global Insight’s Alistair Thornton definitely entertains.

In combination with better-than-expected numbers out of the United States and what would appear to be an improving situation in Europe, a relatively mild slowdown in China would prove a boon for global markets. Unfortunately, the situation is not entirely positive, despite some signs of resilience in China’s deceleration. IHS Global Insight has picked out a few “behind-the-scenes” indicators which give a slightly different take on the macro climate.

While it is important to note that micro indicators do not necessarily have macro implications, they can help shed light on nascent trends, particularly when there is a modicum of scepticism about the quality of Chinese data. Taking a cue from Vice-Premier Li Keqiang, who when Party Secretary of Liaoning joked that China’s provincial GDP figures were “man-made”, we first turn to freight volumes at major coastal ports. China’s export growth has been suffering under the weight of unravelling demand in advanced economies, and growth in freight volume sagged considerably in November—down to 8% y/y from October’s 16%. This suggests lacklustre demand both overseas and, to some extent, in China, which will drag on growth going forward.

To give him an indication of the state of domestic activity, Alistair took a look at cement production widely regarded as a key feeder for the nation’s property sector, which itself is a key component for investment and the wider economy. What he found was that cement production growth slid to 7% y/y in December (see chart above), down from 11% in November and 17% in October. T

This also fits in with data showing a recent contraction in real-estate construction and anecdotal evidence suggesting an extremely weak project pipeline. More worrying, he found that machine production and machinery sales indicate a severe contraction in construction activity to come.

While metal-cutting machines sound an obscure piece of kit, they are an integral part of China’s construction and investment economy. They are highly pro-cyclical, with the global downturn of 2008–09 pulling production growth to around -30% y/y, before ultra-loose credit policy and construction activity buoyed growth to over 50% in 2010. As of November, however, y/y production growth has been negative, with December’s figures sinking to -11%.

While this demonstrates receding construction activity, the pull-back in machine production has not yet reached the nadir seen in 2008–09. Sales of excavators, on the other hand, have fallen below those depths, reflecting the intense pressure stacked on the real-estate sector. With data from China Construction Machinery Business Online, smoothed using a three-month moving average, we can see that sales growth contracted almost 40% y/y in December.

Little Momentum In Non-Europe Developed Economies

Moving back to the developed world, Japan showed marginal growth, but far from sufficient to help the country overcome the growing sovereign debt problems. The strong yen and the weaker demand from both Europe and China is clearly taking its toll, despite many earlier predictions of a “V shaped” bounce back.

As Alex Hamilton, economist at Markit and author of the report said in his comment:

“January PMI data suggest that the sector has begun 2012 on a firmer footing following a year in which supply chain disruptions emanating from March’s earthquake and flooding in Thailand disrupted firms’ production plans. However, the survey findings paint a relatively flat growth picture, and demand for Japanese manufactured goods remains muted. Although new business and new export orders both returned to growth in January, rates of expansion were marginal. Companies cited sluggish demand from China and Europe as the principal drag on new export order growth. Some respondents also mentioned persistent yen strength, which made the cost of imported items relatively cheaper and by doing so contributed to an easing in the pace of input price inflation to a 15-month low.”

 And finally, even while the US manufacturing sector continued to grow in January, the momentum behind the expansion remained far weaker than in earlier post-recession activity bursts.  Hence the substantial fiscal deficit plus the promise of keeing interest rates near zero till at least the end of 2014 are still having a hard time producing output growth, with the implication that the Economic Cycle Research Institute US Recession call may not turn out to be as “loony” as many appear to think it is.

Related posts:

1. The Global Manufacturing Contraction Eases Again In June
2. The “Three Speed” Global Manufacturing Recovery Continues in February
3. The Global Manufacturing Contraction Stabilises In April

On the one hand there is Luis de Guindos, the former Lehman Brothers Spain CEO, who is now economy and competitiveness minister. Then, on the other, there is his dopellganger, Cristobal Montoro, long time professional politician with the country’s Popular Party, who is the country’s new finance minister. And then, of course, there is Prime Minister Mariano Rajoy who has decided he himself will personally assume overall responsibility for economic policy coordination and effectively be the country’s economy “supremo”, even though it is important to understand that he will normally communicate his decisions to us through the lips of his deputy prime minister, Maria Soraya Sáenz de Santamaría.

The key point to grasp here is what Soraya says goes.

Now having got that straight, and putting this important question to one side, we might like to consider other matters like economic policy, and how to handle that most serious crisis which Spain’s economy finds itself in. Here Luis de Guindos has recently been most helpful, since he decided to use the pages of the Wall Street Journal last week  to outline the general policy approach of the new government. As he tells us, “Fiscal consolidation is not a choice”. In other words, Spain was going to stand by its commitment to try for a 4.4% fiscal deficit in 2011. This reminds me of one of those old “billion dollar question” quiz shows, you know, will you go for the big question, even though if you get it wrong you might loose everything? Spain is, he tells us, going for it.

This public revelation was, to say the least, curious, since at more or less exactly the same time the “other” economy minister – Cristobal Montoro – was telling the Financial Times Deutscheland (that’s why I mentioned several tongues) that the government was having a rethink, and maybe in the light of such a strong recession in Europe, a slightly smaller deficit reduction would be more appropriate (for those who will loose the subtelty of the argument in the German version here is a brief English account).

Naturally – you already guessed – Soraya was quick to come out and make the position clear.

Hours later, the Spanish government scrambled to nuance the comments, which appeared to deviate from what has been a strict policy of deficit-cutting. Deputy Prime Minister Soraya Saenz de Santamaria said the government was determined to meet the 4.4 percent goal and if “more reforms and greater rigor” were needed to achieve it, they would be enacted.

Don’t miss that bit, more reforms and greater rigour. Spain is evidently being entered for the “iron man” contest, and indeed it wouldn’t surprise me to soon see references to our dear Soraya as the new “Iron Lady”.

Not that this was the first time the government had had to step in and separate the two apparently squabbling economy ministers. Signs of tension between their respective departments had already appeared during the first days of the government, with Cristobal Montoro claiming the 2011 deficit was 8%, a complete 8%, and nothing other than 8%, while Luis de Guindos heavily hinted that the final number was likely to be several tenths of a percentage point above that number. On this occassion it was not Soraya, but the interior minister Jorge Fernández Díaz, of all people, who came out, banged their heads together, and announced the official government version of 8.2%.

Complete &  Perfect Knowledge

Going back to the Luis de Guindos WSJ article, I would highlight a number of points. In the first place he makes a pretty strange claim.  ”We perfectly understand,” he tells us, “the reasons our country has been brought to the outrageous situation of having the highest unemployment rate among developed economies.” Now I don’t know if I am alone in this, but I do find that a rather incredible way of putting things. The phrase is even more incredible given that it repeats almost word for word a statement Prime Minister Mariano Rajoy uttered earlier in the week. “My government,” he told his audience, “knows perfectly well what it needs to do to improve Spain’s reputation, stimulate growth and create jobs”.

At face value all of this seems an almost arrogant way of putting things, given that perfect knowledge is something we humans are not normally thought to have, and doubly so since even among “experts” there is still a huge debate going on about why Spain’s economy didn’t start to recover along with most other developed economies, but then it occurs to me that such a bold posture may be sheer bravado, and more to do with uncertainty and insecurity about what to do. The aparrent disarray among the various economy representatives does seem to give this idea some credance.

The suggestion that the Spain’s new government have been drinking the elixir of total knowledge looks even more questionable when we look at the next claim de Guindos makes:

“In Spain, we have inherited a very centralized wage bargaining system that establishes salary increases at the sector level. This system has proved to be one of the main reasons for the loss in competitiveness we have suffered during the last decade”.

This is a strong claim, a strong and highly questionable one. In fact I think Mr de Guindos is confusing two things here: why Spain lost competitiveness, and why Spain now has the highest unemployment rate in the developed world.

It’s The Housing Bubble, Stupid!

Simply put I think Spain’s centralised wage bargaining system can explain why Spain hasn’t had an internal devaluation and wage and price reduction of the kind Latvia, or even, Ireland had. Spain’s labour and product market structures are inflexible, and this is why the economy is having so much difficulty adjusting, and making the transition from a construction and consumer-demand driven economy to an export-driven one.

But this lack of labour market flexibility isn’t NOT the main reason competitiveness was lost before the start of the crisis. The reason competitiveness was lost was the availability of excessively cheap borrowing made available by Europe’s large and deep capital markets and cheap interest rates at the ECB. It was this massive and cheap liquidity which generated one of the largest property bubbles seen this century. The bubble created huge distortions (many of which have still to be unwound), and basically meant that it was too easy for everyone (workers and employers alike) to make money, so there was no pressure even on the employers themselves to address the fact they were paying increasing wages without getting increasing productivity. It was simply a “cool” time for everyone.

Other countries lost competitiveness during those years, but not all of them had the same labour laws or bargaining systems. The problem here is that if you don’t “perfectly understand” why the country had the crisis in the first place, then you may not be able to put the consequences straight. Spain’s problems have a clear European dimension, a dimension which goes well beyond the simple difficulty of selling bonds which forms part of the Sovereign Debt Crisis. Strangely Mr de Guindos’s article has little to say on this point, so here he and his government would do well to study a little more closely the playbook Mario Monti is working from.

Now obviously Spain’s labour laws and bargaining system needs reforming, and Spain’s economy minister suggests that his government is working towards the kind of single contract being proposed by the authors of this article. Certainly they make a convincing case for the changes they propose, but my feeling is that a reform of this type won’t be sufficient to dynamise growth in the way everyone is expecting, since the measure relies essentially on job churn to have an impact and this in an economy where employment is contracting, and likely to continue contracting over the next two years at least.

Evidently there is currently a high volume job churn in Spain, but this process is only taking place among those workers the authors term “ousiders” – the ones with secure long term contracts (the “insiders”) tend not to move (for obvious reasons, and naturally this is why the labour market is rigid and inflexible). Basically the present system favours older workers to the disadvantage of  younger ones, who have to face very high levels of unemployment (not far short of 50% in some age groups) and those who leave their studies with often excellent qualifications find few opportunities for rapid promotion and all the evidence suggest are voting with their feet and steadily leave the country, following in the footsteps of an Italian experience which was already very clear even during the first deacade of the century. If you are going to rely on labour market reform to carry out your competitiveness devaluation, then something much more radical needs to be contemplated: like resetting the whole current system of contracts and staring over again.

A Country Fit For Young People To Stay In

Naturally Spain’s political leaders are reluctant to contemplate this, since the response from older workers already benefitting from seniority would be monumental. The electoral weight of voters over 50 in a rapidly ageing country like Spain is very important, and as far as politicians are concerned their neeeds are much more “strategic” than those of the far smaller generations of younger voters. It is not without significance that one of the fisrt measures the new government announced, despite the existence of what they call a most grave financial situation, was to raise pensions by 1%.

Part of the problem with restarting a broken and structurally distorted economy like the Spanish one how to enable companies to restructure and downsize. In particular, if the country is to adopt a “new economic model” this process needs to be made much cheaper for the individual concern,  and wages need to be tied to productivity, not seniority, with compensation funds for redundancy being held by central government, and not at the individual firm level.

Spanish workers, like their Japanese counterparts, need to accustom themselves to the idea of adopting a second, less well paid, career in the 55 to 70 age group. We also need to get away from the idea that doing so-called “menial jobs” has some sort of social stigma attached. It sounds marvellous to talk about high-tech, high-value growth models, but the reality is that most of Spain’s 55+ workers lack the necessary skills to participate in this, while there are lots of socially useful jobs (looking after old people, which is now almost entirely done by recent immigrants who continue arriving) that people could take on. Subsidising people at 58 to go for early retirement is no substitute for a sustainable employment policy.

Naturally Spain is not alone in suffering from this growing brain and talent drain. There is a  steady flow of young talent away from Europe’s periphery, and it continues to cause controversy. Only this weekend Ireland’s finance minister Michael Noonan got himself into some hot water by saying that an important factor influencing young people in leaving the country was a lifestyle decision. Naturally there is a lifestyle choice involved, in particular since many of the young people leaving don’t want to spend the rest of their lives in societies driven by “depresssion economics”, accepting the kind of lifestyle their older compatriots seem quite content to vote for. They don’t want to first have to accept the main burden of the crisis (as the “oustiders” in all those inflexible labour markets), and then the cost of maintaining in perpetuity the various oversubscribed health and pension systems which Europe’s ageing societied are going to produce. Michael Noonan is quite right, leaving is a choice, and in many cases it is an appropriate and intelligent one. What is not appropriate and intelligent is the response of national politicians either denying the phenomenon doesn’t exist, or suggesting the consequences won’t be important.

No Money, No Credit, No Credit, No Jobs

Which brings us to the third strand of the new governments “gamechanging” policies, the reform of the financial system.
“The new financial reform we will launch shortly will oblige banks to increase their provisions sufficiently to cover any writedowns that may emerge on their real-estate-related assets and loans. Taxpayers’ money will not be used to finance the additional regulatory requirements arising from the reform. All the funds implied will have to come from the system’s own internal resources”.

What this basically means is that while the ECB’s 3 year LTROs will help banks with their liquidity problems, the banking system is going to be left to itself on the solvency related issues. Capital ratios have to go up, as will provisioning, and doing this without taxpayers mone lending will need to be cut back, there are no “ifs” or “buts”. But if lending is cut back, how do you get growth or job creation?

Why is it so obvious, you may ask, that doing Spain’s financial restructuring with only a minimum of government money will lead to a reduction in lending. Well actually, this idea is not so surprising, Spain’s financial system is struggling, and if you look at the charts below you will see that lending in Spain (to both households and corporates) is falling and has been doing so for some time.

As Charles Penty reported in Bloomberg last week:

Loans and deposits at Spanish lenders fell at their fastest pace on record in November and defaults jumped as Prime Minister Mariano Rajoy prepared measures forcing banks to recognize more real-estate losses. Lending fell by 2.94 percent from a year ago and deposits slid 2.99 percent, the biggest drop since the regulator’s records started half a century ago, the Bank of Spain said on its website today.

Basically the issue here is that most of the economies on the Euro Area periphery are currently over leveraged. That is to say the proportion of their TOTAL debt (public and private) to GDP is too high relative to their future capacity to pay, and this problem is really behind why we had the global financial crisis in the first place (in most developeed economies including in the US). If 4 years into the crisis people haven’t gotten thru to this simple point, then they can’t  have  been reading the right kind of material.It is important to understand that from this point of view it doesn’t matter whether the debt is public or private.

Now, and here comes the issue where there is debate, if you have too high a debt ratio (that is, if you are overleveraged) you can reduce it either by growing GDP (nominal GDP) or by reducing the debt. That is why Paul Krugman tries to ridicule those who say you can’t reduce debt by contracting more debt. It isn’t that simple. If you run a company, and you have a good product, then getting some working capital from the bank to let you produce, and even a subsidey from the government to get you started, then maybe by going to work you will be able to pay back more of what you owe. And as with the single company, so with the whole economy on aggregate.

But, here comes the rub: the countries on the periphery can’t get the growth they need until after they have deleveraged, since getting more credit will only make them even more leveraged  and since they have a competitiveness issue they can’t  expand their export sectors as fast as they need to to get traction. So they are stuck, and this – and not the credibility of some ratings agency or other – is what the whole Euro Area debt crisis is about.

Once these economies have deleveraged, which means the banks will have less credit on their balance sheets, then, of course, the banks can leverage again and offer new credit. This kind of deleveraging is long painful and arduous, since it also produces deflation (economies contract along with credit) but with time (let’s say a decade) competitiveness is restored. In the meantime it is not clear how many of the countries young people will have already thrown the towel in and left.

The other alternative is to write off bad loans, but this means accepting losses, and with these government intervention in the financial sector. So banks and governments are reluctant to do this, since it balloons the deficit (see Ireland), and prefer the slow process.

What I am saying is not that no new loans are possible, but that new loans can only be issued after old ones are paid or written off, and after the balance sheet has been reduced to deleverage a bit. Which means the quantity of new loans is not sufficient to produce growth or (in Spain’s case) stop unemployment rising.

This issue is deep structural (if complex) and there is no simple rule from a central bank which can produce new credit (although see my Masssendowngrade Effect post for more detailed explanation about bank “liability management”, and how this interferes with the process of “creative destruction”).

A Tripod That Doesn’t Work
So Spain’s government is basing its strategy on an attack on three fronts – the deficit, the labour market, and the financial system. They have made their analysis, and now they are going to work.

On the fiscal deficit, their argument is not, of course, incorrect. Fiscal consolidation at this point is not a choice but an obligation for Spain. However I can’t help asking myself, given that Spain’s debt to GDP at 70% is still significantly below the EU average, and given that the government isn’t going to use public money to help clean bank balance sheets (at least it is going to try not to, it remains to be seen if it can avoid this outcome) whether it wouldn’t have made sense to do what Cristobal Montoro was suggesting, and negotiate a bit more “wiggle room” with the EU on the 4.4% objective for this year, since really the cumulative effect of having a negative external environment, banks deleveraging and such drastic cutbacks will surely be – as I’ve been arguing – to send Spain into a serious economic depression (even the IMF now see Spain having a 1.7% contraction this year and a 0.3% one next, and the actual outcome could be significantly worse).

Spain’s economic problems are very grave. The country is facing a decade long depression, and if enough young qualified people leave during this period then the country could enter a negative dynamic from which it will never properly recover. At the outset (2007) I and others argued for a 20% internal devaluation to shift resources over to the export sector. This did not happen, and virtually no one is interested in the idea. The main priorities are still reducing the deficit, and restructuring the financial sector without injecting any significant quantity of public money. Both these policies are contractionary in their impact. In addition the proposed labour market reform is timid, and won’t act quickly enough to stop the rot on the growth front.

One of the key reasons given by Standard and Poor’s recently for downgrading the Spanish Sovereign by two notches was preoccupations about the growth outlook in the context of the cut-backs and recapitalisation. Investor confidence and credit ratings will come back up when economic growth is put realistically back on the agenda for Spain. I have a feeling S&P’s understand this reality a little more “perfectly” than Mr Guindos and his advisors do. In any event, at the end of the day we all live in an imperfect world where perfect knowledge is available only to gods not mortals.

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IMF to Seek $1 Trillion Boost Amid Euro Crisis

The International Monetary Fund is proposing a $1 trillion expansion of its lending resources to safeguard the global economy against any worsening of Europe’s debt crisis, according to an official at a Group of 20 nation.

The Washington-based lender is pushing China, Brazil, Russia, India, Japan and oil-exporting nations to be the top contributors, according to the official, who spoke on condition of anonymity because the talks are private. The fund wants the agreement struck at the Feb. 25-26 meeting of G-20 finance ministers and central bankers in Mexico City, the official said.

IMF Managing Director Christine Lagarde said yesterday her staff are studying options to increase the fund’s war-chest beyond the current $385 billion. While euro-region nations have already pledged to contribute 150 billion euros ($192 billion), the U.S. has said it has no plans to make new bilateral loans and G-20 leaders ended last year at odds over the issue.

I do hope they aren’t telling the Chinese, Brazilians, Indians etc that the more money they put up the less likely it is to be used. (For further clarification on what this is all about, see here)

And as if to “ready up” potential funding participants for the IMF the World Bank has issued this warning to emerging economies.

Developing countries should take steps to plan for a global economic meltdown on a par with 2008-09 if the European sovereign debt crisis escalates, the World Bank warned on Wednesday in its latest economic forecasts. Predicting significantly slower global growth in 2012 than it expected last summer even if the eurozone muddles through its crisis, World Bank economists said that if financial markets deny funds to eurozone economies, global growth would be about 4 percentage points lower than even these figures, with poorer economies far from immune.

Andrew Burns, head of macroeconomics at the Bank, told journalists in London: “Developing countries should hope for the best and prepare for the worst.” Stressing the importance of contingency planning, he added: “An escalation of the crisis would spare no one. Developed and developing-country growth rates could fall by as much or more than in 2008-09.”

“The motor of the global economy – developing nations – is slower at the same time as the world’s largest economic area – the EU – is in recession and these could feed on each other,” Mr Burns said.

If such a vicious circle were to develop, developing countries would find it impossible to decouple from European woes, he added. Many would be affected by falling oil and commodity prices, remittances sent home from workers in rich countries could fall more than 5 per cent along with income in rich countries, banking systems in poor countries would be vulnerable to financing risk as many developing countries have significant short-term debt falling due in 2012 and a confidence crisis would also hit spending in rich and poor countries alike.

Edward Hugh, head of global economic strategy on Facebook said, “Threatening people with dire consequences seems to be in fashion these days. Mario Monti is telling Angela Merkel she could face a populist revolt on the periphery if she doesn’t help him, while the World Bank seem to be warning the poor countries that if they don’t go along with the IMF whipround they could become ever poorer.”

Related posts:

1. Out of Balance
2. How Not To Pick The IMF’s Chief
3. The volcano crisis and the financial crisis

“If you’ve got a bazooka, and people know you’ve got it, you may not have to take it out.”

The reference is, of course, to former U.S. Treasury Secretary Henry Paulson, who famously used the remark in 2008 congressional testimony. But as Republican Senator Bob Corker pointed out in a subsequent hearing:

“I do want to remind you that the theory behind the bazooka was that if you have a bazooka in your pocket and the markets know that you have it, you will never have to use it. I would like to point out that you not only pulled it out of your pocket and used it, huge amounts of ammunition was pulled out of the taxpayer arsenal to solve that. I think you’ve done some very deft things and I compliment you on that, but the point is that things don’t always work out the way people, in their best efforts, think they’re going to work out.”

Well, the idea just surfaced again, this time from the lips of Mario Monti:

“I’m convinced, and the IMF is also convinced, that the more pledges are made [to the rescue fund], the higher the volume of pledges made, the smaller the probability that a single euro of cash will have to be disbursed.”

But, as former IMF Chief Economist Simon Johnson once explained, the latest version of the “bazooka” is unlikely to be any more successful than the previous one.

“Today’s proposed bazookas are about providing enough financial firepower so that troubled European governments do not necessarily have to fund themselves in panicked private markets. The reasoning is that if an official backstop is at hand, investors’ fears would abate and governments would be able to sell bonds at reasonable interest rates again. This idea is just as dubious as Paulson’s original notion. Markets are so thoroughly rattled that if a financial backstop is put in place, it would need to be used — probably to the tune of trillions of euros of European debt purchases from sovereigns and banks in coming months. Whether or not it is used, a plausible bazooka would need to be huge.”

Fortunately the ECB has deep pockets, and as I argue in this post, these will probably suffice to keep short term bond yields down to acceptable levels, and help the banks fund themselves and recapitalise. What the ECB’s LTRO’s won’t do is get new credit moving (one significant part of the initiative involves banks in the troubled periphery economies not having to write down the asset side too much too quickly, so there will be little room for “creative destruction”). As fund managers Bridgewater put it recently:

“We believe that a) there are logical limitations to the amounts of debt that creditors will choose to lend to debtors, b) at this time numerous debtors have passed their limits, and c) the projected rates of adjustment that policy makers are using, which generally mean slightly slower rates of increase in indebtedness rather than debt reductions, cannot happen. In other words, despite attempts of policy makers to push this debt expansion further, they can’t. Significant funding gaps will remain……. understandably, central banks are now trying to fill the funding gaps with abundant liquidity. At the same time, banks must contract and consolidate as they can’t adequately recapitalize.”

Leaving aside the tricky issue of the extent to which the latest Euro management initiative will work, Monti does have more interesting things to say. He is, for example, quite positive about Standard and Poor’s:

“If I ever dictated anything, it must have been what S&P had to say about domestic Italian economic policy,” he chuckles, before quickly correcting himself: “I never said the three letters BBB,” a reference to Italy’s new S&P rating of triple B plus……..“It’s very interesting when they go through the various factors, and concerning the political risk factor they say there is one negative: ‘The European policymaking and political institutions, with which Italy is closely integrated’,” he says. “And then they go on, saying, ‘Nevertheless, we have not changed our political risk score for Italy. We believe that the weakening policy environment at European level is to a certain degree offset by a strong domestic Italian capacity’. “I think I’m the only one in Europe not to have criticised the rating agencies,” Mr Monti boasts.”

As Peter Spiegel and Guy Dinmore not unreasonably conclude, the reason for this positive tone is clear: “Mr Monti’s 60 days in office have been enough to convince the agency that his government is on a path of reform that could return the country to growth and shrink its debt levels, but that European Union mismanagement of the eurozone debt crisis is dragging down struggling countries, including Italy with its €1,900bn ($2,400bn) debt mountain”.

“Over the course of the 90-minute interview, Mr Monti is careful not to challenge his counterparts directly. Asked whether the S&P analysis is a condemnation of Ms Merkel, who is widely viewed as the driver of the current response to the eurozone crisis, he is diplomatic: “I don’t think we can really single out one country or one person,” he says. Later on, when asked how concerned he is that strikes by taxi drivers and pharmacists could derail his reforms at home, he insists that when he wakes up in the morning, he is more concerned with “European leadership” than domestic unrest. “European leadership – not the German chancellor,” he quickly clarifies.”

No related posts.

Just as we were recovering from that initial shock, Irish stockbrokers Goodbody poured even more cold water on our breakfast cornflakes by telling us that Ireland would probably need a second bailout, since economic performance in 2012 was likely to be below expectations, while prevailing financial conditions would make an early return to the financial markets virtually impossible. Our spirits were fleetingly brightened by the news that Spain had managed a successful bond auction, but the cork was just as swiftly rammed back into the bubbly bottle as it had been pulled out when we discovered that Italy had not, and that LCH Clearnet had promptly reacted by raising the margins on the country’s debt when posted as collateral.

On the other hand Thursday did give us another brief soothing interlude, as Mario Draghi reminded us of all the beneficial consequences of the recent 3 year LTRO (Long Term Repo Operation), and cheered our spirits by informing us that he was not lowering interest rates again at this stage due to the growing signs of stabilisation his technical staff had been able to identify. “According to some recent survey indicators, there are tentative signs of stabilization of economic activity at low levels,” he told the assembled journalists, although he did go on to warn that the debt crisis continued to pose “substantial downside risks” to the economic outlook and the ECB stood “ready to act” if need be.

Apart from the evidently weakening inflation, possibly the most important single indicator he will have had in mind in making the above statement would be the monthly PMI survey. The composite index (which combines manufacturing and services) shows economic activity contined to contract in December, but at a rather slower rate than in November, and in fact the rate of contraction in November was slower than the one recorded in October. So things are getting worse more slowly!

Despite the evident differences between countries in their rate of deterioration, the stabilisation pattern is pretty generally reproduced across the Euro Area. In Spain, for example, where services activity plummeted in November (at rates reminiscent of the last recession), the decline was significantly slower in December, although it was still, of course, a substantial decline.

The EU sentiment index has also fallen much more slowly in the last two months, indicating that confidence is not deteriorating as rapidly as it was.

And the widely followed German IFO Business Climate index has perked up slightly in the last couple of months.

So Mario Draghi is absolutely right, stabilisation is precisely what we see. But this is stabilisation during a decline, and there is little in these indicators to tell us which way the next move will be, and in fact the few forward looking components we have suggested things might be about to get worse rather than better, a point which was not lost on Markit’s Chief Economist, Chris Williamson, who said in his comment accompanying the monthly PMI report:

“The uplift in the Eurozone PMI in December does little to dispel fears of the region sliding back into recession. Despite the upturn, the fourth quarter saw the steepest contraction since the spring of 2009, and forward-looking indicators suggest that a further decline is on the cards for the first quarter of 2012. In particular, orders for goods and services continued to collapse, suggesting that output and employment will be cut as we move into the new year”.

Of course, as everyone is by now only too well aware, the week finished on a crescendo as S&P’s announced the widely anticipated downgrade of nine Euro Area countries. And just to ram the point home that something somewhere in the works wasn’t functioning as it should, at around the same time the talks on Greece’s Private Sector Involvment debt swap broke down.

That being said, surely pride of place in this extraordinarily agitated week must belong to Hungary, whose bleary eyed Prime Minister Viktor Orban can be seen in the photo below. It is early morning, and he probably hadn’t slept that well after learning that the IMF would defer to the EU on all matters relating to whether his country was in compliance with its Treaty obligations before taking any decisions on future loans.

As one country after another temporarily surrenders its right to an elected government to put itself in the hands of the technocrats (as Hungary did in 2009, before the election of the Orban government) I cannot help asking myself whether recent developments are mainly the result of the countries peculiar (and almost unique) history, or whether it is giving us an idea of the sort of thing we can expect to see if simple austerity as it is being practised all along Europe’s periphery doesn’t work out as planned. Certainly Mario Monti is alive to this possibility, as he said in an interview with Die Welt Online this week (German only I’m afraid), unless Europe’s policy is flexibilized it will be a case of “after me the populists”.

All Alive And Well On ECB Cool Aid?

Perhaps the main point to take to heart from the events of the last week is the way the recent ECB liquidity measures have apparently been able stabilised the debt crisis, at least for the time being, even while it is not clear that they will have the same success stabilising the deterioration in the respective real economies.

In a liquidity-providing operation which some have described as “unleashing a wall of money“, in the week before Christnas more than 500 EU banks borrowed a total of €489 billion in three-year loans – equivalent to roughly 5 per cent of eurozone gross domestic product and the largest amount ever provided in a single ECB liquidity operation. In fact only about €190 billion of this was new money, since the majority of the borrowing involved the consolidation of lending that had already been taking place on a shorter term basis.

Despite the size of the demand, and some relatively succesful bond auctions, much attention is still focusing on the way Eurozone banks’ overnight deposits with the European Central Bank have been rising in the wake of the move. In fact these themselves hit yet another all-time high last Thursday according to the ECB, with the quantity deposited hitting €489.906 billion, up from €470.632 billion the day before. This phenomenon has lead some analysts to suggest the operation may be a failure. Such a judgement would be a premature and erroneous in my humble opinion.

It’s The Real Economy, Stupid!

In order to assess the extent to which the recent ECB measures have succeeded we need to think about what the objectives really were. In the first place the bank clearly hoped the commercial banks would use some of the money borrowed to buy new issue government bonds in the primary market, and earn themselves a bit of “carry” (the difference between what it costs them to borrow from the central bank and what the bonds purchased pay) in the process. The much needed additional income will help them improve their bottom lines and allow them to accumulate some additional capital to help with their capital ratios. This has lead some observers, like Nomura’s Kevin Gaynor, to argue that the ECB is now doing overt (as opposed to covert) QE. In some senses this is surely the case, since the bank was already doing what some called QE by stealth way all the way back in 2009 (as Claus Vistesen argued here, and I argued here).

But before digging into all this a bit further, let’s go back to the issue of those growing overnight ECB deposits. For some observers the very size of these deposits constitutes evidence that the ECB 3 year LTRO isn’t working as anticipated.

This argument, as Danske Bank’s Senior Economist Frank Hansen argues, is misleading, since the volume of ECB deposits only give us a measure of aggregate excess liquidity across the Eurosystem, and doesn’t tell us anything about the distribution of that liquidity between countries or between banks.

“Does this mean that the operation has failed to stimulate government bond purchases? No, not really. If a bank uses money from the LTRO to buy government bonds (or any other paper) in the secondary market, the amount will still show up as a deposit at the ECB (now on behalf of the seller’s bank). If a bank buys government bonds in the primary market, the amount will also show up as bank deposits at the ECB if the government spends the receipts or places them at a private bank. Thus, the increase in deposits does not imply that the 36 months LTRO has failed to stimulate government bond purchases (or other trading for that matter)”.

So basically, if we think for a moment about maturing, and not new, additional issue, government bonds, then commercial banks along the periphery buying the replacement issue can allow their peers in the core to recover their investment, and park the money. The only way the money from these sort of bond transactions doesn’t show up as excess liquidity is if the national government concerned places the takings on deposit at the central bank, or if an investor takes the money they have recovered from a redemption out of the Eurosystem. The same goes for private bank debt, which often just moves from being a liability one bank has with another commercial bank in the Eurosystem to being a liability with the ECB. Naturally the bank that recovers its money may well then park the proceeds on deposit and hence it will show up as excess liquidity at the ECB.

So, while short term liquidity needs may be being catered for (at least up to 3 years), there may be a deeper phenomenon at work via the LTRO, whereby the core leaves the periphery. In fact that seems to be happening. The charts below (which were prepared by Citi Research) show the situation up to the end of October (latest data), and make clear that it is commercial banks on the periphery who are, in the main, making increased use of the ECB’s open market operations, while it is banks in core Europe who are using the deposit facility.

There is no reason to suppose that data post October will reveal any fundamental shift in tendency. Spanish banks, for example, increased their ECB borrowing from roughly €70 billion in September to €118 billion in December (nearly a €50 billion – or 75% – increase), while use of the deposit facility only went up from €9 billion to 15 billion, so the Spanish banking system clearly needs this liquidity.

Write-downs On The Liabilities Side?

Another area where the transfer of liquidity doesn’t show up as a change in aggregate excess liquidity is when banks offload their wholesale liabilities to other EuroArea banks and refund via the ECB. Here again, if they do it smartly, they can even earn a bit of “quasi carry” in the process, by buying back their debt at well below face value from those who are anxious to exit the periphery, and then refinancing at the ECB without writing down the underlying asset. This could be termed a liability “write down” (or a liability management exercise as the FT more euhpemistically puts it), and again the procedure earns the bank a nice bit of income which can subsequently be used to help the recapitalisation process.

Take the Portuguese Bank BPI (the country’s fourth largest), which is making public tender offers to buy back its debt. If all concerned tender their bonds to BPI, BPI will pay something short of €1.5bn cash to investors. Mortgages which were previously sitting in one of their SPVs will return to their balance sheet, and ECB money will now be on the other side financing them allowing significant profits (and capital) to be reported. In this particular tender the smallest discount is 35% and the largest is 65%. Investors may initially baulk at the offer, since they will nurse a heavy loss (equal, naturally, to BPI´s profit) but ultimately they will probably be only too happy to be able to walk away from Portugal, and with some cash in their pocket to boot, although Banco Santander bondholders weren’t too happy when they tried to do something similar last November with an offer which affected a third of its total outstanding “lower tier 2 capital” junior debt with call dates – on which the bank can opt to pay back the debt – ranging from March 2012 to September 2014. (update 21 January, in fact in the end Portugal’s PMI investors weren’t either happy to take the money or eager to walk away – see this report – but it wasn’t for want of trying on BPI’s part).

Iberian banks were already aware of the benefits of this kind of restructuring during the 2009-2010 liquidity wave, and went about quietly repurchasing their bonds (bank capital, securitizations, senior bonds) on a selective and private basis at a discount. Much of their reported profits in those years in fact came from either the ECB carry trade or this kind of transaction. So when we read that another Portuguese bank – Banco Espirito Santo – has just had €1 billion of debt guaranteed by the Portuguese state (a soverign which can’t itself go to the markets) it isn’t hard to imagine that the process going on in the background is something similar to that seen in the BPI case, and that the debt is being guaranteed so it can go over to the ECB to be posted as collateral.

The National Bank of Greece has been doing something similar. They recently offered to buy back some €1.5 billion in covered bonds and preferred securities, offering 70% of face value for the covered bonds and 45% for the preferred hybrids. As the bank itself says, “The purpose of the offers is to generate core Tier 1 capital for the group and to strengthen the quality of its capital base….The offers would generate a gain for the group.”

And Italian banks would seem to be doing something similar, since they issued around €40 billion in government backed bonds specifically to take to the ECB. The bonds are held by the banks themselves and stay on their books to maturity, their only purpose being to provide collateral for use at the ECB. In fact Italian banks took something like €116 billion from the LTRO, or almost 25% of the total. Perhaps this is why Unicredit CEO Federico Ghizzoni and other European top bankers met ECB officials in Frankfurt back in November, to discuss new rules for collateral.

In Spain securitised mortgages sitting on the balance sheets of the bank-owned Fondos de Titulizacion de Activos could also be recycled in this way (here’s a complete list, although note that these Funds are regulated by Spain’s CNMV and not the Bank of Spain, which is why their presence is relatively unknown and people are able to accurately say that the central bank has been very strict on SIVs, since they weren’t their responsibility). Here’s a link to an article (in Spanish unfortunately) which explains how Bankia are issuing cedulas they buy themselves, and retain for collateral posting at the ECB. They issued 3 billion euros worth in November, and are about to issue another 2 billion euros worth.

That something like this may be happening, with the ECB “buying into” public and private Euro Periphery debt while investors are discretely getting out is suggested by this report in Bloomberg:

The euro is losing the relationship with riskier assets that underpinned the currency in 2011 as the deepening sovereign debt crisis reduces the creditworthiness of even the biggest economies in the region. The 17-nation currency has fallen 8.7 percent against the dollar since October, while the Standard & Poor’s 500 Index has gained 3.4 percent, and the correlation between the two dropped to 58 percent from a record 91 percent in November, according to data compiled by Bloomberg. The euro had moved almost in lockstep with investments linked to growth, including stocks and the Australian dollar, since January 2011.

This decoupling is taking place as European Central Bank President Mario Draghi cuts interest rates and promises banks unlimited cash for three years to rein in soaring borrowing costs for governments… Strategists also anticipate more losses as the US economy improves while the euro zone shrinks, driving international investors away from the region’s assets.

So if the first two objectives were to help the struggling sovereigns, and enable the commercial banks to refinance their debt, then to some extent these objectives have been met. But what about the third objective, moving credit on the periphery to get the real economy moving again? Well, here the ECB’s measures are likely to have far less effect, and indeed what effect they do have may be in some way a mixed blessing, since the banks seem far more worried about demonstrating they have an adequate level of core capital than they are about participating in solutions to real economy problems.

Credit Crunch Is NOT Uniform

To understand why this simply increasing aggregate liquidity doesn’t necessarily help individual countries, it is important to realise that credit conditions in the Euro Area member countries are not uniform (a much more detailed exposition of this point can be found in this earlier post). In countries like Germany, Finland and the Netherlands, credit is more or less freely available, even if demand for it is limited – German corporates are awash with cash, and it has been a long, long time since German households were digging their way into debt.

Although in France, the rate of new loan generation in the private sector has been sliding since mid summer, especially if you look at the thin black line in the chart below (Bank of France), which shows the rate of change on a three monthly rather than an annual basis.

A similar position can be seen in the case of home mortgages.

Now in the French case, given that the private sector is not heavily overindebted, unemployment is not excessively high, and a demand for credit from solvent clients exists, it is quite possible that the ECB measures can help stabilise the situation, and put a brake on the implosion.

On the periphery, however, where populations are heavily endebted either directly, or via their sovereigns, where the economy isn’t functioning properly, and unemployment is high and rising, the problem isn’t only the unavailability of credit, but also the shortage of solvent clients who actually want to leverage themselves.

Day Of The Living Dead?

For increased liquidity to mean that credit becomes expansionary for the real economy again, it is the banks themselves who need to deleverage (and not simply write down their liability side), by disposing of the large volume of continually restructured but basically non-performing credit they have on their books. Behind the credit crunch in these countries lies a problem of massive economic structural distortion, produce by the lending and borrowing boom during the “good” years. What is needed is what Joseph Schumpeter referred to as a process of “creative destruction”, whereby some enterprises die so that others can be born, and naturally some loans are written off, despite the fact this has unpleasant effects on bank profitability and capital ratios. To really get credit moving again in some of these periphery economies, a large chunk of loans need to be written down, and support needs to be offered by the sovereign to enable this to occur.

Unfortunately the ECB’s liquidity provision could have precisely a perverse effect in this context, as it may well enable those who should die to stay alive. Commercial banks, at the discretion of their central bank, may now package straighforward bilateral commercial loans to present as collateral at the ECB. This measure, which in theory was intended to enable the banks to extend “good credit” may now enable them to restructure and keep on their balance sheet loans that should really be classified as “impaired” and somehow resolved.

In the case of Spain, for example, in addition to the properties they have acquired, banks still have oustanding loans of over €300 billion to developers on their books according to Bank of Spain data. The majority of these loans are not classified as either non-performing or sub-standard, and are hence considered to be “good” (I will refrain from saying “excellent”). In principle there is no reason why a significant number of these “good” loans cannot be packaged in some way or other to serve as collateral to be posted at the ECB. Naturally this takes some of the pressure off Economy Minister Luis de Guindos to establish a bad bank, since for the time being the ECB can, in part, serve this purpose for him. And if the banks write down their liability side a bit, then this may also help him with the €50 billion or so he estimates will be needed for bank recapitalisation. No wonder he feels the amount of public money needed will be minimal! The only real downside on this is that foreign investors may well be dumping Spain, while the country (which still runs a current account deficit) continues to have an external financing requirement.

None of this is either uniquivocally good, or unequivocally bad, it depends. What the liquidity move will do is buy the banks time to sweat out some capital onto their balance sheets, and make them better able to withstand more of those dreaded “stress tests” (assuming, that is, that the European Banking Authority allows some “wiggle room” to enable them to keep maintaining their risky sovereign debt holdings). What it won’t do is help put the real economy straight, or allow the banks to get back to what some would consider is their basic task which is guaranteeing a normal supply of credit to the economy.

Working Against The Clock

All of which brings us nicely back to those horrid S&P downgrades. According to S&P’s own literature, the dowgrades were prompted by a number of concerns:

Today’s rating actions are primarily driven by our assessment that the policy initiatives that have been taken by European policymakers in recent weeks may be insufficient to fully address ongoing systemic stresses in the eurozone. In our view, these stresses include: (1) tightening credit conditions, (2) an increase in risk premiums for a widening group of eurozone issuers, (3) a simultaneous attempt to delever by governments and households, (4) weakening economic growth prospects, and (5) an open and prolonged dispute among European policymakers over the proper approach to address challenges.

If we look at the list of 5 issues they identify, the recent 3 year LTRO may do something to help ease the first two of their concerns, especially in core countries as far as credit conditions go, and at the short end in terms of peripheral sovereign debt spreads, but it will do virtually nothing to resolve the other key issues, and it will not alter the course of the crisis in the longer term. In other words it is not a game changer, even though it will buy time.

But time is – if we look over to Hungary – something we will eventually run out of. Handing over the adminsitration of one country after another to a group of approved technocrats may well work for a while, but it won’t work forever. One day or another, if the measures taken don’t work, Mario Monti will be replaced by the populists, and a new chapter in European history will open. At the present time the policy emphasis on fiscal rectitude and structural reforms, to the neglect of the deep competitiveness and imbalance problems which exist within the Euro Area, is leading us all to no good place. A quick glance over in the direction of Hungary might suggest to us what that place could look like.

Well, that really was the week that was, wasn’t it. It’s over, let it go, there’s another one coming just around the corner, and my initial impression is that it is unlikely to be a quieter or more relaxing one.

On one level, Friday’s news was not really surprising. The French rating downgrade was a shock foretold. As was the breakdown in talks between private investors and the Greek government about a voluntary participation in a debt writedown. A proposition that was unrealistic to start with has been rejected. We should not feign surprise.And yet both events are important because they show us the mechanism behind this year’s likely unfolding of events. The eurozone has fallen into a spiral of downgrades, falling economic output, rising debt and further downgrades. A recession has just started. Greece is now likely to default on most of its debts and may even have to leave the eurozone. When that happens, the spotlight will fall immediately on Portugal, and the next contagious round of downgrades will begin.

Wolfgang Munchau, Financial Times, Sunday 15 January 2012.

This post first appeared on my Roubini Global Economonitor Blog “Don’t Shoot The Messenger“.

Related posts:

1. The Baron Münchhausen Effect
2. Exaggerating for Effect?
3. More News From Italy

Brussels now has issues pending with Budapest on a number of fronts. In the first place Hungary has been tried and  found wanting in relation to its compliance with the conditions of the EU excess deficit procedure to which it has been submitted for some time now. This issue is important in its own right, since it was with the balooning of the fiscal deficit in 2006 that all the recent political problems really began.  The current deadlock with Budapest on the deficit front has added importance in the present context since the EU is in the process of formulating a new treaty whereby states using the Euro will be compelled to bring their debt and deficits into line with EU regulations or face sanctions.

All of this will sound very hollow if Hungary, which is not in the Euro but is bound by the excess deficit agreements already in the Treaty, cannot be brought to heel. The issue is a complex one in the Hungarian case, where many of the underlying issues are interconnected (like the decision to change the constitution and the appropriation of assets worth about 9.75% of GDP from the private pension fund, since without the constitutional change those having their assets effectively expropriated would have had recourse to law on the issue). What the EU are concerned about is the credibility of their policy, and in this case the key question is the sustainability of the Hungarian debt and deficit, since one-off measures (like money from the sale of private pension fund assets) do not reduce the underlying structural deficit the country has. As the EU statement says:

“Hungary has not made sufficient progress towards a timely and sustainable correction of its excessive deficit.” The EU executive proposes to “move to the next stage of the Excessive Deficit Procedure (EDP) and recommends that the Council of Ministers decides that no effective action has been taken to bring the deficit below 3% of GDP in a sustainable manner.”

This is a bit of bureaucrat-speak, but what it effectively means is that the European disciplinary procedure is being put to work on the country, and that one of the consequences may be the application of a sanction involving the withholding of EU structural funds (estimated to be equivalent to 1.7% of GDP):

 ”Subject to this Council decision (under Article 126(8) of the EU Treaty), the Commission will then propose to the Council new recommendations addressed to Hungary (under Article 126(7) of the Treaty) with a view to bringing to an end its excessive government deficit,”

Prime Minister Orban is very proud of the fact that the deficit came in at under 3% of GDP in 2011 for the first time since the country joined the EU in 2004. In fact the country had a budget surplus, estimated to be  between 2% and 3% of GDP, but this surplus is entirely due to juggling with revenues that come from appropriating the private pension funds. As the EU Commission put it in their autumn forecast.

“Following a deficit of 4.2% of GDP in 2010, the  general government balance is expected to turn to  surplus thanks to one-off revenues linked to the elimination of the obligatory private pension scheme. The official estimate for this year’s surplus has been revised up from 2% of GDP (contained in the April 2011 Convergence Programme update (CP)) to 3.9% of GDP in the autumn notification. The larger surplus is mainly due to: (i) higher one-off revenue stemming from the elimination of the obligatory private pension scheme (now amounting to 9¾% of GDP, i.e. ½% of GDP higher than previously assumed); (ii) an intention not to assume the debt of the public transport companies (1.4% of GDP) and not to buy out selected PPP projects (0.7% of GDP), contrary to earlier plans; and (iii) additional measures of 0.4% of GDP adopted in September 2011″.

The EU Commission calculate that the underlying deficit in 2011 (that is the deficit stripping out the one-off cash injections) was around 6% of GDP, and while the budget promise for 2012 is under 3% of GDP there are lots of factors (like lower GDP growth, higher interest costs, and higher expenditure from automatic stabilsers) that could easily mean the real number continues to be over 3%.

So, enough is enough with “unorthodox fiscal policies” is what the country is now being told.

But the fiscal deficit is only one, small, part of the problem as far as the EU is concerned. Of much greater concern are the recent changes in the constitution and the independence of the countries institutions like the central bank. The EU is now studying whether parts of the constitution violate the fundamental EU Treaty, and Hungary has been given until Tuesday to present changes to the constitution which would comply with EU membership requirements. If the Commission decide the unchanged constitution does violate the Treaty, legal action against the country will surely follow, and it is not to be entirely ruled out that the country could be temporarily suspended from the EU under the terms of Article 7 of the Treaty (details of which can be found here). As Commission spokeswoman Pia Ahrenkilde Hansen told the press:

“A legally stable environment, based on the rule of law, including respect for media freedom, democratic principles and fundamental rights, is also the best guarantee for citizens’ trust and confidence of partners and investors,” Ahrenkilde Hansen told journalists. “This is particularly vital in times of economic crisis.”

So the question now posed is that someone here is going to have to back down, and to do so  significantly. The question really is “is Orban ready and willing to do so”. Friends and acquaintances of mine in Hungary had been warning me for some time that this kind of confrontation would (almost inevitably) come. Orban had gone one bridge too far, and it would be hard for him to turn back. Over the last few days a close acquaintance, who has been becoming increasingly concerned about the situation, has sent me a number of e-mails on the topic. Below I reproduce a selection of extracts, just to give a feel for how some (perceptive and sensitive) people inside the country see the situation.

As far as finding a way out is concerned, I am very, very sceptical. Given the super-majority in parliament and the trenchwarfare between left and right, except for a full blown revolution or the landing of US paratroopers (both, eveidently, extremely unlikely), the only way to topple Orban is to have a revolt within Parliamentary group of FIDESZ. This is also very unlikely, as Orban is a very charismatic and ruthless leader with an uncanny ability to get through to people and to preserve his leadership.

Moreover, all FIDESZ MPs are personally selected by Orban, and only God knows what kind of “documents” are existing in Orban’s hand with which he could blackmail them. There ought to be a good deal given the widespread corruption in the Hungarian political system. It seems that nobody either could or would be ready to challange him. Even, I could safely say – reading the right wing press and speaking with supporters of Orban – that a decade of gradual shift towards a radical and anti-capitalist and anti EU (“Empire”) position has created a mindset which may even accept a break with EU in order to save “freedom”, “independence” and “national goals” and reduce “foreign capitalist exploitation”.

Thus, I don”t really see the internal force, which could stand up to the government. Those lonely voices, who criticised Orban on grounds of economics, have been successfully isolated and there was never any attempt to build up a formal institutionalised form for expressing different policy options within the broad right wing camp. We could even find that any measures on behalf of EU against Hungary only reinforce Orban’s stand-alone policy and rally behind him the ultra-nationalist camp, which could be easily as large as 30% of the population.

Given that he controls state administration and the armed forces, and taking into account the complete reaoganisation of these branches of the state together with the wholesale nomination new staff, he may have enough resources to sustain a populist autocratic order for a long period of time, like in Belorussia. Here comes to play also the aging population and the flight of young professionals into other  EU states: older people typically are not those one who are revolting, and those who would revolt may increasingly decide to try and escape in time before the new “iron-curtain” falls down.

Actually,  to be precise: maybe a break with the EU is not an option at this point, but once the  EU suspends Hungary, that option maybe more easy to sell.  We are faced with a charismatic leader who may  actually have an agenda, and not be only “surfing” on the current reality trying to get the best for himself.

Launching WWII was huge misinterpreation of their own capacity on the part of Germany, especially when coupled  with  Barbarossa, and was not supported by much of the population and may be even the army and the conservativies had their misgivings, but still, Hitler prevailed, and…. I dont want to say that Orban is comparable with that truly evil person, but we are facing with a similar charismatic leader with a strong will and with deeply internalised goals. ..

And maybe there is not a masterplan a la Mein Kampf or Hossbach notes. But the changes, the events, the steps he is taking, sometimes irrationally, sometimes rationally, are taking him towards this final irrational step. He may stop at the last moment, but it may happen that fear of loosing power pushes him over the brink and he may choose the completly irrational step. I cannot say how the future will happen. But I can say that his speeches, acts, messages belong to a distinct political family of radical right wing views and these inevitably lead to a break with the current EU. And his personality traits also suggest a certain kind of personality, one who is able to carry out this radical step, if the circumstences arise, and he feels forced to do so. Lets just hope that this scenario will not be the real one. ..

I think we need to be clear at this point, nothing here is inevitable, but the usual kind of “bandaid” kick-the-can-a-little-bit-further-down-the-road solution is not going to be easily available. I think it is going to be very hard for Orban to back down significantly, and especially so in the case of having the constitution rewritten significantly. In many ways this  is why I used the cryptic headline and final paragraph in my last Hungary post.

What I was getting at there is the thought that this is now Orban’s great opportunity to go down in the history books, possibly even as the man who opened up a chain of events which finally destroyed the Euro. This is his challenge, and his possibility to live eternally ( I doubt there is any other one). He is currently just three steps from heaven, so it is comparatively easy for him to get to his intended destination. But its also easy for him to get things wrong (from his point of view). I mean, he could do the “right thing”, be a gentleman and back off to make a deal with the EU under which he had to retire from politics. I can just see José Barroso now, alighting from the plane and waving the critical  piece of paper to the delighted press photographers. That way, of course, five years from now no one would even remember Orban’s name.

So the question of whether a deal is still possible is  the billion dollar issue in  all this. We have a chicken and rooster situation: who will blink first. Hungary may blink since the country’s leaders may not wish to find themselves outside the EU and forced into default. Or alternately, some of Orban’s advisers may already accept this scenario as an inevitability, and welcome default as the only way of getting to grips with the forex debt problem. They may even already be thinking in terms of a post Euro scenario, and assuming that the Euro cannot hold together. On the other hand the IMF (under EU pressure) are unlikely to accept the forex default and debt restructuring that Hungary probably needs to achieve sustainability in the longer term while they are still in the EU.

The constitution law is probably going to be the real sticking point, since if the government needed this to avoid letting the people who had their pension savings appropriated take recourse to the law, then unwinding it would probably mean the public finance issue would quickly get bigger, and quite possibly right out of control.

On the other hand while the EU may dig in for a time, they may ultimately fear contagion more than they do an unruly Hungarian government. Europe’s leaders have basically been motivated by fear of something or other throughout the whole Euro debt crisis, they have never really been out there in front of the curve. No pain today please seems to have been the rule. So with the second Greek bailout visibly wobbling, and much of the rest of Eastern Europe vulnerable to retrenchment by West European banks, fearing the inevitable contagion they may well finally go for a “peace in our time” deal.

Naturally, in this post I have dwelt on the political dynamics (and dangers) of the current situation (and indeed the post contains not one single chart), but we should never forget there is a real economic backdrop to what is happening in Hungary, one in which IMF programmes in Eastern and Southern Europe are not working out as planned, possibly due to a faulty diagnosis of the problem (see my earlier post for explanation). In addition, it is hard to say at this point whether what is happening in Hungary is unique (due to its 20th century history) or whether it is a harbinger of what is to come along the EU periphery as populations steadily get disillusioned with policy packages which simply don’t work. To answer this question we  will need to see into the future, but to see into the future we will have to get there first.

Postscript Friday Morning

In the above post I argued that the IMF was very unlikely to open negotiations with Hungary before the Hungarian administration responded satisfactorily to the EU requests for compliance. Last night the IMF issued a press statement where Christine Lagarde made plain that this is indeed the stance they are taking.

“I met today with a Hungarian delegation led by Minister Tamas Fellegi. We had a useful exchange about the latest economic developments in Hungary and about how best the IMF can assist the country in addressing the current economic situation.

“I indicated that, before the Fund can determine when and whether to start negotiations for a Stand-By Arrangement, it will need to see tangible steps that show the authorities’ strong commitment to engage on all the policy issues that are relevant to macroeconomic stability. Support of the European authorities and institutions would also be critical for successful discussions of a new program.”

Thus Orban’s “divide and rule” strategy isn’t going to work. On the other hand, reading between the lines in his latest speech, I don’t think Orban is getting ready to eat humble pie, rather he is getting ready to play “now you see me, now you don’t” with Europe’s leaders.

“Our general approach is that we are open and flexible, we are ready to negotiate all the points, but what we need is not political opinion but arguments. And when the arguments on behalf of the European Union are convincing, then it’s better to accept and follow that line. There is no reason not to do that. We are absolutely open and flexible and waiting for the argument. But yesterday’s comments from the EU did not contain any argument, just opinion, saying that they don’t like it, it’s against the general legislation of the EU. But we would like to get more specific points on the points (where) they would like to see modifications or corrections. And we are ready to consider it.”

As far as I can see, he is simply stonewalling. He is saying a lot and saying nothing, which may well be his best strategy, effectively copying Merkel and Sarkozy on other issues. Continuing in this way he will force the EU’s bluff, either they have to act and try to see things through to the end, or they have to back down. They show no sign at present of having any inclination to back down, so we are now facing a very high risk situation.

Back in the summer of 2010 György Lázár wrote the following very perceptive lines:

“Orbán’s unusual high-wire act might work, but he must avoid Hungary’s debt downgrade to “junk”. This is easier said than done, because the debt is currently under review and the other shoe can drop at any moment. A sovereign debt downgrade, with a run on the forint or on the banks will probably finish his government”.

Of course, that’s just it, Hungary’s debt has now been downgraded to junk, and Orban’s government is now facing a “life or sudden death” situation.

No related posts.

The industrial economics of extreme wealth is an interesting subject. It’s often been observed that a lot of the spending of the rich goes into positional goods. A positional good is, in a sense, in fixed supply, or rather, position itself is in fixed supply. If more of a positional good is produced, its positional value decreases. More spending on them can only inflate their prices.

The quintessential positional good is land. A lot of land is useful in itself, but it is true everywhere that owning x amount of land gives you more positional utility than an equivalent position in cash or securities, and the most sought-after land by area isn’t farmland or building plots near a container terminal or an oil well, it’s billionaires’ row, whose value is entirely positional. Land is the classic case of economic rent, and that’s what I’m driving at.

Just as rent doesn’t reflect costs of production, but only a monopoly position, the price of positional goods reflects only their positional nature and the income of those competing for them. Let’s now switch to the economics of the firm; if the price of X is dominated by economic rent, an increase in the price is mostly an increase in profit. If profits rise in some sector, capital should be preferentially allocated to it.

Clearly, you can’t manufacture Hampstead or Palo Alto or the Prinzregentenstrasse, or only with great difficulty and the risk of destroying its positional quality. You can easily manufacture more iPhones, which therefore are gradually becoming less positional. You can manufacture Vertu phones by sticking diamonds on mid-2000s down-ticket Nokias, essentially creating purely positional items. Joseph Schumpeter would of course point out that it is the aim of all enterpreneurship to be able to claim the economic rents of monopoly.

In order for capital to be reallocated to the positional sector, then, it’s necessary to invent new forms of positional competition, and ideally, ones which escape from the temptation to just be a good product that can be produced on a big scale like iPhones or VW Golfs or my trainers. And indeed, we see a sizeable economy devoted to just that. One way of achieving this is to dematerialise the product – Cory Doctorow once remarked that if they can’t define your job they can’t outsource it, and the greater the immaterial content, the more of it is concentrated in the mind of its creator and the place and time of its consumption. Therefore, it is harder to replicate. In that sense, it’s a form of economic growth that is light on resources, but it seems intuitively difficult to defend activity that is pointless, other-regarding, private, and directed to snobbery.

Another way is to increase the service content of the product. We noted that land confers more status than most goods. But servants are almost as good or better, and would you bet against slaves being better still? This is very interesting indeed, as it may well represent a deliberate reduction of productivity and therefore a net loss to society. Where wealth is used to display power over others, by deliberately wasting labour, perhaps we’re seeing something like the costly-signalling logic of the peacock’s tail, or a form of bourgeois potlatch.

I didn’t expect to end up at this conclusion, but then that sort of dépaysement what a good blog is for.

There are of course other options. In so far as positional spending is directed at public beauty, it is perhaps worth having – having your name prominently displayed as a benefactor of the Royal Academy, much as I find the place annoying and reactionary, is better than spending your money like Dennis Kozlowski on that giant ice sculpture of Michelangelo’s David, pissing vodka into your guests’ glasses. (Although to be honest, if anyone’s up for reconstructing the thing as an installation somewhere public, even I’d contribute to your Kozlowski Memorial Fund. Yes, I know he’s not dead yet.) And some bits of the positional industry have complex business models that rely on everyone else as much as they do on the super-rich – fashion couldn’t support its baroque R&D-and-advertising-and-French-heritage-project top end without the high-street and wouldn’t have any ideas without the low-street.

But then, if there’s a good reason to unlearn economics in the first place it’s to respect institutions and complexity and the notion that people’s motives ought to be taken seriously, not only when they are convenient.

No related posts.

To make matters worse, the country has now opened up a second front by generating a serious dispute with the EU Commission, and other European institutions like the ECB, so it is only to be expected that the Fund will not reach any sort of agreement with the Hungarian government, until after the path has been cleared at the Brussel’s level. Indeed such is the degree of dishumour of Europe’s leaders with the present government, that it is still not clear whether the price for any form of aid might not be Orban’s own head, and the installation of a more technocratic caretaker government. There are, after all, recent precedents for such a development in Greece and Hungary, and indeed the former Hungarian prime minister Ferenc Gyurcsány was effectively forced out by Brussels in March 2009.

Not unnaturally Viktor Orban has been visibly trying to back away from the rapidly deteriorating confrontation, and only last Friday said his administration believes striking a deal with the European Union and the International Monetary Fund on a financial safety net for the indebted country is “an urgent task”. Just to rub it in, he went on to declare his total support for the idea of central-bank independence. Government spokesman Andras Giro-Szasz went even further, saying the country was ready to “adjust any law that’s against European Union regulations.”

Yes…….Sorry No… OK, Yes Is What I Really Meant To Say

Meanwhile both the EU and the IMF are digging their heals in, and taking a hard line. European Commission President Jose Manuel Barroso has written to the Hungarian prime minister, calling on him to withdraw recent offending legislation since they likely failed to comply with community law and could well prove to be incompatible with the EU Treaty itself. According to a report which appeared on the website Origo.hu, Barroso asked Orban to withdraw the legislation on the central bank as well as a ‘stability law’ proposed earlier this month which would tie the pace of debt reduction to the rate of economic growth. “I would forcefully advise you to withdraw two pieces of cardinal law now in front of parliament,” he is reported as writing in late December. Taking a leaf out of Angela Merkel and Nicolas Sarzozy’s book perhaps, Orban seems to have ignored Barroso’s plea, since the bill went into law on 30 December.

In fact, in what might now turn out to be a classic example of “famous last words” a defiant Viktor(ious) Orban stated after the passage of the bank bill: “It is a European fashion that the central bank must be in a sacred state of independence…Nobody can interfere with Hungarian legislative work, there is no one in the world who might tell the elected deputies of the Hungarian people which act to pass and which not to.”

Only 6 days and a downgrade or two later, the mood is rather different, and Tamas Fellegi told reporters before boarding the plane to Washington that Hungary is open to talks about the central-bank law, indeed there is nothing the country isn’t open to talking about if need be to secure a loan.

Nonetheless both the IMF and the EU will surely continue to play hardball, after all they now have the upper hand. Hence a report which appeared on another Hungarian website (Figyelo) this weekend, which cites a “precautionary” programme that was being prepared for Hungary. The document the website reproduced also suggested the IMF board (which will meet on 18 January to discuss Hungary) was of the opinion that the country could receive a Stand-By Agreement – which carries more conditions than a precautionary agreement.

According to the document summary, the IMF will require Hungary to re-establish the independence of the National Bank of Hungary, strengthen the Fiscal Council, exercise a stricter fiscal policy, reduce and then withdraw crisis taxes, end ad hoc economic policy measures, fully implement agreed reforms, restructure the social welfare system, restructure public transport companies, and introduce a personal bankruptcy law. ,

The report describes Hungary’s political climate as “complicated”, and suggests the chance of Hungary losing its EU Cohesion Fund support because of an excessive deficit procedure that has dragged on for eight years a “real danger”. Should this eventuality materialise Hungary would loose funding equivalent to 2% of GDP.
Short Term Crisis, But Long Term Deep-Seated Issues That Won’t Simply Go Away

Yet whatever the political obstacles, it is very likely that some sort of deal will be patched together. The consequences on both sides of the fence are too large to play with for too long (although remember accidents in history do happen, indeed following one school of thought they are the very motive force of history).

Last weeks downgrade from Fitch (to BB+ aka “junk”) will have concentrated everyone’s minds, since it was one further warning of what would quickly happen if agreement were not reached – the currency would fall through the floor, the debt would become rapidly unsustainable and the country would default, and even continuing membership of the EU would be put in doubt. As in then Greek case, it is doubtful at this point that anyone is ready to walk through this particular door, even if they repeatedly keep getting shown it.

Naturally the financial markets have responded badly to all the brinksmanship and uncertainty, with the forint repeatedly hitting record lows against the euro (the latest was of 324 to the Euro on Thursday), while the yield on 10 yr government bonds has spiked sharply (see chart above from Portfolio Hungary). Following the Fitch decision Hungary’s 5-yr CDS spread leaped by 38 basis points to 754 bps, dragging Poland’s (up 16 bps to 307 bps) and those of the Czech Republic (up 15 bps to 194 bps). Naturally, as in the Greek case, it is the risk of regional contagion which is the biggest headache facing policymakers.

Chronicle Of A Problem Foreseen But Not Dealt With

The danger to the Hungarian CDS has been obvious for some time, since six months ago markets were badly underpricing Hungarian risk. As I said in July:

“And if we move over to Hungary, then we find that as of last Friday CDS stood at around 285, well below the highs of over 400 seen as recently as last November in the wake of the Irish crisis. Arguably the Hungarian case is the most glaring example (of risk underpricing), since it is the East European country with the highest debt to GDP levels (around 80%, of GDP, of which 45% is forex denominated) it has very high gross foreign debt (around 135% of GDP), and it is a country where institutional quality is a constant cause for concern. In many ways Hungary is the Italy of the East. Apart from the presence of a strong trade surplus there is not that much to commend in Hungary’s recent economic performance, yet its CDS has fallen into line with a regional pattern, and there is little in the way of what is happening in Spain and Italy to be seen in the spread, let alone what is going on in Slovenia and Slovakia”.

Obviously market sentiment has changed, and the question now is whether markets are overreacting. In the short term they may be, since although the danger of falling into a default spiral is real, there is the also a genuine possibility (but not certainty) of a deal being reached. But in the longer run they are not, since what Hungary is not suffering from is a short term liquidity crisis (or even a balance of payments one, the current account is in surplus), but a long run solvency and social sustainability one.

But to get to see what the end of this story may be, we need to go back to the beginning, and the origins of the present Hungarian crisis in the market correction of 2006. Those who could see that the global imbalances which were developing would eventually unwind couldn’t fail to see the warning signs that year, as Iceland, Turkey and Hungary all wobbled under the force of those early seizmic tremors. That was when I got interested in Hungary, and took the decision to set up a dedicated blog for the country.

Hungary seemed interesting for a number of reasons. It was a harbinger for many of the things which were to come, the rapid expansion of a fiscal deficit following the ending of a credit driven consumer boom (think Spain or the UK today), the ageing and declining population phenomenon in Eastern Europe, and it became the test pad for the application of “confidence building” measures, austerity programmes and structural reform to the economy of a country which had serverely lost competitiveness.

Nearly six years later, and with the Hungarian economy on the brink of a possible default, perhaps it is now a good time to take stock of whether this approach has worked.

The 2006 Fiscal Deficit

The key to getting inside the Hungarian problem is to ask yourself the simple question why the country had such a whopping fiscal deficit (over 9% of GDP) in 2006. For the popular press the answer was easy, it was the result of a spednthrift government trying to buy votes. In fact the then Prime Minister Ferenc Gyurcsany made it easy for them, he inadvertently admitted what they had been up to:

Some came who did not bother whether they would have a place in the country’s government, because they understood that this bloody country is about something else. They can understood that it could be worth being a politician here at the beginning of the 21st Century because we can create a different world……Instead, we lied morning, noon and night. I do not want to carry on with this. 

While this answer may well satisfy journalists and political sociologists, it cannot be entirely satisfactory for economists, who realise there are underlying processes (beyond flawed and corrupt individuals) behind these phenomena and want to get tot he heart of them. Could it be, for example, that the 2006 deficit was the culmination rather than the start of something. Certainly there had already been large deficits from 2002 onwards.

I’ve looked at a number of examples now of where fiscal “extravagance” suddenly breaks out in a country – Portugal in the late 1990s, Spain more recently – and a common pattern I note is that government deficts often surge at the end of a consumption boom as politicians try to keep economic growth humming and living standards rising, even while revenue falls. To some extent this does seem to have been Hungary’s case. As can be seen in the chart below, the country did have a very large consumption driven boom between 1999 and 2002.

After 2002 the thing evidently eased off, meaning government revenue slowed, and hence the start of the deficit problems. Why the consumption boom ended is not clear, but it does form part of a pattern. Although conventional economic theory doesn’t seem able to account for the phenomenon, many countries seem do seem to pass through some sort of transition wherby they move from been consumer driven to export driven economies. Germany is a good case in point, since as we can see Germany had a substantial consumer boom in the 1990s before converting itself into the export champion we have now grown to know and love.

But impressive as all this looks, it has not been enough to get the kind of GDP growth that Hungary evidently needs (among other things to pay its debts and its contingent liabilities to its elderly population).

In fact, despite the massive increase in exports since the end of the global financial crisis, Hungarian GDP has only recovered slowly. Hungary’s economy fell by 7% in 2009, grew 1% in 2010, and is heading back into recesssion at the end of 2011. Even leaving out the crisis year of 2009 Hungary has only managed average growth of under 1% since the austerity measures began in 2006. Something, somewhere evidently isn’t working as it should. In addition to the ongoing programme of structural reforms what Hungary needs is a short sharp shock in the form of forint depreciation, to recover a large chunk of competitiveness and boost investment into the export sector. In this sense “competitiveness” means having an export sector which is large enough (as in Germany) to drive GDP growth forward. At present value added in Hungarian manufacturing is only just over 20% of GDP as compared with over 40% in the German case (the gross export values are misleading, since Hungarian industry is highly intergrated with German industry, and a lot of the activity is processing components which are imported and then re-exported).

But this kind of forint depreciation (which to some extent we are seeing now under the impact of the crisis) is impossible to achieve without debt restructuring (or outright default) since so much Hungarian debt is denominated in other currencies (largely Swiss Franc – roughly 85% of Hungarian domestic mortgages are denonominated in CHF). Gross external debt is around 140% of GDP and rising as the forint falls, while government debt stood at 83% of GDP at the end of September, and around 45% of this is forex denominated.

No-Devaluation High-Interest-Rate Trap?
So far from wishing for the forint to fall, the central bank is busily raising interest rates to try to sustain its value. Base rates have now been increased twice since October, and now stand at 7%, even though the country is heading towards recession and most central banks are near the zero bound.

Naturally, raising interest rates only helps choke off declining domestic demand even further.

Incidentally, the sharp drop in Hungarian retail sales that can be seen in July 2009 is the product of a 5% rise in VAT, a rise from which Hungarian sales have never really recovered. So much for the received folk wisdom that consumption tax hikes are “comparatively harmless”, since the real situation is “it depends”.

Naturally, this export dependence is not simply anecdotal. Hungary, like many of its Central and Eastern European peers, has a massive demographic problem. Population is already falling, and any sudden default would only precipitate the added issue of a sharp surge in the numbers of qualified young people packing their bags and leaving.

And the potential labour force is both ageing and shrinking.

So the problem isn’t going to go away, and is only set to get worse with time.

The Harbinger Of Things To Come On The Periphery?

Thus Hungary is in a similar situation to many countries on Europe’s periphery (in or out of the Euro), without real devaluation the economy will never get enough growth traction, and restructuring of the debt at some stage or another is more or less inevitable.

But there is another factor which gives what is happening now in Hungary special significance, and that is the problem of “reform weariness”.

Basically, if the solutions which are being promoted by the IMF and the EU Commission are based on a faulty or incomplete analysis of the situation, then the measures being promoted eventually won’t work as they should, and this will lead to disappointment. The political dynamics of what then happens is what should be concerning those who are able to think about such things. Could Hungary be the first example of a country that has lost hope and gone down the road of believing in demagogic politicians? Will there be more Hungaries? Could this be what the future in countries like Greece, Latvia, Portugal and Italy will look like. And if it is, how the hell do you hold the EU, let alone the Euro together? This is the burden of responsibility that now falls on the shoulders of those with responsibility for taking the decisions.

It was, after all, in Hungary that the new orthodoxy of relying on “non-Keynesian” effects related to expectations and credibility was formally announced and put to work.

In emerging market countries with debt overhangs, the “Keynesian” effect of fiscal adjustment is likely to be outweighed by “non-Keynesian” effects related to expectations and credibility. Non- Keynesian effects have to do with the offsetting response of private saving to policy-related changes in public saving. In particular, if fiscal adjustment credibly signals improved public sector solvency, a fiscal contraction could turn out to be expansionary, as private consumption rises based on the view that future tax hikes will be smaller than previously envisaged. IMF – Hungary, Request for Stand-By Arrangement, November 4, 2008

Naturally this approach was subsequently transferred from emerging market countries (like Hungary) to more developed economies along Europe’s southern fringe. Private consumption, unfortunately, has notably failed to rise. Perhaps there will be more than a little historic irony involved in Hungary being the country where the whole experiment eventually went badly wrong, although I doubt the Hungarians themselves will se it that way.

Back at school I remember learning about the example set by the British army sargeant at Vimy Ridge who lead his troops out of the trenches and into the withering fire of the German machine guns with the phrase “Come on You Bastards, Do You Want To Live For Ever!” This was the classic example, it seems, of charismatic leadership. Only years later did I twig the double entendre of the expression (which could also have been, “Come on You Bastards, Don’t You Want To Live For Ever!”

So this weekend, as he tosses the coin to decide whether to accept the EU conditions or not, Viktor (she loves me, she loves me not, she loves me….) Orban may do well to pass an idle moment or two perusing the immortal lines left for our greater edification by the late, great and one-and-only Eddie Cochrane.

Now there are three steps to heaven
Just listen and you will plainly see
And as life travels on
And things do go wrong
Just follow Steps 1, 2 and 3

No related posts.

Naturally then she will not have been amused to learn last Friday that rather than the 6% promised under the Spanish stability programme, the country’s deficit in 2011 is going to be something like 8%. Some sort of overshoot was long being anticipated, but such an overshoot? Naturally it isn’t (quite) Greek proportions, but it is still hardly evidence for a credible and praiseworthy effort. This is the thing about Spain, it obviously isn’t Greece, but still all isn’t quite what it should be. Add to this deficit result the fact that the Bank of Spain is reported to be frantically pressuring banks into revising the valuation of their property asssets following the publication by ratings agency Fitch of a report which claims they are currently on average 43% overvalued. And, of course, any major downward revaluation of the repossesed assets will give an entirely new reading for the balance sheets of many of the institutions involved (the Caja de Ahorros del Mediterraneo went from having a 50 million euro profit at the end of 2010 to 1.7 billion euros in losses in June 2011 following the application of just such a mark-to-market procedure – and the savings bank was finally sold to Banc Sabadell for the princely sum of one euro). Put two and two together here, and it is clear that the country’s bond spread may once more be in for a bumpy ride when investors finally recover from their yuletide hangovers.

Excuses are, of course, already being prepared for this lamentable state of affairs, and in particular the argument is being run that in fact the responsibility here does not lie with Spain’s central government (which was entirely composed of choirboys and girls), but with a lamentable set of constitutional arrangements which give far too much spending power and control to the country’s regional governments. To some extent this is true, but as I say, it is important not to take everything here at face value, since as ever, all is not what it is made out to be.

This advice could, as it happens, have proved useful to New York Times reporter Suzanne Daly who vertently or inadvertently seems to have been taken for a complete ride with the article she wrote for the newspaper last Friday. The focus of the article was purportedly on regional extravagance in Spain, but in the event she seems to have allowed herself to be used to float a political agenda which primarily seeks to take the attention away from the country’s central government, and the responsibility it has for the current lamentable state of affairs. Naturally examples of regional extravagance certainly abound (hell, the entire country was living beyond its means), but I started to smell a rat when I saw the example she chose to highlight in her article – the prison at Puig de Les Bases, Figueres (which just happens to be located only a few kilometres from where I live).

What worried me is that the prison you can see in the photo above is NOT an example of something that isn’t needed, like a phantom airport, or a golf course where no one will ever play golf. The problem with Puig de Les Bases is not that there aren’t prisoners waiting to be moved there from the two outdated prisons which are scheduled to close (there are, 300 of them, to which can be added an additional 450 once the new one is open). No, the problem here is that there isn’t enough money to run the place after it opens. This situation is not untypical, since many town halls and regional governments, not to mention the central government itself with its new high speed train network that the country can ill afford, find that they invested money on projects using the extraordinary income they were receiving during the years of “excess” but that now they don’t have the current revenue to keep the facilities created operating.

In fact Suzanne Daly does notice this, but she seems to get so carried away with the force of her own rhetoric that she doesn’t catch the significance of the point.

“Evidence of the regional profligacy dots the countryside. On the top of a hill here in the birthplace of Salvador Dalí, in northeastern Spain sits a giant, empty penitentiary. But even without a single prisoner in residence, the prison is costing Spain’s heavily indebted regional government of Catalonia $1.3 million a month, largely in interest payments. If prisoners were actually moved in, it would cost an additional $2.6 million a month. So it sits empty, an object of ridicule around here, often referred to as the “spa.” ”

So the question is, is this an example of regional profligacy, or an example of cuts which are biting, and a country which is coming to terms with its new reality?

The issue, however, goes deeper. The offending prison is in Catalonia, and Catalonia is a region which has long been seriously underfunded by the central government – indeed as was suggested by the regional minister of economics, Andreu Mas Colell, it looks suspiciously like the central government were not paying funds owing to some key regional governments to make the regional deficit look worse, and the central deficit look better.

Mas Colell who is a former Harvard professor, and distinguished micro-economist in his own right, recently told the central government that it should be ashamed of itself for withholding money which legally belonged to someone else (in this case 759 million euros for investments which have already been completed) and basically acting in complete bad faith.

“Els hauria de caure la cara de vergonya”, “és una mala jugada poc honorable i que no oblidarem”, “estan fugint i fent servir excuses de mal pagador”, “són molt poc exemplars”, “no poden desentendre’s amb arguments pobres”, “els avergonyirem”. Són algunes de els expressions que ha utilitzat el conseller d’Economia per referir-se a l’impagament dels 759 milions per part de l’Estat…… Amb tot, el conseller veu una clara intencionalitat en el no pagament d’aquests diners. “L’Estat vol que se’ns carreguin a nosaltres els quatre punts de dèficit que suposen aquests 759 milions i no a ells. I no paga perquè no vol pagar i no vol augmentar el seu dèficit”,

“They should be ashamed of themselves… its an injustice without honour, and we won’t forget… they are running away from their responsibilities using the typical excuses of someone who doesn’t pay their debts… this is hardly setting a good example… they can’t ignore the situation isung pathetic arguments… we will make them feel ashamed”. These are some of the arguments used by the Catalan economy minsiter with reference to the non payment by the Spanish government of the 759 million euros … The minister did not mince his words when it came to the reason behind the non payment. “The central government want to put on our account the 0.4% percent of deficit which these 759 million euros will involve for us, and they don’t want to add them to their deficit. They aren’t paying simply becuase they don’t want to pay, and they don’t want to increase their deficit.”

Naturally, the Catalan government is taking the central government to court over the issue, but given the efficacy with which justice is executed in Spain, I don’t think I’d be waiting for the result before finding solutions to the problem all this represents.

The central point here is picked up on by a group called Collectiu Emma, (an association of activists which spends it time correcting factual inaccuracies which appear about Catalonia in the international press, inaccuracies which in no small part have their origin in a constant public relations campaign conducted from Madrid). As they say:

“One key point that is overlooked in your otherwise informative article on Spain’s economic difficulties (As Spain Acts to Cut Deficit, Regional Debts Add to Woe, December 30, 2011) is that Spain is not a federal State. Under the country’s fiscal arrangement taxes are collected by the central government, which will keep part of the proceeds for itself and distribute the rest among the regions to pay for the services that have been devolved. There is no correspondence between what the regions get to spend and the wealth they have generated.”

“For the last year Catalonia, one of the most productive and most heavily taxed communities, has been undergoing painful cuts in services. And yet, the share of tax money that it contributes to the State and never comes back is estimated today at a staggering 8-9 per cent of its annual GDP. If Catalonia could use even part of those funds to finance essential services for its own population, it would have no deficit and no debt, and could even afford one or two extravagant schemes like those that other regions -and the central government itself- can enjoy as long as they are paid for with somebody else’s money. Catalans would not mind a serious revision of the regional setup, but only if it envisages fiscal responsibility on the recipients’ part, better control over their own money by those who have earned it and more transparent procedures by the central government”.

Now one of the points Collectiu Emma didn’t make, but could have, is that Catalonia is one of the few regional governments (and maybe the only one) which has responsibility for administering the prison service. Catalonia also received so little money from central government in 2011 that it effectively ran out of cash in December (not because it is “extravagant” but because it is seriously underfunded) to such an extent that it was not able to pay all public servant salaries for December before the end of the year. So in fact one of the reasons the prison is lying idle is that the central government is not forwarding money it has a legal responsibility to transfer, and the reason it is doing this is to massage its own deficit, and encourage people like Susanne Daly to write the article she wrote.

It gets worse, since some of the “misinformation” about the situation in Catalonia has, in my opinion, a deliberate political intent – to recentralise Spain. This is certainly the objective of tax minister Cristobal Montoro, since many in the Partido Popular are already very fed up with the fact we insist on using our own language, and doing things our own way (like banning bull fighting).

“And while Spain’s overall fiscal status is nowhere near as dire as Italy’s, it has another problem all its own, as the new budget minister, Cristóbal Montoro, made clear Friday: serious budget shortfalls in its 17 autonomous regions, which have spent recklessly in the past decade”.

It is also striking how the article also draws attention to spending issues in the community of Andalusia (which is the only community the socialist PSOE really controls now, and which the PP hope to win in elections in the spring) while there is no real mention of communities like Valencia, or Galicia, which are controlled by the PP and where there are plenty of examples which could be mentioned, like the phantom airport in Castellon, built under the eager eyes of former Valencian President Francisco Camps, who had to resign and is now facing corruption charges in a trial which is currently attracting a lot of media attention.

Now I am sure, as the Collectiu Emma people point out, there are many examples here in Catalonia of projects which were not needed (the Alguaire airport in Lleida would be one), but the key difference here is that Catalans overspent using their own money, while many regional governments (some of them ruled by the PP) did so using Catalan money. So it is curious, to say the least, that the author decided to kick the article off with a big picture (see above) of a prison in Catalonia to serve as the stylised example to epitomise the problem.

But there is another issue being raised here, since it is not clear whether all the attention which is being focused on the Figueres prison is not – in some warped way – a by-product of protests by prison staff unions against the all the reecent spending cutbacks. Searching around for background information, I discovered a most interesting article in El Pais (sympthetic to the Spanish socialist party PSOE) entitled “locos por ir a la carcel” (desparately seeking to go to prison). The gist of this article concerns the plight of a number of unemployed people who have passed the exams needed to have places in the prison service, but who can’t be offered work since the prison is not open.

What the El Pais article offers us is the view of a heartless Catalan government making swingeing cutbacks on important social projects. Far from putting the blame on the outgoing socialist lead catalan government who built the prison in the first place, the article blames the new justice department head, Pilar Fernández Bozal, who hasn’t opened because she hasn’t been able to obtain the funding needed. The impression I get is that in this game it is hard to win.

At the end of the day the lesson I would advise Suzanne Daly (or Angela Merkel if it comes to it)  to learn from this whole affair is that nothing in Spain is exactly as it appears to be, and that few of the arguments politicians and so called “experts” advance are entirely innocent. Mostl “information” circulating in Spain is highly politicised. Really “independent” analysts are virtually unknown.

Government and opposition in Spain operate like a revolving door. Crickey, I even saw outgoing Minister in the Zapatero government Alfredo Rubalcaba on TV yesterday, openly criticising Mariano Rajoy’s government for all the cutbacks that have just been announced and for having no policy up to the task of dragging Spain out of its crisis, without even blushing or mentioning that the cuts in question were so big because his government overspent – or tolerated overspending – or that the policies the new government are following were basically identical with those which guided his own government.

Far from suggesting that the prison project was an extravagant excess, El Pais implies it is badly needed (since space in the Catalan prison system is extremely scarce), and my feeling is that with crime on the rise after 4 years of continuous crisis, El Pais is probably more right about this than the New York Times author is. Lesson to be learnt: simplistic answers to complex situations are rarely satisfactory. And if you want to come to Figueres and look for a spending white elephant, well, you need go no further than the high speed railway line linking the town with Barcelona. The track has been up and ready for around a couple of years now (see the bridge to nowhere in the photo above), but there is no sign of any train, since there is not sufficient money available to finish the job. But then this particular piece of short term redundancy was planned and executed by the central government on a live-now-pay-later basis, but that wouldn’t fit the story we are being sold, now would it?

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Not that Italy is any stranger to recession, since the country has now had five of them since entering Europe’s Monetary Union at the turn of the century. In fact the Italian economy has now contracted in eight of the last 15 quarters, and GDP is back in the good old days of 2003, stuck below the level it first attained in the first three months of 2004. And of course it is now going backwards in time again. Depending on the depth of the recession now being provoked it is touch-and-go whether the economy might not at some point even revisit levels last seen in the closing years of the 1990s. And remember, this is not deflation ridden Japan, this is real, not nominal GDP we are talking about here. So far Italy hasn’t been experiencing deflation, or at least not yet it hasn’t.

All in all, it would be hard to say that the Euro has worked well for the Italians. Maybe it was a great opportunity that the country was unable to take advantage of, but in any event all they are going to see from here on in is the downside part of it. The inability to adjust the value of a domestic currency they don’t have to compensate for all that wantonly lost competitiveness means they are going to have to do things the hard way, subjecting themselves to a collective ingestion of codliver oil the like of which the country has not seen since the harsh days of the1920s.

Sinking Below Ground

The extent of the problem the country now has can be easily seen in the chart below, which shows annualised growth over a decade (as a moving average). What is absolutely shocking is that in the ten years  up to 2010 Italy had an average annual growth rate of just 0.28%. Assuming growth of about 0.5% in 2011 (which may now be generous), in the decade to 2011 this will drop to 0.15%, and if we pencil in a contraction of 1% in 2012 (perfectly realistic, in fact it will probably be worse) then the number turns negative. That is to say, on average the Italian economy will have shrunk every year for a decade.

Some may say that this result is in part a by-product of the global crisis, and they would be partly right. But look at the trend over the last three decades, far from seeing some stylised version of steady state growth hovering around a constant mean, the rate of expansion in Italian output has been heading relentlessly downwards, so logically it was always bound to cross the zero line at some point. That point now seems to be about to arrive in 2012, a year which may mark a before and after in modern Italian history.

Naturally, the reason why Italian growth has fallen so far is the big point at issue here. One of the reasons is obviously a competitiveness loss resulting from higher than Eurozone average inflation sustained over a long period, but another component is possibly the impact of population ageing, which has hit Italy more than any other European country except for Germany, and it is with Germany, of course, that Italy has the largest competitiveness loss. Demographically speaking Italy is Germany minus all that export competitiveness.

Looked at from another angle, like many other countries Italy probably grew rather over trend in the years between 2004  and 2007, and then dropped back sharply in 2008. But the Italian economy fell further than most of its peers, and subsequently really failed to recover. This is the clearest demonstration of the competitiveness problem, and it won’t be easy to address.

It’s The Competitiveness Silly!

As is well known Italy is weighted down by a massive burden of public debt (120% of GDP). Even before the recent surge in Italian bond yields servicing this debt consumed an onerous volume of government income. But this debt alone does not explain why Italy has such a poor track record. Japan, for example, has a debt burden of over 200% of GDP and still manages to eke out a better growth trajectory. The two countries are similar in that domestic demand is permanently weak (they both have elderly populations, with a median age of around 45) yet difference between the two countries is obvious, since Japan (like Germany) has a large and dynamic export sector which generates a trade and current account surplus, and this buoys investment and GDP growth. Italy, on the other hand, has a trade and current account deficit, and both of these have been worsening since the end of the last recession.

Naturally a negative trade balance weakens the GDP reading, given the impact of the net trade effect, but curiously the recent GDP slowdown has been associated with a drop in government spending (which is what previously had been sustaining Italian GDP in positive territory), a fall in domestic consumption, and a consequent fall in imports (which is why the trade balance has been improving somewhat of late). Indeed, the reduction in imports meant that the net trade effect was one of the few positive points in the latest GDP reading - even while the economy contracted by 0.2% net trade added 0.8 percentage points to what would otherwise have been a devastatingly bad number. So there is no need to call in inspector Clusot to find out what happened, it was clearly the sharp cut in government consumption that finally killed off the fragile Italian recovery, although naturally, given that government debt was – and has been for some years – on an unsustainable path, the spending tap had to be shut off at some point. What Italy now needs – like so many of the countries on the EU periphery –  is a sharp improvement in international competitiveness and a significant surge in investment into the export sector. The two of these naturally go together, since few will invest in activities which are unlikely to be competitive and profitable.

Italy does have a stronger export sector than some of its Southern European counterparts, and exports did surge as the global economy started to recover (see chart above), but they never managed to reach their pre crisis level, and now, at least according to the latest PMI surveys, they are weakening once more as the European and global economy slows.

Italy was far from having a consumer boom during the good years of the first decade of this century. In fact household consumption grew by less than 5% between 2000 and 2008, and in any event the pace was much slower than in the 1990s (see the shift in steepness of the slope in the chart below).

Retail sales have been falling since 2007.

And construction spending has been one steady slide down.

And yet, despite all the pressure on Italian banks there is (as of October) no sign yet of a sharp credit crunch affecting either firms or households, since private sector credit is still growing at an annual rate of around 4%, a stark difference from the picture in Greece, Spain, Ireland and Portugal where private sector credit is steadily contracting.

No Boom, No Bust

So to be clear, Italy did not have any sort of housing or credit driven boom during the first decade of the century, Italian households and companies are not massively in debt when compared with their Euro Area peers, and credit is not in especially short supply. Ageing population dynamics lead domestic consumption to be weak in Italy (following a pattern which is strikingly similar to that seen in Japan and Germany), yet Italy’s export sector has been allowed to drift as competitiveness has been lost. Really the most telling chart I have is this one, which shows how as the current account surplus has widened (ie as competitiveness has been lost) long term growth has steadily declined.

With neither exports nor private consumption able to pull the economy the state has been under constant pressure to offer support via deficit spending, leading to the accumulation of an unsustainable quantity of government debt. This deficit spending is about to come to an end (permanently according to the latest EU agreement), and under these circumstances the economy is likely to remain in or near contraction for as long as it takes to recover competitiveness. The question is, how long is that going to be, and what will happen to the debt dynamics in the meantime.

To take the second question first, one of the reasons that many are confident Italy will make it on through with the debt challenge is the country’s recent record in controlling the deficit. According to OECD data, while Italy ran a cyclically adjusted primary deficit every year between 1970 and 1991, it ran a cyclically adjusted primary surplus every year since 1992. That is to say, before allowing for interest payments Italy has not been running a deficit for many years now, and it is simply the burden of servicing the accumulated debt which is causing the country to spend more than it receives in revenue. As many of those who are in the “optimistic” camp on the question of the country’s ultimate solvency eagerly point out, Italy’s cyclically adjusted primary balance as a proportion of GDP has remained in a better shape than those of the largest developed countries as well as those of European peripheral and core countries since the onset of the crisis. It is only the legacy of the past which acts like a dead weight pulling the country down, but what a legacy this is, and especially as yields on Italian debt have steadily risen.

Poised On A Knife-edge

But given everything it is clear that Italian debt, and with it the future of the Euro, now sits poised on a knife edge, as is illustrated in the chart below (which comes from Barclay’s Capital). If you take a neutral scenario where Italy has a balanced budget and a sum total of zero nominal GDP growth (ie growth+inflation = 0) debt stays put at 120% of GDP out to infinity.

But then imagine the average finance cost of Italian debt rises, and stays high. In this case  the only way to compensate  is by running a larger primary surplus (ie more spending cuts, or revenue increases to compensate for the extra interest cost). The net effect of this would either be to generate deflation or a more sustained economic contraction, in which case debt to GDP would start to rise indefinitely. Think of it like this, either prices fall by one percent and GDP (via exports) rises by 0.5% (for example), in which case nominal GDP falls 0.5% a year (the Japan type case), or prices rise by 0.5%, exports lose more competitiveness, and so growth falls by 1%. I mean, this example is only illustrative, but it is meant to give some sort of feel for what “knife edge dynamics” really mean.

In fact, before the recent surge in the spread, average interest costs on Italian debt had been falling in recent years, but now they are evidently rising again. It is very important here to remember that  yields in bond auctions only affect new emissions of debt (and changes in the secondary market only really affect banks, and sovereigns through possible needs to recapitalise banks). So it is a question of years before the higher levels “lock in” – the average maturity on Italian debt, for example, is around 7.2 years, and indeed since governments finance at fixed and not floating rates (not at a certain % above 3 month Euribor, for example), debt costs are at much at risk from increases in ECB base rates as they are from the actual spread with German bonds. Any substantial increase in interest costs naturally makes selling debt more expensive. Fortunately for peripheral sovereigns, the likelihood of ECB rate rises in the foreseeable future is near to null.

No Way Back Home

But again, let’s do another thought experiment. Imagine I am right, and  Italian debt is on a knife edge path, and suppose the average interest rate on the whole debt creeps up by 1 percentage point. With debt at 120% of GDP, then the primary surplus to cover the added interest costs and maintain a balanced budget would be 1.2% of GDP. But suppose, for the sake of argument, that increasing the primary surplus by 1.2% pushes Italian debt to gdp up to 125% (via a combination of either deflation or economic contraction), then the next year the primary surplus would need to be up by an additional 0.05%, helping force debt to GDP up even further and so on and so forth. This is why people call this the debt snowball. The point is, whichever way you turn, you seem to find the exit door locked.

Coming back to the details of the present situation, the Italian government has committed itself to a consolidation program worth €74bn over the next two years amounting to roughly 3.7% of GDP. This is designed to bring the budget into balance (or the deficit to zero) by the end of 2013. On quite conservative assumptions, just to tread water, and maintain the debt level where it will be in 2013 (which will be more than 120% of GDP due to the recession), Italy will need a primary surplus of 2.3% of GDP.

But then we need to think about the recently undertaken commitment to reduce the debt (the last EU summit). The exact numbers have yet to be agreed for the new pact, but it looks like a cyclical maximum of 0.5%, and (even more importantly) a commitment to reduce outstanding debt over 60% of GDP by 5% a year. This, in Italy’s case will mean the country is going to need (from 2014 onwards) a primary balance of something like 5.5% of GDP (depending on the evolution of interest costs) over the rest of this decade. Which means the Italian economy is going to face an even more restrictive fiscal environment.

Now, those who argue the Italian crisis will have a happy outcome point to history, and argue that Italy was able to achieve a primary surplus of around 5% on average during the years 1995-1998, so why shouldn’t the country be able to do this again? The main counter argument would be that that was then, and this is now. That is to say, these were the years of Italian “coupling” with monetary union, sizable privatisation programmes, falling (not rising) interest rates, and basically Italian trend growth had not fallen as far as it has now.

Moreover, the external environment in Europe will not exactly be conducive to boosting exports. Even core Euro Area countries are commited  to undertaking additional fiscal consolidation beyond what is currently envisaged in order to comply with the new debt rule. Taking 2014 as the starting point, debt to GDP for the Euro Area as whole might be something like 90%. Hence the 1/20th rule would imply that on aggregate the Euro Area will need to reduce its debt ratio by around 1.5 percentage points per year. If this agreement is complied with the adjustment will almost certainly imply a net fiscal drag on growth in the years following 2013. Of course, if it is not complied with then it will almost certainly be “bye bye Euro” (assuming the common currency still exists that far up the road).

It’s All About Structural Reforms, Or Is It?

So basically, what the whole argument about whether or not Italy can make a final burst and reach the finishing line is all about structural reforms, and whether the country can get enough growth (quickly enough) to turn the “knife edge trap” around. Personally I am extremely doubtful that it can, which is why I placed so much emphasis on the growth performance in the first section. The turnaround needed here is massive. It is a 30 year decline we are talking about, and I doubt short of outright default and substantial devaluation we have historical examples of anyone doing this. The adjustment made in Germany between 1999 and 2005 was much smaller in comparison.

One of the proposals is to introduce labour market reforms to increase participation rates, but in fact the Italian labour force grew substantially between 2004 and 2008 (due to large scale immigration), with employment being up by over a million (or around 5%, see chart above), yet the increase in output was ridiculously small. On the other hand we know the Italian working age population is contracting (and the average age rising), while the elderly dependent population is increasing rapidly. Conventional economic models tend to be silent on this issue, but common sense should tell us that this is going to take its toll on growth – a factor the “structural reform answers all our problems people” don’t seem to have given enough thought to.

The Monti government needed  just five weeks in office to push through an additional 30 billion-euro emergency budget package, but how long will he need to get GDP growth back up above 1% annually? And how much time does he have? Investors initially cut him some slack, but judging by the reaction to the final approval of the package by the Senate - the yield on Italy’s 10- year benchmark bond was pushed up by 12 basis points to 6.91%, dangerously close to the key 7% level (although still somewhat below the Euro era record hit on November 9, just before Monti took charge). 7% is  widely considered to be critical if sustained for any great length of time, partly due to the cost of debt servicing but also because of the level of dependence of Italian banks on the ECB that it would produce.

Till The Dowgrades Fall

So the “Full Monti” effect now seems to have  been priced in, while investors nervously wait to see what the real plan for Spain and Italy actually is.

The first quarter of 2012 looks to be critical for Italian debt, with about one third of the total Euro Area debt maturing being Italian. Indeed the battle starts this week with the Treasury having to sell an assortment of T-bills and 2 year and 10 year bonds. In addition the Italian government is now increasingly guaranteeing bonds issued by Italian banks to be used as collateral at the ECB  – with about 40 billion euros being issued last week according to some estimates. So effectively Italy is now more or less guaranteeing the banking system with the likely outcome that ratings agencies will be even harder on the sovereign rating.

Not that the outlook was exactly bright on that front anyway. Understandably, Italy was among the 15 Euro Area countries Standard & Poor’s placed on review for a possible downgrade on December 5. This follows an earlier downgrade to a single A by the agency in September. In addition, Spain and Italy were both warned by Fitch (which cut Italy’s rating to A+ in October) on December 15 to brace for a further debt downgrade after concluding that a “comprehensive solution to the eurozone crisis is both technically and politically beyond reach”. And to complete the set, Moody’s, which cut the country to A2 on October 4, maintained a negative outlook, signifying that a further dowgrade in the coming months was highly probable  The bottom line is that Italy is both too big to fail and too big to be bailed out, which is why it is still hanging dangerously in limbo-land. Since, as I argue in this article, some sort of restructuring or other is well nigh inevitable in the Italian case, the sooner Europe’s leaders work up a credible plan on how to achieve this, the better. Otherwise it will not only be Italy’s citizens who are subjected to the Full Monti, Europe’s leaders may also find themselves with their credibility stripped naked.

This post first appeared on my Roubini Global Economonitor Blog “Don’t Shoot The Messenger“.

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