Merkel and Sarkozy’s fiscal plan doomed to fail?

9th January 2012

Today’s version of the programme is that the two leaders who now meet so often that many have merged their names to the acronym Merkozy tell us that they will set a fiscal plan for the 17 Euro zone members. However let us take a look at how their previous grand designs have progressed.

May 10th 2010

Shock and awe

EFSF

The only “shock and awe” from this meeting was at the incompetence of the grand design. For example the Euro zone rescue fund which became called the European Financial Stability Facility has been a damp squib. Rather than the “shock and awe” 440 billion Euros it has in fact deployed some 12.5 billion Euros according to its website or 2.8% in 20 months. Along the way the guarantees for it have been expanded to 780 billion Euros so you could argue it has actually spent only 1.6% of its guarantees.

If you wish to see how the new improved EFSF is doing well there is a clue in its latest newsletter.

The issues initially scheduled in Q4 2011 in support of Portugal could now be issued in early 2012.

Yes even now it needs to delay a quarter and notice the use of the word “could” meaning that it was not sure. I will lead readers to mull over the fact that an organisation rated at 780 billion Euros and full of hype and bombast using the word could in raising maybe a few billion for Portugal.

It did in the end raise some money (3 billion Euros) on the 5th of January but the signs of retreat were there too as it only issued a 3 year bond rather than the originally intended ten years. Does anybody believe Portugal’s problems will be solved in the next three years?

European Central Bank peripheral bond buying: The Securities Markets Programme

In concept this operation is simple when a nation in the Euro zone finds that its government bond market is facing heavy selling and price falls the European Central Bank steps in as a buyer. In the original incarnation this was to support Greece and her bond market. How did that go? The initial phase of the programme reduced Greece ten-year bond yield briefly to 6% but more generally into the 7-8% range. Success? Er no as it is 35.25% as I type this. So Greece is now in a much worse position and is unable to fund herself with any form of bond issuance ( as she would immediately be demonstrably insolvent). In addition the European Central Bank which has approximately 45 billion Euros of Greek debt on its books as a result of this programme has accumulated very large losses.

If we take the books of the balance sheet of the ECB it could quite easily be losing 15-20 billion Euros on its investment in Greek bonds alone. It has a capital of 6.36 billion Euros if we count just the Euro area on its own ( for nervous UK and other non-Euro nation readers the commitments made by those ten nations are relatively small and are 3.75% of ECB capital). I hope that this paragraph illustrates why I have been writing articles for some time challenging the financial position of the ECB itself.

Now if we add in that the ECB has intervened in the government bond markets of Ireland ( ten-year yield of 8.2%) and Portugal (13.3%) and lost money their too you can see that stage one of this programme failed in every respect I can think of. It managed to cripple the balance sheet of the ECB whilst failing to improve the situation of the three nations involved and in fact they got worse, much worse.

Faced with failure what do you do? If you are Merkozy and co. you repeat it of course! If we move into 2011 the ECB was instructed to intervene in the government bond markets of Spain and Italy too. After their July 21st meeting the ECB surged into the Spanish and Italian bond markets like the US cavalry. Unfortunately for it the surge into the Italian bond market in particular was like the US 7th cavalry at Little Big Horn. In spite of very heavy intervention ( the SMP now totals 211.5 billion Euros) the intervention which was supposed to stop Italian benchmark bond yields of circa 6% now sees them at 7.1%. So we see the ECB’s balance sheet accumulating more losses and Italy looking insolvent which I would call a defeat.

The situation is Spain is not as bad but sadly I feel that this is likely only to be a matter of time. It was only on January 3rd that I described the poor outlook for Spain in 2012 with the latest retail sales numbers for example down 7% on the previous year.

At this point it may be  hard to see how this programme could have failed more comprehensively. But unfortunately you can as two members of the ECB Governing Council have gone “man overboard” on this issue and they were both German. The media has tended to ignore the implications of two influential Germans leaving the ECB when Germany is the biggest shareholder in the ECB (and EFSF) at 27%. Imagine the impact of any sort of German disengagement and I think that you will get the idea and indeed the danger.

A Greek debt haircut

This section at least has the advantage of being about something that I genuinely feel could help. I have been arguing on this blog for a debt haircut for Greece since the early part of 2010. Unfortunately as timing and psychology do matter here ( whilst we are rational beings in some respects we are also irrational in others) it is disappointing that the Euro zone took until the summer of 2011 to address this.

Even worse the proposed haircut at 21% was far too small. Indeed the fact that the haircut was going to be more like 30% if you did the calculations helped very little. Yes it was a little more realistic but you had to then face the fact that the Euro zone appeared to have incorrectly calculated its own plan. Either way the bondholders themselves were not very keen and their assent was required as otherwise this would be officially recorded as a default.

If you cannot get investors to agree to a 21% (30%) haircut then raising it to a  a 50% one seems doomed to failure, but this seemed to deter no-one in authority in the Euro zone. Indeed moving up to today we see that there is now talk of raising the haircut to 55/60%. Apparently those who did not sign up to a 21% haircut and and 50% will be keener on a 55/60% one…..

There is a deeper flaw in all this and that is as it stands a 100% haircut on the current basis would not bring genuine benefits to Greece. This is because of two factors. Firstly Greece’s projected national debt seems set on a collision course with 200% of her annual economic output as measured by Gross Domestic Product so any change needs to be substantial. Secondly the bondholder plan excludes substantial holdings of which the ECB’s described above is one and the Greek banks are another. If you haircut the Greek banks you will see them immediately collapse so they need a bailout. This is before you get to the impact on Greek pension and insurance funds. Accordingly the benefit from the current plan is too small.

As the young girl called Newt put it in the film Aliens when told that some “mucho hombre” marines had come to rescue her.

it won’t make any difference

Today’s fiscal austerity

Today’s communique is likely to tell us about the plans for the Euro zone to implement a fiscal contraction. So far it has looked like the previous Growth and Stability Pact which everybody ignored. Rather ironically the worst offenders were France and Germany who at 1:30 pm will presumably have leaders telling us that this time is different.

One might also like to muse on how the existing plans are going. Let me see, higher fiscal deficits (not lower as promised by Merkozy) in Greece, Portugal, France and Spain. Belgium has seen
its plans criticised by the European Commission as unrealistic which they might not unreasonably think is the pot calling the kettle black but there you go. Maybe Ireland gives us the best clue from its press statement on its finances and if we ignore the introductory blizzard of bombast we see this.

The Exchequer deficit in 2011 was €24.9 billion compared to a deficit of €18.7 billion in 2010.

It is not an exactly fair comparison but it is not exactly unfair either. So when you hear promises for the future today please also remember that the track record so far is the opposite. Indeed austerity needs to go into my new lexicon of financial terms.

 

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