Tuesday, November 30, 2010

Welcome to the war

Those of you watching the news feeds this week will have noticed intensified pressure on Portugal, Spain and Italy from financial markets. This is the same pattern of rising interest rates that occurred to Greece before it was unable to borrow any more, and to Ireland as well. Governments feel this incapacity quickly because unless they are paying down their debts, they are rolling them over--issuing new debt to cover the old debts, and now at a much higher interest rate. What is happening to these countries is much the same as happened to homeowners in the United States with adjustable rate mortgages. They're all unable to pay.

These three countries have different debt structures and their governments have managed their economies differently. Portugal has never really had a handle on its public finances and pretty much enjoyed a free ride on the credibility of being a euro zone member until recently. It will probably be hit the hardest. Spain was a poster child for a catch-up economy that could manage its finances reasonably well--until the financial crisis burst the property speculation bubble on which all of its growth ultimately depended. Italy had a brief period during which it managed to pare down public borrowing, but has a deserved reputation for being as profligate as Portugal. Yet none of this matters at this moment. The markets are treating them as more or less the same.

They can. What is so important is not Portugal, but Spain and Italy, which are too large to save under the existing resources of the European Financial Stability Facility unless its resources are expanded, either directly, or by floating its own bonds on the market. A final alternative is that the ECB intervenes in a long-term way to purchase government bonds.This would be a new step in the institutional reform of monetary union to watch if it happens.

It should be clear by now that the small countries in EMU were but the first battles in what could turn out to be a much more wide-ranging war on the euro. Small countries are an excellent place to target. It is more likely that a change in policy will be dramatic enough that investors can bet on it and get a decent return on their bets. And investors can use these skirmishes to test how public authorities react before they consider when, how, and whether to go after the bigger targets on the battlefield. When confronted with an opponent, one may choose to deter (before hostilities resume) or to counterattack (wisely deploying the limited resources one has to protect one's most prized assets), but letting one's opponent set the pace and location of battle, where and when one uses one's capabilities, is always a losing strategy.

Yet that is precisely what has happened until now, to the detriment of EU governments. Until now, the desire of those who saw the poor fiscal discipline of small countries as the only real problem to be tackled led EU governments to hesitate when it came to fully appreciating that the ultimate targets of speculators are not small countries, but big ones. The absence of haircuts in the Greek and Irish battles simply provided further encouragement and resources to those who will take the next bets against Portugal, Spain or Italy. The result will be that unless EU governnments reform the EFSF further, and move toward some kind of fiscal union in name or in practice, the EU's money will run out before it can protect all of its targets.

The EU has less freedom of manoeuvre now. It could have previously decided to have a stronger bailout fund to deter attacks from the private sector, and to weaken the private sector with haircuts, but it didn't. It could have, alternatively, let a small country fail at an 'acceptable' cost relative to the collapse of a large state--the overall impact on the eurozone economy and on international migration would have been less--but it didn't do that either.

In short, the EU has been wasting its precious, limited resources on small battles that seemed more important to politicians than they were at the time. Now it is backed into a corner. The resulting fight will be messy, and nothing will be the same as it once was when it is over.

Whatever the outcome, politicians' understanding of how to deal (collectively) with speculative attacks in the future will change as a result of the lessons they learn in the time to come.

What the course of the war suggests so far, however, is that they would do well to gather together experts on military affairs, people with a good grasp of strategic issues and the impact that technology has on them, to advise them on how to wage and win the financial war they face.

Monday, November 29, 2010


A Franco-German agreement on haircuts that found support in the European Council was made public today. When countries require assistance from the European Financial Stability Facility, a standard agenda item will be whether and to what extent bondholders will be asked to accept a reduction in the value of their holdings.There is nothing automatic in this, but it has both precedent (it is standard in other venues) and the political support of the European Central Bank.

Who pays when a country defaults?

Yesterday's deal to bail out Ireland rejected a long-standing German demand that investors holding Irish government bonds take a haircut in return for EU aid to the banks.

Accepting a haircut is financial market-speak for accepting a reduction in the value of the bonds you hold. The German government, which has been one of the most openly critical of the behaviour of investors during the crisis, has insisted that there is no reason to provide public insurance for private risk-taking. Investment is a rewarding business, but also a risky one, and when investments go bad, investors have to accept losses.
When a government like Ireland can't pay its debts, bondholders run the risk of receiving nothing in return for their scraps of paper. The alternative is that they collectively agree to avert total disaster by agreeing to take only a portion of what is owed them, and extending new loans to give the country extra time. This is what is known as restructuring a country's debt. Outside governments can increase the likelihood that they will agree by sweetening the deal with extra loans to the country that can't pay. This gives the group of private bondholders a bigger pie to distribute, it softens the blow for the country that can't pay, and it prevents the country from collapsing. This is why the most likely source of this outside funding is the country's most important trade and investment partners. This was the case for Mexico in the mid-1990s, when the United States helped bail it out. And it is the case for Ireland and Greece today. It's enlightened self-interest.

Except that the European Union, unlike the United States, asks nothing of bondholders in return. They are, unless anything changes, getting 100% of their investment guaranteed by the euro zone in the final instance. And they are using that money to wage a further war against other countries they have in their sights. This week, the first salvos were shot at Portugal and Spain.

This European attitude is something to watch. So far, Germany has been unable to convince its fellow member states to make bondholder haircuts a condition of EU aid. Instead, the message that the Irish and others, including the European Commission are sending out, is that they are terrified that bondholders will turn their backs on the country entirely.

Why watch this point if European countries are not united in their assessment of whether bondholders must share in the cost of the crisis? Because the war has only started. We have yet to see financial markets attack a large country. If and more likely, when that happens, the EU will have to make some very tough decisions about how much it is prepared to give now (and that is limited), how much, if any, it is prepared to borrow collectively to bail out its weakest states (which implies a radical re-thinking of European economic principles and law) and how much the bondholders must pay.

If European governments listen to Berlin and make bondholders share the burden, they will be doing nothing different than has happened many times before. International investment will not dry up as long as the crisis is used wisely to restructure the economy, improve corporate governance and improve the regulation of financial markets as Ireland rebuilds.

Ireland's failure, the rise of the eurogroup, and Iceland's revenge

Ireland's caretaker government (the governing coalition collapsed as a consequence of the crisis) has accepted an emergency loan from the EU and the IMF worth 85 billion euros. As I predicted in my last post, Ireland is stressing that the money will go to the banks, either directly (45 billion in immediate aid) or indirectly (to cover banking losses that the government converted earlier into public debt).

At the end of the day, Ireland needed cash, and the UK promises of up to 8 billion euros (7 billion pounds) proved too small to be useful.

One element that Irish prime minister Brian Cowen has stressed from beginning to end is that Irish sovereignty will remain intact. The main issue he is concerned about is keeping the Irish corporate tax rate of 12.5 per cent that has brought so many companies to Ireland, and that has won Ireland a lot of hostility from the European continent. Now that the financial service industry has bottomed out, the last thing Ireland wants is the multinationals that moved to Ireland in recent years to pack up shop and leave. There is already an exodus from London toward Geneva and other ports, and Ireland doesn't want to be next.

Three additional points of this deal are worth noting. First, at the same time that the EU and the IMF are providing assistance to Irish banks, whether directly or indirectly, Ireland is raiding the national pension fund of 17 billion euros to ensure that the amount borrowed isn't even greater. This is a matter of grave importance for Ireland's future, as pension funds worldwide have been hit very badly by the double whammy of demographics and  the decline of pension portfolios as a result of the crisis. This is the perfect example of what economists call time inconsistency...and what the rest of us would call borrowing money today and never keeping the promise to pay it back. Because there never is a good time.

This point has been critical in bringing the Irish out into the streets in protest. Why should they pay for bad bets by Irish banks?

Second, Iceland has had it's moment of sweet revenge and has underlined that the Irish government is making a clear choice to subsidise bankers at the expense of the general populace Iceland's President Olafur Grimsson commented this week that his country doesn't have debt like Ireland because it let the banks fail and didn't guarantee bank failures with public money. This will surely prove to be a wiser choice than Ireland's.

Third, this deal was decided by the finance ministers of the eurogroup, who met on Sunday evening to finalise the deal with Ireland. Although it is sensible for these countries to have a formal role in euro zone matters, they do not, primarily because the UK has opposed it since before the euro existed. Instead, it is formally ECOFIN, the Council of Economics and Finance Ministers of the EU, which has this power.
What is happening and why is it so important? The euro zone, not the EU per se, is putting up the money to save its weaker members, and so it stands to reason that its ministers must meet to approve loans. This means that ECOFIN's role within the EU has been sidelined in an important policy area, and that attempts to keep the eurogroup down as a fact of life have failed.

The new EU, which is in the process of forming, will have to find room to accommodate this new reality.

Wednesday, November 17, 2010

The Irish Crisis

How it must hurt to be Irish right now.

Bond markets have been sending clear signals that lending to Ireland is a risky endeavour, that the risk of default is rising. Dublin must offer 665 basis points more for 10-year bonds than Berlin does, an astronomical 6.65 percent. The Republic of Ireland took on debt in 2008/2009 to assist its massive banking sector and prevent it from collapsing. Debts were transferred from the private sector to the public sector, with the consequence that swingeing cuts in public spending have been necessary, and the capacity to borrow when needed has shrunk.

Ireland is on the brink of being a developing country once again. And its government is looking for a way to avert catastrophe without resorting to a public bailout from Europe and the IMF under the auspices of the European Financial Stability Facility (EFSF).

As a result, Irish Finance Minister Brian Lenihan is seeking a bailout that would go directly to banks and not the government, saving the government the shame and humiliation of publicly receiving what amounts to institutionalised development assistance. If Lenihan is successful, he will secure an enormous state aid programme for the Irish financial sector. This would be ground-breaking (an EU facility to bail out private companies in addition to national governments),  expensive (no programme like this is restricted to a single recipient in EU politics), precedent-setting (other countries would line up for handouts if the Irish package were approved), and a massive violation of EU rules against public subsidy of private companies. All of which are reasons why it shouldn't happen. The EU has already broken rules on providing subsidies to banks in the financial crisis,. but until now it has been national governments who have been providing the cash injections.

It appears that Ireland's rescue may come from the country that sees itself as next to be torpedoed if the Irish ship sinks: the United Kingdom. This offer is for bilateral aid from London to Dublin, bypassing the EU and the EFSF, and possibly subsidising the banks directly in a way that would not set European precedents. In doing so, London is also keen to discredit the EFSF, which it has allowed to be set up but refuses to actively support. London stated today that whatever bailout plans Europe might offer would be too little and too late, and that national action was imperative and right.

UK Chancellor George Osborne today underlined the UK national interest in underwriting Ireland's survival and ensuring that Dublin can hold to its present course of budget cutbacks and structural reforms to the economy. That interest is not only based on the similar economic profiles of Ireland and the UK, including a distinctive reliance on low taxes, light regulation and a strong financial services sector. He sees the UK and Ireland as ideological comrades on the fringe of Europe, and he is right. The Conservative/Liberal Democratic government in the UK is also intent on preserving national sovereignty and inflicting massive budget cuts on the UK economy. Universities will have their funding cut by 80%, and welfare cuts are pending.

In Dublin Castle, there are portraits of James Connolly and other martyrs of the Easter Rising of 1916. It is there, looking into the faces of these men long gone, and listening to a tour guide explain how the British rounded them up and executed them, strapping Connolly to a chair to shoot him because he was too ill to stand, that you begin to understand just what it means for Ireland to have Britain as its only hope. Lenihan hasn't rejected this offer as he has rejected EU and IMF aid. He and the Irish government will take it if it will avoid the shame of institutionalised aid to the Irish government. Because the Irish Crisis isn't simply economic. The whole country is on the line.

That's how much is at stake.

Monday, November 15, 2010

The New Politics of Economic Aid

How quickly and thoroughly times change

Recently, EU governments bellyached about establishing the European Financial Stability Facility. Now they, especially Germany, want to force it on unwilling recipients. What is going on and why?

Ireland is allegedly under pressure to accept money from the fund. Why would it resist? Accepting money from the fund is politically equivalent to accepting money from the IMF. The money handed over is enveloped with the stench of political failure, both at home, and internationally. In the latter case, the country's entire economic philosophy comes under attack.

Ireland has a history of strongly defending national sovereignty when it feels that the EU has gone too far in the demands it makes on national economic policy. Throughout the 2000s, the European Commission made regular demands that Ireland rein in its overheating economy with tax increases and restrictions on public spending. It did this in the context of annual economic reviews contained in the Broad Economic Policy Guidelines (BEPG). The Commission wanted every country in the EU to have the same levels of growth and inflation, and tried to use the BEPG to expand its power from countries with huge budget deficits (where there are indeed rules) to countries like Ireland, where there are no such rules. Ireland, as a typical catch-up country, had higher growth and inflation levels than more established economies, and underlined its continued sovereignty over economic policy. It is not about to let that principle go down without a fight. Aid always comes with strings attached that Dublin has always rejected in principle.

Beyond this constitutional angle on accepting, rejecting or demanding use of the Facility's aid, there are strong ideological principles at stake with regard to choosing Ireland. Ireland has seen itself since the 2000s in particular as living proof that market forces are the best means of economic and social development. It benefited greatly from foreign investment into the country during the last decade, and is holding true to the creed of market first by drastically cutting public borrowing, spending and wages, so that private capital will return to Ireland. If it succeeds, it will bolster those who insist that structural adjustment policies in Europe must be radically strengthened to ensure higher levels of economic growth and employment.

It will correspondingly weaken the other camp, which has chosen to make financial market participants at least partially responsible for the financial and economic crisis, which wants to see a number of regulations and restrictions on their activity imposed, and which wants to leave social security nets left largely intact. The name of this game is not adjustment, but stabilisation and prudential regulation

And to make that work, it would be best for that camp to lure, or cajole Ireland down the other path.

Friday, November 12, 2010

Paying for the euro

Who pays when the euro gets into trouble? Almost everyone, it seems, but in different ways. After the euro's inception, low-inflation countries like Germany, the Benelux countries, Austria and Finland, suffered interest rates that were far too high for them as the European Central Bank fought higher rates of inflation in Spain, Portugal Italy, Ireland and Greece.

The possibility of a Greek government default has changed the cost of euro zone membership permanently. By June 2010, the German government had gang-pressed all 16 member states in the euro zone into contributing two-thirds of contributions to a new European Financial Stability Fund, which would be topped up by the IMF to reach a total of 750 billion euros. If anyone doubted whether these contributions were voluntary, they were dispelled by a vitriolic attack on Slovakia by the German government when the Parliament in Bratislava refused to ratify the Slovakian commitment. So we now have the first principle of who pays for the euro: all the member states do. (Instead of Greece and similar countries paying by being forced to leave). But for how long will countries that are in better shape have to foot the bill for their weaker and less disciplined neighbours?

Permanently, it seems. In November, France and Germany reached agreement on making the Stability Fund permanent rather than temporary. Both of them were aware that competitive devaluations of countries being forced out of the euro would hurt them, and that pressure on the weakest links of the euro zone would continue as long as the Stability Fund remained temporary. The result is that the no bail-out clause of the EU Treaties, which states that countries will not be held responsible for the debts of their neighbours, will have to be re-negotiated. To prevent further domestic backlash, expect German governments to bolster their credentials as economic conservatives by exerting sustained pressure on high-debt countries to reform their finances. This will be a long-standing feature of European macroeconomic policy for a long time to come.

The agreement also shows the primacy of Franco-German deals on the foundations of Europe's economic constitution, and not the efforts of other actors. Germany and the Commission both entered talks to make the Fund permanent demanding automatic sanctions on deficit sinners, only to be blocked by Paris, which insisted on a measure of political discretion that typifies the Excessive Deficit Procedure that currently applies to euro zone members. Greater institutionalised pressure will be brought to bear on countries like Greece, but because of powerful countries pushing for it. Not because of any autonomous power of European rules and institutions. Herman van Rompuy, the new President of the European Council, in whom pro-Europeans placed so much hope to promote coherent European government in the Council, found himself and his plans for automatic sanctions sidelined by traditional Franco-German summit that was presented to the rest of the Union as a fait accompli.

Fiscal conservatives can relish in the fact that countries like Greece will pay a price, however. That price is to bond markets, which are waking up and charging all of southern Europe and Ireland more to borrow than other euro zone countries.

Regulating Hedge Funds

The European Parliament passed yesterday a directive to regulate hedge funds, officially known as the Alternative Investment Fund Management (AIFM) Directive. The directive requires hedge funds and private equity funds to register with statutory regulators and provide basic information about their activities for the first time.

The AIFM Directive is Europe's interpretation of global principles of hedge fund regulation set out on 22 June 2009 by IOSCO, the International Organisation of Securities Exchange Commissions. Those principles require registration, reporting and require banks lending money to hedge funds (known in the business as hedge fund counterparties) to review the riskiness of providing the leverage that they do.

Hedge funds attracted investors before the financial crisis and criticism during the financial crisis because they make money by speculating on market trends, and then 'leveraging' the cash on hand they have from investors with loans picked up at low cost from Japan (this practice of shopping around for loans across currencies is known as a carry trade) and engaging in short selling. Although hedge funds were not responsible for the banking practices that led to the financial crisis, they actively bet against the financial institutions and instruments that did, hastening the speed and intensity of banking collapses in 2008, and making enormous profits doing so. At certain points during the crisis, trading extended into naked shorting, which was then criminalised in some jurisdictions.

The AIFM Directive had a bumpy ride through legislation. It passed the Council the first time only by virtue of the UK changing from a Labour to a Conservative government, which then fought hard to ensure that American hedge funds, many of which have offices in London, would have equal access to the financial markets of all EU member states based on the regulations prevailing in their EU bridgehead. The UK therefore agreed to accept hedge fund registry if it could effectively retain the light-handed approach to financial market regulation for which it is known.

The deal has been struck.

Wednesday, November 10, 2010

The new architecture of financial market regulation

The European Union now has three new Supervisory Authorities with the responsibility of regulating financial markets (in distinct areas), and two new bodies responsible for managing the grand task of systemic risk.

The European Parliament voted on 22 September 2010 to establish the European Banking Authority, the European Securities and Markets Authority and the European Insurance and Occupational Pensions Authority. Each of these bodies is restricted to regulating the type of financial market activity for which it is specialised. They are then brought together into the European System of Financial Supervisors, which bridges the gaps between the sectors.

Finally, the European Systemic Risk Board is responsible for actively seeking out weak links in the system, like a pig looking for truffles. Stress testing is one of their principal responsibilities, which includes deciding where to look hardest for problems. In this body, the three Supervisory Authorities are brought together with the European Central Bank to assess risk and to issue warnings and recommendations.

Interestingly, the EU has chosen to adopt a set of colour-coded risk statements, much like the United States developed for terrorism threats after 2001. Are financial market participants the new terrorists of the 2010s? Perhaps in the eyes of some Members of European Parliament, who were behind this innovation.

Also of note is that these institutional developments mirror and depend on developments globally and in the United States. The Financial Stability Board is the global equivalent of the ESRB, whilst the Financial Stability Oversight Council is Europe's equivalent in the United States. This means that Europe has created the institutional capacity to coordinated with the rest of the world in not only responding to, but in defining our understanding of systemic risk and in global regulatory standards.