The Single Supervisor Mechanism is not a Banking Union

The EU member states have just reached a deal to grant the ECB oversight of roughly 200 EU banks. That is a small fraction of the roughly 6000 that would have been supervised under the original plan that the Commission proposed.

The most important features are still to be determined, but the ECB has stated clearly that it would require extensive powers to make the project work. For the goal, as far as the ECB is concerned was to establish some type of banking union that would mean forced mergers and takeovers, the power to take away ownership rights from shareholders (some of who are member states themselves), engage in other forms of strenuous intervention, and be responsible for all banks, getting beyond the myth that only large institutions can cause systemic failure.

The agreement in principle this morning is not yet a banking union. There will be further international negotiations that appear fated to water down the powers even further than they have been already, and the legal challenges have already been flagged.

Banking Union and the United Kingdom

If the BBC talks about leaving the EU over banking union, then you know you've hit a nerve. The key concern is that the euro zone will develop its own identity within Europe, and that will be bad for Britain's banks. What this says between the lines is that the prospect of a shift change in the tenor and content of banking regulation in the EU might be more than the City of London can stand.

It's conceivable that the English might vote to exit, deciding they have had enough, and are better suited to a partnership with the EU rather than membership. But if they do that, it's also conceivable that the Scots will vote to exit the UK to stick with the EU. The Prime Minister will have to think about that potential cost.

Banking Supervision is not a Banking Union

At 4 a.m. this morning, heads of government reached an agreement in principle to transfer supervision of banks to the ECB. The details of how far the ECB's powers will go, and how it will relate to the European Banking Authority to and national regulators is unclear at the moment.

This is a statement of intent rather than a substantive agreement, but a step in the right direction nevertheless. The distributional conflicts that have bogged down negotiations until now have not been swept aside. A banking union involves not only supervision of banking activities, but also measures to intervene in the affairs of the banks themselves. There is no agreement on this. More importantly, there is no budget.

The Germans are banking on the introduction of a financial transaction tax to fund cash injections, to avoid using existing tax revenue to fund bailouts. This has  a number of problems associated with it, however. The most important is that if the euro zone manages to introduce such a tax and the EU does not, it will incite euro zone companies and retail investors to move their assets offshore...to the UK or Switzerland, and deter new financial flows from entering. The investment strike will take its toll on the euro zone, if such a thing is not established at the EU level. Reuters reports that only 11 euro zone countries are currently in favour.

Defense, Offense, and the Euro Zone War

Nearly two years ago, I predicted that the main targets of the euro zone crisis would be big countries, not small ones. That has since turned out to be the case. But what does it mean for Greece? And what does it mean for the EU in an economic policy sense?

Briefly, the most important issue at stake is whether Greece will go bankrupt, and/or leave the euro zone. That is not a sure thing, but looking increasingly likely. There are limits on EU funds, and ECB purchases of Greek debt will come with intrusive audits and demands by the IMF. There will be no free lunch within the confines of the euro zone. It may prove unbearable for the Greeks to stay, or brush their pride the wrong way. The alternative of a short, sharp Argentinian crisis may be the alternative.

This means that unless the EU takes the offensive and builds a financial mechanism capable of fighting for large countries and small ones, that it must put a great deal of effort into defensive mechanisms that will help its members (both countries and banks) survive a Greek collapse, and then a Portuguese one, at the very least. Good boxers don't just learn how to hit. They learn to take punches as well.

A decade of austerity

UK Chancellor George Osborne thinks that government will have to continue austerity until 2018, a full decade after the financial crisis started. That's the optimistic view of finding the bottom of a downward spiral of deflation and budget cuts.

Public Talk on the Euro Zone Crisis

Tonight I will be talking about the euro zone crisis at the University of Twente, with a focus on what has and has not been done, and why the consequences are so dire:

http://www.utwente.nl/gw/sg/programma/Europa.doc/

Germany limits the European Stability Mechanism

Germany's consitutional court ruled today that Germany may participate in the European Stability Mechanism, but with strict limits and conditions. The ESM is the permanent fund meant to prop up finances in some of the euro zone's countries.

Condition one is a cap on Germany's contribution at 190 billion euros. No salami tactics in which the commitment becomes larger.

Condition two is full consultation with the German parliament on an ongoing basis. This means the terms of the loans and the compliance with the terms.

Condition three is a new treaty to write those conditions down. Even a modification of the existing treaty is a new one, so that is clear.

These conditions mean that those opposed to the ESM's establishment will not get their way entirely. But they will have it in their power to make the recipients of ESM funds wish they had. Those in Germany that want to cut off Southern Europe entirely will have to settle for cutting them down to size. They will now have the tools do so with all their might. And Europe will suffer again.

Conservative Change in the Euro Zone

There are hurdles to be taken before the decisions are definitive, but EU government leaders made decisions this week that set the course for the future of the euro zone. Austerity has won a host of demands that lock in  debt repayments from Europe's periphery to its richest member states, and that prop up banks in the periphery just enough to prevent them from defaulting on loans, once again to the EU's richest member states.

The European Financial Stability Facility and the European Stability Mechanism (from July 2013) will be changed to make it possible to bail out banks directly. In the current climate, that means bailing out Spanish banks, Bankia in particular. In return, Germany has won creditor countries seniority rights on the loans they've made, which means that if things go badly, they will be paid out first of whatever money is left, before private bond holders. This reduces the risk of throwing good money after bad, at least in principle. It also increases the demand for such subsidies. Ireland has already demanded more. Italy has demanded, and received a commitment to aid for growth in exchange for austerity. These demands will not be the last.

It is a solution of sorts. It is the opposite of what most of the G20 and a transnational coalition have called for, which is a European banking union. Restructuring and recapitalization would take place across national borders, and allow the toxic assets to be dealt with in a way that markets will greet, not continue to punish. At a time when Europe is threatening to drag down the rest of the world economy, calls have become louder for the EU to take the plunge. The main problem, however, is economic nationalism--the fusion of national purpose with bank ownership. That has become much stronger as a result of the crisis, and the EU's member states show no sign of backing off.

Imagine that the political, social and economic revolutions that occurred in the 1930s and ushered in modern economics had never happened. That is why the initial stability that Europe achieved this week is unlikely to last.

Grexit: G20 to the rescue again

Open Europe reports on Twitter today that the President of the European Council has apparently called for a video conference of the G20 countries, to be held in approximately 3 hours time. The topic will undoubtedly be support for a new infusion of cash into the global economy ahead of Greek elections on Sunday, as suggested by Daily Forex. Support for austerity is low, but support for leaving the euro is also low, meaning that the Grexit, if it comes, will be messy.

The G20 talks point to an expectation that the Greek election will leave the rest of Europe with an enormous problem. The key players in those talks will have to be the main central banks, which have rescued the situation before. And they will have to again if the politicians in Greece and the rest of Europe can't agree.

And now we wait.

Greek elections and capital flight

Greece is bleeding out in advance of Sunday's elections, and is in danger of dying on the operating table. And it is the Greeks who are making this happen, not the EU or the international community. News reports are that Greeks have been withdrawing an average of 800 million euros per day from the country's banks. Greek companies are doing the same. An attempt to make Greeks pay tax or have their power shut off has failed, money to pay for electricity production is running out, and Greek companies can no longer get lines of credit that are vital to the import-export business, or insurance to cover imports. The result is that imported items are disappearing from the shelves.

There is now nothing the EU or the international community can do but wait for Sunday's election results. The current behaviour of the Greeks does not yet support the idea that another infusion will be productive. Greek voters may want to stay in the euro for reasons of national pride, but membership in this euro zone, with its globally peculiar emphasis on orthodoxy and restraint, comes with responsibilities that they will either articulate a willingness to accept on Sunday.

Or not.

Bankia, Spain and the Euro Zone

Bankia in Spain has become the next institution to require a bailout in the euro zone, and as is now a familiar pattern, Bankia has been declared too big to fail. 40 billion are needed immediately, and 80 billion eventually. The IMF has already suggested that the money simply has to be spent, and reassured markets that a bailout will be coming. European finance ministers meet next. This is the last in a series of moves to use the money reserved for public bailouts for private institutions.

What Bankia does, beyond costing the EU a great deal of money, is call into question the quality of stress testing at the European Banking Authority. as the EBA says itself, the information is provided by the banks themselves:

"We have to remind you that this is a bottom up exercise, conducted by the banks in most cases using their own internal models. The estimates of risk parameters by banks are sometimes very diverse, also for exposures in the same portfolio and against counterparties in the same country. Although the EBA took action to achieve greater consistency and more rigorous estimates. More work on this issue is needed in the future."

Although the last round of stress testing revealed a high concentration of undercapitalisation at Spanish banks, Bankia was not considered one of the banks worthy of regular review (which you would expect of  banks that are too big to fail). The banks reviewed can be seen at the end of the EBA's last stress test review for 2011.

Dexia's / Belfius' Persistent Problems

Reports this week indicate that the investment and retail bank Dexia needs yet another bailout. That problem is shared by three countries: Belgium, France and Luxembourg. Something needs to be done about Dexia (now officially rebranded Belfius to avoid the stench of failure attached to its previous name) if anyone is to have confidence in the public finances of Belgium and France. Luxembourg has the money.

The Dexia case is particularly vexing because it is strongly responsible for purchasing French municipal bonds, plus Belgian municipals, and bonds for social service bodies. If Dexia imploded, so would an entire tier of government and public services in France and Belgium, which is why those governments won't let it fail.

But will it ever stop? This is another sign that the crisis for Europe is far from over.

Reading on Debt and Rescues

I was reading today on debt crises and rescue packages and thought--most of what we have had written in the past has been about debt crises in developing countries, or as they are more congenially known these days--emerging markets. Two of those I've been reading today are 'The political economy of the Bretton Woods institutions', by C. Randall Henning and another of his works: The Exchange Stabilization Fund: slush fund or war chest?  The first provides a nice history of how the IMF and World Bank developed and changed alongside private finance. As part of that history, you'll get to read how debt crises arose in Mexico particularly, and were dealt with periodically by the American government and the two Bretton Woods institutions. You'll also get to read how, after those crises, the bulk of finance to Latin America shifted from investment in bonds to investment in stock markets, and direct investment. Bond holding shifted elsewhere, particularly Europe, which is why someone ought to write about how those two eras are different.

One obvious difference is the absence of a US Government interest in funding a rescue plan. That's something one can understand, too. The United States has enough problems of its own, and money is funnelled much more easily through the IMF these days from the countries that have it.

The second work looks at the degree of discretion that the President of the United States has to spend money on stabilising the exchange rate and the international monetary system. There are some clues there to constructing a mechanism within Europe to distribute money where its needed, because it looks at the relationship between the executive branch and Congress, of how accountability could be infused into a European mechanism for sorting its internal financial affairs.

The fact that Europe now falls into a literature applied to less prosperous countries underlines a few lessons for international political economy, and comparative politics as well. The first is that advanced and emerging market countries are plagued these days by much the same problems, and should not be treated separately. That's arrogant and presuming and passe.

The second is that it should renew our interest, if it's not already sparked, in long-term decline of advanced economy countries, and the responses to that threat. There is a history of such writing on the United States and the United Kingdom in the 1980s that emphasised strong states as exacerbating decline and strong markets as reversing it. Those messages are already being reversed in contemporary analysis that looks at the crisis generally, but how does the return of the state translate into analysing Europe's choices during the current crisis? How strongly do state intervention, (neo)Keynesian economics and international cooperation factor in giving Europe a chance to deleverage without destroying the economy? Does Europe possess sufficient political coherence and direction to construct a rescue package that compensates for the lack of a European government? Is Europe's economic constitution preventing Europe from recovering?

These are questions that affect us all, and the answers look unfavourable unless Europe changes course.

Banking and the Euro Zone Crisis: the next phase

As an ongoing symptom of the interconnectedness of private finance, public finance, and the lack of infrastructure in the euro zone, the IMF has warned that banks are expected to withdraw 1.2 trillion dollars of credit from the euro zone economy over the next 18 months. That's 10 percent of the EU economy, and even more of the euro zone economy.

The IMF, which views this contraction as the natural consequence of deleveraging (destroying reliance of the financial sector on credit to the same degree as before the crisis started), suggests that the only way to avert an even greater disaster is to accept a milder one--in which banks are closed, merged and restructured across national boundaries to reflect the lower amount of money in the economy.

That, in itself, may make sense. But will national governments in the EU break from their existing pattern of saving national banks to allow such restructuring?

That would indeed be a revolution in thinking, and it's just possible that national governments haven't hit bottom yet. I'm not putting any money it.

INET talks about the crisis

The Institute for New Economic Thinking, INET, is meeting in Berlin today until Sunday to discuss the current crisis, and the state of economics and economic policy: (Paradigm Lost: Rethinking Economics and Politics). This is important and worth watching. Check out the information on the website, and most importantly, comments from folks tweeting at the conference. Just search for #inetberlin  on your twitter feed.

Early messages:

Classical economists are trying to grapple with the new recognition (new for them anyway), that human behaviour is not as rational and predictable as their theories to date would have us believe. (See @LynnParramore)

Re-working the basics of economic policy to let up on austerity measures.

And my favourite quote so far, tweeted by Megan Greene (@economistmeg)

'Gurria: Markets are like heat-seeking missiles. They go after your weaknesses, not your strengths.' #inetberlin

Externally-Imposed Adjustment and Contraction in Greece

10 days ago, the Greek government successfully arranged a reduction of its outstanding debt with private creditors.This was a requirement of the EU and the IMF approving the next bailout of Greece.

Adjustment means contraction, both for Greeks and for investors. A 20% reduction of the minimum wage and broad budget reductions in advance of the deal followed a 7.5% contraction of the Greek economy in the last quarter of 2011.

In the debt swap deal, private holders of Greek debt, many of them pension funds and other investment funds, were paid 15% of face value in cash and 31% of face value in longer-term, lower-interest bonds. Those that did not accept were forced to accept the terms by collective action clauses that the Greek government recently legislated. Note that Greek pension funds were badly hurt by this restructuring, which means that Greek pension will have to be massively cut. That battle is yet to come.

After that deal was sealed, attention then turned to the private body that decides what happens to credit default swaps when something like this happens. The ISDA, or International Swaps and Derivatives Association, determined that a so-called credit event had occurred, but that it was not that large. Current estimates are that payouts from CDS contracts will cost European banks around 3 billion euros.

This means that for the moment, if you look at it from the perspective of those trying to make the deal, that the cost has been low and catastrophe has been avoided. Catastrophe means a disorderly default, in which investors lose everything and CDS payments become enormous.

Although those who promoted the deal argue that catastrophe has been averted, they are wrong. It has merely been delayed and been made more costly. As the head of the private bank Berenberg says, there is no prospect of growth with which Greece could pay back the rest of the debt it owes. An ever-shrinking economy means ever-growing incapacity to repay. The latest IMF Report on Greece has come up with new figures today on how the current bailout will be insufficient, and how another 21 billion might be required until 2016. Given the recent bailout, and the current trends of the Greek economy, which is deliberately designed by the IMF to focus on 'internal devaluation' (falling prices and wages, despite rising taxes) (see executive summary of the report), which cost the IMF 28 billion euros until 2014, that seems rather hopeful.

What is striking in the IMF report is the clear expectation that Greeks will choose, if given a choice, not to fully implement the deals they've signed on to. Which is why foreign administration is the governance of the future.

Welcome to the new face of the euro.

Greek Default and the Euro Zone Crisis

Standard and Poors downgraded Greece today to Selective Default status. The International Swaps and Derivatives Association is now debating whether this means that credit default swaps are due to be paid as a result. It will decide by the 29th. If it argues that they are due to be paid, then a great many contracts will have to paid out, some banks won't be able to fulfil their obligations.

This is an excellent time for national governments in the EU to consider whether the core business of retail banking ought to be connected to the world of financial derivatives, investment banking and international finance. It still is, and perhaps should not be.

Europe's autocratic politics of debt

Two things have come across the news this week, neither of which bodes well for the EU.

First, the EU Commission and Council, following up on agreements made with the Troika, insisted on written statements by both major political parties in Greece that they would be denied a bailout unless they both declared in writing that they would accept the ultimatum that the Troika had imposed on the current government. Elections are coming up soon, and the EU's creditor states are intent on ensuring that choice is off the table. Of course, Greece could chose to fold and walk away from both the euro and the aid, but neither Commission nor Council are saying that. (Though one politician is now talking openly about Greek exit.)That should again give everyone pause about what the EU stands for.

In the absence of agreement, a Council meeting scheduled for tomorrow has been cancelled.

Second, the Commission is busy preparing to punish Spain, which has been ahead of the curve and the Commission in dealing with the crisis, by charging the government money for not moving any further. I don't know what the responsibles in Brussels are thinking, but whipping the most compliant is not going to further their cause. If anything, it reeks of desperation, to show that the excessive deficit procedure is relevant, somewhere, somehow. That's no way to run the EU.

Once upon a time, the EU stood for democracy. It brought both of these countries into the Union to bolster democratic movements and to prevent a return to dictatorship. And now, it views democracy as the greatest threat to the Union.

Ironic, isn't it?

This is a bad move on the part of the EU

Who Pays Attention to ECOFIN?

Southern Europe, that's who. Log onto Twitter, search ECOFIN (the EU's Council of Economics and Finance Ministers, responsible for decisions on the euro zone), and you'll get mostly posts from southern Europe. Type in a country name, like Portugal or Greece, and the sources become more varied.

It says something about how the power relationships are currently felt in euro zone politics.

What impact they have remains to be seen. ECOFIN meets tomorrow to discuss public policy progress and debt restructuring for Greece. One demand has already been made clear: aid is conditional on all main political parties accepting it.

A Europe of the States or a European Union?

It's been a while since I last wrote. Things got busy.

In the meantime, Europe's leaders have announced a fiscal pact that will institutionalise EU control of member state finances, which will mean the most for countries that lose control and need outside aid to stay in the euro zone. This isn't a fiscal union, involving real transfers, and it reinforces the responsibility of the member states of the euro zone to get their own houses in order. It's more a Europe of the Member States rather than a European Union per se. If that is what they really want, then fine, but beyond the question of who 'they' are, and I think it means creditor states, supported grudgingly by debtor states for fear of hurting at the hands of financial markets even more than they do today, but it means that periodic crises are likely to happen from time to time in the euro zone.

It's not the only economic policy area related to the financial crisis in which the EU has effectively pushed the member states to the fore and demanded more of them--institutionally, financially, and in terms of pre-determined policy. I'm currently attending a workshop on banking in the EU and the impacts of the financial crisis that the University of Denver and the University of Colorado at Boulder are so kind to organise and support. I'm learning a lot from my esteemed colleagues. What interests me is how national financial stability measures remain in Europe, despite claims by some to the contrary. I'll follow up on that in a subsequent post.

What does this mean? Europe remains fragile and vulnerable. Strength requires more.