Terror, Greece, and European Collapse

Over the last week, it has become apparent that the Greek tragedy could soon become a European one. If that happens, there is a significant risk of financial collapse in Europe. The good news is that policy makers are trying to avoid it. They may succeed. But it is possible they will fail. If they do, then a cascade of bank failures will reach to the heart of the EU's financial centres. Banks that are not yet under public ownership could find themselves under government stewardship. The threat of that might be the only thing to prevent all of this from happening.

First things first. The European Central Bank has been arguing vehemently for some time now that a default of Greek debt, a partial default, a restructuring, a partial restructuring, call it what you will was completely and totally unacceptable. This has had a number of people scratching their heads.

At first, the ECB offered the explanation that defaults, even partial ones, would result in a lot of credit default swaps becoming payable. That could cause some banks to go bankrupt. A credit default swap is effectively an insurance policy that one bank sells to another in case someone fails to pay a loan back to them. In theory, the swap is a good way of insuring a bank against a loan going bad. It's supposed to be good for stability. In fact, one of the recognized principles of good banking is that banks should use them. And they use a lot. The last I looked, there were more than $62 trillion in credit default swaps out there.  So the ECB is telling us that one of the key tools that was supposed to prevent a massive collapse of the financial system is precisely the thing that could bring it about.

This is not only a point that Europeans should be concerned about. It's one that everyone should worry about, for it continues to be one of the supporting pillars of financial stability on a global scale. I will return to this in another post. The important part here is that even if everything else were in good shape, the ECB is telling us that the safety features that will save our lives should there be a crash will not and cannot work. It illuminates the fact that credit default swaps are really intended to work when only one debtor fails to pay. If several fail to pay, then you suddenly have a problem again. Effectively the swaps simply transfer risk from one bank to another. Someone still has to pay, and then that bank goes under in the second round. Unless the original bank invested in that bank and goes under in the third round, and so on. On top of the losses caused by swaps that undermine the banks who sold them, there will be direct losses for banks that held the loans without the swaps. Bottom line: a lot of money will disappear off bank balance sheets, and the ECB, the Bank of England and so on will be back to the choice of saving banks or not. As will national governments who will have to consider nationalizing more banks. For they have no more money to pump into them.

But there is more. Because the ECB has been buying Greek and Portuguese bonds, a default, even a partial one, will destroy part of the central bank's capital. This is one of the reasons why the ECB isn't technically supposed to buy these bonds from them. The ECB, like any other bank, needs to have assets on its books against which it issues currency into the system. If those assets drain away in significant numbers, you have a problem. You can accept a big dip in the money supply and the economy, or you radically expand the ratio of currency to real output. That means you either print money outright, which the ECB can't do legally, or you provide it for every piece of toxic waste financial paper that a bank waves your way, which is unwise but legal, and what the ECB did during the earliest days of the financial crisis.

All this would mean low interest rates (or at least an end to higher interest rates) at a time when global inflation is running relatively high. That would mean a radically devalued euro, if it continues to exist at all. The alternative is a new, radical wave of nationalizations coupled with an extended economic crash, the likes of which Europe hasn't seen since the 1930s or the 1870s.

That's why there has been so much pressure on the banks to hold onto Greek and Portuguese debt, to not ask for their money back. Technically, that wouldn't be a default, so bank balance sheets will stay clean, swaps will not be paid out, and the problem will 'go away'. For a while.  If they don't, Greece will be bankrupt by October at the latest, and we will see how quickly the contagion spreads to the heart of Europe. That can happen overnight.

The prospect of going bankrupt themselves and being nationalized is the only incentive the banks have left to play along. Roughly 65% of the banks were on board as of today, according to press reports this morning. There will need to be more if the plans are to work.

Terror has a new meaning in the second decade of the 21st century. For 50 years after WWII, it meant the threat of global nuclear holocaust. After 2001, it turned into the threat of terrorist attacks on a smaller scale.

We're back to the threat of global meltdown again. And the epicenter is Greece.

Democracy or Europe? Trichet's call for a European Finance Ministry

Jean-Claude Trichet, the sitting President of the ECB, called for a European Ministry of Finance (a European Department of the Treasury) this week. This is an important proposal that needs to be looked at carefully, for there is both opportunity and danger. Even if it is unlikely to happen, by the very act of proposing it, Trichet has put Europe in a do-or-die dilemma.

What Trichet argued for was a Ministry of Finance that could do three things: put the regulation of financial markets in the hands of a politician (rather than a committee of professional technocrats); push the member states to reform their economies to make them more competitive (rather than protecting existing jobs and businesses); and most importantly of all, to control the budget policies of the member states.

No federation on earth allows full control of the second and third goals, because no self-respecting state in the union would allow its powers to be so radically cut and controlled from outside. It would end the democracy on which the federation depends. We're talking about tax policy, budget policy, economic development policy, social policy, welfare policy and regional development. Competitiveness policy sounds harmless, but in Europe, it explicitly extends to unemployment insurance benefits, training, and social welfare generally as disincentives to work in new kinds of industries.

The European Commission, which is something like a federal bureaucracy, but must constantly push to achieve that status, has never dared to make the case for a European Ministry of Finance, because it knew the member states would not support it. It tried for a short time between 2002 and 2004 to take a tough line with the member states and act like one. This was a pretty simple job in theory. Member states had entrenched rules in the treaties on which the EU is based, and had to respect those commitments. All the Commission had to do was insist that the rules be obeyed. Moving a little beyond that, the Commission tried (unsuccessfully) to get the member states to devote more than the 1% of European GDP that it gets in tax revenue.

If you read the Treaties, you'd expect the Commission to succeed. The only problem is that the Treaties only work if the (powerful) member states want them to. Germany, instead of respecting Europe's economic constitution, drove a sword through it. Together with France, it led a revolt against those rules in 2005 that other countries joined until the Commission backed down and negotiated. The only thing that saved Greece and Portugal from being attacked at that moment was that Germany and France, facing the same fate, had told the Commission that hell would freeze over before they accepted punishment and control. European law, effectively, was what it and the other member states in the Council of Ministers (of the member states) said it was. Greece and Portugal simply got lucky. France was never fanatical about forcing national governments to restrain themselves, and Germany was afraid of being exposed for exercizing a naked, all-out power play in which it flouted the rules but insisted they be applied to others. That is no way to drum up support for even a rump Ministry of Finance, a rump that could only tie the hands of the member states but not actually help anyone. And so the idea faded into the background.

What remained was the realization that there were very real limits to European integration, limits that still exist today. One of these is the clash between democratic demands and the treaty-based rules that say what goverments are allowed to do. Other limits are national pride, and the very simple fact that Europe is not a country. Europe is not a people. Europe does not share the sense of common destiny that allows citizens in other countries to put up with a government they disagree strongly with, because the majority of their fellow citizens voted for it fair and square. And none of that is likely to happen soon. There is such a thing legally as European citizenship, but there is no common citizenship in the minds of European electorates. On the contrary, Northern Europeans and Southern Europeans, regardless of how much they might like each other personally, are busy demonizing one another as if the apocalypse were already here.

Trichet's proposal is well-meant and should not be demonized. A European Ministry of Finance, if it were a fully-fledged office on par with that of the American Secretary of the Treasury, and the other Finance Ministries of China, India, Brazil, Russia and so on, would indeed be a very good thing. Money could be moved within the EU to where it is needed most. Agreements could be made with other world leaders on all the things we need so badly, from regulating financial markets to averting economic collapse when the next bubble bursts. But Europe's national governments won't allow it, and that is why he didn't propose it. It wasn't an oversight. He explicitly said he didn't want to suggest it.

So what does this mean? A European Ministry of Finance, as Trichet presents it, will do all of the smothering and none of the nurturing. It is pre-destined to say no and rarely to say yes. It will insist on the right to control member state finances without the responsibility of helping to make things better, and without the democratic representation that citizens deserve and expect. And worst of all, the clash between democracy and a European Ministry of Finance will be directed squarely at nearly all of the countries that have been democratic for only a generation. All of these countries will have traded one dictatorship for another.  That is no way to run a union. It would be better to admit that the differing wishes of the member states can't be contained within the same currency.

One day, when Europe's national leaders get over themselves, when they allow European Ministers to be elected, and when they agree that they will bow to the rule of law rather than institutionalising might makes right, and when European voters see themselves as Europeans rather than Prussians and PIIGS, a Finance Ministry would be a fine idea.

But until that day, an EU Ministry of Finance will re-introduce authoritarian rule in Europe, at least for the South, and then surely for the East. That can't be what we want.

Portugal's deceptive shift to the right

It's a clear majority on paper, but messier in reality.

The polls in Portugal have been closed for an hour, and it is already clear that the Socialist Party led by Jose Socrates have been thrown out of office with its worst showing since 1987, and that a centre-right coalition of Social Democrats (PSD) and the People's Party (CDS) will form a majority. It is a sign of Portuguese politics that the social democrats are on the political right. You might wonder who is actually a conservative. That would be the People's Party in this coaltion. They got 10.86% of the vote at the time of writing.

A notable part of this election is that voters, especially young voters, appear to have boycotted the election, while others took an extremely long time to arrive at the polls. By mid-day, when polling stations normally would have already registered a 60% participation, only 20% had voted.  At the end of polling, the number of voters who had stayed away from the ballot box was more than 44%, a 10% rise over the last election. The main reason for people staying home is that there is a sense of despair that voting won't change anything, that whoever is elected will simply do what the foreign powers of the Troika (the trio of IMF, the European Commission and the European Central Bank) tells them to do. The despair amongst left-of-centre supporters is immense.

Another notable part of this election, is that, somewhat like Obama's election in the United States in 2008, that the victors campaigned for change, but apparently with few details, as the CDS made clear in an interview today. As the CDS and the PSD negotiate the terms of their coalition, people will find out kind of program they actually elected.

It is possible that Portugal's new government will turn the ship around, but more likely that the country is in for a period of internal strife over its future. Those on the left who stayed home today are more likely to turn to the streets tomorrow. The voters who want economic austerity the most make up only 10% of the votes cast (for the CDS). They are concentrated in the cities, as the CDS had no luck in the politically important countryside. All of this means that the constituents supporting the incoming government are unlikely to support an iron-fist approach to austerity that one might expect from the CDS. Flip-flopping and backtracking are likely, especially now that Portugal is still shrinking economically. The austerity measures, if agreed and implemented, will drive the collapse of the economy even further.

Portugal has shifted to the right on paper, but there are very few constituents and voters who really support economic austerity. That should give the new government pause for thought, as well as the IMF and the EU. Some will say "Look! We've got a shiny new mandate to cut borrowing and spending. Let's get started!"

But the lower turnout means they speak for fewer Portuguese. There will be foot dragging. There will be backlash. And there will be reminders that this was the election that wasn't.

Default, deception and European debt

Europe has economic and political problems that just won't quit. There is a stench of desperation in the air that has gotten so strong that the President of the EU Council, Herman van Rompuy, has effectively told heads of government to STFU, lest they freak out the markets and send investors fleeing unnecessarily. On the contrary, Europe is suffering from a deep psychosis.

It's unlikely to make much difference unless there are real reasons for investors to think that Europe has its act together. And Europe doesn't. Standard and Poors has already downgraded bonds from Greece and Portugal to within a breath of junk bond status earlier this year. Those bonds, as well as those of Spain and Italy, are under renewed pressure as S&P considers a further downgrade of Italy.

The only question that anyone cares about, but that the politicians haven't accepted yet, is which of these countries will default on their debt this year, and by how much. If no default were likely, the problem would take care of itself. Imagine raking in the high interest payments on debt that you just bought for a big discount. The markets aren't buying it. Literally and figuratively.

Europe, with the exception of the ECB, (For its part, the ECB is demanding that the Greeks and everyone else pay in full, and that Europe reject any talk  of default, under whatever deceptive label it might come .) sent a strong message last week that it wants to let Greece default without actually calling it a default. A partial default is called a restructuring and is pretty common. But no one wants to say that. Talk started to circulate of 'soft restructuring', as if this would make an difference to anyone. When it was clear that it wouldn't, European finance ministers started talk of 're-profiling' the debt, which did nothing but slap a new label on an old plan. Last week, realising that someone would have to do something, the EU Council asked banks holding bonds from these countries not to ask for the money back.

Why does Europe think that banks and other institutional financial investors would hold on to such a crappy investment? It's the state equivalent of a sub-prime mortgage. Sooner or later, you want to get rid of it. The less confidence you have in the ability of the borrower, the sooner you want to sell. And if it isn't clear by now, holding on to that debt in the hope that it will be repaid, or at least that markets will re-invest in it at some point out of speculation, is hoping that a new economic bubble will wash the problems away. Or at least onto someone else's balance sheet.

That is a really bad idea. It's like a serious alcoholic who's trying to hide the booze bottles rather than admit having a problem and taking on the pain and responsibility of rehab. But lies and delusion don't make a problem go away. They prolong the disease and the agony. And everyone turns their backs on you.

Under these conditions, when Europe is deliberately trying to mislead the world about the depth of its problems, there are serious reasons to object to Europe insisting on its right to head the IMF. It wants to hold on to its prestige and power by birthright rather than merit, a point that is both legitimate and gaining steam internationally. It's like the town drunk, insisting on running the liquor store. Unless Europe shows a change of heart, that is another really bad idea. Europe hasn't hit bottom yet, and still thinks its in control.

It's time to take away the keys.

Portugal's next

It's been clear for some time that Portugal would be the next target, but the timing was an open question. This week, however, interest rates for Portuguese bonds have held above 8 per cent, and a political crisis has followed, which is likely to collapse the Portuguese government. 

The Prime Minister's office will now reap what it sowed when it acquiesced to tighter fiscal constraints on national governments that Germany and a few other creditor countries have demanded in return for institutionalising financial aid to the euro zone's debtor countries. That deal has been cemented just recently. It remained silent, hoping that financial markets would believe they had reason to be confident they wouldn't be next in line. 

But this is folly. Bluffing doesn't work when the situation is entirely clear to everyone. Portugal has never had anything resembling control of its public finances. Yes, it has had devastating natural disasters that have hurt the economy and the government's tax revenue for which it can do nothing, but Portugal also has no discipline. This is key in assessing its capacity to reform its finances. There is no evidence that successive Portuguese governments every intended to restrain the country's finances. They got a free ride during the euro's early years, as Germany and France were breaking the rules, but the free ride is over.

There are three ways to interpret the behaviour of the Portuguese government with regard to the austerity measures demanded by Europe's creditors. The first is that they realised they were in grave financial danger, and were willing to reform, but simply hoped that signalling strength would reassure markets not to flee the country. The second, is again that Portuguese parties are willing to exercise discipline, but no one wants to be first and reap the political backlash that ensues. The third possibility, and the one I fear is most likely, is that Portugal is in the grip of a Greek-style delusion that they can go on living as they have, because someone will bail them out. 

They're in for a rude awakening.  

The Pain in Spain

has been bad enough these past three years without the curse of being associated with Portugal. The Spanish may have floated their economy on a credit-fuelled real estate boom during the last decade, but they have managed to fulfil the budget criteria for EMU membership for most of that time. Whereas Italy, Greece and Portugal only managed to enter the single currency with what was generously depicted as creative accounting, Spain demonstrated the steel and determination to bring down inflation, reduce unemployment and keep public finances on an even keel.You can read more about it here, in my book. It's only problem was moving too quickly to be sustainable.

Spain's principal problem is that international investors and European politicians don't distinguish between Spain and Portugal. When the original list of member states was being drawn up in 1998, Spain almost didn't make the cut despite doing its homework because of Portuguese problems rather than questions of its own merit. And the same problem is happening today. No one is entirely sure what toxic ooze lurks within the depths of Spain's mammoth banks, but there are good reasons to view Spain and Portugal differently. The most important is the political will and capacity of the Spanish to sort out inflation and public finances.

Today, late on a Friday evening, the Spanish government contacted me directly to let me know about a new statistical website they are setting up to inform people about their performance. The fact that there is a Portuguese election on Sunday is no accident in my estimation, and the Spanish are reacting appropriately. No matter what happens, election results have a way of unmasking the true face of public opinion and public demands. Portugal is going through the most unpleasant period of its young democratic history, and the resentment and frustration against discipline that contributes to Portugal's status as the poorer of the Iberian sisters is likely to be confirmed. That will typically lead to investor sell-offs and capital flight.

Spain's legitimate interest now is to convince investors as best it can that Spain is not Portugal. That is not only a good thing for Spain, but a good thing for Europe if it succeeds. That message needs reinforcement from other European governments, who must make a clear distinction between Spain and its western neighbour and underline that it's based on facts and a reputation for discipline. Spain will fight the good fight, but it will need help to deter an attack.

Or the first run on a major euro zone country will not be far off.

Portugal's Road to Nowhere

Portugal is holding presidential elections on Sunday. The centre-right incumbent, Anibal Cavaco Silva, is running for a second and final term in office. He was elected in 2006 with a razor-thin majority of less than 51%. Now, as in 2006, the political left is represented by a spectrum of candidates. One of three things could happen. Silva could benefit from the divided left and be elected again; he could fail to secure 50% of the vote and there will be a run-off election between the two most popular candidates; or he will win by a comfortable margin. The polls suggest he will do better than last time and be re-elected in the first round. The main contender on the political left, Manuel Alegre, has no chance of winning.

A good number of Portuguese voters are protesting budget cuts that the Portuguese government is carrying out to reassure investors, or supporting those protests. This is not a time when the social democrats can profit from the disappointment they have in public policy. They hold the office of Prime Minister, and are associated more directly with budget management than the President is.

There's nowhere left to go.