Spain gets it right again

Spain has proven once more adept at reading the signs of an attack and going on the offensive. As everyone closes around Greece and France, Spain has passed a balanced budget amendment to its constitution. I expect it will do better than otherwise possible in the turbulence that is coming up this month and next. Indeed, with Spain's lower overall spending profile, the adjustment should hurt less than it does elsewhere.

It's not that budget retrenchment is objectively necessary, especially for Spain, with its low public debt. Nor is it that the current hysteria about deficit reduction is somehow right in treating Spain the same way as Greece or Portugal. Instead, the objectively good reason to move is that markets collectively are sloshing in a huge wave around Europe and don't really care about economic fundamentals any more. They care about political signals like this that identify a country as one of the winners.

Spain has decided it's going to come out of this crisis even stronger than it started. With such a big wave coming, whilst other countries are looking at it and wondering whether they can swim, Spain has just pulled out a surfboard. 

They may just pull it off. Whether it works or not, you've got to admire the balls behind that move.

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.

A Marshall Plan for Greece?

Yes, you heard that right. The idea for a Marshall Plan for Greece comes from Michael Diekmann, head of the Allianz Insurance Group. It would differ from the original Marshall Plan that financed the re-industrialisation of Western Europe in that Greece isn't an industrialised country.

And therefore, Diekmann is not only calling for a Greek Marshall Plan, but for the massive transfer of manufacturing from Western Europe to Greece. That way, he argues, the Greeks would have an economy into which the money could be productively invested.

There is a point in what he's saying from an economic standpoint, but does anyone think that this is going to happen? It could, if protectionism in the EU's more established economies wasn't running rampant. It's better to spend loads of cash to keep Opel German than allow production to close and shift to places like Greece. Then there is also the point that shifting production can also be counterproductive. Volkswagen shifted production outside of Germany during the 1990s and 2000s, drawn by low wage rates, but poor productivity ate up the expected savings.

One part of what made the Marshall Plan so successful in West Germany was the iron determination of the population to work, the sometimes overlooked fact that despite the devastation of World War II that Germany emerged with 50% of its industry (including heavy industry) still intact, that German companies were incredibly well-connected with one another, and that banks had their hands in many of these companies as shareholders or major lenders or both. The result was that the portion of the Marshall Plan funds that were invested in West Germany were invested in a country that had an above-average chances of putting it to good use. The French had the planning capacity of the state, the links between the Ministry of Finance and the country's banks, which then organised what would be produced and what would not. The Brits had a high degree of planning and public ownership well after the war that wasn't really relaxed for quite a while, and which functioned.

But Greece doesn't function, precisely because of the Greeks. Unless it becomes an effective colony of Germany, to the point of changing who the Greeks are, Diekman's Marshall Plan, as noble as it is, won't work.

Character is everything.  Diekmann's suggestion does serve a purpose, for it points to what stands in the way of making it effective: old-style protectionism in the EU's established economies, and a lack of willpower in Greece.

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.

The Rise of General Trichet

The writing is on the wall for Europe's political leaders this week, and so far they have done nothing. The consequence of this is that the ECB is taking over areas of policy out of necessity.

It is not as if the warnings have not been made. One after the other this week and last, the key economists who played a role in establishing the euro have warned that the Stability Facility is woefully inadequate and in need of support. Willem Buiter warned last Friday that the war to defend the euro was running out of ammunition because the Facility was too small. Today, on Wednesday, European Commission President Manuel Barroso, made the plea for member state governments to funnel more resources into the fund. Ottmar Issing underlined yesterday, in contrast, that no solution would ever be sufficient unless euro zone member states addressed the need to impose budget discipline on all of its members. Meanwhile, Jean-Claude Trichet, President of the ECB, confirms that the European Central Bank will continue to purchase government bonds for the foreseeable future from countries that cannot place them on the market to avert even greater catastrophe. 

In the meantime, Germany is denying that it needs to do anything, bondholders are denying they will have to take a haircut, Portugal is pretending that markets have confidence in its bonds, and Greece is pretending it will not default on its debt this year. This is reckless denial on a catastrophic scale. Economists may not always be right, they may not agree, and they are rarely popular, but in this case, Europe's political leaders would do well to listen to the list of choices they have at their disposal. 

An ominous warning in Buiter's statement to the press was that if the governments of the euro zone could not sufficiently fund the Facility, the ammunition to fight the war would have to come from elsewhere. For unless the euro zone admits defeat and ejects its weakest member states, or admits that they are bankrupt, someone will have to fight the war that the politicians haven't been willing to wage on their own behalfs.

Enter Trichet. Under his leadership, the ECB is purchasing government bonds from the euro zone's weakest member states. The Bank is far from happy about doing this, but sees no alternative for the time being. As the politicians fight one another and refuse to face the enemy, it is up to the bank to save Europe.

Trichet's position today resonates with the historical development of his own country of origin. The French Fifth Republic was the creation of General De Gaulle, a necessity for a country that lay in political shambles in the 1950s and could not govern itself. It required strong, centralised political authority that ordinary politicians were incapable of providing. That was not so much a statement of De Gaulle's authoritarian character as of France's polarised, fragmented political class that was allowing the country to collapse without his intervention.

Trichet's position is not the same as De Gaulle's, but his potential importance is at least as great, and arguably, immensely greater. In a world where the greatest challenges to public welfare are economic, and where decisions have to be made to harden and mobilise the country to keep it strong, the ECB is the only institution with the overview and the means to act where politicians have failed. And Trichet is the General.


There has been some speculation about what will happen when Trichet's existing term of office ends in late 2011. His term cannot be renewed under the terms of EU law. There await blistering divisions within Europe about what candidate should replace him. Nothing less will be at stake than what kind of single currency survives 2012.

But. The member states of the EU are busy negotiating changes to the Treaties to allow the Stability Facility to be funded. They could, and should amend it as well to allow Trichet's reappointment if he were prepared to serve on, at least until the crisis is over and calmer political temperaments prevail. In a highly polarised environment, that is probably the best thing that could happen to Europe.

China and the Euro

Savvy observers have noticed that China is the new big investor in Europe. Chinese money is flowing into European sovereign debt and into European companies. This is part of a diversification strategy for the Chinese, who have been shifting some of their assets out of the US dollar and into assets. This trend will be uneven over the next year, but if Europe plays its cards right, it stands to benefit greatly.

The Chinese are not looking at Europe with rose-tinted glasses, but there are reasons to be optimistic about the future of the Chinese-European relationship from an economic standpoint. The return on investment in Europe depends on how quickly and how strongly Europe can manage economic revival. This means restructuring the European economy so that it is producing competitive products and services, getting unemployment back down, and with it, consumption back up. This is the job of the EU's Europe 2020 programme, which I will leave to another day. It also means sorting out the problems of the euro zone with higher degrees of stability than are presently found in America. Relative performance is the key. If Europe succeeds at getting its economic house in order more quickly and thoroughly than America does, it will be the first and biggest benefactor of the crisis' biggest winner. Both China, as the country that has gained most from the crisis, followed by Europe, will emerge much stronger.

Timing, Generals, and the Euro

At the beginning of the new year, thoughts return to time. We think of what has passed over the last year and look to the year ahead.

But what is more intriguing than time is timing. Why does a crisis erupt when it does and not sooner or later? Why do the successive stages of a speculative attack on the euro take place when they do?

They say many things about fighting a war. One of them is that it is hard to wait and not know when the next battle will be or from what direction it will come. Some insight can be gained by considering the following factors.

First, an awful lot of money is required to wage a successful speculative attack on a large country in the euro zone. Since financial speculators are dispersed, they require a means of deciding whether and when to place their resources on  a particular country, a direction, and an outcome. Just as in the horse races, the better your prediction, the better the payoff. Unlike the horse races, the target a speculator is trying to hit is determined not only by the target country but by the market as a whole. This is not an entirely anonymous and invisible market, but one that is dominated by a variety of financial institutions looking for opportunities for profit, and hoping that other market participants will prove them right.

That means that there must be a tipping point at which some trigger leads the first of the speculators to stick their necks out and the rest of them to follow until the rush becomes unstoppable. The question is, what is that tipping point? One thing that has emerged from the history of the financial crisis to date is that quarterly company reports are windows of time during which financial markets pay close attention to the way the wind is blowing. This makes sense from their perspective. When businesses slump, so do government finances, either because public finances will remain generally weak, or because catastrophic failures, which means the failure of a key company with knock-on effects for the rest of the economy may tempt the government to respond with costly, debt-fuelled state intervention that the market will eventually flee from.

The ebb and flow of reporting season, four times per year, is therefore central to whether investors are presented with a focal point that can lead to crisis. The full-blown financial crisis was triggered by quarterly reports on financial institutions. Attention has spread to the wider economy as well, in search of signs from strategic economic sectors.

What we need to watch and understand better is when and under what conditions the markets actually turn, when and how they can be held at bay, and what that deterrence is likely to cost (and what form it can take) if it is to be effective. Deterrence is a notoriously difficult thing to observe. If it works correctly, there is no battle.

However, it is possible to detect how public authorities marshall resources and how they position them. The EU heads of government are currently debating treaty changes that will allow the long-term establishment of the EFSF, and possibly bonds that use the EFSF as collateral to leverage even further funds. This is a risky move that I will return to in another post.

For the moment, it should suffice to say that using the funds available to the EU through the EFSF will not be enough. The EU will have to deploy those funds strategically when the time is right and where they are needed. That requires clear political authority that can be exercised within hours, if not minutes. Currently this authority is lacking in Europe. The Heads of Government must convene to fight whilst the enemy is overrunning them. There are no generals in command.

If Europe wants to defend the euro, that will have to change.

Estonia and EMU

Estonia is joining the euro zone today. One might wonder why a country would join the single currency when it's been under such fire this year. But Estonia is a model of what official EMU policy requires of national economic policy. The country won't have any problems with EMU membership, as it requires no adjustment. It therefore can only gain in opening up the country more fully for business and aiding consumers as well with more transparent pricing and lower financial transaction costs.

The Politics of EMU Survival

EMU has been through a lot in 2010. As we start 2011, it is worth considering the following points on how Europe has responded:

EMU may lack an accompanying political union that various political architects called for when the currency union was established, but it was political solidarity that kept the single currency together in the darkest hours of 2010.

2010 showed us that political solidarity does not have to rest on a common sense of identity and purpose, at least in the sense that everyone has to like it. The acrimony, bellyaching and arm-twisting that accompanied Europe's collective action in 2010 belie that. Some will support a specific form of cooperation because they believe it is right. Others will do so because they believe it is necessary, even if it is far from their ideal preferences. Indeed, it seems that all European governments felt the hot breath of necessity on the back of their necks last year, compelling them to do things they really didn't want to.

Under conditions like that, nearly anything could happen. EMU may very well survive the year, but not as it once was.