Hanging together and hanging separately in Europe

Greece, the euro and Europe

We can bang on all we want about what should have been. The narratives are well known by now. The orthodox rules for euro membership should have been strictly applied from the beginning. The orthodox rules for euro membership should have been accompanied by the stabilizing effects of a fiscal union as in other large currency areas (meaning countries). The orthodoxy itself was a mistake that has brought the euro zone to its knees in a lasting depression since 2008. Or that despite the failure to do one of those things originally, better late than never: Europe can still get it right once the tensions build up and the internal contradictions of the euro start hurting the citizens it was supposed to benefit. The current proponents of one path over the other now reflect the same divisions as 20 years ago, when the Stability and Growth Pact was fought over and adopted.

But those choices are an illusion. Europe cannot retroactively enforce orthodoxy on Greece now without destroying the country, its citizens and democracy. And it cannot force Greece out of the euro without destroying the EU and its reason for existing. Either the other critics of orthodoxy will follow suit and the euro will become a repeat of  Bismarck's kleindeutsche Loesung, or the eurogroup will set about suppressing democracy in other states as it has in Greece to keep the voters in line. The kind of gold standard European order that the eurogroup leadership is now trying to retroactively impose on its members has never been attempted before, and no democracy has ever survived the downward spiral that the imposition of such hardhip entails. The long persistence of the historical gold standard was only possible because regular people could not vote. We can't go back there, and so that path is a road to nowhere, at least for Greece. If the remaining members follow Germany, Finland, the Netherlands and Slovakia down that path, it will damage European democracy extensively. The old saying will become reality, that if it were possible to vote to change the system, it would be illegal.

If Europe had any smarts, it would find the courage to introduce a  fiscal union that would help keep the currency union together without the debilitating demise of the euro zone periphery, both economically and politically. It needn't be that big a transfer. But it would soften the internal divisions of a continent sufficiently to keep it together and prevent a far worse future.

As Franklin once said, we all hang together, or we all hang separately.

Europe was once about promoting and protecting democracy on the continent by supporting 

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.

Poland, the new member states and the financial crisis

I am getting seriously tired of referring to countries that entered the EU in 2004 as the new member states. There has to be a better way.

The point of this post, however, is to consider an interview with Lech Walesa on the financial crisis. Desi Anwar interviewed Walesa in 2010 and got to hear two key things from him: that Poland weathered the crisis fairly well because it didn't engage in the same kinds of banking practices as in the West, and that dealing with the crisis requires strong international cooperation.

One could add to the list of reasons why Poland is not the source of speculation: it isn't in the euro, and it has had robust public finances. Part of the consequence, however, was a strong emigration of Poles to other countries during the lean years, due to the lack of economic opportunity at home. Austerity has its costs as well.

Authority, the public and the euro

Within the last 24 hours, Italy and Greece have gotten new heads of government. One is a former central banker. The other a former European Commissioner. Both favour the TINA approach to dealing with the euro zone crisis, that there is no alternative to those countries accepting their obligations, repaying their debts and staying within the euro zone.

There is merit in that approach, but only if the Greeks and Italians are fully on board with the changes that would have to happen. Those who work for the state, receive a pension, or have a contract with the public sector would have to be willing and able to live with far less income, however that is required. Private sector wages would have to decline. All of this would be required to ratchet back the expenses of the state, and to ratchet back the cost of production for export products. These dual measures are required to start reducing borrowing, reducing payouts, and earning more money. 

This means that Greece, Italy and Portugal must accept, if they go down this path, that the next generation is a lost one. Most of them will become poorer. The achievements they have made will be diminished. The lie of their prosperity, built on a bubble paid for by bondholders, will be exposed for the sham it is.

These are harsh words, and there are equally harsh words that can be pointed at the bondholders who lent their money to these countries. They are equally at fault for being so reckless and delusional in investing in countries like these without the recipients using that money as an investment in future productive income. That is the only kind of investment that the private sector should be undertaking. The worst part of all this is that we not only need to ask the pointed question of what kind of crack that asset managers at hedge funds were smoking when they treated these countries as equals of more productive countries, but why the other investment managers we expect to be more prudent were doing precisely the same. Pension fund managers and insurance managers were part of this as well.

If Greece, Portugal and even other countries were required to default on part of their debt, it would finally force creditor countries to start doing more than treating Southern Europe as the evil shadow of irresponsibility, recklessness and demise. It would force them to face questions about why they were the first in line with the money to give these countries.

Those are answers that voters in creditor countries should be demanding. Why is economic decision-making in the financial centres of Europe so irresponsible? A departure of Greece from the euro zone, as painful as it may be to begin with, would ultimately benefit both it and the euro zone. An important impact would be making euro zone membership more compatible with economic objectives again, as would be aligning membership with democratice choice. But the pressure it puts on financial centres will force some hard questions about why Europe's rich countries thought that their own economic welfare depended on speculation in a bubble in financial instruments, even if they were in government debt. What all of this has in common is that a short, sharp downturn could force a return to realistic assessments--of political motivations and political choices, not just in Greece, but everywhere in the EU. 

The new leadership of Italy and Greece is based on the premise that political authority can force a country to embrace low inflation and public borrowing. Chile has done that fairly successfully, but only through a military dictatorship. This will be the first attempt at such authoritarianism inside democracies. I almost wrote functioning democracies, but that is giving the countries too much credit at the present time.

This is a social science experiment of great proportions, the likes of which have not been seen for a very long time. Can you use public power to change who a people are and what they want?

We shall see.

Slovakia tumbles, and with it, aid for Greece

Expanding the EFSF: the European Financial Stability Facility, has just hit a wall as the Slovakian parliament refused to support it. The Slovakian government coalition has fallen apart as a result, smashed on political rocks that have nothing to do with Slovakia. You can be sure that Berlin will approach whoever is next in charge and start issuing demands. 

The argument in Slovakia was simple--that there was no reason why a poor member state of the EU should be forced to pay for policies over which it has no control. And they are right in principle. Forcing Slovakia against its will to pay for Greece was not only questionable on the grounds of economic fairness, but on democratic grounds as well. Slovakia has no democratic control over the bills that are being run up in Greece. If it accepted demands that Berlin should dictate its foreign policy and its budget policy, then the German plans to eclipse democracy in Greece would start spreading north. 

What all of this shows is that Germany (and France and the Netherlands) have become terribly attached to saving Greece at any cost. And that is precisely the problem, because the costs are not bearable. Haircuts are needed, i.e. a partial default that will limit the liabilities that taxpayers are expected to bear. This is doubly important because no one in their right minds believes the liabilities will be limited to what we know now, either in Greece or in other countries.

When you become too attached to one single outcome, and here it is the all-or-nothing approach to repayment you distort reality and your ability to deal with the real world. You develop, as any armchair crime investigator knows, pathological personality traits that start hurting yourself and everyone around you. In the attempt to preserve a 100% repayment rate, Germany is demanding that we throw good money after bad. The horror of the one scenario looms so great that the even greater horror of the path they're heading down is not acknowledged.

It's like telling the troops at Stalingrad that there will be no retreat, no change in plan, a denial of the realities on the ground. We all know how that worked out. 

The fall of the Slovakian government, but above all, the arguments that were made in refusing to pay further (they had already paid into the pot and said that enough is enough) is a wake-up call to Europe's creditor countries to rethink how they want to deal with the crisis, and whether they really want to start crushing European democracies to ensure that some bonds get repaid.

Greek default

Here is a link to an interview I've done on Greece. It lists in more detail why haircuts are a necessary component of keeping the euro together, and why that's unlikely to happen. A deep, downward spiral of the European economy is looking more and more likely as long as the EU's creditors demand full repayment.

When you demand all or nothing, you often get nothing.

War Games and the Euro

In a previous post, I argued that Europe needed people with experience in military affairs to work out strategy and tactics for dealing with speculative attacks against the euro.

And they are here. Breugel is influential. And rightly so.

Things just got a lot more interesting

And the War Continues

It has been but a few days since European leaders agreed a new bailout for Greece and financial markets are already tightening the screws as if little had happened. This applies not only to Greece, but to Italy, Spain and Portugal as well. Why?

In a nutshell, the problems are simply to big and the resources are simply too modest to dampen future speculation against southern rim countries in the EU. The first set of problems lies within the affected countries themselves: there is still no sign from Athens or from Lisbon that they have adopted a new way of looking at things and will radically restructure their public finances. We are seeing emergency measures in Greece, but there is no discussion of what sustainable finances look like. As long as Greece and Portugal remain in the euro, and as long as the euro zone resists institutionalised fiscal transfers, sustainable will mean stingy. Tax collections will have to increase, social benefits will have to decrease, and public infrastructure will have to be sold off to private corporations. What little is left will have to go into regulating the private companies providing previously public services, if anyone is capable. The bottom line is: more for less and a loss of public control over the necessities of life. If I were 20 and Greek, and the country continued down this path, I would leave, period.

The second set of problems lies with Europe itself and the way it takes decisions. The response to the Greek crisis in particular has been a series of talks between France and Germany, long periods of German absence from discussions intended to heighten the sense of desperation by others, and German reluctance to spend much of anything. Of all the options available to it, Europe seems incapable of forcing real policy change in targeted countries, incapable of  kicking a country out of the euro, and incapable of agreeing on the fiscal transfers required to keep a country inside. Something has to give, and there will be changes yet to come.

The third set of problems is one that Germany seems intuitively aware of, and if so, is entirely right about: that if they continue throwing money at the countries that are now in trouble, they will themselves be pulled under water. German banks have been worried about the impact that a Greek default would have on their balance books (as have been French and British banks), but the other side of the coin is that ratings agencies have already started to warn that the credit ratings of Europe's more solvent countries would eventually be at risk if the problems in Europe's south are not solved. This is the reason why the European declaration stated time and again that under no circumstances would the arrangements be extended beyond Greece, and that everyone would strictly adhere to the budget and debt criteria. The word 'strictly' was used a lot.

Given all of this, there has been a lot of money spent, but it isn't by far enough to solve the euro zone's problems. The war will continue. Until Europe gets off the pot and does something real.

Hemlock, Death and Greece

We are at this moment waiting for yet another delayed vote by the Greek parliament on austerity measures in return for another bailout. The decision has been labelled a suicide vote and a grave mistake by the governor of Greece's central bank, George Provopoulos. The politicians are about to drink the hemlock.


That pronouncement, coupled with the tear gas, batons and full riot gear employed by Greek police to show the authority of the Greek state, shows the stakes in the current vote. Greece stands at the precipice of entering an agreement into long-term servitude and foreign administration to save core banks in Northern Europe, or a period of momentary disgrace, devaluation and a true discussion in Greek politics of what they want to do next. 


One thing is clear: if so much opposition exists to the reforms, in the streets and within the establishment, they will not hold, regardless of what the Greek Parliament votes today.

The European Systemic Risk Board and Default in Greece

Greece will default on its debt this year, whether Europe helps it or not. The only questions now are: how big will the default be; will the default take Europe down with Greece?

The answer to those questions will look far more positive in relative terms if the European Systemic Risk Board is used to figure out and manage the impact of a Greek default. The ESRB was designed for a different purpose: for preventing financial collapse when a private bank collapses. Now, if its members have any sense at all, it must start making contingency plans for a Greek default. It will have to run through a number of scenarios, from total and unregulated default, with uncontrolled consequences, to a negotiated, managed and partial default. Each will bring its own set of consequences for the rest of Europe, particularly for banks.

For that is the ESRB's job. It exists to plan what will happen when one or more banks collapses. It was not really designed for a country collapsing, but the job is the same, and it is of vital importance that they step up to the plate and do something.

There are reasons, however, due to the ESRB's institutional design, to believe that the ESRB will be a political cripple and not fulfil the role it needs to if it waits for a green light before forging ahead. First, the head of the Board is the European Central Bank, which is refusing to cooperate with anyone on the issue of a managed default. It may have a contingency plan for when Greece can't pay, but if it does, it isn't admitting it. Second, the Board lacks the political clout to make the deals that are required to make a rescue plan work. Its members are the ECB, the central banks of the EU member states and representatives of three European Authorities that regulate or advise the Commission on regulating banks, securities and insurance companies respectively. Unlike the Financial Stability Board in Basel or the Financial Stability Oversight Council in the United States, there are no representatives of national governments at the table.

These are the reasons why we are hearing so much from the European Commission, the European Central Bank and the European Council of Economics and Finance Ministers, but so little from the one institution that was created to ensure the stability of Europe's financial system, at the moment of its greatest peril.

The European Systemic Risk Board needs an explicit mandate to intervene and give much-needed advice on the implications for financial stability of full and partial defaults. It also needs to provide advice on how to manage a Greek exit from the euro. And it needs to start making contingency plans for propping up the European financial system when the Greek default comes. That means it will have to have specific information about bond holdings by banks, and model through who will need what, when and how, once Greek bonds implode and Greek private banks cease to exist. It may also have to consider how great the knock-on effects will be for pension and insurance companies who invest in such bonds, as well as capital requirements for banks. Banks need not set aside reserves for loans to governments, a policy that surely must end.

The Board has this mandate already, even if it is implicit. If it does not get it explicitly from the Commission, the Bank and the Finance Ministers, it should claim it directly for itself without asking permission. That is how the European Court of Justice established its position and the position of EU law in Europe. It claimed it. Right now, national governments are bickering, putting partisan plans forward and kicking the can down the road rather than facing the threat in the eye and dealing with it. That is catastrophic and will become Europe's demise if allowed to continue. If Europe is to be saved, the European Systemic Risk Board will have to assert itself, and others will have to accept a new, larger role for the Board than they originally envisaged. There are two advisory boards within the ESRB that can push for these developments where the key members may not: the Technical Advisory Board (which does the work of modelling the causes and impacts of defaults); and the Academic Advisory Board, which collects experts on a variety of issues related to financial system stability. These are the groups who must start doing some persuading and drawing contingency plans.

Europe's existence is hanging on a thread. Regardless of how long national governments take to agree on strategy, there is both a moral and existential imperative that the ESRB start acting like what it needs to be: Europe's best hope for averting catastrophe once the defaults start rolling. When the politicians look at the tsunami that starts rolling toward them, they will hopefully look at the Board and its plans, and say Yes.

Helping Greece Default

The EU governments, if they want to avert disaster, need to assist Greece, and other countries as well, in an orderly default of their debt. A default is never easy to propose, but as I indicated in my last post when referring to the assistance of the United States government to Mexico in defaulting through Brady Bonds, this assistance makes all the difference between making the debt load manageable and total collapse.

There will be a lot of bellyaching from Northern Europe. Indeed, the finance minister of the Netherlands' right-wing government, Jan-Kees de Jager, has declared he takes pride in taking the toughest stand of all European countries on the terms that Greece will have to meet. That could be a costly position to maintain.

There is a difference between rebuilding on terms everyone can figure out, and terms that no one can figure out because the plan won't be kept. Creditors in Europe may look at a 100% repayment plan as only fair, whilst Greek critics will look at it as imposing unrealistic demands. The only part that is important though is: can Greece really pay 100%? If it can't, then an orderly default is better than a European shit storm. 

The Government vs. The People: Greece and the EU

There must be a great deal of irony for Greece's social democrat government (the PASOK party) and the voters who brought them into office, that it is they who will preside over the deepest budget cuts in Greek history, that it is they who will look out over what Pantelis Boukalas of the Greek newspaper Ekathimerini has called the Sea of People protesting in Athens, despite being on the left of the political spectrum. Those cuts were agreed with foreign powers on Thursday and will be brought to the Greek legislature this coming week. We are sure to hear voices that say TINA: There Is No Alternative. Indeed, Barack Obama has joined the TINA chorus, arguing that there will be devastation throughout the global financial system if Greece defaults.

There is no doubt that a Greek default would be costly, but it is an alternative, and regardless of what the parliament chooses, a real democratic debate of the options will be both legitimate and useful for all. Those who have been watching Iceland lately have seen that the country is back in grace already. Mind you, the debts involved were private ones taken on by Icelandic banks, but the country was told many times that it was obligated to take on those debts and service them for decades, lest the international financial community ostracize the country. The investors indeed turned their backs for a while, but they are back.

The real examples to look at, however, are Mexico and Argentina. Mexico is a good example of a country that went through a partial, but relatively orderly default with the assistance of the United States. Loans to Mexico made through the Brady Bond system helped to bring the country back on track after a collapsing bubble in Mexican public debt, that is reminiscent of the Greek situation (with the exception that Mexico's economic situation was in some ways better). Argentina, on the other hand, is a good example of what happens when such compromises are not made, and when such assistance is neither sought nor granted. Riots, fires, food shortages, collapse and chaos.

Those compromises will not come unless the Greeks make it clear there are some things they must insist on. Is there anything they really must have in order to respect themselves as a democracy? And what price are they willing to pay for that?

And given the response, should they remain in the euro? 20 years ago, dollarization was all the rage in Latin America and East Asia. Everyone was doing it, until they realized it was actually bad for them. We have different currencies for a reason. Having a common one has advantages, but disadvantages as well that can outweigh the benefits, as they do in Greece.

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.

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.

DSK, the IMF and Europe

This weekend brought a WTF moment from New York that will be bad for Europe, regardless of how the trial turns out.

DSK, Dominique Strauss-Kahn, has been arrested on allegations of attempted rape at the Sofitel in NYC. Since he heads the IMF, folks are now speculating whether it will impair the IMF's ability to play its role in the Euro crisis.

You would think it need not, but the euro zone fund is complex. One-third of the money is provided by the IMF, and Finland reluctantly agreed at the end of last week to support financial aid for Portugal if the IMF is totally happy with the deficit reduction measures that the country's government is implementing.

What DSK's effective departure does is open up a power play for the top role of the fund. With that contest comes an opportunity to upset the existing status quo, and to set new priorities within the fund. You can bet that various camps within the IMF are assessing each other's strengths, thinking of whom they can best work with, securing alliances, hatching plots and so on. 

Europe can only lose from this. In a tradition dating back to the original Bretton Woods agreements of the 1940s, America heads the World Bank and Europe heads the IMF. Both institutions have been reformed to  increase the representation of emerging markets within them, but the effects this will have on the institutional leadership have never been tested. Europe can only get weaker from here on in. It would be revolutionary if a non-European were to take the helm of the IMF. It is inevitable, however, that the opinions of the BRIC countries in particular will carry more weight from this morning onward. America should not be too smug either. The new constellation of interests is somewhat more critical of American public borrowing practices than pre-crisis.

For the moment, the immediate impact will certainly be that the IMF, as it deals with Portugal, will be in the process of transforming itself after a long period of pushing for internal reform. This is less likely to be a naked power struggle and more likely to be one that is done in secret. But DSK is politically finished, his parting has sped up something that has been in the works for years.

This means that Portugal will become the first test of what the new IMF is transforming into. What will it demand? Will it be harder? Or will it be lenient, considering that the Chinese have been lending money when other sources dried up, and are now more powerful in the IMF?

This case will not be the last, for it is now clear to all European leaders that Greece will default on its debt this fall. They've been talking about how to deal with this.

It's time to watch both the IMF and national governments very closely indeed.

American investments and European problems

It's possible that America is headed for a patch of economic trouble. If that happens and further American investments are liquidated in Europe to shore up the books on the left side of the Atlantic, that will spell further trouble for the entire EU, not just the euro zone.

The IMF yesterday warned that public finances in the United States are spinning out of control--specifically, that the deficit is growing whilst the economy is not declining. Financial papers and pundits are all over it, from the mildly crazy to the staid and respected. There is therefore a convergence of attention and assessment. Public debt levels are at 100% of GDP. It is not too late to recover. Belgium and Italy both came back from debt levels exceeding 130% of GDP, but that road was hard.

The problem for Europe is this. Once the US government starts reducing borrowing and spending, the economy will shrink, and with it, corporate profits and investment positions. The likely impact will be large enough to incite companies and other investors to sell off some of what they have abroad to make up at least some of the difference. This means redemptions (investors cashing in their positions and repatriating the funds) from investment houses in Europe, reflected in reduced volumes of cash in European financial markets.

We saw what happened last time this occurred in 2008/2009. The dollar started out low in 2008 and then rose in value in 2009 as American redemptions meant selling euros and converting them into dollars. This means that they value of the euro will be pulled in two ways that may cancel each other out initially, but drag Europe down in the medium term. There will be a push upward on the euro for a short time, but those redemptions will lead to stock market declines that may very well spill into the real economy.

Ultimately, Europe will have to start thinking about how it will deal with American decline. When a key global institution joins the chorus of critics who demand you live more modestly, change will eventually happen. What we don't know is what exactly the timing will be or what event will start the rush toward the fire exits. There are no elections this year which serve as a defining moment of political clarity. But the current American showdown between Republicans and Democrats over the national budget will probably play the biggest role of all. 

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.