Greece, Spain, France...whither policy in the Eurozone?

Ireland, Greece, Portugal (sort of)...yup, all struggling... at the 2012 European Football (Soccer) Championships. A nasty parallel to the struggles afoot in these peripheral Euro economies, although at least Spain is bucking the trend – not least after their 4-0 thumping of Ireland last night.

Should be interesting indeed should one of the Iberian teams face off Germany in the Quarter-Finals or beyond!

Spain’s gift of utterly watchable total-football is equally utterly at odds with the sinking state of its economy and banking system that finally led to its government seeking and getting EU Aid to the tune of €100bn.

Connoisseurs of footy will know that perhaps the similarities are more than meet the eye if and when the debt-fuelled success of its two pillars of Barcelona and Real Madrid are factored-in and which may also see come-uppance when UEFA’s Fair Play rules come into play with the aim of tying expenditures to revenue and without recourse to bailouts. Sound familiar?

There are several questions that immediately come to mind from events in the last week and in the coming days:

1. Greek Elections on Sunday. Is this really a Referendum on the Euro? Is it the Lehman-moment of 2008 when US policy action went into over-drive to solve banking and sub-prime problems in the US?
2. Does the aid for Spain do anything beyond the short-term fix?
3. What does the relatively softer conditionality for Spain imply for the existing recipients, particularly Greece?
4. A lot of focus on Greece, but what does the outcome of the French parliamentary election presage in terms of European polity?
5. What does this mean for the overall health of the Eurozone and wider EU economy and the policy mix required?

Greek Elections

Whatever the outcome, I don’t see this as a watershed moment. As I’ve written before, this is the “prisoner’s dilemma” problem where nobody gains by a Greek Exit or Grexit. Moreover, there are legitimate Greek demands for a stabilisation programme that is realistic and feasible in terms of the conditionality as well as understandable requirements by donors, particularly Germany, for credible reforms in Public Finances and structural adjustment.

Spain et al

In short, this was expected but it does leave a lot of questions. Anyone familiar with EU negotiations and the pattern of recent years will appreciate that we are likely at the starting point of what will be the final size of the financing required for Spain – particularly if we start to see an outflow of non-Spanish capital in the way experienced in Greece.

The deployment of the EFSF monies for recapitalising Spanish banks through its recapitalisation tool or fund is perhaps not surprising. But is this liquidity support sufficient or are we facing a solvency issue as in Ireland and a likelihood of larger liquidity support from a new liquidity splurge by the ECB complemented by further official aid and budgetary support? Are we facing the likelihood of debt write-offs in the end –something that may explain the response of bond markets there.

Conditionality

Anyone familiar with programming aid programmes and budgetary support is familiar with the prima-facie requirement that for a credible programme the conditions must be relevant and feasible. In practice political considerations tend to dictate the design and this is essentially what’s happened in every programme to date in the Eurozone.

The evolution of the Euro crisis to include Spain means that the ultimate design of the package for Spain will in turn lead to re-design of programmes for Greece, Ireland and Portugal. The problems in Cyprus means that we are not far off a programme there.


Implication of French Elections

To my mind this is perhaps the more interesting of the elections taking place. The noise since the start of his presidency is decidedly more lower but the likely victory of the socialists for the French Assembly will leave Mr Hollande in a very powerful position to push for a more expansive approach – both in France and within the Eurozone - for governmental intervention to expand Aggregate Demand.

Mr  Hollande may well become the lynchpin for a coalescence of the southern Euro-members seeking a more growth-centric approach that reverses the fiscal compressions of the last 3 years.

Implications for Policy Responses

Short-term measures to boost investment via the EIB and faster use of Cohesion and Structural Funds are sound measures but are no panacea without an overall framework (there is plenty of evidence of poor impact, lack of sustainability and simple lack of value-for-money from previous internal structural funds transfers within the EU).

In particular the framework has, ultimately, got to be about the overall design of the Euro based on the overall fiscal-monetary mix in the Single Currency zone.

Real convergence of Public Finance Management is a sin-qua-non for the ultimate functioning of the Eurozone in the long-term. This in turn will require not only the co-ordination of national fiscal plans but also the rigour of financial controls and audit channels and the related issue of value-for-money –meaning structural/microeconomic reforms: governance reforms (re-design of public administrational functions with a focus on much smaller states, much more transparent and fairer public procurement, more effective competition policy,...) as well as convergence of norms in social care (eg pension age) and banking standards.

Without this convergence there will always be the risk of moral hazard for the debtors to seek ex-post aid or simple arbitrage for  a country with a much lower pension age (say Greece v Germany) or much looser bank regulation.

And thus we reach a conundrum. A lot of this was discussed before the design of the Euro but remained theoretical. Now that we are in the middle of the Euro-crisis the Germanic position that forthcoming financial assistance or pooled fiscal liabilities would be acceptable but only if the re-design ensures that fiscal competences of soverereigns are too constrained or pooled cannot be shirked.

Current measures for a common deposit facility for banks and a single supervisory node are steps in the right direction for this overall needed convergence. The political reality of the 17-State Single Currency Zone however means that we will continue to see a chess-game of those who favour a ceding of national fiscal sovereignty as the eventual cost of co-sharing access to the German and Nordic exchequers.

Don’t hold your breath...

Eurozone and Bank Runs: Deja Vu or Self-Fulfilling Prophecy?

We are now clearly in a new and troubling phase of the Euro-crisis. There is, like most things in life, a sense of diminishing returns to continued reference to “crisis”, “precipice” and similar doomsday pronouncements when in fact the Eurozone has continued to survive. And accompanied with modifications to the monetary-fiscal mix through increased liquidity support, moves toward a Fiscal Compact and a firewall to help Euro-members.

And yet, there is a clear sense of a worsening situation as Spain has become the country in the headlights but with less-pronounced but equally serious issues facing other countries – from Cyprus through to non-Euro peripheral emerging economies such as Serbia.

Mass withdrawals are a natural reaction by savers who fear either devaluation (Greece), likely freezing of FX accounts following a possible Euro-exit/devaluation (Greece again) or mass panic due to uncertainty and lack of confidence (Spain, Cyprus).

There is ample evidence of the outflow or transfer of a wall of money from Greece to safety in the northern Euro-zone countries or conversion to assets (just ask real estate agents in London and elsewhere).

We are now seeing the same in Spain with reports of mass withdrawals, which in turn feed into further bouts of risk-aversion aka the Mary Poppins moment.

And we know from the history of bank runs that contagion is not a linear process and no one can predict when and if the speed of withdrawals might accelerate and become a systemic crisis – both within the southern Eurozoners – but also to other Eurozone countries and to other non-Euro states such as the UK, or indeed to the ring of emerging economies ring-fenced in 2009 by the Vienna Agreement put-together by the EBRD.

We also know from historical bank runs that the role of the lender-of-last resort is vital, coupled with confidence provided through deposit-insurance.

Although the ECB has ramped up liquidity in recent months to Eurozone banks, a formalisation of this indirect fiscal liability is not forthcoming until and unless the Fiscal Compact becomes a credible reality which in turn allows net payers – particularly Germany – to feel that it is not going to be dumped with toxic and limitless uncontingent fiscal liabilities.

And the same argument applies for a common deposit insurance scheme.

Access to firewall financing, albeit do-able, would not itself tackle the core cause behind the bank solvency and attendant structural fiscal deficits in Spain – as well as other southern Eurozoners.

A cul-de-sac?

Potentially. But Spain’s volte-face in recent days toward reluctant acceptance of the idea that national budgets should be approved in Brussels highlights that there is no alternative when creditworthiness is declining, access to markets increasingly expensive and unsustainable and alternative policy options unavailable – including its first attempt for a domestic policy response of forced mergers between weak banks and cajas.

We are entering the central phase of the Euro crisis and I expect it to continue well into 2013 (the German Bundestag election is due by October 2013) and probably into 2014.

Spain will need external aid. This means a Programme – likely one based on the Troika-model for Greece.

Cyprus will likely need one too, given that largesse from Moscow is unlikely to continue and given its vulnerability to Greece, particularly through its banking system.

And what about Malta? How about Italy? Shhh but how about France?..

Very soon we may find that the entire flank of the Eurozone south is having to undergo forced structural adjustment – although hopefully on a more realistic macroeconomic framework than was the case for Greece.

Will such external programmes be politically feasible? Would they come with capitalisation for banks and in the scale that might be required? Would this be sufficient to give the Fiscal Compact credibility and in turn sufficient guarantees for Germany to agree to mutualisation of sovereign risk?

The risk of Spain entering the maelstrom of the crisis has indeed been a déjà-vu. Spain is too big to save through bailouts and so we may have reached a critical point in the crisis.

Iterative policy responses from Eurozone politicians may be a natural response to domestic politics but the very real threat of bank runs in Spain and possible spillover to the north (witness recent de-ratings for German and Austrian banks), however small the risk,  could well become a self-fulfilling outcome.

In the short-term, confidence in the Spanish banks and Spain’s “irrevocability” with the Euro will require external support and I expect the IMF to play a key part.

However it is vital that any programme focuses beyond the narrow prism of re-capitalization of banks and fiscal reforms to also focus on measures to put in place

Eurozone and Greece: Policy Options to ward against Contagion and Beyond

So what are the policy options on Greece?

In the last blog I asked the somewhat rhetorical question at the end of the review of the Greek election and the rise of the anything-but-austerity message and de-facto mandate of the Syriza party.

Listen to Syriza’s young Turk – sorry Greek! – leader, AlexisTsipras and you will get a sense of the policy cul de-sac that faces the Eurozone and indeed Greece. Strip bare the posturing in the run-up to the Greek re-election and the core message is blunt:

•           we want to stay in the Eurozone because the alternative is worse – including a likely further widening of gulf between the Euro-have rich and the rest of Greek society left with a devalued drachma.
•           but we want growth, jobs and an end to austerity
•           we’ll renegotiate the austerity package with the EU and the IMF

-          and …here’s the trump card:

• if we leave the Euro then Portugal is “toast” by mid-morning next

The risks of contagion is the key reason why the Greece will not be forced out of the Eurozone and why the stand-off will continue into the summer, and beyond the 2^nd election in June.

And the key risk is that of bank runs – both in Greece but across the Eurozone. Purportedly close to €1bn was withdrawn in recent days in Spain, itself set against a tide of de-ratings of its banks. The Greek  banking system is itself on a €100bn life-saver drip feed via the ELA – the emergency liquidity assistance from the ECB – which was used successfully to save the Irish banking system after it went belly-up.

By corollary preserving confidence in the banking system must be a key policy goal for the Eurozone.

The inherent problem of a single currency without a single fiscal companion is a root concern. But another – and equally important – concern has been the lack of a formal Lender-of-Last-Resort function at the ECB. The ECB was coy about asserting this necessary central bank function when the Greek crisis started in Greece in 2010 with deposit withdrawals and subsequent deceline in Greek lending.

In effect the ECB under Draghi has started to ramp up liquidity financing to its banks in the Eurozone that has helped to dampen immediate risk of bank-failures. But given recent German recalcitrance on the extent of monetary easing underway, there is a palpable need for a firm Eurozone wide blanket deposit protection scheme.

Secondly, the focus on growth will require banks to start lending. And here we have a conundrum. The EBA is busy dealing with a lagged policy concern on bank capitalisation. Paradoxically lending will decline as banks, already risk-averse in the current economic climate, are forced by regulators to focus on building capital buffers.

But these measures will only go so far.

Whence growth?

The current institutional dynamics will continue to mean a step-by-step approach. 

Pooling fiscal risk at a Eurozone level is not likely in the near term but interestingly a step in this direction has been made through a common €230m project bond that will  be signed-off  by Eurozone leaders for project finance financed under the European Investment Bank. According to the EC there is potential demand for €1.5-2 trn to 2020 in order to modernise infrastructure. 

Unsurprisingly there has been angst by the northern Eurozoners to what could become a contingent fiscal liability. 

And there will be problems with anyone familiar with EU structural funds let alone large-scale financing generally – ready made projects are hard to find and “absorption capacity” is often the key problem rather than of obtaining funding, particularly if real rate of return exceeds a notional benchmark of 4%.

As well as the other obvious issue that often co-financing requirements will actually lead to rising fiscal indebtedness for the very countries such as  Greece, Portugal or Spain that need this rise in Gross Investment to boost GDP when private demand remains moribund.

But on the bright side, the idea does suggest we may be moving down the road of some form of EU-style shift toward on how to raise Aggregate Demand. It will be interesting to see how the Hollande presidency emerges in its discussions with Berlin on the issue of EU-wide bonds generally. 

It may also lead to co-opting with the slush of excess global savings sloshing – both with Asset Managers and petro-rich Sovereign Funds.

Greek ownership of the structural reform will still be required and the signs are that the re-election there – seen in the EU as a de facto referendum on its membership of the Eurozone – will lead to a government willing to continue implementing the austerity medicine. 

A massive scale-up of funding to ensure a safety net is needed, particularly as the economic compression has exceeded forecasts/expectations in the IMF-EU programme. And here the rise of Syriza may actually have worked to shake the EU body politic a few degrees, even if Syriza does not come to hold power (it will be mightily interesting if it does come to play a part in government, although I expect Greece to still stay in the Eurozone).

Notwithstanding these above possibilities, ultimately there has to be some form of fiscal transfer for the Monetary Union and the Economic Union to which it is linked to work. 

These already exist in the form of Structural Funds to the tune of 4% of GDP that were designed to reduce asymmetries across the Union, and through the Cohesion Fund that was specifically a political pay-off to the southern EU in return for the “convergence pain” of having to ditch their currencies in favour of the common Euro in the first place. 

This also shows that – leaving aside the niceties of possible modification of the EU Treaties – that in practice scale-up of targeted financing through an established transfer mechanism is feasible.

It all depends alas, as always, on…politics and political will.

Greece: Syriza – z =?

Syria of course…gallows humour or is the situation really so pre-determinedly defined to doom and gloom?

I have focussed in recent  blog entries on the current electoral cycle in Europe that has seen a sea-change in leaders across the Eurozone and the extent to which political leaders have genuinely reflected – or not - electorates’ democratic choices on economic policy and management. Rightly or wrongly the answer thus far has been a series of “niets” for incumbents.

Following France, the Greece is back in the news. And, as I have been commentating, the austerity-only polity has eroded support for the status-quo and the middle ground of political co-habitation. It is no surprise that Syriza has received support for its non-conventionalism for austerity backed thus far by the existing parties in Greece.

What next?

•  Repeating the mantra from the last few blogs, domestic politics will continue to dominate – including in Greece. This means Syriza has more to gain by being the outlier by being seen to stand up to domineering foreigners from the north of Europe. So new elections.
•  I expect Syriza to gain ground but remain short of a majority.

Will Greece leave the Eurozone?

Possibly but it would imply a possible exit out of the EU itself, something that has not really been mentioned.

There is no provision for exit from the Euro – it is “irrevocable”. Then they said the same for the Roman Empire! In the end, like all previous empires and unions, the binding glue is political will. The same applies today – Greek exit will be determined by a confluence of political calculus in Greece, in Brussels, and to a large degree in Germany – both in the capital Berlin and at the ECB HQ in Frankfurt.

In this sense we are not much further from the prevailing situation of pre-elections in Greece. The Euro-zone and the EU economy in general continue to flatline in growth and contagion is no longer a risk but fact.

Despite the ECB’s efforts to turn on liquidity to help the banking sector – and in turn recycle funds into the sovereign debt market – the current travails of the Spanish banking sector shows that the core “stock” problems remain despite “flow” solutions. If anything, the recent attempts to mark-to-value banking assets in Spain will likely highlight need for further capital injections.

And so back to Syriza and the brinkmanship we have seen previously on the debt negotiations. Syriza will not want to see Greek meltdown and assumes – explicitly – that the rest of the Eurozone is bluffing and will not walk-away. The party will aim to maximise the anti-establishment wave of popula

And it is right…

·         The cost to the Euro 16 of a Greek exit would be incalculable and far in excess of any number of guestimates around. If there’s one thing we’ve learnt since 2007 is that estimates tend to  be grossly out of kilt to actual needs.

·         Any student of banking history and bank crises will be quivering at the thought of a Greek exit and the implications not only for Greek banks, but a wave of bank runs that would ensue in the rest of the southern Europe, most likely the rest of the EU, but also EMEA countries in the EU periphery.

·         With credit crunch a reality across the EU – and even worse for EM Europe – we could quickly enter a self-perpetuating cycle of compression of credit, private consumption and growth.

·         Although the vulnerabilities are less than in 2007 the EU economy will still face massive contractionary shocks. The EU firewall is there but a pyrrhic symbol insufficient in scale should a post-Greek exit contagion reign.

·         The cost of ECB financing to Greece is, as I’ve written before, a contingent fiscal liability for the rest of the Eurozoners so there will be a direct hit on EU Public Finances – and which may not yet have been fully factored in by rating agencies.

…and so

1. An explicit forced exit by the rest of the Eurogroup will not happen.
2. Expect status quo, more EU talk of solidarity, a good likelihood of a 3^rd Greek election and some form of fudgy agreement with the eventual Greek coalition that ensures the next tranche payment goes through.
3. Greek opinion does not favour a return to isolation and exit from the Euro. But there is a tail risk that this confused message of a popular backlash against governing elites  (poorly) implementing the EU/IMF blueprint coupled with this continued sense of being part of the EU family may actually lead to a situation where Greece declares an exit from the Euro – but as yet it remains a small risk.

But what of policy? Is Greece solvent – now or even in present value terms projecting ahead? If not, then how will Greece get out of the economic malaise that could otherwise see a decade of misery ahead?

Elections: the French "Go Dutch"

Sorry Hollande... Then again “going Dutch” in English encompasses the notion of paying for one’s own bill. So does Monsieur Hollande’s presidency presage a fundamental shift of French polity in general and in particular as regards the EU and Eurozone?

In recent blogs, I raised the likely scenario of a change in leadership at the Palais de l'Élysée as the wave of popular discontent against austerity in Europe continues to knock existing leaders off their perches.

And that the debate on all things Euro has, with the return of sovereign yield widening, led to a much greater interest on intra-EU political dynamics. Put another way, we are all now watching the debates, political trends and election results within the EU countries much more so than was the case pre-crisis where yield-compression was the order and convergence had purportedly arrived...dream on.

The French result puts into question the continuity of the Franco-German axis as the lynchpin of EU and Euro-centric institutional dynamics. Mr Hollande will want to exercise his genuine belief in French socialism and a resultant focus on government intervention. Whilst this position may mellow in the well-trodden “Euro Summit-itis” where everyone gets what they want in terms of grand-standing but rather meaningless statements, it will definitely affect a whole host of issues in the near term:

1. Expect a further weakening of the Germanic focus on balanced budgets in the current cyclical downturn as Mr Hollande finds common ground with Euro-Med partners – and even with Holland. With smaller and the newer EU member states privately unhappy with the implications, the Fiscal Compact will increasingly lose its intent and credibility.
2. Mr Hollande’s focus will remain in the forthcoming parliamentary elections in June so expect continued “noise” that further exacerbates the sense of fissure in the Franco-German template.
3. An unknown: will a socialist president now insist on further austerity for Greece and possibly in the Iberia should Portugal be asked for further cuts, or, indeed should Spain require of it?
4. A Growth Compact? As Jeff Sachs has noted in recent days, growth is an outcome and not a policy. Alas, the EU machine and inter-governmental waffle-merchants will continue to come out with these mantras. Too soon to say – the Eurozone crisis is no way near resolved and I expect the iterative nature of EU-decision-making to continue - but expect a tepid change of direction with possible, and relatively small-scale financing via EU Structural Funds and/or debt-financing for project from the EIB – but without any clear-cut framework for growth, or the real pressing issue, of competitiveness.
5. The Euro will continue its devaluation. And thus the conundrum, particularly for Germany: the devaluation itself acts to help the Eurozone through helping to improve external competitiveness but the impact magnifies on Germany: both for its own exports to the rest of the world but also for exports to the rest of the Euro-zone. Put another way, a falling Euro reduces the German incentive to “go Dutch” and return to the DM.
6. Continued weakness of the European Commission which is often the glue that holds the various competing national interests at bay. 

Conclusion: Put it together and...Status quo...ie continued volatility in the Eurozone both politically and economically, no real change in the overall fiscal-monetary mix involving a loose monetary policy and sort-of-coordinated deficits, continued angst in Germany against further bail-outs, continued disgruntlement in the southern EU and a resultant growth path which will remain moribund. 

But what of Greece I hear you ask? Good question..

Governments,Governance and Elections - Implications for the Eurozone

In the previous blog entries I focussed on how good governance is a desirable public good but that it is tremendously difficult to export. Effective demand requires domestic political will and often it is in difficult times of austerity that sacred (policy) cows are sacrificed to the alter of balanced-budgets and sovereign de-ratings. And this equally true in developed mature economies.

Which brings me back to the challenges of governance back in the EU which often preaches developing and would-be EU entrants on the morality of good governance.

We are now in the 5^th year since the onset of the financial crisis in 2007. And nowhere near the end of the pain. The news from Spain grows ever-more grim: unemployment is now 1 in 4 and the yields on its debt beginning to inch up. The new government of Rajoy has been in power since November and is in a governance-bind: its domestic political mandate is in effect hostage to the Eurozone agreement for greater austerity to balance books through the Fiscal-Compact .

And pretty much the same picture facing other so-called core Eurozoners: domestic audiences want to see growth: prosperity and jobs in their cities and countries from Finland to Portugual and from Ireland to Slovenia, irrespective of what is agreed for other places.

And this places the current Eurozone framework and, in the absence of a common fiscal policy, the intended 2^nd best fiscal co-ordination through mechanisms such as common surveillance and fiscal rules with binding restraints, in a very sticky situation.

In the same way as donors call the shots in the development world since its their money, it is broadly true also for the Eurozone with the creditors doing the same -  be they via the writeoffs of Greek or Irish debt or explicit transfers in the form of EU Structural Funds.

What is different now in 2012 is that domestic EU politics is now taking centre stage and slightly away from the economics/financial debate of what is now the “new norm” of negative or low-growth trajectories for almost all economies aside from Germany and the Scandanavian countries – and even here the dynamics of political economy have changed as Finland has highlighted of late.

How will this play out at the Eurozone level? I expect increased volatility as populist sentiment of pre-electoral phase leads to a more centripetal trend within each of the countries facing elections as simple self-interest comes to the fore. In this sense every Eurozone as well as other non-Eurozone EU countries are in the same boat.

There is already a whiff of this as EU politicians feel the political winds and adjust their antennae accordingly – whispers of a more growth-enhancing focus have quickly matured to Euro-speak and the rather boringly termed Growth Compact that needs to be incorporated as a complement to the Fiscal Compact.

In the end it will still come down to who is the net creditor and Germany will continue to be the ring-master but expect a continuity of EU salami-style economic decision making with gradual weakening of German resolve for pooling sovereign risk and the weakening the Fiscal Compact deficit limits as the new government heads – most likely led by the equally soporific-looking would-be new French president Hollande – gang up. Expect a continuing policy of loose monetary policy under the stewardship of Mr Draghi to soothe bank balance sheets. The EC as the EU’s executive already has off-the-shelf papers ready to be launched if and when we see something like the Growth Compact emerge.

In the meantime, there will be some rocky moments still ahead including the always entertaining Referendums in Ireland – this time on the Fiscal Compact on May 31^st coupled with a  possible tail risk that the apple cart of political stability is genuinely toppled through the election of extremists bent on fighting the EU diktat, leading to a possible exit from the Eurozone.

Folk have previously discussed the possibility of Greece exiting the Eurozone, but what probability of say Holland or another core country doing so?  

Governments, Governance and Elections 2

I chose the theme of this set of blogs under the Governance plank because it has received so  much attention in recent years, not least in development circles with everyone from the UN talking about “democratic governance”, the World Bank with its large data set that covers a range of political, economic and transparency indicators through to the herd of donors from the EU to bilateral government donors committing funds for all manner of financial support under the guise of governance-enhancement.

Moreover, a considerable amount of the EU’s Budget Support initiatives - ie dollops of Euros that can be hundreds of millions of Euros - are predicated on sound macroeconomic and public finances – or governance in the fiscal sphere, to ensure that these aid transfers are not simply siphoned off for new jets or simply wired to an offshore zone by the recipient country’s leaders.

One of the fascinating aspects as an economist-cum-policy advisor has been to see how this focus on governance has actually affected outcomes in emerging economies. Put simply, does it actually have any impact?

An army of evaluators will come out with positives as regards process, transfer of knowhow and value-for-money where hard money is transferred. But the bottom line is that well-meaning advice and fingure wagging only goes so far. At the end of the day there is no substitute for domestic ownership.

Example: the Arab spring. This had nothing to do with external support or advice. The EU’s had initiatives such as the Euro-Med Partnership and now the External Neighbourhood Policy Framework in place. But frankly the EU and the West generally was caught out by the timing and speed of the contagion across the MENA region, and which is sadly now engulfed in Syria. External initiatives are now trying to catch-up by offering assistance through aid and debt-finance via IFIs including oddly the EBRD that initially started with a mandate for the transition countries in the CEE region.

The dismantling of decades-old regimes in Libya, Egypt and Tunisia coupled with modest changes in Morocco and Jordan suggest a political structural adjustment and hopefully improved political and economic governance. On the other hand, the transition toward Arab-style democracy will take time and have a specificity in the same way Asian or Latin American democracy developed, but endowed with Arab history, culture and religious values.

Whether this transition is smooth or temporarily reversible remains to be seen. But outside support will have temporary and marginal effects – be they dollops of cash from GCC countries, pledges from hard-pressed countries in the EU or the US, or well-intentioned technical assistance. 

So does outside support work anywhere? Yes, where there is a buy-in. Or put another way, where there is incentive-compatibility or demand from the recipient country. The EU Accession Process is one such success story (although some might argue about Bulgaria and Romania) and possibly where financing through Budget Support has targeted Low Income Countries.

The Accession Process was a major success in terms of the transformational effects on the formerly planned economies that underwent radical changes from economic management to the roles of the executive, judiciary and all aspects of governance. Yes external ratings and qualitative appraisals confirmed this, but the real drive was a genuine wish by these countries to meet the challenges of compliance with the EU Acquis in order to become full members of the EU. And in turn the external assistance had bite or credibility, often with solid pre-conditions as well as followup support to deepen the reforms.

Counter-examples exist as one moves east towards the CIS where a similar approach has not been credible due to lack of genuine demand by the beneficiary governments or their electorates coupled with a lack of clear goal such as EU Accession. One even wonders the relevance for sometimes highly dubious support for resource-rich countries in the 'stans when EU tax-payers are toughing it.

For the Low Income Countries I believe there is evidence that support works. In fact I authored a report for the EC in 2011 that reviewed counter-cyclical budgetary support to 20-odd LICs in Africa, Caribbean and Pacific Regions that received targeted budget support in 2009-10. Such funding worked to alleviate pressure on vulnerable countries by helping to act as safety nets for what would otherwise have been devastating cuts in budget lines for social protection and education and by leveraging funding from the IMF, the World Bank and regional development banks. But alas, it had nought to do with governance!

So all doom and gloom? Not at all. I draw key lessons:

1. Governance is determined domestically and cannot be foisted on governments or peoples.
2. What the Arab spring and similar movements elsewhere – eg Russia in the run up to the presidential election – shows is that the real catalyst for change is actually the rapid rise of information flow and ideas that empowers people. The fall in the marginal cost of acquiring and dissemination information is the currency of the early part of this century and will be the key driver for changes in political opinion and therefore governments and governance.
3.  For the MENA countries the challenge is how to navigate the political changes and attend the basic demands of citizens and families everywhere: stable food prices (big issue for low income families and which will only rise given the secular rise in food prices in the coming few years), job creation (again a big issue for these countries with high youth unemployment) and access to jobs based on merit rather than party or clan loyalty.
4. New political leaderships will mean uncertainty will continue to see high country risks although on the upside all of the countries in north Africa except perhaps Libya retain reasonably good administrative systems that will help to mitigate some of the volatility.
5. Channels and modality of external assistance are well developed but remain tied to supply-side preferences from the donors. This is natural in terms of ensuring value-for-money for donor governments and their taxpayers and is unlikely to change. Focus on sound fiscal management and budget programming is an area which should continue to receive focus as this is often the most important tool for sectoral policy reforms.

Governments, Governance and Elections 1

I have been away in the CIS, the Balkans and to Egypt over the last few weeks – the latter to lay down on the sun-fuelled beaches where the Sun God, Ra, still pontificates on a daily basis, to its current 21^st Century crop of worshipers who fly over on a weekly basis – mostly a pale-faced lot from Europe!

So where are we in late April?

The Euro Crisis continues to mutate although the chances of the imminent collapse of the Eurozone has not materialised as some commentators unfamiliar with the political nature of the EU would have led you to believe.

Continuing with the classical theme, perhaps a more apt description would be to term the Euro Crisis more akin to a Madusa-isation: a wonderful creature that the gods (of Economics in this case) turned into an ugly thing to behold: that would turn any market that looked at too long -currency, credit and bonds -  into stone.

The focus continues to shift from Euro Member-State to Member State. 24-7 coverage magnifies formerly domestic political situations into another potential banana-skin, hurdle or potential fissure for the Eurozone. We have shifted from the periphery towards the core. Spain is now in the headlights but the news of the collapse of the Dutch government highlights how domestic political machinations - in this case by the rather aptly named wilder Mr Wilders who pulled out his Right Wing party from the governing coalition to protest against diktat from Brussels providing limits to the Dutch fiscal stance.

Madusa’s head was full of snakes if I recall from my school day review of Classics (and updated by the recent remake of the Clash of the Titans movie!). In this case we have 15 Eurozone heads and in fact 12 more non Euro-zone snakes for the rest of the EU countries facing the chilling impact of a faltering Eurozone on their growth coupled with the increasing realisation of what the Fiscal Compact implies.

Put more simply, we now have a potential conflagration that is affecting political calculus pretty much everywhere in Europe: Eurozone, the rest of the EU (Czech, Slovakia, Poland…) and those wannabee EUers such as Croatia and Serbia.

What does this mean in terms of strategy and outcomes for macro and political risk?

Ignore the white noise about “is there a return to growth or not”. The plain fact is that the Euro crisis is entrenched and will take a good few years to resolve. Policymakers are making efforts but are themselves hampered by domestic politics in each of these countries that means that efforts to resolve the crisis will continue to be gradual, piecemeal and sometimes perverse.

The Dutch instance is a case in point – until literally a few weeks back the Dutch were busy chastising the fiscally weak countries and now the country’s politicians find themselves facing the same challenge: fiscal machismo is possible only if you have a strong domestic plebiscite – as when the Scandinavians did so in the 80s following the banking crisis.

Programmed elections in France and forced elections through fall of government – Ireland, Greece, Italy…Slovakia, Holland…- will lead to spikes in risk as politicians rip up the European scripts and focus on the prime directive for any politician, of ensuring political survival.  

Implications of the Eurozone Crisis for EU Growth and Institutional Dynamics

Hind sight is a luxury not available when amidst the maelstrom of fast-moving real-time events. Just look at the haggard nature of both EU politicians and Eurocrats and one wonders if they have time for enough kip let alone time for reflection on the strategic direction the EU is taking.

On the other hand “the action is on the tails” and we are amidst a protracted tail-event in the form of a prolonged EU downturn coupled with a synchronised global slowdown – notwithstanding signs of green shoots over the other side of the pond in the US.

If the Eurozone is to survive then we are likely looking a decade or more of flatlining and only modest growth as households, banks and sovereigns go through a macroeconomic "detox" to cleanse the EU economic body.

Before reviewing possible implications, its worth skating over a brief list of how we got to where we are.

The Sovereign debt-and-banking crisis that emerged in the EU was caused by the flaws in the design of the Euro Currency Union:

•  A single currency but with no single national fiscal policy, let alone fiscal federalism
• So a second-best co-ordination of fiscal stances through nominal criteria was set up via the Maastricht Criteria and the Stability Pact…best referred to as the Instability Pact
• Free movement of peoples and capital in the EU led to flows of capital to the less developed south – in turn fuelling asset bubbles and related rise in private consumption through equity withdrawals.
•  Southern Governments became “free riders” of EU growth, relying on lower financing cost rather than any intent to focus on supply side reforms, leading to rising gaps in productivity with northern EU-ers (eurogroup or not).
•  In the meantime, the northern Eurozoners continued to innovate and move along on the productivity chain. Germany re-emerged from the German re-unification process successfully and like its near neighbours, showing a massive 25-30% rise in productivity over the last decade.
• The financial crisis that stated with the sub-prime problems, voodoo financial engineering had a direct hit on European banks. That in turn filtered through to the sovereign debt.
• QE by central banks (inc. the ECB) has helped to allay – but not resolve – a pending banking crisis by massive injection of liquidity that is now cycling back into sovereign debt, helping to lower yields.
• But credit to the real sector remains  moribund across the Eurozone as banks rebuild balance sheets by borrowing at near-zero rates from the ECB and investing in high yielding (non Greek ) sovereign bonds of the rest of the southern Eurozone.
• Distressed Southern Eurogroup members have been bailed out to varying degrees with further write-downs a near-certainty.

So Whence Next?

At least three themes are emerging.

The first is that the Fiscal Compact, signed off by 25 of the EU group of nations on March 1^st  (except the Czech Republic and the UK) has the explicit aim to add bite to the previously well-intentioned but weakly enforced Stability and Growth Pact through deeper Fiscal Co-ordination.

Will it work? The Irish threw a spanner in the works last week which may presage increased democratic review which the Eurocratic elites would rather avoid although unlike previous EU Treaties it will not hold it up....although an Irish "no" would make things interesting, at least for what it means for Irish monetary policy and future assistance from the rest of the Eurogroup.

As with the Stability and Growth Pact in the past success will be determined in reality when Germany and France abide by the rules – these two countries broke the rules previously whilst smaller states like Portugal faced Detention through the Excessive Deficit Procedure. 

The second theme emerging and which is worth review is what this means for the existing transfer mechanisms that exist in the EU - relevant for both the southern periphery but also the new EU Member States in Central and Eastern Europe. Structural and Cohesion Financing aims to ameliorate economic imbalances across the EU. Too early as yet but the real impact of the Fiscal Compact will be the spillover into how Structural Aid is delivered and – more importantly for value-for-money  for the donor tax payers in the north EU –  in terms of where this funding goes precisely and the impact it has. I will write more of this separately, as it has possible ramifications for the future aid flows to emerging countries – particularly putative candidate countries for the EU. Hungary (now an EU Member State) is already facing the music through a freeze on Cohesion Fund payments of €0.5bn in 2013 or 0.5% of Hungarian GDP.

Thirdly, the Institutional dynamics of the EU may go in one of two directions: “convergence to the mean” in institutional power play as the Commission continues to become the Death Star that has the magnetic staying power to sustain and possibly raise its powers through an incremental step-by-step process over time; OR we may see the emergence of a French-revolution that leads to a genuine Inter-Governmental approach that effectively dilutes this “competence” from the Commission.