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.

Bail-out, Debt (Un)-Sustainability Analysis for Greece: where are we in the Crisis Resolution?

Another marathon session in Brussels and, as expected, Greece got the 2012 bail out.  Talk of a possible Greek default through a refusal by the donors to cough up proved to be hot air.

As argued in my earlier blogs, the brinkmanship was all part of the to-be-expected Intergovernmental  and collegiate nature of Eurozone decision-making and to show national electorates in the donor Eurozone north that their politicians have cojones (as well as substantial tolerance of caffeine for the 13-hour sessions) to defend the budget support/aid flows into Greece at a time of growing angst about domestic growth and austerity in their own economies.

So where are we now?

Well Greece has got the €130bn and a PSI that results in an effective reduction by 50% and a projected creditor take-up of 95%.

Lets start with the Debt Sustainability Analysis paper presented to the Eurozone Group .  Dated 15 February 2012 and jointly authored by the Troika (EC, ECB, IMF) it is notable in its honest frankness about the substantial downside risks ahead. Lets look at the main points before assessing what it means:

1. Growth will be lower in Greece in 2012-13 than previously forecast which in turn means public debt as a share of GDP in 2020 is now expected to higher than the target 120% target by 2020 and as high as 178% before declining thereafter (it is hoped..).
2. There is formal acknowledgement that Greece will require further “official” financing and the range is between €50bn -€245bn, highlighting the uncertainties ahead.
3.  The converse of point 2 is that Greece will remain locked out of access to private flows via capital markets  - both due to its credit fundamentals but also because any new debt will in effect be junior to existing debt . Add to this a revision of costs of bank capitalization by €10bn to €50bn.
4. A re-hash of the first point: an explicit recognition that fiscal compression - to first eliminate the deficit/s and then to run surpluses in order to reduce the debt burden – is at odds with the aim to raise the competitiveness or internal devaluation in Greece since the debt to GDP ratio will actually and initially rise (debt constant but GDP will be lower)
5. Acknowledgement that the ECB’s Securities Market Programme (SMP) which is valued at €282bn and with guestimate €50bn in Greek bond holdings, could be used as one future channel to reduce the exiting debt burden further .

What does this all mean?

1. There is a tacit acknowledgement that Greece is in effect insolvent (ie. including projected revenues from privatisation receipts) and as such will need further bailout/s with a real possibility of total write-off of its external liabilities an increasing probability.
2. The timeframes  for further support will , as until now, be conditional on the iterative step-by-step measures  and further caffeine-fuelled sessions in Brussels, the political machinations of the EU and the emerging Eurozone Fiscal Grouping/Fiscal Compact, the election cycles of the donor Eurozoners and of course the outcome of the Greek elections.
3. In return for the current bail out the official creditors have asked for a de facto EU Convergence-cum-IMF Stabilisation Programme, with the first part for would-be EU-entrants but much harsher. Greece ducked the strict criteria applied to the new entrants in Central and Eastern Europe in 2004 (and which I was involved with and now so in the W.Balkans) and that has partly been the Achilles heel for the rest of the Eurozone Currency Union. The real test will be whether this focus on re-visiting the necessary part of the convergence machinery:   institutional building, regulatory reform eg land registries etc.  as well as liberalisation of service and product markets plus a massive shift in fiscal management on both revenue and expenditure management will carry traction – the key difference with the new EU Member States is that the latter had “ownership” of these reforms as part of the entry ticket to the EU’s Single Market as well as promise of soft transfers through Structural and Cohesion Funding.
4. Although not covered in the Debt Sustainability Analysis, one major worry has to be also the Current Account Deficit and the financing thereof. With outright devaluation not feasible and with little sign that Net Exports will provide sufficient upside, Greece will have a Financing Problem on the External Account. In one sense the reduction of capital flows on the Capital Account will limit the financing capacity and thereby help to negate the problem. That said there will be need of sufficient financing to ensure that the country doesn’t run out of sufficient necessities – at least in the form of energy imports.
5. Credit crunch and the private sector. With a smaller State and Net Exports in doldrums, the private sector has to be the engine. However there is worrying evidence that the sector is compressing  in part due to the credit crunch domestically and also to problems with trade finance across borders.

Summary:  

A lot of imponderables and uncertainties still ahead for Greece and the Eurozone. Whilst the financial markets and asset managers have focus on particular time-frames and returns, from a policy perspective there is real need to shift to a longer-term strategic focus of what is the future of Greece in the EU and the Eurozone.

Exit from the Eurozone (aside from the costs) will still leave Greece in the EU and with existing structural flaws that need address. Within the Eurozone, now, continued and accelerated austerity alone – with a further  envisaged decline in real primary expenditure by 20% up to 2015 is simply not credible in terms of the already fragile social cohesion in Greece (with Syria in flames and the Arab spring not quite bearing fruit this has to be avoided at all cost). Encouraging initiatives emerging out of Germany about a de facto Greek Marshal Fund suggest a good start – and point out another corollary likely to emerge and which will be the focus of the next blog.

Greece and the Euro-crisis: the End-Game or the Beginning of the End?

In an earlier blog on the issue  I concluded that brinkmanship will take us to the edge but that Greece will get the next bail out of €130bn and in turn allow it to meet the March 20th repayment of €14.4bn. This remains my baseline scenario.

Even if the baseline holds, the Sovereign Crisis will by no means be over. The resolution of Greece's external debt overhang will still not be complete and the 120% of GDP target by 2020 that has become a gospel-esque benchmark will require further reduction, particularly against a further deterioration of the economy.

Secondly, as also concluded in the earlier blog, the Crisis is pan-European in nature and as such whatever happens to Greece will affect how economic agents - both debtors, creditors and market participants - assess the probability of replication to other soverigns facing the music.

What has changed in the last two weeks is a growing schism in rhetoric from both sides of the de facto Transfer Union: growing angst among the donor countries whether they are about to throw in good money after bad and whether Greece will be able to comply with the already onerous conditions being imposed. And from the Greeks vociferous complaints about German-fostered austerity and what many there see as de facto colonialism. Elections in Greece are due in April and the polls show an erosion of the centre and toward the extremes on either flank, which raises political risk beyond April.

There is also a gung-ho attitude emerging from the donor north that is now openly airing the possibility of a Greek default and exit from the Euro. This is supposedly premised on the robustness of the new defence lines and safeguards via the EFSF and the ESM.

Sand-castles and Maginot Lines of defence more like...one only hopes that this is gung-ho talk as part of the back-and-forth fine-tuning of conditionalities under the aegis of the Troika (EU, IMF and ECB).

On the other hand we have increasing market chatter of a likely Greek default - in part fed by the statements from Finance Ministry officials in the donor Euro-north - and the likes of John Paulson (Hedge Funder) are forecasting and betting on the total break-up of the Euro.

Put it together and we have the continuing uncertainty and volatility in the markets and in policy circles....now and looking ahead for the rest of 2012.

Why the (messy) status-quo will remain and the Euro won't break up (at least in the near term):

1. The markets - particularly outside the Continent - do not fully appreciate the European mindset that exists not only among the political elite but reflects a general consensus in society for the need of a European framework. The EU is the glue that emerged out of the last World War and has enormous groundswell of support. Its institutional structures will therefore continue to grind forward toward consensus and agreement - it is in the DNA of the EC - but also among the EU Member States.
2. This in turn means that at an operational level the machinery to ensure process and procedure will continue to take its course and which tends to gravitate toward risk-neutral outcomes.
3. The Franco-German axis will continue to set the agenda and neither wants Greece to collapse. Germany has, despite howls of Greek horror, put up massive amounts of capital but understandably wants surety that there will be value-for-money. However Merkel's vision is clearly focussed on imposing German-style fiscal rigour and an incremental approach to the crisis that is not everyone's flavour. A disorderly Greek exit which if followed to its logical conclusion to a collapse of the Eurozone, the return of the DM and it subsequent strengthening would not be in the German economic interest. French president Sarkozy on the other is an election mode and fighting to save his presidency - the last thing he needs is Greece bellying-up, an immediate impact on banks in France and a possible banking crisis and risk to re-election.
4. Firewalls? Yes they exist but do we really want them tested? One lesson from the Banking Crisis has been that number-crunchers tend to always underestimate the true scale of woes and related costs. And the European banking scene  has not really undergone the reparation of balance sheets seen in the US. Remember the "dis-stress tests" by the EBA last year?
5. Not assisting the Greeks is self-defeating as any exit from the Euro will lead to an even bigger economic shock and meltdown there - in the end Greece as an EU Member State will require massive aid flows from the rest of the EU (and which will suck in non Eurozoners like the UK), but its exit would be the canary in the mine that acts as a catalyst on expected attacks on other sovereigns in the Eurozone but also among dodgy CEEs outside the EU (Hungary, Serbia, Romania...), runs on banking systems, a deeper credit crunch and goodbye to fragile signs of growth in the EU and ultimately growth globally. And hit Eurozone Treasuries through the quasi-fiscal liabilities of their share of support to Greece via the ECB.
6. It is in the interests of Greece to sign-off on any demands but the EU will need to start focussing on how to improve the growth prospects and bring a degree of genuine solidarity and ownership. 
7. Supply side reforms will bring benefits in Greece (and in Italy) which in many ways is a transition economy in terms of institutional structures and inter-operability of IT systems in budget planning, execution and financial reporting that have been shown to provide fairly quick wins for the new EU Member States - but standards for which were not strictly applied to Greece during its accession to the EU in 1981 or indeed in terms of the rigour for the benchmarking when Greece submitted its request to join the Eurozone in 2000.

The doomsday scenario is how a disorderly Greek default would amplify pan-country risk and in turn deteriorate already fragile growth trajectories is worth painting out next time. 

Finally, and continuing with the doomsday scenario, were Greece to exit, then I would support the Paulson thesis that we could see a very quick and messy Euro-break up - and far faster than models project. We know when economic or political unions break they can do so very quickly when a point of  inflexion is reached - as anyone who recalls the domino effect of the collapse of the Iron curtain will recall.

Scottish Independence and putative rise in Haggis Country Risk: Fact or Fiction?

I mentioned slightly tongue in check whether the Scottish would-be independents are following the Euro crisis in my piece on the Implications of the Sovereign Debt Crisis in http://rupinder-econ.blogspot.com/2012/01/psi-budget-commissioner-for-greece.html .

The National Institute Economic Review (NIESR) has come out with a review following which the three main rating agencies have echoed what might be best-described as “cautiously  cautious” rather than optimistic or pessimistic – no an independent Scotland would not immediately piggy-back on the UK’s Triple A status.

So does this mean Scotland risks being bunched more with Iceland than Norway? Far fetched.

There’ll be a lot of discussion about what a full-scale divorce from the UK would entail, not least in terms of the splits to the Defence Forces, but if the Soviet Union dissolution could be done in 1991 then political will will take care of this, if it goes that far….which I think nobody really expects. But worth thinking through the policy aspects and potential Country Risk aspects of which there’s been a good deal of hocus-pocus in the last week.

From an economic perspective, key points of interest:

1.       The political part of the political-economy will carry the greater weight in any final outcome and the degree of fiscal autonomy/independence the Scots vote for (depending on the questions..) AND not marginal concern about a potential rating – mentioned in the last couple of days on behalf of the 3 major rating agencies. Recall the IMF giving advice to the 3 Baltics in 1991 not to leave the Ruble zone….yet these countries did exactly that, dumping it for their own currencies and successfully so.

2.       Greater fiscal autonomy via independence will go hand-in-hand with monetary independence. The focus of the Scottish National Party has been to focus on the potential oil-manna and the implied fiscal boon. With their Calvinist tradition of tight money and history of puritan Scottish Banking (recent excesses aka RBS et all excluded) there is no reason why the Scots cannot make a good fist of this – even if there is a starting point of a national debt burden through pro-rata sharing of existing UK-wide liabilities….although the new Scottish Central Bank will want a slice of the Bank of England’s reserves no doubt that will mitigate this in part.

3.       Monetary Policy? Again, harking back to the experience of the Balts or other Soviet legacy States, in principle this should  not be a major concern in terms of the institutional or functional setup. 

4.       Yes there will be interesting questions about whether to peg to the UK pound, the Euro or “do a Montenegro” and have the Euro as the Scottish currency (unlikely), peg it (common model from the GCC to Hong Kong, vis-à-vis the US$), or have their own.  But again, these are secondary technical issues to the real political demand that often drives the drive toward total separation between States  - where it happens...

5.       Two and a half other issues of note going forward for any putative independent Scotland: Taken together, Scotland wouldn’t  have the economic independence of Norway …remember Norway is not an EU Member although it shares many of the advantages through a partnership arrangement with the EU through the European Economic Area…a sort of friendly merger of sorts between the EFTA group of nations that includes Iceland (now bidding to join the EU), Liechtenstein and Norway….that allows them to participate in the EU’s Internal Market but without full-fledged membership. 

a.       Within the EU, the increasing – German led – foisting of co-ordinated economic and fiscal policies will effectively constrain significant deviation of Scottish economic management

b.      A real exchange rate rise will be a given over the coming years which will very quickly translate into a massive surge in the wages of the non-tradeable sector and make the non hydro-carbon sector increasingly uncompetitive, lead to a massive property bubble and bring with it a different set of problems of demand management.

c.       The half point: Hmm would Scotland I wonder become a net payer into the EU Budget ?

    …so perhaps the real test for Scottish independence would be to go the full hog and seek exit from the EU but have a loose link with the EU in the same way Norway does through EFTA…

Mary Poppins and the Eurozone Crisis: will a Spoonful of ECB medicine be enough?

Aside from the historical aberration of the Planned Economy Model in the 20^th century where diktat replaced the invisible hand in directing the allocation of resources and of savings there has been little change in how Financial Intermediation has worked over the last two Millenia.

To a large extent Financial Intermediation has always involved deposit taking banks. And despite the liberalisation of financial markets and the advent of new forms of financial intermediation this remains broadly the case today…as do the risks of bank failure, contagion and the impact on the real sector.

In simple terms a bank pools deposits from individuals or companies and aside from a buffer to meet withdrawal demand, lends the rest…and …in the process creates credit as it can lend a multiple of the original savings. Add in some safety valves such as depositor insurance and a regulatory framework to ensure banks keep adequate capital…and so went banking theory…you could more or limit the risk of both bank failure and bank runs. Especially if you have control over the printing presses…ie you have an independent monetary policy allowing a “lender of last resort” function.

Stability often went hand-in-hand with the psychological elements. So you want a sense of stability with your bank and indeed with your Central Banks...names like Rock…Northern Rock…no just joking…coupled with a sense of age,maturity, stability and plain boringness…although I recall walking into the Central Bank of Estonia in the late 90s for the first time and seeing a totally different take which was more modern art than the stodgy, bulky Stalinist buildings  designed to intimidate citizens and which the Estonians wanted to get away ASAP in their journey from Moscow to Brussels…and now Frankfurt where the ECB is located.

Why stability…well there’s a huge history of bank runs that can start with a depositor run on a single bank. …for a quick multi-media and more enjoyable take see http://www.youtube.com/watch?v=eOi6c3NPYms&feature=related for the excerpt from Mary Poppins and how it can all start….

OK, fast forward to 2012…..and to the Eurozone, the banking sector, the role of the ECB and Emerging Economies in Europe.

Starting point and not really a point of contention now: the sovereign and banking crisis are intertwined (this at least differed during the Bullion era where sovereign crisis were country-specific).

What was perhaps less appreciated at the outset has been the potential spillover of the financial crisis into the real economies  - particularly the debt-fuelled private sectors in Western Europe and the US (although the signs are that de-leveraging or dis-saving there is much faster as households in particular pay off debt). 

Previous financial crises had not really affected mature banking sectors and hence the transmission to the real sectors was broadly unaffected. Not this time. With banks haemorrhaged initially hit by the collapse of the US housing market and subsequent pressures that led to significant bail outs by governments, and a gradual softening in both the US and Europe, there was a much more pronounced pass-through to credit – particularly for personal and housing sectors.

And then, partly as a result of the EU-wide slowdown, we had a growing realisation of the emerging Sovereign Debt crisis that has been rarely off-screen during the last 18 months, which started in Iceland and then ingulfed the former Celtic Tiger, Ireland, before spreading across the southern flank of the EU.

…and more pain for  banks…many of them with substantial exposures to these economies on the assumption that there was no deviation in Country Risk within the Eurozone…

Leaving aside the institutional and legal aspects of what the ECB can and cannot do, in practical terms what is clear is that the ECB under Super Mario has started to soothe market nerves through a much more active monetary stance in recent months, acting as the de facto lender of last resort – even if the term in heresy if spoken in Germany. In addition to buying Sovereign debt from the struggling PIGS it has more or less managed to solve the liquidity crisis in the banking systems – at least for now - and in particular in the inter-bank markets by allowing banks to borrow, on fairly good terms, for up to 3 years – even for dodgy collateral.

Great! And the real sector.. in the Eurozone? Hmm…still not much happening…. Thus the sudden rush among policy-makers to talk about Growth, how to push banks to lend more to the real sector or even – copying the supposed successes of State Capitalism from China to Brazil – a growing appetite for dirigiste policies of state intervention, Industrial Policy and directed credit...

A quick look at the key points and what I’d regard as real downside risks to the talking the talk in the Eurzone and EU about Growth, and why:

• 1.       ECB: its balance sheet is now heavily exposed to the PIGS which market participants talking about the cost of Greek exist from the Euro do not in my mind fully factor in. Under the existing system of the Eurozone, any hit will be shared out – so this is in effect a Eurozone-wide contingent liability (i.e. any  Ministry of  Finance in the Eurozone should have a number for potential fiscal risks if the worst happens and the cost to their budget). The arguments for the PSI in Greece have rightly touched on why the ECB should not also share the “solidarity” of haircut to its €40n exposure to Greece….so the contingent liability could become real much faster than ancipated…in turn affecting the fiscal positions of the rump Eurozone members should Greece (and/or others in the zone leave the Euro)
• 2.       If Greece exists the Eurozone, then contagion will be instant, with Portugal already in the headlights…..so the costs of Greek default for the ECB will be higher both directly as liquidity support is cranked up to fragile banks and the mark-to-market values of its lending to the sovereigns and banks takes a nosedive.
• 3.       Eurozone Banks: what is clear is that a duality is emerging – good banks not in need of support are depositing at the ECB whilst the weaker banks are the ones hoovering up the liquidity support to plug balance sheets and the ill-timed strengthening of capital requirements in the EU and towards Basle III….ill-timed because right now banks need to be incentivised to lend to support real asset markets, Investment and Consumption …not just financial assets..whilst using the existing interest rate spreads to repair capital (“time inconsistency”  problem for fellow nerd Economists).
• 4.       Systemic overview… the ECB is now the Financial Intermediary…maybe worth another look next time…and it is also the lender of last resort…something wrong here? The ECB is keeping afloat bad banks and helping out distressed Euro Sovereigns. Sustainable? Niet.
• 5.       Depositors…a wall of money has already been heading from, in particular Greece to “safer” northern Eurozone banks and into the real estate in London property market. The big risk…aka “I want my money back” cry from the lad in the Mary Poppins clip above…is that deposit withdrawal rises and there is evidence this is already happening…deposits at the ECB fell €25bn in December…which is likely to mean that the relative problems are greater in the southern Eurozone….and the political risk that the externally imposed austerity could derail if we get to a tipping  point in terms of social cohesion.
• 6.       The December data tells us that banks have a perverse incentive to ...reduce loan books!!...whilst still hunting for additional capital to meet stricter new capitaliation rules. Unsurprisingly lending was down close to €50bn in December in the Eurozone….worth repeating the implication: what this tells us that we have a real and present danger of  a credit crunch, fear of lending, fear of borrowing and a declining propensity to consume…why spend your savings if you might not have job?
• 7.       Historical episodes of bank-runs and contagion form the last 200 years tell us that this can happen very fast. In the 24-7 world of today and a “flat world” the speed would be far faster than in the era of the Gold Standard….and not taking into account innovations such as shorting the market, and computerised trading platforms that could add enormous “overshooting”, volality and pollution across asset markets…..put another way, the transmission channel today is much faster and the multiplier effects greater of a Greek exit….which makes it all the less likely. (see http://rupinder-econ.blogspot.com/2012/01/greek-debt-crisis-key-issues-and-likely.html for a review of key issues re Greece).

dWalking-the-talk for growth-enhancing policies in the Eurzone is going to be a lot more difficult than implied by recent statements. A co-ordinated response within the EU and Eurozone will ultimately bear fruit – in particular through sustained structural adjustment, if and when the sovereign/banking crisis is resolved. In the short term, we should send out for Mary Poppins and ask for a bit more medicine --perhaps in the form of continued sustenance of growth in China/Asia and the US.

PSI, Budget Commissioner for Greece: Implications for the Sovereign Debt Crisis and the future of the Eurozone

So a PSI is almost a done deal for Greece. Is the beginning of the end for the Greek-cum-Eurozone crisis? Not On Your Nellie…

In my last blog I signed off with some fundamental concerns about both the impact and sustainability of the process in Greece set against a clear lack of consensus and domestic ownership for the austerity forced in Greece – either among the rulling classes or across society more generally (and to date putting the Greek situation at odds with Italy).

What is clear from both the last IMF report in December and the data so far is that the economic compression in Greece is worse than baseline forecasts from even mid-2011. Whilst the Fund is focussing on a medium-term path to sustainability of debt to 120% of GDP and a return to growth fostered by fiscal and structural reform, the facts are that an economy heading south does not bode well for any projections   – leaving alone the intention of widening the tax base or ramping up the efficiency of tax collection.

There are no signs of productivity growth but instead, as to be expected, indications of internal devaluation Latvian-style through a decline in domestic wages....and unlike Latvia growing signs of ever-increasing domestic opposition as the pain of austerity bites deeper.

How long can this continue?

Economist's Answer: …until marginal gain = marginal cost!...

Or put another way, there is a argument to be made that it is in the interests of (at least the elite) Greeks to secure the maximum in terms of transfers, aid, soft financing and reduction in Net Present Value of external liabilities….until it becomes too painful and the marginal cost/pain outweighs the marginal gain.

Have we reached the point of equality of the marginal changes?

The leaked terms of the new EU-IMF deal has some pre-conditions which both crank up the requirement for further cuts in civil servants by a reported 100-150k and …here are the interesting parts:

i.                     A legal commitment to prioritise future debt service  and an implicit requirement to meet future budget constraints due to non-disbursement of traches through cuts in primary expenditure.

ii.          A formal “Transfer of National Budgetary Sovereignty….see the full text below:

Budget consolidation has to be put under a strict steering and control system. Given the disappointing compliance so far, Greece has to accept shifting budgetary sovereignty to the European level for a certain period of time. A budget commissioner has to be appointed by the Eurogroup with the task of ensuring budgetary control. He must have the power a) to implement a centralized reporting and surveillance system covering all major blocks of expenditure in the Greek budget, b) to veto decisions not in line with the budgetary targets set by the Troika and c) will be tasked to ensure compliance with the above mentioned rule to prioritize debt service.

The new surveillance and institutional approach should be formulated in the MoU as follows: “In the case of non-compliance, confirmed by the ECB, IMF and EU COM, a new budget commissioner appointed by the Eurogroup would help implementing reforms. The commissioner will have broad surveillance competences over public expenditure and a veto right against budget decisions not in line with the set budgetary targets and the rule giving priority to debt service.” Greece has to ensure that the new surveillance mechanism is fully enshrined in national law, preferably through constitutional amendment.

As someone who has worked with over 20 governments and Ministries of Finance – and therefore a certain amount of operational knowledge on fiscal positions - I cannot recall even developing and aid-dependent countries being asked to, in effect, delegate its fiscal sovereignty to this extent – although policy conditionality can be tough – and where it is, it is in effect requested and signed-off  by the country.

And needless to say the initial reaction from Athens has been vociferously negative.

Moving on from basic economics to slightly more advanced stuff, lets take a leaf out of Game Theory…..

i.                     Is  Germany, which is clearly behind this initiative – given the blueprint in action of the Fiscal Compact – willing to take this to the limit? Does it expect Greece to comply, get the funds and thereby help placate German public opinion (which is against handouts to Greece) and then in future take charge through the implementing arrangements being put in place, or

ii.                   Are the Greeks being pushed to exit the Eurozone…if yes game over

iii.               Lets go to time period 2: Assume the Greeks bite the Bratwurst…sorry the bullet…and agree to the deal and then renege…what happens………yup, back in the Twilight Zone!

iv.            Introduce dynamics…Portugal sees what’s happening (Miguel look forward to  your views!), then the Cypriots, Irish,…Spain…and why not those peddlesome new Member States that never really sorted out basic corruption issues…say the Bulgarians or the Romanians….hmm how about the French while we’re at it. Will the other sovereigns in the firing line or those reliant on EU aid transfers within the expanded EU start to put up a coalition of resistence towards greater fiscal co-ordination or sign-up?

As far as Greece is concerned, there have to be grave doubts about the democratic legitimacy of the proposal but I can see a watered down version waived through in the EU-language of solidarity and partnership that allows  both Germany and Greece to get their desire. However, we’ll not be much further down the road from answering whether the entire process is credible – where I started or if we’re anywhere nearer a resolution of the Euro-Crisis.

From the donor side – and this is an apt term as Greece in effect aid dependent – there is a real (and understandable) concern about how to introduce a clear incentive-based approach that binds Athens to structural adjustment – however painful, and that if sustained lead to a sense of “revelation” for Greeks sometime in the next few years.

What is clear is that the fiscal measures agreed are not working so far. 

Sales of assets to raise €50bn? The original timeline of 2015 was stretched to 2017 but aside from the risk of achieving firesale prices or low value as far as the Greek tax-payer is concerned, there is a paradox in play – the Greeks need to sell but the fear of “Drachma-sation” and de facto devaluation in Greece (with a likely dose of high inflation) is putting off potential buyers. By corollary, the more the markets feel that Greece can stick the course  the more likely that the risk of drachma-sation will recede and appetite pick up.

So what we’re left with is …further budget cuts in the offing…including a further to-be programmed cut of 1% in the budget outlay in 2012.

Conclusions:

i.                     A bit like the end of the transfer-deadline today for football in England, gamesmanship means leaving things till the 11^th if not 12^th hour.

ii.                   A Greek default is not in anyone’s interests in the Eurozone or in the wider EU. The PSI settlement will be followed by some fudged-compromise agreement to the new conditionality and subsequent disbursement of a new €130bn tranche. And (back to Game Theory) the Greeks know this, the Germans know this, the Greeks know the Germans know this...the Germans know that the Greeks know that the Germans know this...hmm do the Scottish Nationalists know this ? :)

iii.                  Greece will meet the March 20^th deadline for meeting the next debt payment of €14.4bn

iv.                 Expect increased vigilance at the Eurozone level of Greek budget programming and implementation….no bad thing in terms of broader governance for the Greek taxpayer…

v.                   …expanding over to the other sovereigns who, like Oliver Twist,  come round asking for more.

vi.                 Does it solve the economic collapse in Greece…No…so back to Oliver Twist we all need more...and more means a co-ordinated response for "more growth please!"

vii.                Will the risk on Greece meeting future debt repayments decline? Difficult to say at this stage: possibly, but push-come-shove  and Greece could still default in the future although the starting conditions will be significantly improved….

viii.              What it may do is to increase a typically iterative EU advance towards a fiscal Union through pooling of resources – cross-country collateralisation of debt issuance or Eurowide bonds. It may also as a consequence lead to a clear segmentation of countries within the Eurozone towards comparable zones…hmm wasn’t that the DM-zone before?