(1) Massive credit downgrades by Moody's to unsecured debt of nationalized Irish lender Anglo Irish knocked stock markets in Europe back over fears of a Greek-style rehash. Massive bailout costs exacerbated by downgrades to near-junk are a fear:
Moody's cut the nationalised bank's senior unsecured debt by three notches to Baa3- just one notch above junk status - citing a small risk the government would not continue to support that class of debt, the agency said on Monday. It slashed Anglo Irish's subordinated debt by six notches to Caa1...(2) So why was the €440 billion European Financial Stabilization Fund not activated as per the gossip above? Wolfgang Munchau believes the mysterious EFSF, alike many now-shunned and similarly structured CDOs, uses a lot of "credit enhancement" to bring about a AAA rating. These guarantees may likely push final borrowing costs to troubled European countries into the 7.5 to 8% range:
According to unnamed government sources cited by German business daily Handelsblatt on Monday, the European Central Bank gave serious consideration to activating the euro zone's bailout fund for Ireland but in the end decided not to [my emphasis; see more on this point in (2)]. Finance Minister Brian Lenihan has said it was unthinkable that Ireland would default on senior debt but, in the absence of such assurances given on subordinated paper, analysts say those might face a buyback at well below par...
Facing political pressure to shut down Anglo Irish, whose loan book soured dramatically after a disastrous property binge left it heavily exposed to the impact of the financial and market downturn, the government has outlined a compromise plan. It is splitting the lender into an asset recovery bank and another entity to house its deposits which will not lend any money. Though the final cost of the exercise is not expected to be revealed until later this week or early October, the 25 billion euros so far earmarked would already push Ireland's 2010 budget deficit to well over 20 percent of gross domestic product.
Let us assume the EFSF raises the €1bn at an interest rate of 4 per cent. With administration charges and lending margins of 350 basis points, the effective interest rate to the borrower would be 7.5 per cent. What about the cash buffer? The EFSF must reinvest the buffer in the best triple A rated securities in the market. So if its own funding costs are 4 per cent, and if it invests the cash buffer into German bonds at a hypothetical yield of 2 per cent, there is a loss of 2 percentage points. This also has to be paid for by the borrower. This comes on top of the 7.5 per cent interest. It is not all that hard to conceive of a situation in which the borrower would end up paying a total interest rate of 8 per cent.(3) Meanwhile, Martin Wolf offers his now-familiar theme of "We can only cut the debt by borrowing." In essence, it's the old argument that growth cannot be restarted if both the private sector goes into austerity mode as a necessity while the public sector does the same due to misguided "belt tightening" policies. He is particularly hard on the UK:
“You can’t cut debt by borrowing.” How often have you read or heard this comment from “austerians” (a nice variant on “Austrians”), who complain about the huge fiscal deficits that have followed the financial crisis?Note though that the IMF has given the UK plan a thumbs-up.
The obvious response is: so what? Shifting debt from people who cannot support it to those who can - the population at large, both now and in future - seems to make a great deal of sense if the alternative is an economic collapse that leads to a loss of output and investment now and so of income in the long term. Indeed, under the latter alternative, even the fiscal deficits may end up little, if any, smaller if one tries to slash them, as the UK could be about to discover.
(4) Heading back to the frontlines, there are political clashes aplenty as Eurozone members attempt to thrash out an agreement to avoid future Greeces (and Irelands, for that matter). Although an agreement is supposedly due Wednesday, there is much wrangling over how sanctions should come into effect. Essentially, Germany wants more of the sanctions to take effect when limits are breached without political input, while France and Co. are wary of this approach. Cynical old me observes they want to retain the ability to water down sanctions despite giving lip service to being tough on repeat offenders:
European Union ministers backed tougher sanctions on Monday for euro zone budget rule-breakers and disciplinary steps for countries running high debts, but clashed over how automatic the penalties should be. "The discussion today showed a very large degree of convergence on important issues related to budgetary and economic surveillance," EU President Herman van Rompuy said after chairing the finance ministers' talks in Brussels.And here is the key point of contention involving "reverse qualified majority voting." Instead of sanctions being levied after a qualified majority decide to do so alike in the present system, the EC (the executive branch of the EU) wants to require a qualified majority to override sanctions that automatically kick in once stipulated limits are breached. There's also talk of withholding EU cash to repeat offenders:
They agreed much more attention must be paid to debt, and countries which have debt higher than the EU limit of 60 percent of GDP and are not reducing it fast enough should face disciplinary action, he said in a statement. There was also backing for a new system of sanctions. "Sanctions would be introduced at an earlier stage, be more progressive and rely on a wider spectrum of enforcement measures. There was broad support that, as a first step and on the basis of the (European) Commission upcoming proposals, sanctions should be strengthened in the euro area," Van Rompuy said.
In a letter to the officials meeting on Monday, German Finance Minister Wolfgang Schaeuble said he wanted the EU's budget rules to be given "more bite" and that they should include quasi-automatic sanctions The Commission also wants to reduce the scope for discretionary decisions by EU finance ministers.(5) And finally [whew!] the European Central Bank is weighing in bigtime on the EC to come up with a programme to deal with repeat offenders with teeth--or else. Apparently unhappy with having to implement extraordinary measures time and again, the ECB wants the Brussels bigwigs to sort matters out once and for all:
To achieve that, it has proposed that only a qualified majority of EU ministers should be able stop sanctions, or what the Commission calls reverse majority voting. Under the current rules, a qualified majority is needed to impose sanctions. But French Economy Minister Christine Lagarde said the automaticity of the rules was a bad idea. "To foresee a complete automaticity, a power totally in the hands of the experts, no. We believe that the political power, the political appreciation should remain fully in the game," Lagarde told reporters...
Another German notion - to freeze the flow of EU funds to countries that do not respect EU budget rules - seemed to be put off for more discussions, but not dismissed. "Conditionality for the use of EU funds linked to sound implementation of the Stability and Growth Pact should also be introduced as soon as possible," Van Rompuy's statement said.
The European Central Bank has warned eurozone governments that it will sound the alarm if they fail to agree reforms to Europe’s monetary union that are tough enough to prevent a future Greece-style crisis. Jean-Claude Trichet, ECB president, set out on Monday a series of “five questions” the governments had to address in a system for surveying and imposing sanctions on countries that lose control of their finances. “If the responses were too timid in our opinion, we would make clearly the point,” Mr Trichet told the European parliament in Brussels.Trichet's speech spells out his wish list...
To summarize, the “checklist” for a review of proposals for euro area governance would be affirmative answers to the following five questions:It's a lot to digest, I know. If the sheer enormity of EU institutions begin to overwhelm, a volume I can unreservedly recommend is Baldwin and Wyplosz's The Economics of European Integration--one of our textbooks here at the LSE. Hopefully Brussels folks will sort out a workable plan by Wednesday, though it's a bit of an optimistic schedule. As many of you know, I ultimately have faith in the European project--especially the ECB and the currency it issues. Having come this far, it makes no sense to throw it all away.
* First, does the fiscal surveillance framework effectively address the weaknesses that might give rise to a future crisis?
* Second, is there a macroeconomic surveillance framework that can trigger effective adjustment of imbalances, of external indebtedness and of losses of competitiveness?
* Third, are the enforcement mechanisms of fiscal and macroeconomic surveillance quasi-automatic and the enlarged sanctions sufficient to protect other members and the monetary union as a whole?
* Fourth, does the framework include appropriate independence in surveillance, and impeccable quality checks of analysis and statistics?
* And finally: are the new principles of economic governance anchored within national frameworks?