Lessons from Europe

Last week, Open Europe participated in a discussion in Washington DC hosted by the Heritage Foundation, looking at the debt and deficit spiral haunting both the US and Europe. The discussion can be viewed here.

In a note published last week, in tandem with the Heritage Foundation’s Sally McNamara and J.D. Foster, we also outlined ten economic lessons from Europe. We noted,

The primary lesson from the Eurozone sovereign debt crisis is that running large deficits and accumulating debt with no indication of changing will always translate into higher interest payments and likely higher interest rates, meaning more tax revenue will be consumed just paying for past fiscal sins. Greece, Ireland, and Portugal are now facing interest rates of 13 percent, 10 percent, and 9 percent, respectively, and still face the very real possibility of defaulting.

The U.S. is on dangerous ground by not tackling its current and future deficits with enough urgency. The Obama Administration seems to be relying on markets continuing to provide it with near unlimited liquidity at reasonable rates. But this cannot last forever. Even absent a fiscal correction, interest rates are widely expected to rise substantially in the next few years as the global economy rebounds. For example, the Administration forecasts a rise in the 10-year Treasury rate of 230 basis points. Add in the ongoing deficits, and investors will eventually give the United States the Irish treatment, raising the cost of borrowing much more.

Read the full note here.

The Great Euro Gamble

In today's Wall Street Journal we argue,

"When European Union leaders forged their monetary union without a full political and economic merger, they gambled on two vital factors: That economic forces could be kept in check, and that national democracies could be managed.

Over the past 16 months, we have been reminded time and again exactly how big and how irresponsible those gambles were. Sunday's was arguably the strongest reminder yet, courtesy of the anti-euro True Finns party that may hold the balance of power in the next Finnish government. Paris, Berlin and Brussels seem not to have factored Nordic populism into their grand plans for the euro. But ultimately the euro zone is about politics, and politics remain as local as they ever were."

We go on,

"The True Finns' success will not change European politics overnight, and the party may not even succeed in blocking Finland's participation in future bailouts. But, irrespective of what we think of the True Finns, the election does highlight how powerfully a euro-zone crisis can contribute to shaping national politics. Euro bailouts were also an important issue in Slovakia's elections last year, and helped to deliver a new governing coalition that refused to take part in Europe's Greek bailout. That government only reluctantly kicked in later to help create the temporary bailout fund that euro leaders are now looking to replace after 2013.

This year the True Finns asked voters to consider the same question that Slovaks did last year: Why should they work harder and retire later to pay for the mistakes and wasteful habits of southern European governments? This "triple-A populism" has proven a powerful force in a number of countries with sparkling credit ratings, including Germany. Writ large, this weekend's Finnish elections are a rebuke of one of the euro zone's central, and fatal, conceits: that political ambition can trump economic and democratic realities."

Looking at EU leaders' gamble on being able to keep economic forces in check, we note,

"Markets have now finally woken up to the fact that Greece and Germany are poles apart; it is time for EU leaders to do so as well. Ireland, Greece and Portugal have made all too clear that economic forces can rarely be predicted, let alone contained.

Some particularly federal-minded EU leaders took this as a pretext to push even harder for a full-fledged fiscal union. Former European Commission President Romano Prodi wrote in an op-ed in the Financial Times last May that "When the euro was born everyone knew that sooner or later a crisis would occur. . . . I was warning years ago that, through no one's fault in particular, extraordinary events could occur that would force joint co-ordination of fiscal policies."

That sentiment spurred EU leaders to take their next major gamble, which was even riskier than the first: They bet that once they did start to effect robust economic and political union, national voters and parliaments would play along and vote the "right" way. So last year, when the EU elites decided to break their own treaties and turn the euro zone into a de facto debt union, they forced taxpayers in some countries to take on the liabilities of foreign governments in other countries—without the possibility of voting these governments out of office. But taxpayers are now showing signs of revolt. "

We conclude,

"Will EU politicians' second gamble turn out as ill-judged as their first? Time will tell. But one thing is clear. The political price that European leaders are paying to keep their flawed project afloat continues to rise."

First to the Finnish line

This is a graph showing the support for the different parties, according to a poll published last night, ahead of the Finnish national elections on Sunday. All international eyes are on the True Finns (fourth from the left) - the party that has said it opposes a bail-out deal for Portugal and putting any more cash on the table for struggling eurozone economies. In fact, the party doesn't want to be in the euro at all.

A lot has been said about the True Finns, with the European media all of a sudden forced to become experts on Finnish national politics - it has to be said with varying degrees of success. That many still refer to the True Finns as a "right wing" party indicates the need for a bit more analysis and a bit less reliance on labels that are flying around. The party is pretty skilfully moving along the right-left scale. It's effectively social democratic on economic and welfare issues, favouring a big state, combined with a pretty clear socially conservative flavour. It's definitely populist and not exactly enthusiastic about immigration (and this in a country which accepts some of the fewest migrants in Europe).

So what will happen on Sunday? We wouldn't bet our money on any player. The True Finns have seen a drop in support recently - 15.4% in the poll published yesterday, down from 17.2% a month ago. The National Coalition Party extended its lead to 21.2% in yesterday's poll, while the Centre Party was the second largest party at 18.6%. The Social Democrats were at 18%. The Nordic bookies don't think the True Finns will make it into government and will give you 2.10 times your money for a bet on them winning ministerial seats, while a bet on them not making it only gives you 1.65 times your money.

Regardless, the True Finns are likely to make huge gains compared to the last elections in which they scored just over 4% (see the rise of the True Finns here, in yellow). And a second thing to remember, the Social Democrats - currently at 18% - have also expressed pretty clear opposition to a Portuguese bail-out, instead arguing for a restructuring. Between them, the two parties could well reach above 30% - that's a pretty powerful anti-bail-out bloc. As we've noted before, this could potentially hugely complicate a Portuguese bail-out, as well as efforts to top up the temporary bail-out fund (EFSM) and cash injections in to the permanent rescue mechanism (EFM).

The elections in Finland have made people - not least many opinion formers - start to realise that, shock horror, ultimately the eurozone is about politics. And as we know all politics is local.

In fact, it's difficult to find a more conspicuous example of the inherent flaws of the eurozone - the idea that political ambition can stamp out both economic and democratic realities - coming up against the full force of national democracy.

The political lesson from the Portuguese bail-out: don’t give up EU vetoes

Over on Conservative Home we argue that the main political lesson for the UK government from the Portuguese bail-out is don’t give up EU vetoes without thinking through all possible consquences. We argue:

"And here’s the thing, the reason why the UK is now required to underwrite a Portuguese bail-out to the tune of £3-4 bn (partly via the EU budget, the legality of which is dubious, party via the IMF, which is fair game) isn’t Alistair Darling, who signed the emergency bail-out deal in May last year, or George Osborne, who allegedly was consulted by Darling. The UK long ago gave up its veto over the part of the EU treaties – the now infamous article 122 – that can be used to commit Britain to financially assisting an EU country in trouble, if that country is hit by a “natural disaster” or “occurrences beyond its control.” Even if Darling, or Osborne for that matter, had objected to the emergency EU bail-out fund last May, they would probably have been outvoted as the decision was subject to majority voting (whether a UK Chancellor, even if he had had a veto, would have wanted to block the deal, given the enormous financial and political pressures at work is also open to debate).

The question then is, whose brilliant idea was it to give up the veto over article 122 – which has effectively become the financial equivalent to Nato’s Article 5 on mutual military assistance?"

To get the answer, read the full post.

When those who claim to know get it wrong

Last June, we published a pamphlet titled "They Said It: how the EU elite got it wrong on the euro", in which we compared what politicians, central bankers, journalists and opinion makers said about the Single Currency before the eurozone crisis erupted - to what they say now. It's a pretty shocking read, and should make people think twice before making the argument against EU-related referenda on the grounds that 'average people are too stupid to understand such complex issues'. On the euro, by far the most important issue relating to the European project, it was the elite (in politics, in media and elsewhere) who got it spectacularly wrong - for whatever reason: political vanity, ideology, short-term thinking, ignorance or plain incompetence.

Take the FT's Wolfgang Munchau, for example. For years, the guy churned out columns praising the euro, sometimes with caveats, but nothing like the stuff we're seeing now.

Back in 2006, Munchau argued:

"There is not the slightest danger of a break-up of the Eurozone. On the contrary, I expect the Eurozone to be exceptionally stable in the long run. Make no mistake, the Eurozone is here to stay".

And in 2008,

"The world's two large reserve currencies, the dollar and the euro, offer more protection from speculative attack than a free-floating offshore currency unit. The UK will at some point have to make a choice whether it wants to be in the Eurozone or whether it wants to seek an alternative use for those rather tall buildings in the heart of London".

We're not saying that he's not making many valid and interesting points in his columns. But seriously, these are painfully inaccurate predictions. And compare to what he's been saying over the last few months:

“The probability of scenario four [eurozone break-up] cannot be zero or even close to zero. When the eurozone crisis broke out, the probability of failure was considered as small, but non-trivially positive. It is higher now despite the ‘whatever it takes’ pledge…My point is that if Germany is serious about limited liability – and I believe it is – the probability of a break-up is anything but tiny.”

Trust us, we can make the list of contradictory quotes from Munchau very very long. In fact, we could write a new "They said it" every single month, and wouldn't have any difficulty filling it with material, as established figures continue to contradict themselves on the euro.

Take this from the BBC's economics editor Robert Peston - who clearly is a clever and nice chap - but on potential UK liabilities in a Portugal bail-out he was just plain wrong, as we noted at the time. Two weeks ago - when it was becoming obvious that Portugal would had to seek a bail-out -he noted on his blog and on the Today Programme (and contrary to what we said):

“Only in the event that the Portuguese financial crisis exhausted the available money in the eurozone's bail out fund - which it won't - would the UK become liable.”

Last week, when the Treasury had confirmed that the UK will be partly liable, Peston did a U-turn:

“First of all, it does now look as though the implied UK contribution to the Portuguese bailout will be around 4.8bn euros or £4.2bn (in line with what I've been saying).”

Excuse us?

Okay, so the eurozone crisis is a moving target and we all get stuff wrong from time to time, but this is pretty bad. It's also interesting that those complaining about the poor coverage of EU issues in UK media never quite seem to look at the flip side of the coin.

A dog eat dog world

This placard seems to capture how a lot of Portuguese are today feeling about their economic future - Socrates is the poodle in Merkel's arms. (hat-tip FTD)

What's the truth about the True Finns?

We have received a couple of comments in regards to our blog post below on the rise of populist parties in the wake of the eurozone bail-outs. Some have been unhappy about our assertion that the Front National is gaining ground in French politics, whereas others have taken issue with us mentioning the True Finns in the same breath as the Front National and FPÖ (the expression "not as bad as FPÖ" has caused particular offence).

But on the point about the True Finns, a clarification might be appropriate. The True Finns party, or Perussuomalaiset in Finnish, has its roots in an anti-incumbency, rural protest movement from the 1950s, leading to the formation of a political party, eventually named the Finnish Rural Party. The party's dissolution in 1995 led to the creation of the True Finns (one of the party's slogans, "Crush the power hold of the old parties", is testament to its heritage). More than anything else, its euroscepticism seems to flow out of this tradition (which also explains its opposition to providing more cash to the temporary eurozone bail-out fund, the EFSF, for more bail-outs - bail-outs which we agree aren't really working).

So clearly, the party has very different roots compared to other Scandinavian populist parties, such as the Sweden Democrats and the Danish People's Party (for Swedish speakers, here's an article breaking it down). The Front National, Geert Wilder's Freedom Party etc are much farther away again from the True Finns.

In other words, the party cannot be described as "far right", as some non-Finnish media insist on so doing. However, it cannot be described as "centre-right" either, as it draws heavily from an old school, social democratic agenda (i.e. high taxes and a big welfare state). Kind of like a social democratic tea party, with a lot of emphasis on national sovereignty and independence.

According to an opinion poll published today, the party has lost some ground over the last few days, and are now fourth in the race (compared to second in a poll published the other week) - a race that is still wide open it has to be said.

What makes this interesting for the EU and the eurozone is that Finland is the first Triple A eurozone country in which euro bail-outs have become a national election issue. As the leader of the True Finns, Timo Soini, put it, the election might evolve into the referendum which the Finnish people were refused when the euro was first introduced.

We shall see.

A populist warning light?

A new opinion poll shows that Austrian, anti-immigrant, populist party FPÖ would end up on top if elections were held today, beating both the social democratic SPÖ and conservative ÖVP. There are of course multiple reasons for the party's rise, but we note that FPÖ leader Heinz-Christian Strachewhich last week slammed Austria's participation in, and the cost of, eurozone bail-outs. "Thank you, [Austrian Chancellor] Werner Faymannm," he said sarcastically.

In Finland, the "True Finns" party, under the leadership of Timo Soini (pictured), has seemingly come from nowhere and transformed itself into a full-scale political force. A recent opinion poll put it second, ahead of this month's national elections. Though not nearly as bad as FPÖ, it does run on a highly populist platform with a strong anti-euro flavour. The party was almost single-handedly responsible for derailing the EU deal on how to increase the size of the eurozone's bailout fund, the EFSF. The decision is now postponed until June, after the Finnish elections. And as Jan Sundberg, Professor at University of Helisnki puts it, "Portugal crashing would be a gift to the True Finns".

In the Netherlands, the government does not have a majority in Parliament, but has to rely on Geert Wilders' Party for Freedom, which is the third largest party in the country. Wilders has also spoken out against the euro-bailouts. So far, the Dutch government has relied on the other Dutch opposition parties to get its EU measures though parliament.

In France, far-right Front National leader Marine Le Pen is gaining popularity, and one poll even showed her ahead of all other candidates ahead of next year's Presidential elections. Le Pen has called for France to leave the eurozone, along with Spain, Greece and Portugal, saying:

"They promised us that this currency would bring growth and welfare, and what happened? People were destroyed, we are talking about a real tragedy. Look at what happened to Greece."

Again, there are numerous factors at work here - and we should be careful to over-simplify or generalise - but it's hard not to detect a worrying trend: four of the eurozone's main creditor countries (and incidentally net contributors to the EU budget), which are underwriting struggling euro governments' debt to the tune of hundreds of billions, are experiencing a dramatic surge in support for populist parties. These parties would not only reject the bail-outs and the Single Currency but also, in all likelihood, the EU itself.

So what about the big kid on the block: Germany?

Germany doesn't really have its own version of the populist parties we see in other parts of Europe - on the left, Die Linke might fit part of the bill, but it's still not quite the same. Therefore, there's no real political platform for the kind of aggressive anti-euro sentiments that we see in Austria for example (which also plays on anti-immigration and anti-incumbency) - and there's unlikely to be one in the immediate future.

It's clear, however, that German public opinion is growing increasingly wary of the direction of the euro. Slowly, these sentiments are beginning to trickle through to party politics. The motion which was passed by a near-unanimous German Parliament asking Merkel to backtrack on an agreement between eurozone leaders, is one example (though it shouldn't be overstated either). But there clearly is a vacuum in EU politics in terms of voicing alternative visions for the direction of the Single Currency and the EU - and a mismatch between public opinion and the political class.

Writing in FTD last week, Wolfgang Münchau - who, until recently, was the arch-optimist amongst eurozone commentators - argued that "a right-wing spot is free" in Germany. He suggested that the liberal FDP will fill the vacuum and turn into a 'eurosceptic' party. Perhaps. If so, the hope is that the FDP could transform itself into a sensible, EU reformist party, pushing for the revolutionary idea (yes, sarcasm) that the single currency and the EU should be based on sound economics and democracy. Such an outcome would benefit both Germany and Europe.

The fear, as ever, is that the vacuum will be filled by other, nastier political forces.

A Europe in which populist, anti-immigrant parties hold strong positions in creditor (or triple A countries), while far-left parties gain prominence in debtor nations such as Greece or Portugal, would really be the worst of all worlds.

But if Europe's mainstream politicians continue to stick their heads in the sand, and refuse to speak about the problems facing the eurozone - they should not be surprised if voters turn to the parties that do engage in some straight talking, however flawed or nasty such talk may be.

Mainstream political parties and their leaders got it spectacularly wrong on the euro in the past. Perhaps it's time to think about some more fundamental solutions to the eurozone's problems?

German Parliament flexes its muscles

As we've highlighted before, a bust-up in Germany over the fate of the eurozone's bail-out schemes could be imminent, both on the EFSF and its permanent successor.

As if Merkel didn't have enough on her hands, the Bundestag yesterday approved a motion that explicitly demands that the German government bans the EFSF from buying government bonds from troubled eurozone countries. In effect, the Bundestag is asking Merkel to backtrack on last weekend's agreement between eurozone leaders which would have given the EFSF the mandate to buy bonds directly. That's a pretty big set-back for the Chancellor.

The motion isn't binding for the government, but still hugely problematic since the Bundestag needs to approve any deal to increase the scope and size of the EFSF.

The vote illustrates the growing gaps between Angela Merkel and parliamentarians belonging to all three coalition parties (CDU, CSU and the FDP). If this happend in the UK it would be labelled an outright "rebellion" against the government.

According to Märkische Allgemeine, the Bundestag gave its consent to a permanent eurozone bail-out fund, a European Stability Mechanism (ESM), which would take over from the EFSF in 2013. However, it attached a number of strings, including:

- strengthened stability and growth pact
- guarantees for the independence of the ECB
- safeguards that the ESM would only be activated in emergency cases
- a mechanism which would involve private creditors in the rescue fund (unclear how this would work)
- a restructuring procedure which would include private creditors
- a guarantee that the eurozone would not turn into a transfer union.

If you think about it, those are not small thing to ask for in the current climate. This one could be interesting.

Will this make countries keener on joining the euro?

Negotiations on the shape and form of the eurozone's permanent bailout scheme - the "European Stability Mechanism (ESM)" - are entering a crucial phase. The fund is meant to be up and running by mid-2013 and is likely to have €500bn available. Of this amount, between €80bn and €100bn will be up-front cash from member states - the rest will come in the form of guarantees.

People are naturally getting nervous about this arrangement, particularly in Germany. Sueddeutsche suggested the other day that German taxpayers will need to contribute between €18bn to €25bn to the scheme in paid up cash (in addition to the guarantees).

Chancellor Angela Merkel isn't too keen on discussing how much Germany might have to contribute in the end. "She doesn't want to talk about this now", a diplomat reportedly said.

We can see why. A direct €25bn liability on Germany's books could increase the country's borrowing costs and hamper efforts to consolidate its budget.

To avoid this, the German government is pushing only for countries without a triple A rating to contribute paid-up cash, as triple A countries - so says Merkel - are lending their good name to the cause, and that's quite enough. But this, in turn, would increase the cash contributions from weaker eurozone members. This has raised alarm bells amongst weaker euro economies as well as a range of non-eurozone members.

Reuters yesterday quoted EU sources saying that eurozone members Estonia and Slovakia as well as Latvia, Lithuania, Bulgaria and the Czech Republic have all criticised the plans. They argue that basing cash contributions to the ESM on a country's proportion of the ECB's paid-up capital is unfair. The countries have even threatened to block proposals for tougher EU-wide budget rules unless changes are made to the suggested ESM arrangement. One representative said,

"Unless there is a change to the ESM capital key we will block the agreement on the governance package once it returns from parliament and EU finance ministers have to approve it by unanimity."

Also non-euro member Sweden has objected to the proposed capital key for the ESM.

Why do these countries feel so strongly about this issue. They're not in the eurozone after all? Well, probably because they understand that, were they one day to join, they could be forced to cough up actual cash to save a Greece, Ireland or Portugal. Paid up cash is a far more serious liability than loan guarantees. Slovakia's refusal to take part in the Greek bail-out gives a hint as to why these countries aren't thrilled by the prospect of a permanent bail-out arrangement linked to the ECB's capital key and credit status. In such an arrangement, smaller economies that haven't really done anything wrong could end up with a pretty hefty bill.

On a related note, where is the UK in all of this? So far, the UK appears to have taken little interest in the structure and pay-in arrangement of the permanent bail-out mechanism. If this is because it doesn't intend to ever join the euro, that's one thing.

But if it's because Britain thinks it has no stake in making sure that the new eurozone rules are fair and make economic sense - rather than facilitating even greater meltdowns down the road (a very real risk) - then the UK government is sadly mistaken.

The euro pact and Germany: Triumph or a coming bust-up?

The Telegraph's Ambrose Evans-Pritchard describes the weekend deal at the EU summit as a "total German triumph". He paraphrases Chancellor Angela Merkel saying that "whoever wants credit must fulfil our conditions".

Regular readers of this blog will know that we rate Ambrose very highly (at a time when most other journalists, including the FT gang, couldn't spot a currency-related credit crisis from a yard's distance, he warned against what we've seen in the eurozone over the last year).

On this one, however, we think that his assessment might be a bit premature.

Perceptions matter tremendously in markets as well as in politics. And the perception in Germany is certainly not one of triumph.

Die Welt quotes a top EU diplomat describing Merkel's "pact for the euro" as an "empty shell", predicting that "in the coming weeks the spreads of troubled countries could further increase". An analysis in the newspaper notes that the pact "remains far beneath the original expectations of the German government", given the large room for manoeuvre that member states are given in its implementation. The headline in the paper reads: "Merkel's secret euro capitulation".

And Merkel might even face a fight within her own coalition about the terms and crucial details of the euro pact.

Although FDP leader and Foreign Minister Westerwelle called the deal an acceptable compromise, liberal MP Frank Schaeffler said that "the result contradicts the position of the FDP group in parliament”. Volker Wissing, finance spokesman of the liberal faction in the Bundestag stressed that an earlier agreement on this among majority parties in the Bundestag "had excluded what has now been decided at government level", as he expected "very difficult talks", which could endanger the German Parliament's approval of the deal.

"It is surely close to a transfer union," Michael Meister, deputy parliamentary leader of the Christian Democrat (CDU) party added (and it was not meant as a positive remark). CSU MP Thomas Silberhorn bluntly said that "the government has stepped over a red line that the parliamentary groups had clearly defined."

Just ahead of the summit, another top Christian Democrat politician, Bundestag Speaker Norbert Lammert, had voiced concern about the whole thing, lamenting that "many representatives still don't feel sufficiently informed".

It is not clear whether these (prominent) backbenchers will in the end vote down the agreement. Bloomberg claimed this afternoon that several backbenchers have signalled their willingness to vote for the deal when it reaches the Bundestag.

But the strong talk is a reminder of the nervousness about all of this in Germany, especially in the run-up to the key regional elections in two weeks time in Baden-Württemberg - a stronghold for Merkel's CDU where the party could now suffer defeat.

It doesn't help that outgoing Bundestag President Axel Weber has stepped up his criticism of current eurozone policies. In a hearing at a Bundestag committee this week, he will warn European governments against making any bond purchases as a means of bailing out weak Eurozone countries, saying

"the result would be that private creditors and national financial policymakers would be relieved even further of their responsibility, and taxpayers of the countries doing the financing would be burdened with further, possibly substantial risks."

Chances are that Merkel will manage to push through this deal in the short term - though the German Parliament may demand some red meat in return for giving its approval.

But, as the EU correspondent for the Frankfurter Allgemeine Zeitung, Werner Mussler, warns: “the consistent loyalty of Germans to Europe is facing a test.” And Europe's biggest tabloid Bild today carries the headline, "saving the euro gets increasingly expensive!".

Some members of the German establishment have already started questionning the very premise on which Merkel has based her bail-out concessions (saving the euro, even with the risk of more bail-outs and a move away from traditional Bundesbank policy is cheaper than refusing to pay). For example, the former boss of the German industry federation BDI, Hans-Olaf Henkel. Although a former euro enthusiast, he now argues in favour of splitting up the eurozone, writing that it has become “a transfer union, a community of redistribution in which a new competitive discipline will emerge: who can tap the others for the greatest amount."

Berlin's biggest fear is that Mr. Henkel is finding it increasingly easier to recruit more allies.

Ostrich banking tests

Remember the EU's banking "stress tests", which were supposed to determine the health of the key financial institutions across Europe? The tests, that were published last summer, infamously cleared all Irish banks. Only a couple of months later, two of these banks were forced too seek help from the Irish state to avoid bankruptcy, which in turn forced Ireland to apply for a bail-out.

To say that this episode exposed some deep flaws in the stress tests is an understatement.

One problem was clearly that the tests weren't stringent enough. Banks were deemed by regulators to need only €3.5 billion of new capital - about a 10th of the lowest estimates that were out there.

Now a new round of stress tests is due to begin, and European Commissioner Michel Barnier has just informed us that the EU will announce the methodology next week.

In November, in the midst of the embarrassment about the Irish crisis, his Director-General Jonathan Faull declared that next time, it's going to be serious. He maintained that the new round of stress tests would be “demanding”, with the European Commission pushing for the tests to also assess liquidity of financial institutions (which seems like a pretty fundamental criterion).

This is actually a hugely important excercise. Europe will never get out of its euro-fuelled slump unless its banks come clean on their exposure to debt in various forms.

So what lessons have been learnt?

Well, there are crucial details of the tests that aren't known yet, but EU leaders and regulators haven't inspired confidence so far.

The European Banking Authority, that will carry out the stress tests, has already declared that the results of the liquidity checks (which will not be part of the stress tests but of separate risk assessments) "will not be published". The German government and Bundesbank have also resisted transparency, with Finance Minister Schäuble warning that "to prevent stress tests from producing more damage than good, we are ready to consider and discuss what of the tests will be published and what not."

This is of course a tricky balancing act - you can easily foresee an immediate run on a bank following stress tests results that aren't favourable. But then again, trying to hide the problem isn't a solution either.

And here we see the most contentious and problematic issue of them all - should a possible future restructuring or sovereign default involving, for example, Greece, be one of the test scenarios for banks?

European Central Bank President Jean-Claude Trichet appears to say NO, it shouldn't.

Financial Press Agency MNI suggests that

distinguishing between the trading and the banking books could mean that the tests will ignore the majority of banks' holdings of sovereign debt, since most Eurozone government bonds are held on the banking books.

This is critical since the debt and solvency crisis facing the eurozone is so intimately linked to the fate of Europe's banks that it's now impossible to separate the two. Clearly, one of the main fears of a possible eurozone default - or even break-up - scenario is the losses that European financial institutions would suffer, which in turn could take Europe right back to 2008 (or in the case of Ireland, 2010). Taxpayers would again be forced to step in to avoid a complete meltdown of the financial world as we know it.

The lesson from the most recent crash must clearly be that financial institutions and governments alike need to plan for the worst.

Even if EU leaders don't believe that a default or break-up is desireable or likely, the worst thing they could do is not to consider it.

Kicking the can down the road isn't a policy. Nor is burying your head in the sand.

The ECB's herculean assumptions on Greece

An interesting presentation given in London last week by Italian ECB Board Member Lorenzo Bini-Smaghi, titled "Sovereign Risk and the Euro", looked at two possible scenario's for the eurozone: Plan A and Plan B (ECB board members aren't known for their imagination)

Plan A: Fiscal adjustment Plan B: Default / Restructuring & Exit / Split the euro

First, Mr. Bini-Smaghi showed how plan B would create direct "wealth effects, a credit crunch, social/political repercussions", etc. None of that is disputed.

Hardly surprising, he expressed his preference for plan A, claiming it "is painful, but most likely it is less costly than the alternative." (emphasis added - it's interesting to note how he qualifies that statement).

He described Plan A, which is the official EU / IMF strategy, as follows:

In the case of Greece, the primary surplus required to stabilise and reduce the debt after 2013 is ± 6%

That's assumption 1.

That Greece would be running a massive 6 percent budget surplus after 2013 isn't plausible, which Mr. Bini-Smaghi also himself sort of admitted:

if the primary surplus needed to achieve sustainability is considered too high because the market interest rate is high, there are two ways to restore sustainability:
- reduce the interest rate burden (and lengthen the maturity), while keeping it non-concessional
- haircut on debt

So if the necessary budget surpluses cannot be achieved then debt must be ‘reduced’, assuming this can be done successfully is assumption 2.

He went on to say that the proposal for a bond buy-back program - under which the eurozone's permanent bail-out fund is used to buy back Greek bonds directly or indirectly - could be a way to cut debt:

Under discussion: buy back at market prices (lower than nominal), by the member state or through the EFSF, subject to strict conditionality

We commented in our recent briefing on a possible Greek default that this, in turn, rests on two sub-assumptions:

1 – Although a large number of bonds are being held by the ECB (around €60 billion nominal value) just buying these bonds back at a discount will only reduce Greece’s debt burden by at most 4.15%. Not to mention the fact that the ECB has stated that it plans to hold all bonds to maturity.

2 – Therefore bonds would have to be purchased on the secondary bond market or in reverse auctions. It also seems that many banks are holding bonds to maturity to avoid declaring losses on already fragile balance sheets. But even if they were willing to sell it might not help. As we have already said: "the sudden increase in demand for Greek bonds, as a result of Greece itself having a €50 billion pot of money with which to purchase its own bonds, could actually lead to an increase in prices".

However, Bini-Smaghi himself admitted that having assumption 2 (reduced debt) might not be enough if assumption 1 (budget surpluses) isn't also realized, saying:

If the debt were cut by one-third, the primary surplus would still be relevant.

In other words, the ECB is relying on two pretty heroic assumptions. Greece needs find around €148.6 billion to refinance its debt by the end of 2014(not including the cash needed for interest payments), according to the Greek Ministry of Finance. Dreaming the debt away won't work.

Bini-Smaghi went on to say that in any case, "growth is key", noting that in order to restore competitiveness, this will need to happen "mainly through domestic adjustment".

He makes a list of all kinds of laudable measures that are needed for the Greek economy to grow again, ranging from" deregulation of transport and energy sectors" and "opening up of closed professions" to "increase in retirement age to 65".

Assuming that this is economically and politically feasible in Greece is assumption 3; in this case he adds no caveats. Given the well documented political unrest in Greece and the significant strength of vested interests this seems like a very large assumption as well. The country has no doubt come some way - but it still has a massive distance left to travel if it wants its economy to become sustainable.

And as an indication of the difficulties ahead, over recent days, we've heard of pretty stiff opposition from the Greeks to the proposed EU-IMF privatization plan (which could free up around €50 billion in an ideal world). A spokesman for the Greek government captured the mood: “We asked them for help...not to meddle in our internal affairs” (more on this here).

Even if the first three assumptions were proved right, and all their goals achieved there is still one more implicit assumption to this whole discussion. It is that once this is all done, the eurozone (specifically the one-size fits all monetary policy which could facilitate boom-and-bust cycles or wipe out achieved competitiveness gains) will not lead Greece down this road again.

Assuming that all of these measures will solve Greece’s long term problems within the confines of a monetary union is assumption 4.

Interestingly, Bini-Smaghi gave another speech recently commenting on precisely this issue, labelling moves towards a political union of eurozone countries "risky". Instead, he said, stronger financial supervision should be pursued in order to stop boom and busts cycles.



However, Bini-Smaghi demonstrates the enormity of his fourth assumption with the fact that he sees this new financial order as

a system of rules and procedures which binds the financial system, in the same way as the Stability and Growth Pact binds national fiscal policies.

The SGP has proven, shall we say, difficult to implement in practice, begging the question why a system for financial supervision based on the same model should be any more succesful.

The point here is that the ECB is throwing around a huge number of assumptions. A business plan being this speculative would never make it past the board in any company (well, perhaps a few). But in the eurozone this is apparently called Plan A.

If the ECB was to re-consider its assumptions, would it also have to re-consider whether plan B might actually be an alternative?

Closer together or further apart?

EU leaders meet today in a bid to patch up the eurozone (while also dealing with other pretty complicated challenges such as Egypt and energy security).

Dutch daily De Volkskrant yesterday had a feature ("Leer eerst eens je broek op te houden") looking at how the atmosphere in the EU's diplomatic circles is becoming increasingly abrasive and more tense. The paper claims to have obtained various statements from diplomats, making clear the eurozone crisis and ongoing bailouts are complicating relations within Europe.

And it ain't pretty. Here goes:

A diplomat from a "small and rich country" finds it difficult to stay calm, and has to express his anger at what he explicitly refers to as the "the PIGS", Portugal, Ireland, Greece and Spain. He says:

it is incredible: these countries are still posturing. Then I think to myself: well, well, perhaps you should learn how to stand on your own two feet first.

When asked if he is not now insulting them by using such harsh language he snaps back:

it's their own fault [why should] hard working Dutch and saving Germans [pay the bill] for the Greeks, who strike continuously, even now when they have received €110 billion in emergency support from us.

A German diplomat gets more and more heated as he talks about Commission President Barroso's calls for propping up the eurozone bailout fund with more cash. Frustrated, he exclaims:

whose money is Barroso actually talking about? Is it his own? No! It's the money of the Germans, the Dutch, the French, the Finns. Is it so crazy that we get frustrated?

A high ranking Commission official complains about the "roughening of the mood":

the word PIGS alone. The image it conjures of responsible Northerners having to pay for a bunch of lazy people sitting under a palm tree by the Mediterranean. That leaves scars. Most citizens in Southern European countries are not to blame for the economic situation in their country. But they are being depicted as the trash of Europe.

A Portuguese diplomat adds that

I see my German and Dutch colleagues getting more and more authoritarian, as if they are in charge. Even the Finnish, who normally don't open their mouths, make interventions. (...) At the same time I get less and less involved in the discussion.

A diplomat from Ireland, which just received a €85 billion EU/IMF emergency loan, concurs:

I watch my words, it's like that. Our banks are down, not the German ones. Our economy is floored, not the Dutch one. We lost, then you better keep quiet.

Spain, which likes to see itself as one of the big powers of the EU, has a harder time accepting the new balance of power. Spanish Europe Minister Diego Lopéz Garrido privately tells journalists:

It's one thing to accept that Germany and France are important for the EU. But it's a whole different thing to accept that they impose an ultimatum.

Frustration is growing with the Franco-German motor, which is increasingly looking more like a tank. "If the other 25 member states would please sign here", is how a Commission official summarises the mood.



Germany, in particular, is causing a lot of anger. France is being taken less seriously. A diplomat from an Eastern European country notes,

The country is after all a bit of an open air museum. That you can keep up such grandeur with a mummy state and a couple of car factories is causing jealousy, but no annoyance or fear.

A German diplomat comments that the Deauville summit, at which Merkel and Sarkozy agreed on the thrust of a new economic order for the eurozone,

was a communication disaster (...) It looked like a diktat. But without Deauville we would still just be talking.

An Irish diplomat remarks that "the dynamics within the EU has completely changed", adding that Germany has evolved from a "mediator" in 2007, when the country held the EU Presidency, to a

role model, but one which imposes itself in a binding way. I understand it, though: we receive, they pay

The Commission official adds that the Commission hears plenty of complaints from Southern European leaders:

they say they are being belittled, or put to the side. The whole Commission is concerned. We should really watch out. This leaves marks. The blood is sticking to the walls.

He notes, however, that there won't be a revolt because of the upcoming discussions on the EU's long-term budget: "they won't bite the hand that feeds them."

Pew! Some people claimed that European Monetary Union was a “dream”. If so, Europe is now waking up to a nightmare.

Is this simply normal bickering in what are tense circumstances or something more? We're not entirely sure, but as Milton Friedman predicted in 1997:

The euro will aggravate the political tensions to the extent that economic shocks, which beat countries in different degrees but which could until now be facilitated through exchange rate adjustments, will change into political controversies.

Eurotrashed

In a letter to today's International Herald Tribune, Former US ambassador Alfred Kingon summarises the situation facing the euro and the EU:

When I was the United States ambassador to the European Union (then the European Communities) in the late ’80s, as preparation for the advent of the euro was taking place, the crosscurrents were strong and visible. It couldn’t possibly succeed, as predicted by many, without a finance ministry for all of Europe, not possible then or foreseeable now.

A real look at European debt, which is far greater than the narrowly reported official deficits, bodes badly. Bailouts are being affected by the imposition of rising and unsustainable interest rates. Just look at recent bond yields in Portugal, Ireland and Greece. And what will happen when more onerous austerity programs are initiated to meet new budgetary targets? Will the E.U. survive? Of course it will. It has succeeded in quelling thousands of years of internal warfare. But the euro and current E.U. structure — well, that’s another matter.

Spot on.

Germans: In the EU we do not trust

Germans' trust in the EU has taken a giddy nosedive of late.

A poll of German citizens, conducted by German pollsters the Allensbach Institute for Public Opinion, for FAZ reveals:

• Trust in the EU has fallen to an all time low: 67% of respondents had "little” or “no trust" in the EU - up from 51% in March 2010. That's 12 points in less than a year... did anyone say bail-out?
  

• Only 25% have a “high” or “very high" degree of trust in the EU - down from 37% in March 2010.

• Only 12% favour faster integration - this has dramatically decreased since 1982, when a majority of West Germans were in favour of faster EU integration.

• 43% of respondents want slower integration.

• And the killer: 68% of respondents have “little” or “no trust” in the single currency – this is similar to poll levels taken on the eve of the euro’s birth, 16 years ago.

• Last but not least, only 4% know who Herman Van Rompuy is (shocker!).

FAZ bluntly states:

In this context it is important to keep in mind that all major policy decisions concerning European integration in the last 20 years were pushed through against the will of the German people: the introduction of the euro, the accession of new Central and Eastern Europe member states, and the opening of accession negotiations with Turkey – all these were rejected by the Germans with very strong majorities.

Does anyone see a slight problem here?

One for the people?

Lars Feld, new economics advisor to the German government, has done something rather radical - called for a referendum on the extension of the eurozone bail-out fund. In an interview which appears in tomorrow's Frankfurter Allgemeine Zeitung, he says:

"When there is discussion about extending the 750 billion euro bailout fund for eurozone member states with excessive debt, then such an important question should be put to the people."

According to Reuters, Mr Feld has an EU-wide referendum in mind.

He also says:

"I don't believe Greece will manage without restructering its debt. And then German guarantees will be needed (...) I hardly know of anyone who thinks that Greece can make it on its own."

(The German government today denied reports that it was planning for a Greek debt restructering, meaning that it's probably working on something).

FTD describes Feld as a "hardliner". He has been appointed by Germany's liberal Economy Minister Rainer Brüderle as one of five members of the German Council of Economic Experts. The opinions of the experts aren't automatic government policy, but hugely influential.

Is China betting on or against Europe?

The role of the Far East in the Eurozone's ongoing debt saga is becoming increasingly fascinating.

China has reportedly bought €1.1 billion of Portuguese debt in a direct sale. And Japan - not wanting to be outdone - has announced that it'll buy €900 million worth of bonds to be issued by the EFSF (the Eurozone bailout fund) at the end of this month.

Bill Gross, who manages PIMCO - the world’s biggest bond fund - dismissed all this action, saying that,

there are claims of Japan and China and so on, but they're really looking for the private institutions like PIMCO and other insurance companies to buy, and we just have not done that yet.

French daily Les Echos has a slightly different take, arguing that "Asia has decided it will save Europe."

But a different analysis altogether comes from leading finance blog Zero Hedge. They write that China's banks are currently switching their euros (which amount to 25% of China's currency reserves) for dollars, meaning that China is actually ditching the Single Currency. The Chinese know that their €1.1 billion "investment" in the eurozone is effectively underwritten by the ECB, which continues to buy Portugese junk bonds.

The result is a temporary increase in the value of the euro relative to the dollar, which allows China to sell their euros for more than if they had not spent the €1.1 billion. The blog estimates that the profit could be in the area of $11 billion. The blog writes:

Here's the math: assuming roughly €510 billion in EUR-denominated holdings, just the last 5 day jump in the EURUSD from 1.29 to 1.31 means that the USD value in a static pool of €-holdings has increased by about $11 billion (on paper). But here's the kicker: it is not on paper, and if the rumors are true, China is actively converting EUR holdings to USD. It appears that the mid-1.31 range is one appropriate exit point. So from an IRR standpoint, China invests €1.1 billion in Euro peripheral bonds knowing full well that the biggest backstopper is the ECB, in essence letting the country frontrun Europe's taxpayers. And in return it gets a marginal improvement in its FX holdings to the tune of $10 billion. In other words, every 100 pips improvement in the EURUSD results in a ~$5 billion boost to the USD valuation of EUR-denominated holdings. And if the latest €1 billion investment allowing the country to "buy" $10 billion in FX gains is any indication, China sure knows what it is doing.

Furthermore, with it allegedly actively selling EURs as a result, it appears that the country is in effect betting against Europe, and is continuing to reduce its 25% EUR allocation, with the USD as a beneficiary.

Speculative, that's true - but does anyone else have the feeling that Europe isn't quite in the ballgame?

An attack from the German heartland

Yesterday, we invited German Professor Markus Kerber to Brussels. He is the initiator of a lawsuit at the German Constitutional Court against the bailouts of Greece and Ireland.

A full write up of the event can be found here. The Professor expressed some profound criticism of the European Central Bank's policy to buy up government bonds on the secundary market - bluntly calling it "illegal" along with the bail-out package itself. He predicted that “the euro will fail, it’s better to face that”.

It is true that we shouldn't underestimate the will of EU leaders to save the euro. But equally, it would be a huge mistake to underestimate the political pressure in countries such as Germany to stick to the rules and the original deal which the German people agreed to, i.e. a hard currency and no bail-outs (via the ECB or the governments) for countries that live beyond their means.

And Professor Kerber is not a lonely voice crying in the desert. In the lawsuit, he is representing a group of 50 notable people, ranging from artists to the grandson of former German Chancellor Adenauer (one of the father figures for European integration). This initiative is coming straight from the German heartland.

Politicians in Europe better take notice.

"A terrible experiment"

It's a terrible experiment which we've begun

- Rolf Krause, the Brussels bureau chief of German State TV ARD, commenting on the euro, adding that it would be a good idea to slim down the eurozone.