Is Christine the answer?

With it being a relatively slow news day, much of the economic and political commentariat has focussed on who ought to and/or has a chance of replacing Dominique Strauss-Kahn as IMF chief. Everyone seems to have an opinion on this; there have been some sensible suggestions, and some totally left-field ones, such as Martin Kettle’s pitch for Peter Mandelson.

Much of the debate has centred around the issue of whether he or she ought to be European, or whether it was time for an emerging economy to take over the helm of the IMF, with China, Brazil and Turkey all pushing for a non-EU IMF chief. Allister Heath made a good point in his City AM column:

“the European-led IMF was always perfectly happy to force much harsher policies on emerging countries. These days, however, it is the Asian and other emerging nations that have put their houses in order and Europe and the US that continue to spend money they don’t have.”

However, as we know, Europe tends to prefer the status quo (regardless of whether the status quo is actually a good thing) and France’s finance minister Christine Lagarde has emerged as a clear favourite.

So is she the right person for the job?

We're sceptical. Yes, she speaks polished English, more Oxford than the typical thick French statesman's accent, which in combination with her background at US financial firms, give her some street cred in the anglo-saxon world (which is enough for the BBC to love her). And she has done a relatively good job in keeping the French economy stable. However, she's nonetheless firmly wedded to what can be described as the ‘bailout consensus’ and state intervetion which as we have pointed out multiple times is a blind alley, and there are plenty of people out there who seem to agree.

FAZ’s Heike Göbel today slams Lagarde’s statist outlook, and argues Germany ought to be supporting a more a more market-friendly voice:

“Lagarde is rooted in the French tradition, that when in doubt, one ought to argue for more coordination rather than for more competition. She is the advocate in chief for unbridled state assistance, and does not want private creditors to participate in the rescue of insolvent eurozone countries."

The Indy’s Sean O’Grady concurs:

“Impressive as she is, the French finance minister is… too steeped in the EU establishment and too much part of the French elite to be able to abandon the euro as an article of faith. For a clear-headed, dispassionate Singaporean, let us say, the decision on recommending that Greece leaves the euro would be a much less traumatic affair. And even if that were not the case, we might still be better off with someone for whom the idea that they are a Sarko crony could never stray into our minds. So while it is true that Ms Lagarde knows the eurozone's funny little ways, she might also be more blind to its failings.”

In fact, the IMF would probably benefit from having someone from outside of the eurozone’s political elite, not least since large parts of this elite - as we have documented - consistently failed to grasp how the single currency would work in practice, and has mis-judged the crisis ever since it broke.

Ultimately, whether this person is European or not is actually of secondary importance.

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?

"Axel Weber geht, die Inflation kommt"

The front page of today's Wirtschaftswoche is not making any secret of how the paper sees the news of Alex Weber, previously seen as the Great German Hope for a stable euro, no longer standing for President of the ECB:

Axel Weber goes, inflation arrives

It adds that "the departure of Axel Weber undermines the trust in the stability of the euro"

Start with the man in the mirror

In an opinion piece in the FT published the other day, Klaus Regling (see photo), the chief executive of the eurozone's temporary bailout fund attempts to counter critics of the common currency.

The unelected official, who looks after €440 billion in loan guarantees, argues that "EMU’s critics will eat their words again", explaining how the euro will be saved through more budget discipline and sounder economic policies in member states.

He gives the example of Latvia, writing:

Latvia which has a currency pegged to the euro, testifies to the success of this policy. Contrary to commentators who predicted disaster for Latvia early last year unless it gave up its hard peg – in line with advice from the commission – it did not devalue its exchange rate. A real effective devaluation was achieved through severe cuts in nominal income. Today its economy is growing again. Those outside “experts”, who always seem to know what is good for Europe, should take note.

He is right that "internal devaluation" can indeed restore competitiveness, although it's questionable whether politicians in countries such as Greece are willing to follow in Latvia's footsteps on this one. Of course Regling omits to mention that, in the case of Latvia, the country's reduced competitiveness was driven by a bust in the real estate market, in turn partly brought about by Latvia's euro peg.

An article on Global Property Guide makes clear that the damage was inflicted by the EU's pressure for a euro-peg on the Baltic country, which isn't eager to go against EU guidance, given that its EU membership is also a matter of geostrategic security.

From 2004 to 2007, property prices doubled, tripled or even quadrupled, just to fall in December 2008 by a crazy 41% in real terms from a year earlier. The euro peg had first pushed mortgage rates disproportionately low, boosting excessive demand for real estate. The following adjustment through increased rates bankrupted many Latvian citizens who saw the value of their investments drop.

In his defence of the monetary union, Dr Regling doesn't mention any cure to the eurozone's most fundamental problem - its one-size-fits-all interest rate policy - which has a tendency to facilitate booms and busts (though not the only factor ). Even the Celtic Tiger, Europe's champion of competitiveness, was floored by these mechanics, as low interest rates created a real estate boom and bust, poisoning systemic banks and bringing the country to the edge of the abyss (despite the fact they passed the EU's stress tests only last summer).

As the German economy continues to boom, there will soon be calls in Germany for the ECB to jack up interest rates in order to prevent inflation. But this, in turn, will seriously undermine Spanish and Irish efforts to get their economies back on track - and potentially off set many of the hard-fought reforms that the two countries are pushing through at the moment.

No matter how much of taxpayers' money EU leaders will put on the table, as long as there really isn't a European economy, Dr Regling should continue to expect criticism of EMU's flawed construct.

And in terms of lashing out at the "outside experts" who know what's "good for Europe", we suggest Mr. Regling starts with the man in the mirror. As Ambrose noted in yesterday's Telegraph,

Perhaps it is unkind to point out that Dr Regling was the European Commission's director-general of economic affairs from 2001 to 2008, more or less spanning the incubation period of the catastrophe now at hand. To borrow the immortal line from Watergate: what did you know and when did you know it?