You call that austerity?

We imagine that will be the response by many in Athens and Dublin to the conditions which have been announced along with the €78bn bailout deal for Portugal. Jose Socrates, the caretaker Portuguese PM, was almost boasting on TV last night about how much more favourable the terms were for Portugal compared to Greece and Ireland. In the cold light of day though, most of the details we’ve seen so far focus on what won’t happen rather than what will, raising the question: Where are the necessary savings actually going to come from? That should be slightly concerning for taxpayers across the EU.

The point that has attracted most attention is the easing of the deficit cutting programme. But in actual fact the targeted cut is higher than before, given the change in the level of the deficit.

Previous 2010 estimate and 2011 target: 7.3% and 4.6% = change of 2.7%

New 2010 estimate and 2011 target: 9.1% and 5.9% = change of 3.2%

Most observers, including us, didn’t expect Portugal to be able to achieve its original level of cuts, let alone a higher level - especially when combined with lower growth prospects. That was before we even found out what was not going to be cut…

According to Socrates the conditions will not include cuts to: minimum wages, public sector pay, education spending and healthcare. In addition, there will be no additional public sector job cuts and the retirement age will not be increased. That is a huge list of things that will be left untouched, especially since savings of 3.2% of GDP are expected.

So, seriously, where is the money coming from?

Well, there are expected to be some, limited, cuts to higher scale state pensions as well as a decrease in the amount and duration of unemployment benefit. There is also a plan to raise VAT on electricity. In terms of increasing revenue, there was talk of privatising €5.3bn in public assets but not Caixa Geral de Depositos, the largest credit institution, which was widely expected to be sold to raise funds. So all in all not exactly an earth-shattering plan for saving 3.2% of GDP.

To be fair, there are more details and plans to be announced but considering what has already been taken off the table we’re not overly optimistic.

Admittedly, too much austerity would definitely be bad for the economy and finding the right balance is a hard line to tread. But for those of us who already believe the bailouts to be a waste of money, since they won’t solve any of the long term problems, these kinds of conditions are almost just adding insult to injury.

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.

Up, up and away…

That’s been the story with Greece’s debt and deficit figures for some time, particularly since it’s become almost customary for the figures to receive at least one upward revision on their original estimates. However, Eurostat’s latest figures suggest the problem (of missing targets) looks to be spreading to other peripheral eurozone countries (not that the spotlight isn’t still firmly on Greece).

Eurostat yesterday released its debt and deficit data for 2010 and it included some interesting revisions – upwards as always. Starting with Greece, we see that the government missed its deficit target by 1.1% of GDP (all % are of GDP from now on), coming in at 10.5% instead of the 9.4% which the Greek government proudly predicted in January. To be fair, this still means the deficit fell by around 5% last year, but the figures show that less than 2% of the decrease came from increased revenue. Things continue to look bad for Greece, as we, amongst others, struggle to see where the government will find the money it needs. The programme of spending cuts is already pushing austerity to its limit and the government just doesn’t seem to be able to increase revenue (tax evasion is still massive but the ongoing recession, which is worsened by the austerity, just makes tackling it all the more difficult).

Meanwhile, Portugal also saw its deficit revised upward for the second time in a matter of months. It now stands at 9.1%, way above the government’s estimate of 7.3%. The government still put the difference down to changes in accounting rules enforced by the EU, although it is strange that it seems to affect Portugal so much more than anyone else…in any case Portugal now needs to cut the deficit by close to 5% to meet its target for 2011. Its debt burden was also increased, putting it at 93% in 2010.

Ireland fortunately didn't see its deficit or debt estimate revised, although with the deficit coming in at a whopping 32.4% this isn't much of a consolation (most of the deficit is down to the bank bailouts, but even excluding them the deficit was around 12% - the highest in the eurozone).

All in all the figures weren’t exactly expected to be encouraging but the continuing string of upward revisions and missed targets doesn’t exactly inspire confidence.

Spain and China: a whirlwind romance gone wrong?

Last week the news was full of talk of a new economic alliance between Spain and China, following Jose Zapatero’s visit to Beijing. Zapatero spoke of promises by the Chinese government to continue buying billions of euros worth of Spanish government debt. There was even some chatter about a substantial $13bn investment by the Chinese sovereign wealth fund (CIC) combined with private investors. It looked like a match made in heaven.

Alas, as with many whirlwind romances (we felt one night stand might be a bit harsh), everything was not as it seemed. As often is the case, one partner (Spain) seemed much keener on the whole arrangement than the other, and went off touting the new relationship to its friends (the Spanish and European media in this case). Unfortunately, the other partner was looking for a more ‘at arm’s length’ type deal and China began to distance itself from the rumours. The whole charade was put down to “an error of communication”.

Spain was eventually forced into a slightly humiliating retraction of Zapatero’s initial statement and an awkward silence has since prevailed. Despite being a slightly comic interlude to the ongoing depression of the eurozone crisis this whole situation highlights that there is no easy answer for Spain. It needs to continue with its economic reforms and spending cuts, and maybe markets will continue to support it. This is especially true now that the hope of finding a sugar daddy to help fund it over the next few years has been ruled out (although we’re fairly sure America has dibs on China’s funding of debt anyway).

(H/T to FT Beyondbrics blog for the brilliant metaphor)

Wrestling with a Greek restructuring

The talk of a Greek restructuring has resurfaced again, following Wolfgang Schauble’s seeming acceptance that one might be necessary in the near future. It looks like he’s back tracked today, claiming he was ‘misinterpreted’, but the damage was already done - Greek cost of borrowing has already hit new highs and the euro weakened significantly.

As we’ve noted on this blog many times (here and here, for example) and in our Greece paper, a debt restructuring is unavoidable, Greece is essentially insolvent. It’s been trying hard to enact the necessary austerity but the evidence is against the government – tax revenues have barely increased, spending cuts are proving hard to enact and the population is already fed up with austerity in all its forms.

There are a couple of points which have been raised with us recently on the negatives of a Greek debt restructuring: it will take down the Greek banking sector and there is significant moral hazard. Undoubtedly, it is a risky proposal but from what we can see, there are few other options to tackle the long term (and in this case short term) problems.

On the risk to the banking sector, there is no doubt that Greek banks hold huge amounts of Greek sovereign debt but that just serves to underline that they’re unsustainable. All the large Greek banks need to be restructured and recapitalised. Combining this with a sovereign debt restructuring is just good sense. They may need some capital injection and a lot of ECB help, they may even need to be nationalised while all this takes place but in the end the newly streamlined banks will serve the economy far better than the bloated inefficient current ones ever could.

As for the moral hazard, it is a valid concern that it could encourage other nations to seek debt relief but unfortunately we’re now in the realm of lesser evils. With bailouts or fiscal transfers you get a double moral hazard – firstly to the governments, who are not being reprimanded for their profligacy, and secondly to banks, who took huge risks which they could not cover – at least a restructuring shares the burden between the two.

It looks like Greece is coming to the end of the road, a decision needs to be made otherwise a chaotic default could be on the cards before 2013 and nobody wants that. Greece is priced out of the markets for the foreseeable future, the public is fed up with austerity and taxpayers across Europe are tired of paying to support ailing economies; what more is there to lose from a debt restructuring?

Why is Portugal in trouble?

Solving the problem should undoubtedly be the priority now, but looking at how Portugal got into this mess might help to formulate a solution.

Clearly there were many factors which helped to precipitate the current crisis, including numerous domestic political and policy mistakes. However, being a member of the single currency definitely seems to have played a part.

According to an interesting paper published by European Commission officials, joining the euro had the following consequences:

"The Portuguese economy went from a boom led by in the second half of the nineties to a marked slowdown in this decade (Chart 1). A major impulse for the expansion was the considerable fall in interest rates when the prospect of accession to EMU became increasingly self-validating. Nominal short-term interest rates fully converged to those at the common low level set by the ECB (Chart 2)."

The paper suggests that the "substantial fall in interest rates, [was] the main trigger for the boom", which later resulted in a bust. The interesting difference with Portugal, compared to Spain, Ireland and Greece, is that it experienced the infamous boom - bust dynamics before it entered the eurozone, but still because of the "prospect of accession to EMU", as the officials put it.

The eurozone's "sleeping pill" dynamics (as Herman Van Rompuy puts it) have prevented investors from forcing the country into unpopular, but necessary, reforms to boost competitiveness, resulting in Portugal becoming 21% less competitive relative to Germany over the past decade (this looks to be true of the past and current crisis).

So when Portugal experienced its bust, long before Spain and Ireland experienced theirs, there wasn't a currency which could come under strain and thereby discipline the politicians. This was surely one of the reasons for the consistently sluggish growth in Portugal following its bust.

There is, obviously, more to it though. Thanks to the ECB's artificially low interest rates, which were designed for a slow growing Germany, the country started accumulating very high levels of private debt, up to more than 200 percent of GDP (just like in Spain and Ireland, however, they managed to grow at the same time ).

On top of all of this, the Portuguese government hasn't exactly been a shining example of sound budgetary management. It has run large budget deficits for many years and has accumulated a significant level of debt for an economy the size of Portugal's (both the debt and deficit figures for last year were recently revised upwards as well).

Fundamentally however, an overvalued currency which prevented growth (the Escudo would have decreased in value following the original bust), combined with interest rates which were an ongoing stimulus to take on new debt, left Portugal with a decade of low growth. The resulting fall in relative living standards, compared to the rest of the EU, and the fall in tax receipts further fuelled the build up of both private and pubic debt.

Interestingly, Portugal's problems can provide some hint at what the future may hold for Greece, Ireland and possibly Spain. Even loose monetary policy and boosts in liquidity (admittedly in debt form) didn't solve Portugal's underlying competitiveness and currency problems, in fact they may have made things worse.

These lessons from Portugal's past should be heeded by those in charge. Tackling the root causes of this crisis - eurozone imbalances, competitiveness problems and the banking crisis - is of paramount importance, as is providing for all eventualities, including a restructuring and possibly even a change in eurozone membership.

The dark side of the ECB

Lots of people have been focusing on the recent ECB rate rise, but the ECB’s role in this crisis has really been determined by its other – more opaque and less publicised – role: as lender of last resort. This has got the ECB into a near untenable position. It faces huge exposure to peripheral eurozone countries, it aims to maintain price stability, but has also acted to stabilise the whole eurozone economy, and it has underwritten a bloated and inefficient banking sector with unlimited cheap money.

The ECB has lent massively to the struggling European banking sector. Although this may have been viable and necessary to halt the systemic risk from the financial crisis it is now out of control. It has propped up banks that should have gone bust and created banks addicted to ECB funding. A mechanism for reining in lending and winding down banks should have been in place from the start. The ECB essentially dug itself a hole without bringing a ladder to get itself out again.

Let’s not forget, these actions also helped fuel the sovereign debt crisis by creating perverse incentives. These banks could take on cheap ECB loans and then invest in high yielding but relatively safe assets (peripheral sovereign bonds at the time), in order to turn quick profit and increase capital. This fuelled the level of government debt and when it became clear just how bad the sovereigns' finances were, markets panicked and the debt crisis hit (but with more debt and more banks involved/exposed than before).

The ECB tried to fix this problem by throwing more liquidity at it (through its bond buying programme). This just increased its exposure to risky economies, distorted bond markets and rightly raised questions over its independence and impartiality (not to mention being potentially inflationary).

Lastly, the ECB has overseen the build up of huge imbalances in the eurosystem of central banks. Some, like Ireland or Greece, borrow huge amounts but contribute little. The loans to these countries are underwritten by other central banks in the system, making them even more exposed to a peripheral default.

The ECB has played a huge role in the cycling of debt around the eurozone, and put itself in a very exposed and compromising position. Its interest rate policy is massively important but the darker side of ECB policy has debatably played a more important (and negative) role in this crisis.

To be fair to the ECB this was not all of its own making, since it was forced into this situation by eurozone leaders inaction, which is further illustration of the politicisation of a once proudly independent central bank.

A fight breaks out in a bar...

Last week we organised a debate in London on the EU's proposed short-selling rules (a summary of the event can be found here). With four excellent panellists, we covered lots of ground and managed to get into the crucial details without losing track of the bigger picture (always a challenge with what is, after all, a highly technical piece of financial legislation).

The proposal is currently gridlocked in negotiations between MEPs, member states and the Commission.

As it stands, the proposed short-selling regulation is a mixed bag - some much needed transparency measures are welcome, but some provisions on the table could be counterproductive and hurt weaker European economies . In particular, MEPs want to impose a blanket ban on short-selling of "uncovered" Credit Default Swaps on sovereign debt, to counter "speculation" against weaker eurozone economies. That the Commission, and virtually everyone else, has pointed out that there is no evidence that short-selling drives up borrowing costs for governments, seems not to matter.

MEPs insistence on a blanket ban is all about political games - it has nothing to do with economic realities. As MEP Syed Kamall (who's opposing the ban) noted at the debate - and others have noted as well - when a fight breaks out in a bar, you don't hit the guy that started the fight, you hit the one you always wanted to hit (see picture - we'd like to say that the two guys sitting down chilling are representative of the UK's approach to Europe but that might be a bit harsh, at least in this case).

We take a closer look at the proposal and state of the negotiations over on Public Service Europe. We acknowledge that,

The overarching goals of the European Union's new short-selling regulations are supposed to "create a harmonised framework for coordinated action at European level, increase transparency and reduce risks". These are commendable aims, which are also widely accepted by those within the industry.

But on the proposed CDS ban, we note

In fact, in many cases, the ability to "go short" increases investments in struggling economies since it serves to reduce risks involved in that investment – while offsetting the exposure investors may have to long positions elsewhere. Take away this form of insurance, and fund managers will grow increasingly reluctant to invest in the very economies that are in need of cash inflows.

For example, take an investor who considers putting his money into a project or enterprise in one of the eurozone economies, which is struggling to cope with large levels of debt at the moment. Naturally, he will want to have a way to hedge or insure himself against potential losses, in what is a risky economic environment. One way of doing this is to take a short position on the sovereign debt of this country in order to offset some of the risk. An excessive ban on CDS short-selling activities would reduce the flexibility of markets to respond to these kinds of risks, which in turn increases the cost of capital and reduces investments in - and lending to - struggling eurozone economies.

Alluding to the "fight in a bar" analogy, we conclude,

The biggest problem with this proposal is, therefore, that it is driven by a narrow political agenda rather than economic evidence, best practice and common sense. It is easier for politicians to accuse "speculators" - a vague group of people that is never really defined - for carrying out an evil conspiracy, than to deal with the real problems facing the EU economy. Such as low growth, an undercapitalised banking sector, an unsustainable single currency and governments spending money they do not have.

Unfortunately, in this fight it seems as if, rather than improving financial regulation, struggling European countries will be hit the hardest

Permanent euro bail-out fund failing before starting?

Standard & Poor’s yesterday downgraded both Greek and Portuguese debt by one notch and kept them on negative outlooks. That hints at further downgrades in the near future, although given the extent of the problems in both countries that could be as soon as next week.

More interesting to us, is the reasoning behind the downgrade. S&P directly puts its decision down to the agreement which was reached on the permanent bailout fund (ESM) at last week’s EU summit. In particular, the fact that, as expected, ESM debt will be senior to all private debt and taking loans from the ESM may be conditional on restructuring debt. S&P suggests this could be “detrimental to commercial creditors”.

Investors feared ESM uncertainty, but if there’s one thing markets hate more than uncertainty, it’s having their fears crystallised by government policy. The ESM undoubtedly makes peripheral government bonds more risky to hold and was always going to be met with a downgrade and higher borrowing costs. The real questions remain: Why did EU leaders decide to announce this two years in advance, thereby massively prolonging and increasing the pain of peripheral economies? And at the same time why did they put off dealing with the temporary bail-out fund, the EFSF?

There's still no agreement on how to top up the EFSF, which in turn makes investors doubt the EU's capability to deal with future bail-outs. Sorting out the EFSF might have helped limit the fallout from the ESM decisions; in any case it makes no sense to delay the more pressing of the two issues. Flagging up the fact that debt restructuring may be possible down the line somehow manages to simultaneously ignore the fact that it should be done sooner while also increasing the need for it.

Eurozone countries continue to complain about rating agencies' actions – which are admittedly far from perfect – but maybe they should stop throwing fuel on the fire.

While the principle behind it is very much welcome - putting the burden on taxpayers rather than investors - due to poor sequencing and timing, the ESM has managed to fail before it even came close to starting. That’s impressive even for an EU policy.

Splitting the difference between the BBC and the tabloids

There have been lots of numbers floating around on what a bailout of Portugal would mean for the UK. The tabloids today reported a figure of €6.8 billion, while on the BBC Today programme, Robert Peston argued that Britain would only contribute through the IMF, and possibly nothing at all.

Please bear with us as we're trying to break down what's going on here.

First, any bailout would NOT be a direct cost imposed on the UK, apart from the cash contributions the country is making to the IMF. The UK would be liable for a possible bail-out under the the so-called European Financial Stabilisation Mechanism, which the Labour government signed up to in the dying hours of its administration. The mechanism involves the European Commission borrowing money on the markets and then lending it to struggling eurozone countries, using the EU budget as collateral. So far, only Ireland has tapped this fund (Greece only recieved money from the IMF and the bail-out fund that only eurozone members contribute to, the EFSF). Since the UK contributes to the EU budget, it guarantees a certain portion of the loans given to any bailout recipient under the EFSM (the UK's share is around 13.6%). However, this is still significant for UK taxpayers, as it effectively requires them to underwrite the debt of peripheral eurozone economies. It's a bit like if you were to underwrite the mortgage of your neighbours house.

Secondly, in terms of the size of these liabilities, we expect a bailout of Portugal to be in the region of 60-€70bn - though we've seen figures of up to €100bn floating around(clearly its a moving target which makes it difficult to predict). If Portugal needs a €70bn bail-out and the rescue operation is structured in the same way as the loans to Ireland were - one third each from the EFSM, EFSF and IMF - the UK’s liabilities would be €3.2bn (13.6% of the total) under the EFSM and €1.05bn under the IMF. This gives a total UK liability of €4.25bn (if the bail-out is restricted to €60bn, then the UK's liabilities will be in the region of €3.7bn).

Are you with us? Pardon all the acronyms - but this is EU policy, remember.

Thirdly, this is assuming that the EFSM - which, again, the UK is partially underwriting - is in fact activated and used. If EU leaders decide to only look to the IMF and the EFSF, we're looking at a different scenario.

So, the question is, will the EFSM be used in a Portuguese bail-out? The BBC's Robert Peston gave no explanation on the Today programme for his assertion that the UK wouldn't be implicated in a rescue operation on the Iberian peninsula. However, on his blog, he seems to suggest that the EFSM will only be used once the eurozone-only fund, the EFSF, has been exhausted (which it won't be in the case of Portugal).

This is a possible scenario (as we explain in our Portugal briefing) - which will clearly limit the UK's liabilities - but it involves some pretty heroic assumptions. EU leaders are currently bogged down in hugely complicated talks over how to boost the fire power of the EFSF (the fund is currently worth €440bn on paper, but a lot less in reality) in order to convince markets that the eurozone has what it takes to save the euro. A deal is currently being blocked by Finland, due to domestic opposition to underwrite the debt liabilities of other countries, with Finnish national elections looming.

Only involving the EFSF and IMF in a bail-out would leave the EFSF almost completely tapped out. And if markets suspect that the EFSF is runing dry, the euro might be in for an even bumpier ride. Therefore, there will be many EU leaders out there who will want to use a large chunk from the EU-wide EFSM (which still have €37.5bn in it).

In addition, the EFSM is much faster to get off the ground as, unlike the EFSF, it's decided by majority voting. The case of Finland (and also Slovakia which refused to take part in the Greek bail-out), shows why this matters. Ergo, there is a very strong case for suspecting that the EFSM will be used, and therefore, that the UK will become indirectly liable.

That Peston seems to be omitting this discussion - which touches on so many important aspects of the ongoing eurozone crisis - is surprising.

Fourthly, the UK tabloids today featured pieces on what would happen if the EFSM was tapped completely (i.e. if it used all the remaining funds). Well, there is currently €37.5bn left, of which the UK is liable for €5.17bn. However, it's very unlikely that this entire amount will used in a Portugal bailout, since the cost will be shared with first, the IMF and most likely also the EFSF. Our estimates that we set out above are far more likely.

So still lots of uncertainty. Time will tell.

Don't fear the R-word

The Portuguese Prime Minister Jose Socrates resigned last night, after failing to get his new austerity measures through the Portuguese Parliament. This has pushed Portugal into a political crisis, and forced them to the brink of asking for a bailout.

As our new briefing on Portugal’s economic situation shows, a bailout could amount to €60bn - €70bn. Based on the structures of previous bailouts, the UK’s contribution could amount to as much as €4.26bn in liabilities (in the form of loan guarantees). That’s a big liability for taxpayers.

That’s why we argue for a combination of a restructuring and bailout. This would shift some of the burden onto investors; it would also help put Portugal on the road to debt sustainability rather than just recycling more debt around the EU.

For you restructuring-phobes out there, we are aware of the risk of contagion, but we believe there are many factors in this instance which make this a viable course of action:

- The bailouts of Greece and Ireland have solved little, they still have no market access to fund themselves and face ever increasing debt burdens.
- Markets are already boycotting peripheral eurozone debt, how much worse can things get (if it wasn't for the ECB, Portugal would have gone bust long ago)!
- Portugal’s debt burden, although large in GDP terms, is relatively small in nominal terms (given the size of other EU countries and banks).
- Exposure to this debt is spread around the EU and does not fall heavily on peripheral economies; the European banking sector will withstand the losses it may incur (although if it coincides with other negative banks may start to wobble - but that's an argument in favour of sorting out the banks!)
- The ‘Portugal goes, Spain goes’ assumption looks to be overstated (see positive market response to Spain despite Portuguese problems). In any case a limited bailout fund should help halt the spread of contagion from Portugal.
- Unfortunately, we’re in a crisis; difficult decisions need to be taken. A restructuring now is preferable to a more costly one later. The alternative is ongoing transfers of wealth to struggling eurozone economies - the sudden rise of the "True Finns" in Finland shows why this is politically very unlikely.

The question that now needs to be answered is when can or will any of this take place? That depends on what powers a caretaker Portuguese government has, but, in our view, the sooner the better. (The double standards displayed by the opposition in bringing down the government over austerity measures, then pledging to do a better job of managing the debt and deficit levels, doesn’t fill us with confidence though).

You can read our briefing here.

Socrates needs to get philosophical

Looks like Portugal could be asking for a bailout by the end of the week.

Pedro Passos Coelho, Leader of the main opposition party, said on Saturday:

“We need external aid. The Prime Minister does not want to admit that, but the whole country has already understood it.”

He also said he will continue to oppose the new austerity measures, which are due to be voted on by the Parliament tomorrow or Wednesday.

Portuguese Prime Minister, Jose Socrates, announced that:

“Should the Parliament vote against, then the government would no longer have the means to act.”

With massive public protests against austerity in Portugal over the weekend, there seems less and less political incentive for the opposition to cave in and support the new measures. The only thing that everyone seems to agree on is that if the new austerity measures are voted down, Portugal will be forced to ask for a bailout.

However, given Socrates stance the government may fall if he fails to garner the support he needs.

That does not bode well given the EU summit at the end of the week. Socrates needs to get his thinking cap on…as going into summit negotiations without a government cannot be a good strategy.

A third way to bail out struggling countries

Much was discussed and a little agreed during Friday’s eurozone summit, but it was enough to give the euro a bit of a boost. Investors - going into the weekend with exceptionally low expectations - seemed pleased with the news that anything was agreed at all.

The most important and controversial measure agreed over the weekend looks to be allowing the EFSF - the eurozone's main bail-out fund - to purchase government debt, under exceptional circumstances.

The conditions imposed on any country wishing to make use of the EFSF's bond-buying scheme are pretty exceptional as well:

- EFSF can only buy bonds on the primary market (i.e. directly from governments)
- For this to take place, the government must enact an austerity programme as it would under a bailout

So what exactly is the difference between a bailout and using the EFSF to buy government bonds under these conditions? Not much, as far as we can tell.

One argument behind restricting purchases to the primary market is that it bails out governments rather than investors. Although that might be true, if the EFSF did purchase bonds in the secondary market the cost of borrowing for peripheral governments would undoubtedly fall by a lot more. There is also the added advantage of purchasing existing debt rather than issuing new debt and increasing the already heavy burden. In the end it looks like the standard EU compromise where both sides meet somewhere in the middle to achieve very little.

The decision also means that the ECB could well be forced to continue buying bonds on the secondary market, since a struggling country will think twice before signing up to strict conditions in return for the EFSF relieving them of some of their junk bonds.

What is significant, however, is that there are now three avenues through which the cost of failing economies can be transferred onto EU taxpayers - about a year ago, there were none (remember the days when some of us were foolish enough to believe that a guarantee in the EU Treaties, i.e. the no bail-out clause, actually meant something?):

1) Direct loans from one of the bail-out funds (requiring unanimity or a majority vote amongst eurozone governments)
2) The ECB buying government bonds, from the secondary market (at the discretion of the ECB)
3) The EFSF buying government bonds, directly from governments (unclear how decisions will be reached on when this can happen).

Many of the key questions remain, however. Such as:

- What interest rate will the EFSF be charging on government bonds purchased?
- Will this option be open to countries who have already received a bailout?
- How will the activation of the EFSF's bond purchasing programme be decided?
- Will Merkel be able to see this through amid domestic political resistance?

We’d hazard a guess that the EFSF would charge below market rates but above its lending rate, but we’d also expect some differentiation from the bailout loans otherwise it would look completely pointless.

Apart from that, we note that Greece - as we expected - has been granted what can only be described as a debt restructuring, though a limited one.

So on the upside, markets are slightly more re-assured. On the downside, expectations are now raised that a meaningful deal will be struck at the summit in two week's time.

When you do scratch the surface, this looks perilously close to more of the same.

Spain gets moody

Credit rating agency Moody’s today downgraded Spanish debt partly based on the massive recapitalisation needed by the banking sector. It put the funding needs at €40bn - €50bn, or €110bn - €120bn under a “more stressed scenario”. Way above the Spanish Government’s previous estimate of €20bn.

Spain was none too pleased with this, suggesting it was premature and that Moody’s should have waited for the official statistics.

Oh, well maybe the central bank was ready to make a more accurate assessment of the banking sector funding needs – which we all expect are far greater than $20bn – ...

This afternoon the Bank of Spain released its assessment: €15.15bn...

A Portuguese bail-out won't be enough

Over on Europe’s World we have a post on the future of Portugal. We argue that a bailout now looks inevitable but that it will do little to solve Portugal’s problems due to:

- Funding requirements topping €39.4bn this year alone, equal to 25% of GDP.
- Unsustainable borrowing costs both in the short term and the long term, as we have already noted.
- Over reliance on ECB funding - both the state and the banking sector
- Massive lack of competitiveness as well as few policy options to facilitate economic reforms and foster growth

Given the mountain of issues facing Portugal, a bailout might give the appearance of providing help in the short term, but restructuring debt and tackling the problem at its source - high debt to GDP ratio and massive amounts of private debt - will provide a much better long term solution for both the country and the eurozone. However, even so, in the absence of some serious reforms to boost the country's competitiveness, going far beyond those that we're seeing at the moment, Portugal may find itself in this position again before too long.

You can check out the full article here.

The cost of dignity

Yesterday, Portuguese Prime Minister Jose Socrates said:

"[Portugal] would lose its prestige and (its) dignity of being able to present itself to the world as a country that succeeds in solving its problems [if it asks for a bailout]."

Today, Portugal auctioned off €1 billion in 2 year government bonds, but the Portuguese really had to pay this time. The interest rate was 5.99% which, for 2 year borrowing, is an exorbitantly high cost. Keep in mind that even with the punitive interest rates of 6% for 3 years, the current bailout loans now look relatively good value for the Portuguese.

Oh, and just in case you thought things looked better down the line: 5 year rates reached 7.82% and 10 year hit 7.70%.

The 10 year rate has been above 7%, the threshold widely accepted as being unsustainable, for 24 consecutive days; Greece and Ireland lasted 13 and 15 days respectively before asking for a bailout. The real question now is not if Portugal needs a bailout but when, and will it be enough? Surely a restructuring would do more for its long term economic stability at this point.

In any case it looks like prestige and dignity are going to hit the pockets of Portuguese taxpayers hard until a decision is made.

Studying the cost of Greece leaving the euro

The "European Economic Advisory Group", CESifo, is a joint venture by two of Germany's most respected research institutions. Earlier in the week, it published an interesting report examining the various potential policy responses to the eurozone crisis.

One of the authors is CESifo Director and heavyweight economist Dr. Hans-Werner Sinn (pictured). When he speaks, Germany listens.

Here are some of the key points in the report:

On establishing a permanent "transfer union" - in which taxpayers in stronger economies subsidise weaker countries, such as happened between Western and Eastern Germany - the report notes:

The persistent flow of public funds has in the end helped eastern Germany only a little, if at all. It has made it another European Mezzogiorno – a region stuck in a low-development equilibrium.

(...)

Whether the EU budget should be expanded for this purpose is a distributional question that will have to be decided by the political process. Politicians should not overlook, however, that there is the risk of Greece becoming addicted to the transfers, since it seems to have become addicted to the capital flows of the past.

It warns against the harmonisation of wages across the EU, citing regional differences in Italy as an example:

The Italian Mezzogiorno has been caught in such an equilibrium for half a century and more. Its GDP per capita is about 60 percent of that of the rest of Italy and does not show any sign of convergence. In Italy, the causes for this situation can be sought in a common wage policy, mainly dictated by the conditions of the North, which has always resulted in wages that were way too high for the South and resulted in persistent mass unemployment.

The under-development has forced the state to help out with transfers from the North. These transfers have provided an alternative income source in the South to which the political system and the economy have grown accustomed, perpetuating the situation, as it seems, even more.

They also explore the alternative to a transfer union - devaluation.

There's a distinction between internal and external devaluation. The former means tough austerity measures and squeezes on wages and jobs at home, as in Latvia (whose economy, as CESifo notes, shrunk by 19 percent in 2009).

The other option is external devaluation, which would involve Greece leaving the eurozone. From page 118 onwards, the report looks at such a scenario, with special focus on Greek banks. They note that if Greece did decide to leave the eurozone there would undoubtedly be a bank run, amongst other problems, therefore the ECB would probably need to guarantee all Greek bank deposits.

After demonstrating that Greece would take a big hit should it embark on external devaluation and head for the exit, they make an important observation: Greek banks might suffer just as much if no devaluation occurs, while private sector companies would be clear winners in the case of an external devaluation:

As Greek banks are net borrowers abroad and net lenders at home, the external depreciation will probably hurt them by shrinking the eurovalue of their assets more than shrinking the eurovalue of their liabilities.

However, this analysis forgets the additional write-off losses on claims against the companies of the real economy that will be driven into bankruptcy after an internal depreciation. If these write-off losses are taken into account, it is not clear whether banks fare better after an internal depreciation than after an external one. It is only clear that companies of the real economy will fare better after an external depreciation.

In view of these uncertainties in the analysis, the EEAG has decided not to opt for a particular policy alternative but only to inform policymakers of the relevant arguments. Definitely, there is no alternative that clearly dominates the other in all dimensions.

This is not a call for Greece to leave the eurozone, but the distinguished economists are clearly toying with the idea - though stressing that every scenario involves huge costs.

Meanwhile, FAZ today reports today that more than 200 German Professors, amongst them Dr. Sinn, have warned in a petition to the German Government, against extending the eurozone bailout. They call upon the German government to prepare

for a possible failure of the eurozone aid scheme and (...) prepare a detailed insolvency plan for eurozone countries with excessive debt

This is the only way, they argue, to avoid

collectivising the debt of member states, which leads to higher taxes and higher inflation in the EU as a whole.

It's not getting any easier for Angela Merkel.