Hugo Dixon

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Euro zone doesn’t need Disziplin union
Hugo Dixon
OCT 22, 2012 08:59 UTC
European leaders nudged forward plans for a fiscal union with discipline as its leitmotif at last week’s summit. But such a “Disziplin union” is neither desirable nor necessary. It may not even be politically feasible.
The consensus among the euro zone political elite is that fiscal union is needed to complete the crisis-ridden monetary union. There are two rival views of what this should consist of: a panoply of rules to prevent and punish irresponsible behaviour; or financial payments to help weaker economies. The former view, espoused by Germany, is in the ascendant. It involves lots of sticks but not many carrots.
The summiteers’ main achievement was to give further impetus to the idea that the European Central Bank should act as the zone’s central banking supervisor from the start of next year after Berlin dropped its insistence that its own savings banks should be excluded from the regime. That was an important political concession. It’s also conceivable that the new supervisor will be better able to clean the cesspits in parts of the euro zone than the current often-conflicted national supervisors.
However, banking supervision is only part of what the experts call “banking union” which, in turn, is only part of a planned fiscal and political union. Just looking at banking union, what has been agreed is the stick. Back in June, when the plan was first agreed, there was also supposed to be a carrot: the euro zone would inject capital directly into struggling banks in countries such as Spain. But Angela Merkel, Germany’s Chancellor, made clear after the summit that this would not happen retroactively.
Full banking union would also include a common deposit guarantee scheme. But there was no mention of this carrot in the summit’s communiqué. There were, though, more sticks to ensure budgetary discipline and economic reform.
First, the summiteers called for the “two-pack” to be implemented by the end of the year. Even aficionados of euro-speak find it hard to stay up-to-date with the whirlwind of rules designed to keep countries on the fiscal straight and narrow. The original “stability and growth pact” was augmented by first the “six-pack”, then the “fiscal compact” and now, if everything goes to plan, the “two-pack”. The basic idea is that there will be coordination of countries’ budgets and enhanced surveillance of those experiencing financial difficulties.
Mind you, this is not sufficiently tough for Wolfgang Schaeuble, Germany’s finance minister. He wants a new European Commissioner to be have the power to veto a national budget if he or she feels the deficit is too large. While that’s not yet a euro-wide consensus, the summit did give some support for the idea that individual countries should be required to enter contracts with the centre spelling out what reforms they would commit to undertake.
Counterbalancing these potential new sticks, one new carrot was dangled: what the eurocrats call an “fiscal capacity”. This is code for a centralised budget which could be used to help countries adjust to economic shocks or even as an inducement to persuade them to move ahead with unpopular reforms. This may turn out to be an important idea. But, as yet, there is no detail on how big such a central budget would be, where the money would come from or what exactly it would be used for.
Plans for yet more bureaucratically-mandated discipline are not desirable. They would hard-wire austerity into the circuitry, potentially deepening the recession in parts of the euro zone. They would also involve a further transfer of sovereignty to the centre, even from those countries that are not in trouble. That is a mistake. It is one thing to turn Greece or even Spain into a quasi-protectorate for a temporary period; it is quite another to centralise partial control of all countries’ budgets permanently.
It may not even be feasible to push through such a Disziplin union. While Germany and other northern countries want rules, the southerners are much keener on a “transfer union” involving ideas such as joint guarantees for their debts. Such mutualisation of debt didn’t get mentioned in the summit’s communiqué, because the southern countries’ bargaining position vis-a-vis Germany is weak. But even if their leaders are eventually browbeat into signing up to a Disziplin union, there must be some doubt over whether the people – who may be asked to vote in referendums sanctioning loss of sovereignty – will agree to it.
A fiscal union is, in fact, not even necessary. There clearly has to be some discipline in order to prevent countries running up excessive debts. But that can be better achieved by making clear that insolvent governments can go bust. The Greek debt restructuring earlier this year was a step in the right direction. But it should have been deeper and occurred earlier. If bondholders know they will suffer a haircut when debts spiral out of control, they will have a stronger incentive to hold countries to account in the first place.
There also has to be some sort of support system for countries in trouble. And the quid pro quo should be a loss of sovereignty for the period of the rescue operation. Deficits have to be cut and economies reformed. But that is quite different from either permanent rules for everybody or permanent mutualisation of debt. The euro zone needs neither a Disziplin union nor a transfer union.
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Spanish circle getting hard to square
Hugo Dixon
OCT 15, 2012 09:20 UTC
The art of politics is about squaring circles. In the euro crisis, this means pushing ahead with painful but necessary reforms while hanging onto power.
In Spain, where I spent part of last week, these circles are getting harder to square. Mariano Rajoy isn’t at any immediate risk of losing power. His 10-month old government has also taken important steps to reform the economy – cleaning up banks, liberalising the labour market and reining in government spending.
But the recession is deepening, the prime minister is a poor communicator and his political capital has plummeted. Madrid will also find it harder than thought to access help from its euro zone partners.
GDP will shrink by 1.5 percent this year and another 1.8 percent next year, according to Funcas, the Spanish savings bank association. That is a result of both a severe fiscal squeeze and private-sector deleveraging. An austerity spiral is in operation. As the International Monetary Fund argued last week, so-called fiscal multipliers across the world are bigger than forecasters had previously estimated.
The severity of the downturn means the government seems destined to miss its deficit reduction targets again. This year, Madrid economists think it will end up with a deficit of around 7 percent of gross domestic product, against a revised target of 6.3 percent. Next year, the deficit could be in the 5-6 percent range rather than the new, 4.5 percent target.
It might seem that these slippages matter less now that the IMF and even some euro zone policymakers are softening their demands for austerity. Foreign governments are less likely to demand Madrid tighten its belt further if a failure to hit targets is not its fault.
However, Spain will have to sell 207 billion euros of bonds, equivalent to 20 percent of GDP, next year – to fund the deficit and rollover maturing debt. That’s even more than the 186 billion scheduled for this year – an amount Madrid has only been able to shift because the European Central Bank lent 230 billion euros of cheap long-term money to Spanish banks, much of it recycled into buying government bonds.
Spain should be able to sell the remainder of this year’s bonds because investors have been lulled by the ECB’s promise to purchase unlimited amounts of sovereign paper. For example, they brushed aside last week’s two-notch downgrade of the country’s credit rating by Standard and Poor’s. But as next year approaches, the mood could turn ugly – especially if Madrid hasn’t by that time taken advantage of the central bank’s security blanket and its credit-rating is junked.
Investors could start worrying about the fact that the state’s debt could well reach 100 percent of GDP in 2015 after including the cost of injecting capital into the banking system. They may also focus on the fact that the ECB’s bond-buying plan is partly a confidence trick because it is limited to the secondary market and short-term bonds – and would end if Madrid couldn’t sell bonds in the primary market. A loss of confidence could be self-fulfilling.
Why doesn’t the government just get on with it and ask for ECB help? That would lower the risk of a renewed “Spanic” attack and cut both the government’s and the private-sector’s borrowing costs – taking the edge off the recession.
Before I went to Madrid, I thought Rajoy’s misplaced pride was the main reason he was not asking for help. This, and the desire to wait until after regional elections in Galicia later this month, may be minor factors. But the two more important reasons for delay are lack of clarity over what the ECB will do and concern that Germany will block the bailout.
Does the ECB just want to cap Spanish 10-year bond yields at around the current level of 5.7 percent? Or does it want to drive them down to, say, 4.5 percent – the level that might be justified if there weren’t residual fears about a break-up of the euro? Rajoy hasn’t asked Mario Draghi, the ECB’s president. Even if he did, he wouldn’t get a straight answer. But it should still be possible to get some rough sense of what the ECB wants.
The bigger issue is Berlin. The ECB’s bond-buying scheme is contingent on a parallel programme being agreed between Madrid and the other euro zone governments. Unfortunately, Germany has been saying that it doesn’t think Spain needs help. That, in turn, seems to be mainly because Angela Merkel, the chancellor, doesn’t want to have to push another bailout programme through the Bundestag only three months after it got parliamentarians to agree to a mega-loan for Spain’s banks. Sentiment in Germany towards bailouts in general and the ECB’s bond-buying plan in particular is negative.
Madrid has seen how Berlin is seeming to renege on an earlier plan that would have allowed it to transfer the cost of bailing out its banks to the euro zone rather than just receive a loan. It now doesn’t want to ask for help only to be turned down.
If there is another panic, Merkel will presumably decide to get parliamentary approval for Spanish aid. It is also possible that she will push a package deal through the Bundestag next month covering not just Spain but also Greece and Cyprus. But it would be far preferable to act before then. Sadly, that isn’t the way Europe, despite its new Nobel Peace Prize, normally works.
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Hugo Dixon: Crisis, what crisis?
Hugo Dixon
OCT 8, 2012 08:59 UTC
The credit crisis burst into the open five years ago. The euro crisis has been rumbling for over two years. The term “crisis” isn’t just on everybody’s lips in finance. Wherever one turns – politics, business, medicine, ecology, psychology, in fact virtually every field of human activity – people talk about crises. But what are they, how do they develop and what can people do to change their course?
The first thing to say is that a crisis is not just a bad situation. When the word is used that way, it is devalued. The etymology is from the ancient Greek: krisis, or judgment. The Greek Orthodox Church uses the term when it talks about the Final Judgment – when sinners go to hell but the virtuous end up in heaven. The Chinese have a similar concept: the characters for crisis represent danger and opportunity.
A crisis is a point when people have to make rapid choices under extreme pressure, normally after something unhealthy has been exposed in a system. To use two other Greek words, one path can lead to chaos; another to catharsis or purification.
A crisis is certainly a test of character. It can be scary. Think of wars; environmental disasters that destroy civilisations of the sort charted in Jared Diamond’s book Collapse; mass unemployment; or individual depression that triggers suicide.
But the outcome can also be beneficial. This applies whether one is managing the aftermath of Lehman Brothers’ bankruptcy, the current euro crisis, the blow-up of an oil rig in the Gulf of Mexico or an individual’s mid-life crisis. Much depends on how the protagonists act.
Students of crises are fond of dividing them into phases. For example, Charles Kindleberger’s Manias, Panics, and Crashes identifies five phases of a financial crisis: an exogenous, normally positive, shock to the system; a bubble when people exaggerate the benefits of that shock; distress when some financiers realise that the game cannot last; the crash; and finally a depression.
While there is much to commend in Kindleberger’s system, it is too rigid to account for all crises in all fields. It also downplays the possibility that decision-makers can change the course of a crisis. A more flexible scheme that leaves space for human agency to affect how events turn out has two just phases: the bubble and the crash.
The bubble is typically characterised by mania and denial. Things are going well – or, at least, appear to be. Feedback loops end up magnifying confidence. In corporations or politics, bosses surround themselves with lackeys who tell them how brilliant they are. In finance, leverage plays a big part.
This is not healthy. Manic individuals don’t know their limitations and end up taking excessive risks – whether on a personal level or in managing an organisation or an entire economy. As the ancient Greeks said, hubris comes before nemesis.
But before that, there is denial. People do not wish to recognise that there is a fundamental sickness in a system, especially when they are doing so well. For example, back in 2007 at the World Economic Forum in Davos, the greed was palpable. Market participants had such a strong interest in keeping the game going that they turned a blind eye to the unsustainable buildup of leverage.
The ethical imperative in this phase is to burst the bubble before it gets too big. That, in turn, means both being able to spot a bubble and having the courage to stop the party before it gets out of hand. Neither is easy. It’s hard to recognise a sickness given that there is usually some ideology which explains away the mania as a new normal. The few naysayers can be ridiculed by those who benefit from the continuation of the status quo.
What’s more, politicians, business leaders and investors rarely have long-term horizons. So even if they have an inkling that things aren’t sustainable, they may still have an incentive to prolong the bubble.
The crash, by contrast, is characterised by panic and scapegoating. People fear that the system could collapse. Negative feedback loops are in operation: the loss of confidence breeds further losses in confidence. This is apparent on an individual level as much as a macro one.
Events move extremely fast and decisions have to be taken rapidly. Witness the succession of weekend crisis meetings after Lehman went bust – or the endless euro crisis summits. The key challenge is to take effective decisions that avoid vicious spirals while not embracing short-term fixes that fail to address the fundamental issues. With the euro crisis:, for example, it is important to improve competitiveness with structural reforms not just rely on liquidity injections from the European Central Bank.
In this phase, there is no denial that there is a problem. But there is often no agreement over what has gone wrong. Protagonists are reluctant to accept their share of responsibility but, instead, seek to blame others. Such scapegoating, though, prevents people from reforming a system fundamentally so that similar crises don’t recur.
Crises will always be a feature of life. The best that humanity can do is to make sure it doesn’t repeat the same ones. And the main way to evolve – both during a bubble and after a crash – is to strive to be honest about what is sick in a system. That way, crises won’t go to waste.
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Euro crisis is race against time
Hugo Dixon
OCT 1, 2012 09:26 UTC
Solving the euro crisis is a race against time. Can peripheral economies reform before the people buckle under the pressure of austerity and pull the rug from their politicians? After two months of optimism triggered by the European Central Bank’s plans to buy government bonds, investors got a touch of jitters last week.
The best current fear gauge is the Spanish 10-year government bond yield. After peaking at 7.64 percent in late July, it fell to 5.65 percent in early September. It then poked its head above 6 percent in the middle of last week because there were large demonstrations against austerity; because Mariano Rajoy’s government was dragging its heels over asking for help from the ECB; and because the prime minister of Catalonia, one of Spain’s largest and richest regions, said he would call a referendum on independence.
But by the end of the week, the yield was just below 6 percent again. That’s mainly because Rajoy came up with a new budget which contains further doses of austerity. The move prepares the way for Madrid to ask for the ECB to buy its bonds and so drive down its borrowing costs.
Rajoy didn’t want to be seen to be told to do anything by his euro partners. Hence, this elaborate dance – where he has now done what he knew he would have been told to do but can claim it was his choice. It’s hard to believe that anybody is fooled by this subterfuge; indeed, from investors’ perspective, it looks childish. But, at least the show is on the road again: the government has had the guts to press ahead with reform despite the immense unpopularity of the measures.
The question is whether Madrid and other governments in Lisbon, Dublin, Rome and Athens can keep up the reforms long enough to restore their economies to health. That, in turn, depends on three factors: how much farther they have to travel; how unruly their people are going to get; and how much help they will receive from their partners.
Economic health requires both that fiscal deficits are eliminated and that competitiveness is restored. The peripheral economies have made some progress on both fronts. But shrinking economies makes it hard to balance their budgets while fiscal squeezes undermine growth. The austerity vicious spiral is still whirring away.
That’s why Spain is unlikely to hit its target of cutting its deficit to 4.5 percent of GDP next year. It can get there only on the optimistic assumption that the economy will shrink by just 0.5 percent in 2013. The same could be said of France, not yet a full member of the periphery, whose budget unveiled last Friday calls for a deficit of 3 percent of GDP next year. Paris is assuming 0.8 percent growth. The French prime minister describes the projection as “realistic and ambitious”. Just ambitious would have been a more accurate description.
Meanwhile, restoring competitiveness is painful because it involves cutting people’s pay. Ireland and Spain have made good progress, covering respectively 80 percent and 50 percent of what they needed to achieve by the end of last year, according to a report last week by Open Europe, a British think-tank. Portugal and Greece have done less well.
Current account deficits paint a similar picture. Spain’s had shrunk to 3.5 percent of GDP last year while Ireland actually had a small surplus. Portugal, though, had a deficit of 6.4 percent of GDP and Greece was struggling with one of 9.8 percent.
Big falls in pay are forecast for the deficit countries over the next two years by Eurostat. It sees unit labour costs dropping 4.7 percent in Spain between end-2011 and end-2013; 3.8 percent in Portugal; and 9.5 percent in Greece. If that happens, competitiveness could be restored. Citigroup forecasts that Spain and Portugal will have current account surpluses next year while Greece’s deficit will have shrunk to 2.8 percent.
The snag is that such pay cuts – especially when combined with higher taxes and rising unemployment – provoke howls of outrage from the population. Short of leaving the single currency and devaluing, the only other medicine for improving competitiveness is so-called fiscal devaluation. This involves cutting the social security contributions paid by employers and, in return, putting up other taxes.
Germany succeeded in pushing through such a fiscal devaluation in 2007. But that just made it more competitive vis-a-vis the weaker euro zone economies. More recently, Spain did a mini fiscal devaluation. But the most ambitious attempt, by Portugal, provoked such a massive backlash earlier this month that the government backed down.
Help from abroad is the main way of easing the pain of adjustment. The ECB’s promised bond-buying plan is the most dramatic example. But solidarity has its limits. There has been a backlash in the German media over the central bank’s plan. Meanwhile, Berlin has been trying to persuade Madrid not to ask for help. The German finance minister also clubbed together with his Dutch and Finnish counterparts last week, proposing rules that will make it harder for Spain to shift the cost of bailing out its banks onto the euro zone.
The consequences of a breakup of the euro zone would be so ghastly for both the periphery and the core that they will probably pull through what looks like it is going to be at least another year of hell. But the risks have certainly not vanished.
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Banks should learn to say “Just Go”
Hugo Dixon
SEP 24, 2012 08:44 UTC
Shortly after last year’s bonus round I was having lunch with the boss of an investment firm. He told me how he heard a handful of staff had been grumbling about what, by most people’s standards, were still extraordinary pay packages. He called them into his office and told them that, since they were unhappy, they should “Just Go”.
Most of them packed their things and left the firm. But the next day one came back and said he had been misunderstood. My interlocutor said he hadn’t misunderstood him at all. The employee clearly felt he was worth more than he was paid. He should take his luck and go elsewhere as he clearly didn’t have his heart in his current job. He should “Just Go”. And he duly did.
These words “Just Go” stuck in my mind because financial services bosses use them far too rarely. My lunch companion was perhaps an exception because his family is a big shareholder in his firm. Most other bosses are stewards for shareholders – and normally not terribly good stewards at that.
Of course, banking and investment bosses do have some equity in their firms but typically they don’t act like owners. They want to get paid a huge amount themselves. They also want to be surrounded by a phalanx of fawning minions who tell them they are masters of the universe. That boosts their egos. The best way of achieving that is to pay their minions millions, even if it costs the shareholders.
During the bubble years, pay in the financial services industry went through the roof. It wasn’t just for the stars either. Fairly ordinary middle-ranking bankers raked it in. Even after the bubble burst, pay has taken a long time to come down. The 2007 bonus round was a record. Although pay was reined in after Lehman Brothers went bust in 2008, it rebounded the following year.
More recently, especially in Europe, bankers have hit relatively hard times. Compensation is being cut and banks such as Deutsche Bank have said they will do more. But returns to shareholders are still miserable. What’s more, as the economic situation in much of the world remains challenging, the general public is resentful towards an industry that played a role in creating the current mess and which has had to be bailed out repeatedly with public funds.
Quite apart from infusions of capital into specific institutions, the whole market has been buoyed by massive injections of cheap money by central banks across the world – whether it is round after round of quantitative easing in America, Japan and the UK or the European Central Bank’s ingenious support operations.
The endless stream of scandals – money laundering, mis-selling of financial services, rogue trading and attempted manipulation of interests rates – has further sullied an industry comprising institutions such as Barclays, Deutsche Bank, HSBC, JPMorgan, RBS and UBS.
On a more technical note, high pay reduces the earnings that banks can squirrel away to build up their capital buffers as a protection against future crises. Although regulators are pushing for higher capital ratios, this can be achieved either by increasing the amount of equity in a bank or by cutting its lending. If banks put too much emphasis on the latter route, the economy will be put under further pressure.
The coming bonus round represents a golden opportunity to reset compensation to a much lower new base. What is needed is not merely to cut pay in line with reduced revenue, but something more radical – a significant drop in the proportion of the revenue pot devoted to staff. Although the final figures won’t be set for several months, now is the time to start planning.
What’s more, this is not something that should be left entirely to managers. Given that there is an intense shareholder and public interest in curbing pay in financial services, investors and regulators should get involved. They should call in bank chairmen and tell them they expect them to take advantage of the current, uniquely favourable, climate.
Managers will undoubtedly say that they are already cracking down on compensation and that it is best not to move too rapidly otherwise key staff will jump ship. But if shareholders and regulators give the same broad message to all banks – even if it is not their role to give specific instructions – there will be less risk of such poaching. With pretty much the whole industry downsizing in response to weak market conditions, there isn’t going to be that much appetite among rivals to hire.
It is perhaps too much to hope bank bosses to think about the public interest. But they are mostly smart individuals who can see how the winds of change are blowing. They understand that it could be in their personal interest to get ahead of the curve. Some of those who didn’t seem able to adapt to the new Zeitgeist – such as former Barclays boss Bob Diamond – have been defenestrated.
Bankers will always be tempted to play their own version of the game of Monopoly one more time and see if they can pass Go and collect another $200 (add several noughts). And, even in the current climate, there will be many who complain if their pay is cut. But the message to them should be the same as that given by my lunch companion: “Just Go!”
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Can EU defend supranational interests?
Hugo Dixon
SEP 17, 2012 09:56 UTC
European integration tends to advance first with squabbling then with fudge. Every country has its national interest to defend. Some politicians appreciate the need to create a strong bloc that can compete effectively with the United States, China and other powers. But that imperative typically plays second fiddle to more parochial concerns with the result that time is lost and suboptimal solutions are chosen.
Amidst the europhoria unleashed by the European Central Bank’s bond-buying plan, it is easy to miss the immense challenges posed by two complex dossiers that have just landed on leaders’ desks: the proposed EADS/BAE merger; and a planned single banking supervisor.
Look first at the plan to create a defence and aerospace giant to rival America’s Boeing. This has been under discussion since at least 1997 when the UK’s Tony Blair, France’s Jacques Chirac and Germany’s Helmut Kohl called on the industry to unify in the face of U.S. competition. London, Paris and Berlin are the key players in this game because they have the major assets.
Since 1997, progress has been patchy. Airbus, previously an awkward Franco-German-British consortium, was gradually turned into a proper company wholly owned by EADS – and EADS itself was created by the merger of France’s Aerospatiale and Germany’s Dasa. But Paris and Berlin insisted on a dysfunctional governance structure designed to balance their respective power rather than promote an effective organisation and EADS’ early years were bedevilled by scandal. What’s more, BAE opted to stay out of European integration, instead merging with Britain’s Marconi and going on a U.S. acquisition spree.
The cost of developing new products, such as fighter aeroplanes, is huge: Europe’s last major initiative in this area, the Eurofighter, was developed through another suboptimal consortium. If Europe can’t get its act together, BAE may eventually find itself swept into the arms of a large U.S. group and governments may ultimately be forced to buy American. Being dependent on even such a close ally should not be their first choice. So there is a strategic benefit in creating a streamlined European defence and aerospace group.
The best solution would be to merge EADS and BAE, and run the new group on commercial lines. The politicians would abandon their right to decide who would manage it or where its factories and research centres would be located. The most important interests of France, Germany and Britain could be protected by ring-fencing their secrets and giving each government a veto over any takeover of the group.
To be fair, the planned merger – which leaked last week – takes a big step in this direction. A complex shareholder pact, which balances French and German interests in EADS, would be scrapped. The private shareholders involved in that pact – France’s Lagardere and Germany’s Daimler – are also expected to sell out eventually.
The snag is that Paris would keep a stake of around 9 percent, potentially letting it pull the strings from behind the scenes. Both London and Berlin seem worried about that. Germany may also be queasy about a plan, so far unannounced, to locate the merged company’s defence HQ in the UK and its civilian aerospace HQ in France.
Even if these circles can be squared, Washington may cause trouble. BAE has been able to acquire a substantial U.S. defence business because of the special military relationship between London and Washington. If the U.S. administration concludes that the new group is effectively controlled by Paris, with which relations are cooler, it may put so many controls on its U.S. business that it becomes commercially unattractive.
It would be better if France sold out of the combined group and depoliticised it entirely. But that doesn’t seem on the cards.
Now look at the euro zone’s plans for a banking supervisor, for which the European Commission unveiled a blueprint last week. Again, the idea is sensible, albeit not a silver bullet. A centralised supervisor based on the ECB might be able to clean up the banking cesspit in places like Greece, Spain and Ireland. This could pave the way for struggling lenders to be recapitalised with euro zone money rather than national money. And that, in turn, could play a role in diminishing the euro crisis.
There are, though, at least two major problems. First, Berlin doesn’t want its local savings banks supervised by the ECB. This is largely a matter of protecting vested interests, as the Sparkassen are closely linked to local politicians. But it is precisely such incestuous relationships that caused mayhem with Spain’s savings banks, the cajas. It would set a bad precedent if Germany could cut a special deal for itself merely because it is the biggest boy in the euro class.
Second, how will the interests of the 10 countries that are part of the European Union but don’t use the single currency be protected as the euro zone moves ahead with banking integration? This is of particular concern for the UK, Europe’s financial capital. Under the European Commission’s plans, the 17 members of the euro would caucus together to decide on matters like technical rules for banking which cover the entire EU. London could therefore find itself perpetually outvoted.
There may be ways of squaring these circles. But, as with defence integration, politicians will need to keep their eye on the big picture even as they defend their legitimate national interests. That hasn’t always been their forte.
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Spain and Italy mustn’t blow ECB plan
Hugo Dixon
SEP 10, 2012 08:23 UTC
The European Central Bank’s bond-buying scheme has bought Spain and Italy time to stabilise their finances. But if they drag their heels, the market will sniff them out. It will then be almost impossible to come up with another scheme to rescue the euro zone’s two large problem children and, with them, the single currency.
Mario Draghi’s promise in late July to do “whatever it takes” to preserve the euro has already had a dramatic impact on Madrid’s and Rome’s borrowing costs. Ten-year bond yields, which peaked at 7.6 percent and 6.6 percent respectively a few days before the ECB president made his first comments, had collapsed to 5.7 percent and 5.1 percent on Sept. 7.
Most of the decline came before Draghi spelt out last Thursday the details of how the plan will work. What makes the scheme powerful is that the ECB has not set any cap to the amount of sovereign bonds it will buy in the market. The central bank’s financial firepower is theoretically unlimited, whereas the euro zone governments’ own bailout funds do not have enough money to rescue both Spain and Italy.
But the new type of intervention, christened “Outright Monetary Transactions”, has three important limitations.
First, the ECB will only buy a country’s bonds if its government agrees to a bailout programme with the euro zone, and sticks to “strict and effective” conditions detailed in such a deal. Second, the central bank will focus its purchases on bonds with a maturity of one to three years. Finally, Draghi has not specified how much he wants to drive down Madrid’s and Rome’s borrowing costs.
This fine print makes sense. But it also means that there is no free lunch. While the ECB seems unlikely to dream up new economic reforms for Spain and Italy, it will probably want their governments to put more precise time frames around what they are already supposed to be doing. The involvement of the International Monetary Fund, which has a somewhat unfounded reputation as a bogeyman, will also be sought. No wonder neither Spain’s Mariano Rajoy nor Italy’s Mario Monti is rushing to take advantage of the scheme.
Meanwhile, the ECB’s focus on short-term bonds means that Madrid and Rome would have to find some other way of issuing long-term debt – which accounts for 66 percent and 62 percent of outstanding debt respectively. If they lost access to the markets, the zone’s bailout funds would have to ride to the rescue. But they still wouldn’t have enough money for both countries.
What’s more, Spain’s and Italy’s borrowing costs are still too high for comfort. The ECB’s main justification for bond-buying is that investors are unfairly punishing them because of fears that the euro will break up. But it also recognises that the spread between their bond yields and Germany’s 1.5 percent 10-year borrowing costs is only partly due to such “convertibility risk”. It is also because of bad economic policies.
While there aren’t any scientific measures of convertibility risk, it seems like the bulk of it has disappeared since Draghi’s comments in late July. A reasonable guesstimate is that the risk of euro breakup might still be inflating Spanish yields by 1 percentage point and Italian ones by perhaps 0.75 percentage points. If the ECB used those numbers to guide its bond-buying programme, 10-year borrowing costs would drop to 4.7 percent and 4.4 percent respectively. To fall further, the countries would need to take more action themselves.
Although investors are currently relatively bullish about Spain and Italy, they are notoriously fickle. Rajoy and Monti should remember how the good mood, engineered at the start of the year by the ECB’s 1 trillion euros of cheap long-term loans to the zone’s banks, vanished with the spring. What’s more, both are facing tougher political challenges than they did at the start of the year when they were enjoying their honeymoons as new prime ministers. Each of their economies has declined this year and will continue to do so next year – shrinking roughly 5 percent over the two-year period, according to Citigroup.
For all these reasons, it is vital that Rajoy and Monti don’t dawdle. Assuming the German constitutional court this week backs the creation of the European Stability Mechanism, the zone’s permanent bailout fund, the Spanish prime minister should apply immediately for a programme.
Italy, a rich country, should still be able to avoid a bailout. But to do so it needs to cut its public debt, ideally with a vigorous privatisation programme and the creation of a wealth tax. With elections due next April and no guarantee that an effective government can be formed thereafter, there is only a tiny window for action. Monti’s technocratic government needs to jump through it.
The ECB has put its credibility on the line with its new bond-buying plan. Germany’s central bank, the Bundesbank, has attacked it on the grounds that it has come close to breaking treaty provisions banning the ECB from bailing out governments. For now, Draghi can withstand the criticism, as long as Angela Merkel keeps backing him. But if Rajoy and Monti don’t move fast, the ECB’s magic will wear off. And if its medicine then fails, it will be hard to conjure up the political will for an even more powerful concoction.
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How to clean the banking cesspit
Hugo Dixon
AUG 6, 2012 08:29 UTC
Five years after the credit crunch erupted in August 2007, banking still looks like an industry running amok. Scandals keep tumbling out of the closet: an alleged ring of banks including Barclays that attempted to rig interest rates; money laundering by HSBC; insider tips passed by Nomura to its clients; and terrible risk management by JPMorgan, where traders have so far lost $5.8 billion.
True, some of these scandals date from the rip-roaring days of the bubble. And the industry is now being reformed. But the public is growing impatient with the slow pace of change, especially as recession bites in large parts of the industrialised world. Some observers therefore want to clear out the entire old guard. The idea is that only new teams can clean the cesspit. There are also increasing calls to break up banks into supposedly low-risk retail banks and casino-style investment banks. Even Sandy Weill, the man who created Citigroup, now advocates splitting up financial conglomerates.
Something must be done. The financial industry has made a mockery of capitalism. Despite endless bailouts, bankers are still paid far too much. Profits are privatised, while losses get socialised.
The regulatory noose around the industry is tightening. After the credit crunch, there was a global push to jack up capital and liquidity buffers, while reining in risk-taking. If lenders get into trouble in future, the idea is that they will be wound down safely rather than bailed out. Bankers’ compensation is also being modified – for example, allowing pay to be clawed back in future years if there are losses.
This battery of new regulations is putting pressure on the industry’s profitability – and its pay. Banks are reviewing their business models. They are cutting back on proprietary risk-taking, slashing jobs, and even pulling out of some business lines.
The snag is that it will take until the end of the decade for all these changes to be implemented. That’s partly because the technicalities are complex; and partly because policymakers fear that, if they come down too hard on such a crucial industry, their economies will be driven even deeper into recession.
In the circumstances, proposals for wholesale management change and breakups have strong popular appeal. But they are not the best options.
Last month, both Bob Diamond, Barclays’ chief executive, and Kenichi Watanabe, Nomura’s chief executive, rightly fell on their swords. But if everybody with a senior position in a troubled firm departed, novices would be in charge. That’s just too dangerous.
If managers are tainted by scandal, however remotely, they clearly need to go. They must also quit if they are unable to shift their mindset from the money-grabbing culture of the past to the more service-orientated culture of the future or can’t apologise sincerely for the excesses of the past.
These yardsticks should be used to determine whether the managers currently in the firing line – such as JPMorgan’s Jamie Dimon and Deutsche Bank’s co-chief executive Anshu Jain, whose chairman has just cleared him of involvement in the Libor scandal – should walk the plank.
Meanwhile, it is naive to think that breaking up banks would be a quick fix to the sector’s problems. It’s just not true that a combination of investment and retail banking caused the crisis. Plenty of retail-only banks – the UK’s Northern Rock and America’s Washington Mutual, not to mention Spain’s savings banks – got into trouble. And remember: the biggest failure of all was a pure investment bank, Lehman Brothers.
What’s more, breakups can’t happen fast. Given the continued euro crisis, a standalone investment bank such as Barclays Capital would struggle to finance itself in the market. The only way it could survive would be through liquidity injections from the public sector. It might even need to be nationalised. Once these investment banks are shrunk, de-risked and recapitalised, breakups may be possible. But that’s at least a five-year job.
So what should be done in the meantime? Further action is possible on at least three fronts.
First, pay. Capping bonuses, as the European Parliament is proposing, is not sensible as it merely encourages banks to boost salaries. A better idea is to require lenders to pay a big chunk of their managers’ compensation in the form of the bank’s own subordinated debt. If the bank then got into trouble, executives would lose a lot of money. That should concentrate their minds on better risk management.
Second, the industry is under-taxed. The best solution here is not the financial transaction or “Robin Hood” tax proposed by the European Commission. That wouldn’t make the industry safer. Better options are to impose VAT on financial services and require banks to pay a levy to the extent that they finance themselves with hot money – a tax that has so far only been adopted in some countries.
Third, boards have too often failed to hold powerful executives to account. That was a big weakness at Barclays and other banks such as Britain’s RBS. Both regulators and shareholders need to insist that bank boards have more clout.
If the existing regulatory package was supplemented along these lines, some of the public’s indignation would be sated. There would also be less chance of the industry running amok in the future.
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Can Super Mario save the euro?
Hugo Dixon
JUL 30, 2012 08:45 UTC
Can Super Mario save the euro? Mario Draghi said last Thursday that the European Central Bank’s job is to stop sovereign bond yields rising if these increases are caused by fears of a euro break-up. While this represents a sea-change in the ECB president’s thinking, it risks sowing dissension within his ranks. He will struggle to come up with the right tools to achieve his goals.
Draghi seemingly stared into the abyss and had a fright. Spanish 10-year bond yields shot up to 7.6 percent on July 24 while Italian ones rose to 6.6 percent. The high borrowing costs are not simply a reflection of the two countries’ high debts and struggling economies. Investors also fear “convertibility risk” – or the possibility that the euro will break up and they will get repaid in devalued pesetas and liras.
The central banker’s statement that dealing with convertibility risk is part of the ECB’s mandate is therefore highly significant. He rammed home his message, saying: “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”
Markets responded swiftly. Spain’s borrowing costs fell to 6.8 percent, while Italy’s dropped just below six percent. But these yields have to drop below five percent – and stay there – before confidence in the euro project will return. What’s more, it’s unclear what Draghi will actually do.
One possibility, immediately latched onto by investors, is that the ECB will relaunch its programme of buying government bonds in the market. But such an operation would be tough to calibrate. If the ECB was prepared to do whatever it took to drive yields below a certain level, the pressure would certainly be off Spain and Italy. But politicians might then stop reforming their economies. When the ECB bought Italian bonds last summer, that’s precisely what happened.
That’s why Germany’s Bundesbank, which has a powerful voice within the ECB but no veto over its actions, is opposed to bond-buying – potentially setting the stage for a stormy meeting when the ECB governing council meets to discuss what to do on Aug. 2. It’s not yet clear how big a spoke the German central bank will be able to put into Draghi’s plans.
On the other hand, if the ECB made its support conditional on good behaviour, investors might not be reassured. Their anxiety would be heightened if central bank bond-buying pushed private creditors down the pecking order. That’s what happened when Greece’s debt was restructured earlier this year: private bondholders suffered big losses while the ECB theoretically stands to make a profit. A half-hearted bond-buying programme might therefore simply encourage investors to dump their holdings on the ECB while having no lasting effect on Spain’s and Italy’s borrowing costs.
Draghi may think that the two countries’ current leaders – Spain’s Mariano Rajoy and Italy’s Mario Monti – are more serious about reform than their predecessors Jose Luis Rodriguez Zapatero and Silvio Berlusconi. But even the new leaders have shown signs of losing momentum. Rajoy’s latest spurt of action – further budget-tightening and a plan to recapitalise the country’s struggling banks – only occurred because his back was to the wall. In Italy, meanwhile, Monti says he will stop being prime minister next spring. It’s not clear whether his successor will be committed to reform.
For these reasons, Draghi seems reluctant for the ECB just to buy bonds on its own. Rather, he seems to want to do so in combination with the euro zone’s bailout funds, which have the ability to buy bonds directly from governments – something the ECB is banned from doing. One advantage is that Madrid and Rome would have to sign memorandums of understanding setting out their reform plans in order to access the bailout funds. It would then be easier to hold them to their commitments.
A further idea, reported by Reuters, could help deal with private creditors being pushed down the pecking order. Policymakers are working on a “last chance” option to cut Athens’ debt – involving the ECB taking a haircut on its Greek bond holdings. If that happened, investors would worry less about being unfairly treated if Spain or Italy ever needed to restructure their debts. They might then not view bond-buying as the perfect chance to offload their holdings onto the public sector.
The two-pronged approach is preferable to the ECB buying bonds solo. But it would still put the central bank in the front line of rescuing governments. A better approach would be to scale up the euro zone’s bailout funds and get them to do the entire job of lending to Spain and Italy, if they need help. This could be achieved by letting the soon-to-be-created European Stability Mechanism (ESM) borrow money from the ECB.
Draghi should prefer lending to the ESM than buying Spanish or Italian bonds because, if either country got into trouble, the bailout fund not the ECB would take the first losses. Unfortunately, the ECB said last year that extending loans to the ESM would contravene the Maastricht Treaty – a position Draghi himself repeated after he took over as president, even though there are plenty of lawyers who think the opposite.
Super Mario is now warming to the idea of lending to the ESM, according to Bloomberg, even though that’s not part of his immediate plan. If Draghi does this, he’ll have to find a way to eat his words without losing credibility. If not, he will have to rely on second-best options with all their drawbacks. Mind you, it’s the job of super heroes to get out of tight spots.
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Confidence tricks for the euro zone
Hugo Dixon
JUL 23, 2012 09:31 UTC
The euro crisis is to a great extent a confidence crisis. Sure, there are big underlying problems such as excessive debt and lack of competitiveness in the peripheral economies. But these can be addressed and, to some extent, this is happening already. Meanwhile, a quick fix for the confidence crisis is needed.
The harsh medicine of reform is required but is undermining confidence on multiple levels. Businesses, bankers, ordinary citizens and politicians are losing faith in both the immediate economic future and the whole single-currency project. That is creating interconnected vicious spirals.
The twin epicentres of the crisis are Spain and Italy. The boost they received from last month’s euro zone summit has been more than wiped out. Spanish 10-year bond yields equalled their euro-era record of 7.3 percent on July 20; Italy’s had also rebounded to a slightly less terrifying but still worrying 6.2 percent.
As ever, the explanation is that the summiteers came up with only a partial solution and even that was hedged with caveats. Although the euro zone will probably inject capital into Spain’s bust banks, relieving Madrid of the cost of doing so, the path will be tortuous. Meanwhile, a scheme which could help Italy finance its debt will come with strings attached – and there still isn’t enough money in the euro zone’s bailout fund to do this for more than a short time.
The two countries’ high bond yields aren’t just a thermometer of how sick they are. They push up the cost of capital for everybody in Spain and Italy, while sowing doubts about whether the whole show can be kept on the road. Capital flight continues at an alarming rate, especially in Spain. The so-called Target 2 imbalances, which measure the credits and debits of national central banks within the euro zone, are a good proxy for this. Spain’s Target 2 debt had grown to 408 billion euros at the end of June, up from 303 billion only two months earlier. The Italian one was roughly stable but still high at 272 billion euros.
The loss of confidence is harming the economy. Spain’s GDP is expected to shrink by 2.1 percent this year and a further 3.1 percent next year, according to Citigroup, one of the more pessimistic forecasters. The prospects for Italy are not much better: a predicted 2.6 percent decline this year followed by 2 percent next year.
Shrinking economies are, in turn, pushing up debt/GDP ratios. Citigroup expects Spain’s to jump from 69 percent at the end of last year to 101 percent at the end of 2013, in part because of the cost of bailing out its banks, while Italy’s will shoot up from 120 percent to 135 percent. These eye-popping numbers then reinforce anxiety in the markets.
All of this is having a corrosive effect on the political landscape. In Italy, the situation is especially precarious as Mario Monti, the technocratic prime minister, has repeatedly said he will resign after next spring’s elections. The centre-left Democratic Party, which is leading in the opinion polls, is still committed to the euro. But the second and third most popular political groups – the Five Star movement led by comedian Beppe Grillo, and Silvio Berlusconi’s PdL – are either outright eurosceptics or toying with becoming so.
The situation is slightly better in Spain because Mariano Rajoy has a solid majority and doesn’t officially have to face the electorate for three and a half years. But hundreds of thousands of demonstrators took to the streets last week to protest against the latest austerity measures. Pundits are starting to speculate that Rajoy may not last his full term. And if the Italian and Spanish governments can’t carry their people with them along the reform path, the fear is that Germany may no longer support them.
High borrowing costs, capital flight, and economic and political weakness: to escape this vortex, the immediate priority is to get Spain’s and Italy’s bond yields back down. The goal should be to cut borrowing costs below 5 percent – a level that would no longer be that worrying. While most of the ways of doing this have been vetoed by Germany, at least two haven’t.
One is to leverage up the European Stabilisation Mechanism, the region’s bailout fund, so that it has enough money to fund both Madrid and Rome. Neither Germany nor the European Central Bank want to let the ESM borrow money from the ECB itself. But what about lifting the cap on how much it can borrow from the market?
Another option would be for the core countries, led by Germany and France, to subsidise Spain’s and Italy’s interest rates directly – giving back to the southern Europeans part of the benefit they are enjoying from their own extremely low borrowing costs. If they agreed to close half the gap between the core and the periphery, such a scheme would cost around 75 billion euros over seven years, according to a Breakingviews’ calculation. An interest-rate subsidy would also give markets the confidence that Madrid and Rome would be able to finance their debts and so could further lower their borrowing costs.
There would, of course, have to be conditions. In Italy, Monti needs to embark on a second wave of reforms. In particular, he should launch a mass multi-year privatisation programme and a big one-off wealth tax to cut Italy’s debt. But after Spain’s recent plan to clean up its banking sector and further tighten its belt, there is little more to be asked of it.
Germany is right to insist on reforms. But it should balance the stick with a bigger carrot. Otherwise, the single currency from which it benefits so much could collapse.
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Hugo Dixon is the founder and editor of Reuters Breakingviews. Before founding Breakingviews in 1999, Hugo spent 13 years at the Financial Times, the last five as Head of Lex. He began his journalistic career at the Economist. Hugo was a Brackenbury Scholar at Balliol College, Oxford, where he gained a first class degree in Politics, Philosophy and Economics. Before that, he was a King’s Scholar at Eton College. He is the author of the Penguin Guide to Finance and Finance Just in Time. He was named Business Journalist of the Year 2000 in the British Press Awards. In 2008, ...
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