New Regulations for Old Sins

I do not know neither Michel Barnier nor Erkki Liikanen (the European Commissioner for Internal Market and Services and the governor of the Central Bank of Finland respectively), nevertheless I quite like their proposals. Here's what the latter's report stated:

"The group has concluded that it is necessary to require legal separation of certain particularly risky financial activities from deposit-taking banks within the banking group. The activities to be separated would include proprietary trading of securities and derivatives, and certain other activities closely linked with securities and derivatives markets."

I do not know how bankers may feel about this, yet still I believe its a good idea. Not so radical and effective as breaking up the banks into independent entities, but still good. What their proposal would do, is to "safeguard" depositors from banks which are willing to invest in forms of investment banking activities and not just the deposit-and-loan model. This would mean that both states and depositors are safer against any trades which end up bad. (You may ask the now bankrupted Barings Bank, once the greatest bank in the world, what may happen when a trader does something foolish. For a more recent example have a look at Société Générale's losses due a single trader's mistake last year)

Although, to be fair, it was not the traders who caused the 2008 sub-prime lending crisis. It was the banks themselves. Through debt securitization, banks are allowed to lend much more capital than they currently have. (for further details on how this works have a look at this). This would mean that they are more susceptible to prices of the assets they use as collateral than they were before.

The expert committee has also recommended that property lending should be underpinned with larger capital reserves than now and executives should receive part of their bonuses in the form of bonds to ensure that they contribute to any bailout of their bank. What would be even better is a solution Warren Buffett has proposed: No bonuses at all, just loans to the executives to buy ordinary shares. This would tie the executives to their firms, knowing that if the bank prospers they will prosper as well. 

On a different note, Mario Draghi is fighting a growing opposition (notably from the German side) about his OMT plan. Concerns about the feasibility or legality of such a move have been raging since the announcement. (For a review of Draghi's responses and his competitors' comments Der Spiegel has a very interesting article, found here). As for myself, I do believe that the longer we may go without using any of these plans, the better. Time allows economies to move from one end of the cycle to another. Yeah, fine, it may also be the case that they stay where they were or become even worse, but still, this does not seem to be the case with any nation in the EU (maybe except Spain). Although things appear bad now, they will be slightly better in 2013 for most countries (again here I exclude Spain and now Cyprus). Let's hope that Draghi will not have to use his guns to safeguard the Union.

P.S. On the Spiegel article mentioned above I read that people in Germany have a fond memory of the mark. No kidding! I bet the Spanish remember the peseta and the Italians the lira with a certain degree of fondness. And would someone guess why? Well, simply because things were better than they are now before the introduction of the Euro in both Germany and the South. Or at least that's how they remember them to be! They were not reminiscent of the mark 3 years ago when everything was fine.

Incredible Threats?

Yesterday, Yanis Varoufakis presented an article over his concerns about the OMT (Outright Monetary Transactions) program announced by Mario Draghi almost two weeks ago. In the article, Yanis, after depicting the arguments in game theory style, states that if Mario Monti decides to take up Draghi's offer for OMT, then the former would be better off by not enforcing reforms and austerity measures in Italy, because the threat that Draghi will stop OMT operations in incredible. In essence, Draghi will be caught between a rock and a hard place.

Yanis states that it would be disastrous for Draghi to back out once he has agreed to fund Italy (or any other country for that matter) since the result would be that Italy would most likely exit the euro. However, I think that in his analysis, Yanis fails to state three points:
1. Money will not be given as a lump sum as soon as the agreement is signed. What should take place is an instalment-based assistance just like in the case of Greece.
2. Economic theory (and game theory) states that rational people will choose what is best for themselves under certain circumstances. However, behavioral economists have proven that people are not at all like the rational beasts economists perceive them to be. (Paradoxically, economists themselves are not as rational as they think they are)
3. The consequences for Italy if the country exits the Eurozone.

If game theory was right, it would mean that the Greek government would have an incentive to exit the Eurozone and declare bankruptcy as soon as

Persistence of Ideologies

I have been reading Yanis Varoufakis's blog post today and what has stricken me with amazement was how much ideology is affecting economists. As you may read from his post, he is criticizing the newly developed plan for purchasing EU bonds in the secondary market, called OMT (Outright Monetary Transactions), my comments about which you may find here.

In the article, Yanis states that the EU is currently facing a battle between Bundesbank and the private German banks which want to avoid banking integration and the EU leadership
who wants to promote an EU-wide banking regulatory system. The main advantage of this proposal is that "small" countries will not be taken down as soon as their banks face disaster. What is most important is that under a common regulatory framework, all banks of the EU should (at least in theory) be treated equally without any national prejudices.

I may be too optimistic, or too pro-European in comparison to Varoufakis. Truth be told, I do not believe that Greece is innocent of all its sins and the situation there should not amaze us:
If you happened to watch any news about Greece over the last 10-20 years you would see how little trust the Greeks had in their governments, no matter what the ruling party was. Add to this an ideology proposed
by the world's leading economists (i.e. Friedman, who I am sure is laughing gaily now since he did not believe a monetary Union could be achieved in Europe) and what we get

ECB Announcement and Criticisms

On Friday, markets around the world were soaring as a result of the European Central Banker's announcement on late Thursday.  This came as a surprise to many, and they rushed to rejoice by raising stock market worldwide. Soon after the announcement, critics of the decision began to appear. Their criticism was expressed in three points:

1. The ECB is removing responsibility for fiscal reforms and austerity measures from the crisis-ridden countries because the bond buying program threatens to relieve the pressure of cutting expenses and deficits.

2. The ECB will flood the economy with money and risk higher inflation and a devaluation of the currency.

3. The Bank will violate its mandate because it will be effectively financing states, something which it is prohibited from doing under current European Union treaties. This would as a result endanger the ECB's independence.

Point 3 is, in my opinion, a matter of technicalities concerning EU Law. The ECB is not allowed to finance Member-States through the primary market, however, the treaty does not forbid it to do so in the secondary market. As for the independence? Well, the ECB did not have much to begin with. If by linking to the ESM the Bank will be made vulnerable to Member-State pressure, then all the ECB has to do is stand its ground and not allow any deviations from what was originally planned. Pressure will not mean a thing if the ECB does not succumb to it. And it has what it needs not to do so. Besides, the Federal Reserve in the USA has been pumping money into the economy over the last 70 years and no one has ever questioned its independence.

Point 2 is an overall policy issue. Fact: If the ECB issues money then inflation will rise. Thus, what the Bank has to do is issue money now and retract it later on. Or, issue money now and delay further issuing in the future until a sustainable, low level of inflation is achieved. I will not be the one to propose anti-inflationary policies to the Central Bank. That is what they are supposed to do better than anyone else. They have done good so far and I suppose we should allow them to do so in the future as well.

Point 1 is the most important of them all. By buying bonds directly, the ECB does promote some sort of moral hazard. Countries will not be so inclined to promote austerity measures and reforms if their bonds will be bought by the ECB. Nevertheless, the ECB has clearly stated that the plan will only assist those nations which have already applied for a bail-out and reforms as well as austerity packages are already on their way (and their bonds are not considered as "junk" by the three rating agencies). The ECB must make a strong point that without reforms and spending reductions no such help will be issued. Otherwise the critics will be right: nations will not do anything to fix what is broken. 

The announcement was a relief to both markets and nations. The ECB will, after a long waiting, play its card and assist in rebuilding confidence in the markets. As Draghi has stated: "The Euro is Irreversible"

A change in mentality?

Over the last week a serious change in attitude towards ailing countries within the EU has occurred. Leading with Chancellor Angela Merkel, the political scene in Europe has witnessed a 180 degrees turn. The change was so radical and impressive that Der Spiegel has published a full article on this. This could mean one of three things: 

1. The South has made real progress over the last month (hmm or week maybe?).

2. Merkel has understood that her policies and stance are making both her as well as Germans in general extremely unpopular in Europe (and elections are coming up in a year).

3. She has accepted that trying to push through many things very rapidly is not such a great policy after all.

Whatever the reason may be (Spiegel states that it's No2) the fact is that leaders now appear to be more united than ever before. Even statements of the "Greece should leave the euro/Union" kind are treated coldly by EU officials now. Still, as progress for unification in the political level appears to be improved the economy still fails to recover. Italy, just like Spain and Greece, has seen unemployment rates soar over the last months. While Mario Monti is doing his best to improve the overall economy, unemployment of youths under 25 has reached 40%. And with recession here to stay in Italy (forecasts expect GDP to contract by 2% this year) the situation does not seem to improve. 

European leaders fail to understand that people cannot live on GDP. After an EU-wide summit on unemployment nothing seems to have changed: the employed have not (cannot?) find anything to do about the jobless. I have proposed my set of ideas over reducing unemployment here, and while the list I have presented is not exhausting nothing has been done yet. Just as I have predicted, the EU will face a recession over the next few months. New evidence indicate that the recession will be far worse than we expected. The Purchasing Managers' Index (PMI) for the Eurozone predicts that the output will shrink by 0.5-0.6% over the current quarter instead of the initial 0.2% prediction. 

The worst part of these forecasts is that the EU's safest economy, the one where people actually paid to invest their money, Germany, is bound to move to the red. The OECD predicts that although Germany has grown by 0.5% and 0.3% in the first two quarters, in the following two an annualized contraction of 0.5% and 0.8% is expected. Only France may be able to remain more-or-less unscathed with output falling this quarter and rising on the next.

In addition to all these, Mario Draghi has announced a program allowing unlimited purchases of sovereign bonds in the secondary market, in order to keep interest rates at sustainable levels. The only opposition to this program is Bundesbank head Jens Weidmann who believes that the program is too close to state financing through the money press. He may be right up to a point, however, I do believe that the program is much ado over nothing, The problem with what Draghi has proposed is that the ECB will only assist countries that appeal for help to the euro bailout fund and submit to the required austerity conditions. What he also meant is that the ECB would only be able to do this for nations which are not considered as junk by the 3 rating agencies (Moody's, Fitch, S&P), i.e. Greece and Cyprus cannot be assisted.

Thus this leaves only two countries: Italy and Spain. However, the announcement failed to mention the amount which would be available to fund this action. Given the size of the Italian and the Spanish economy, it would have to be enormous. Yet, we are still unaware of the size and extent of the intervention and it would be nice to know some more details about it instead of the general idea.

In the meanwhile, what journalists have not yet proposed is that another reason of Merkel's newly appeared empathy towards the crisis-ridden countries maybe be that she is preparing to identify herself with the rest of the ailing nations if OECD forecasts are true. We will just have to wait until the official data is published to find out.

Welcome Recession

Yesterday, Eurostat published a news release concerning the GDP data of the Eurozone countries, compared to last year's. Not surprisingly, the results were that Greece's output shrunk by 6.2%, Spain's by 1%, Cyprus's by 2.4%, Italy's by 2.5% and Portugal's by 3.3%. Even in the UK, output was reduced by 0.8% compared to 2011. The only surprise was France, which avoided recession (which is measured as two consecutive quarters of negative growth) by reporting a 0.0% change compared to the previous quarter.

Germany's GDP on the other hand, rose by 1.0% a change attributed mainly to an increase in exports and domestic consumption, as investment levels have fallen. In general, GDP dropped by 0.2% both in the EA17 and EU27, while in the previous quarter it had remained stable at 0.0% change. What does this mean? Well essentially, if the next quarter is one of negative growth, the EU will officially be in recession. And I am almost certain that there will be negative growth in the next one.

That is, unless Mario Draghi (or any other EU official) decides to do something about this. By something, I mean effectively use his power as the ECB governor and buy bonds directly, which would boost investment and restore confidence in the region, something that he directly stated that the ECB could do in the future. I hope that Mario Monti's statement that "we have to reach the night before the euro collapses in order for the ECB to do what it has to do" proves to be wrong. I really hope that the officials will come to their senses before it is too late and large-scale measures to save the Eurozone have to be devised. 

Nevertheless, I do think that another quarter of negative growth, moving the EU in the recession zone, will be their wake-up call. We are humans, and like human beings most of us have do not care as much about the future as we do about the present (talking about German policies here; to be accurate it's just Merkel policies as many in Germany oppose her actions). In order to change ideas and mentalities we have to be convinced that things are going bad. Entering a recession will do that kind of convincing.

It seems that "smart" people need to wait until the very last minute to be convinced that their policies have created more chaos rather than reconstructing the Union. That is why an EU-wide recession is needed and, unfortunately, we are going to get one. Just wait until the next quarter.

P.S. The only person acknowledging what the bailed-out countries have done is Olli Rehn in one of the best articles I have read about the Eurozone. One cannot wait until September Olli, in order to see whether the ESM will be able to recapitalize banks directly.

Unspecified Policies

Over the history of mankind, whenever politician wanted to speak in presence of the public, their words spoke of broad generalizations on the subjects they were to address and accusations towards their political opponents. Over the centuries this kind of talking was (and is) the norm of political conversation. However, since the beginning of the 20th century, and due to the increased exposure to information mankind has obtained since then, people have started to catch up with them and demand specific answers to specific problems. Unfortunately, politicians (and policymakers as well) are yet to live up to these standards. 

There are only three possible explanations about this phenomenon: 

1. They think that by dizzying their audience with excessive verbiage will make the latter think that they know their stuff

2. They really don't have any idea about a subject and the only way not to look stupid would be to speak in broad generalizations (which would be fine as long as they only did it on a few subjects. Being excessively general means that they either No.1 or No.3 is true or hmm they have no idea about any subject at all!)

3. If they give a specific solution to a specific problem people will expect them to enforce what they propose.

Studies have shown that people respond better to politicians and policymakers who propose specific solutions to specific problems. From my point of view, being specific help people understand how the policy will affect them and even improve it by direct communication with the policymaker. This helps avoid the three I's as stated in Poor Economics: Ideology, Ignorance, Inertia. Specific policies lead to more votes for politicians and more credibility for policymakers.

It is thus not strange that Draghi-type statements ("the ECB will do everything to save the euro") are not very popular. "Do everything" does not mean anything at all. What is everything? Does it mean stand still and wait as it all breaks down? Does it mean financial aid to banks? Does it mean new plans for a Greek haircut? It could mean anything. Or it most probably means that they have no idea of what to do and just hope to boost financial markets by statements. Guess what guys: Markets (and everything else in REAL LIFE) don't go up in words, only in action.

The Big Bang Policies

It has been noted that the Troikans are in favor of rapid changes in bailed-out economies, a policy that has been very cleverly been dubbed "big bang solutions". The same policy is to followed (or at least Troika intends in following it) in Cyprus. As if the consequences in Greece are (unfortunately the past tense cannot be used here) not a great example of what these rapid changes can cause. It looks like some people never learn from their mistakes.

The Wall Street Journal hosts an interview by Mario Monti, with the latter stating that he is certain the ECB will do what it takes to save the euro, the night before it disintegrates. He wonders: Do we have to reach that night before the ECB does something? For me the answer is obvious: Yes Mario we do. The crisis has began to spread amongst the EU countries which were so far resilient, like France which is expected to witness a 0.1% contraction of GDP in the third quarter of 2012, while expectations were that a 0.1% contraction would have occurred as well in the second quarter. Two consecutive contractions and then welcome recession!

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The same holds for Germany which has witnessed both imports and exports declining and is hoping that demand from emerging markets will offset the fall in demand in the EU. German GDP is expected to rise by 1% in 2012. I wouldn't be surprised if that proves to be an optimistic estimation. Even politicians in Germany have started to doubt whether the policy Angela Merkel is pursuing in the EU is a rational one. The next Federal Parliamentary elections in Germany are to be held in September-October 2013. If Merkel is defeated then a new Chancellor may have different views on the subject. Can the euro last until then without any assistance? Most likely not.

Mario Monti said yesterday that high lending costs reflect not only the economic situation in a country, but the fears that the euro will collapse. In addition I believe the markets also fear that the country might leave the euro. Unfortunately, Super Mario is right, although he may not be able to save his country from bankruptcy. (Thank 8 years with Mr. Bunga Bunga for that) If the ECB does not intervene to lower borrowing costs in the South, we may be talking about a euro collapse in the next year. And to think I am mostly an optimist!

What I would love to see is Draghi take some action, and Merkel leaving him alone to act. Holland has been strangely quiet over the last month or so, which makes me wonder whether the "anti-austerity" policies he claimed before the elections were just the usual political promises.

The Politics of Credibility and Inaction

In the postscript of my last article I noted that the difference between theory and action is the difference between masturbation and sex. This was amply proven in yesterday's press conference where Mario Draghi has said that doing whatever it takes (to save the euro that is) might take weeks or months. On hearing this, world markets started moving downwards. It now seems that the ECB governor has found out the hard way that when officials with perceived credibility and a certain position of responsibility say something important, people and thus markets believe them.

Now, Draghi can say goodbye to his credibility. Who will believe a leader if all he does is promise and never deliver? Especially if the specific leader holds the key for reversing the situation in the Eurozone. In response to the recent developments even Obama started making comments about trusting the EU leaders to do what is right (hmm I wouldn't bet on that Barack). His Secretary of the Treasury, Timothy Geithner, (the guy who tried to sell his house in the midst of the sub-prime lending crisis. Now if that isn't being optimistic I don't know what is!) even came to Europe to meet with EU officials. Indecisiveness in the EU can be spotted all the way across the Atlantic and they expect us here not to notice it?

While in Europe, Tim met with my friend Wolfgang (Schäuble that is) and urged him to take immediate short-term measures to support Spain and Italy. (Obviously the Americans don't really care about Greece or Cyprus. Well if they were thinking straight they would. Here is why). Both stated that they have confidence in the member-states efforts. To be honest, I believe Tim, it's Wolfgang I do not trust.

The Germans have a history of seeking financial stability and a low inflation said Tim. I do not think that anyone would disagree on that. It's a wonderful policy and it should be pursued. Nevertheless, it should be pursued when the economic climate allows you to do so. The delay of significant measures to halt the recession will only worsen the situation. (If you don't believe me read about what happened to the Americans during the Great Depression in the early 1930's and during the same period in the UK when policy makers did not want to abandon the gold standard.)

In the end, it all boils down to credibility. A man of higher standing such as Draghi cannot make any statements concerning policy and then try to avoid implementing them. People lose their credibility much faster than they can regain it. It seems that hordes of economists all over the EU have forgotten the consequences of the non-credibility of Central Bankers. The same problem holds throughout Europe. Think about any government. Who would you believe if they said anything concerning policy? Governments in Cyprus and Greece stated that they would not need any help in overcoming their financial strains only days before applying for help. There only two kinds of officials in Europe that I would trust (of the ones involved in the crisis I mean. I have nothing against Scandinavian, Dutch or Austrian governments which are one of the most stable economies in the world): the Germans when it comes to denying any help (and not in saying that they will do anything to help the Euro) and Mario Monti who seems never to say more than is needed.

However, with credible or non-credible leaders the need for decisions remains. In a world where inertia and idleness do nothing but wrong, we have to able to move fast and without hesitation when needed. If it takes 10 summits and 100 voting procedures every time the ECB wants to pass and implement a plan of action then we are going to be forever lost in a bureaucratic troubled ocean.