The Original Sins: EU's entry decisions

Once upon a time there was a continent, which was made up by 50 countries. One day the countries decided they would benefit from being united instead of fighting each other thus they formed a Union which they soon thought would be able to issue its own currency; one which would work in all of these countries and become one of the leading currencies in the world. But who would enter? They couldn't just let anyone in so some rules had to be made. Thus, they thought of the easiest task: you wouldn't be able to join the currency area, unless your public debt was less than 60% and your government deficit was less (or very close) to 3%. They even formalized this by signing a treaty in a smallish town somewhere North.

The problem with this treaty was that it was too rigid for its own good. By the time the new currency was brought to the markets, many of the countries wanted to join the whole charade and play with the big boys but couldn't. The reason was that they were constrained by 3-60 rules of the treaty. Why should they want to enter ans lose the enormous power of issuing their own currency one might ask. The reason was simple: it was better than the one they had until then and it opened the door to numerous opportunities for growth. Up until the initiation of the common currency the countries which wanted most of all to enter the Union and could not grappled with high inflation and perpetually-depreciated currencies. For example, three of the countries wanting to join the currency Union had an exchange rate of 166.386, 353.101 and 1,936.27 to one with the common currency*.

However, those countries really wanted in. But what could they do? Their public debt was more than the 60% limit and their deficit exceeded 3%. There was no real way to reduce the debt by issuing new money as that would mess with the exchange mechanism they were tied to, given their willingness to join the Union. Thus all there was to reduce was the deficit; but which politician would be willing to and announce a reduction in spending and risk sacrificing his chair to the altar of joining a Union? The stakes were too high for such actions. Still, they had promised their voters (and their voters really wanted it) that they would join the Union.

Being mostly politicians and bureaucrats they had no idea of what they could do. Thus they invited the big investment bankers for advice. The latter, known for their quick wit, eagerness to solve a problem they will receive a big compensation and willingness to find loopholes in legislation found a simple solution: they would be able to reduce the deficit using a Swap. In a swap, two counterparts change cash flows, usually in order to reduce risk. In this case, the supposed risk was the exchange rate since there was a bond issue in Japanese Yen. The following graph shows how a swap should look like. Note that these sort of swap transactions were legal and approved both by the sovereign's central bank as well as the Union's.

Source: ZeroHedge

Yet, this is not how the transaction went on. What the investment bankers did was increase the one-off final payment and make the payment coming from the sovereign borrower negative. In simple words, the country was receiving the fixed payments in yen and was again receiving payments at the time it was supposed to pay. The following graph illustrates what happened:

Source: ZeroHedge

Why would they do this if the payment in the end was huge the reader might ask. Remember that the country had no intention of reducing its debt since it could not do it in short notice; it was aiming at reducing its deficit. Using the above swap, the country was receiving two payments from the bankers which meant that first it wouldn't have to pay any interest thus reducing the government deficit and second it was getting money back and it could either repay outstanding loans or use it to show further budget improvement. The country did both. And this is how it fared:

The bond was issued in 1995 and the swap took place in 1996. Note the impressive decrease of government deficit as a percentage of GDP from 1996 to 1997 by 4.3% to within the limits of the 3% rule; something which lasted until 2002, the year when the common currency was introduced to the public (although to be fair, the specific swap expired in 1998). The strategy was so successful that it soon found imitators: others sought to find the magic deficit-decreasing swap. In 2001, Greece tried the same and somehow it worked in allowing it to join the Eurozone:

But things didn't work out as planned by the Greeks: by the time they signed the deal, they were already 600million more in debt than the originally planned 2.8 billion to be repaid. The perils of secret negotiations and under-the-table agreements came up in 2009, forcing the country to require a bail-out. Not that Italy is doing any better now but having a stronger economy can assist in overcoming recessions faster.

The author of "Derivatives and Public DebtManagement", Gustavo Piga (the person who unearthed the story about Italy) suggests that secret treaties are just a way of exploiting the taxpayer. The problems in the Eurozone have not arisen because of some secret agenda or as a result of a global conspiracy. They were there to begin with. Neither Greece's nor Italy's debt management practices were ideal and those who allowed them in the Eurozone knew about this (even Eurostat was to to blame since it had knowledge of the fact according to ZeroHedge) and chose to close their eyes. Evidence of mismanagement were there: just look at the exchange rates of the three countries mentioned earlier. 

The accumulated sins of the Eurozone structures were bound to come and haunt us. They just did sooner than anyone expected. If there is a moral to this story it's that in economics, when you do something bad it will come back and hit, just like a boomerang. But that was not what the Italian and Greek authorities thought when they made the swaps. Too bad; for their taxpayers that is.

*Spanish peseta, Greek Drachma and Italian lire respectively.

Youth, Politics and Incredibility

European Leaders on Vacation. Can you spot a young one? Picture Credit: Euronews

 Recently, the Cypriot Ministry of Finance had reevaluated its estimation on the country's fiscal deficit. The new estimation assumed that the 2012 fiscal deficit would amount to 4.5% of GDP, instead of the 3.5% it had originally announce. Now, as the negotiations with Troika are supposed to come to an agreement, new evidence show that in the January-September period of 2012, fiscal deficit amounted to about 3.27% of GDP, instead of 3.08% over the same period in 2011. Note: 2011's deficit reached an astonishing 6.3%.

Although I have credited incredibility as the main source of trouble for most of the EU-periphery, it looks like no-one has learned anything about what I have been saying for months. It is a political tradition in the South to promise things you cannot deliver. And people have always known about this, yet the times when they actually chose to do something about it were extremely rare. People, especially politicians, have very short memories. It looks like they cannot even remember what they promised, promoted, supported last week if this goes against their interests. The worst thing about this situation: People always followed and supported them.

It is really annoying to find people nowadays who are still blinded by ideology. And ideology based on what? A politicians ideas and slogan? I am not at all against believing in people. Far from it. But following people, and especially obsolete political parties, blindly is what got us to this situation. 

People (especially the young) do not believe (much less trust) their governments anymore. Why should they? What has changed over the last 10,20 or sometimes even 30 years? Just the faces. The same ideas, the same persistent ideologies, the same arguments we have heard for thousands of times over the course of our lifetime and that we have grown so accustomed to that we have even stopped paying attention to what they say. 

Why? Because all they do is talk. Assigning blame to one another, talking about what should be done, about what they should have not done, talk, talk, talk. As for action: none.

I do not know whether they have heard that actions speak louder than words. Well, they do really. Most of the people in the EU are now looking at their governments with mistrust. They know they supposedly are there to serve them but what do they do: they serve themselves. 

People in governments, especially those older than 50, are still reminiscing of a time where the world is not as it is now. When they could promise and not deliver, when incompetence did not matter, where people believed and admired politicians in spite of their inability to rule. Well, this is over. The world moves forward and it seems like they are getting left behind. 

It is not just them, however. It is their voters as well. People who are of a certain age, who are too old to protest, to do anything else but work. People who did not have the same access to information and world events, like we now do and who are too stubborn to change their mind, not because they have some good arguments for their beliefs, but because having those belief has so defined them that they can no longer change.

From what I hear, you have to be at least 25 years of age to be elected in the parliament, and over 35 to be elected as a Prime Minister/President. Yet, the majority of nation leaders are much older than that:

• Mariano Rajoy - Spain: 57
• Mario Monti - Italy: 69
• Antonis Samaras - Greece: 61 
• Demetris Christofias - Cyprus: 66
• Pedro Passos Coelho - Portugal: 48
• François Hollande - France: 58
• Angela Merkel - Germany: 58 

In comparison, Sweden's Prime Minister was only 42 when he was elected, Denmark's was 45 as was Norway's. Even more impressive, Finland's Prime Minister, Jyrki Katainen, was just 40 years old when he was elected in 2011, having before been voted as the best Finance Minister in Europe by the Financial Times in 2005, when he was just 34.

I would not support that every young person is better than any older person. Yet, as you may see from above, the political scene in the South needs immediate youthification. And this are just the ages of the nations' leaders since I could not get my hands on the Parliament's average age or the average Cabinet age in each country . I am sure that we will find that most of them are near (if not) retired as well.

The problem is not so much age as persistence to a failed system and false (or belonging to a different age) ideologies. Youths usually lack experience yet they more than compensate for that with drive, determination and the belief that they can change the world. As the older generation sits back, protesting in their armchairs that the world would never change, the youth try to make the change. 

The young ones do not possess the pessimism surrounding most of the older generation. They start life with enthusiasm and will to achieve something to make the world a better place. Yet, due to this political mechanism under which politicians are elected only when they reach retirement age, pessimism and inaction are substituted with more pessimism and inaction. 

The situation reminds me of a George Bernard Shaw quote (although a bit modified to suit the situation):

 

The old look at the world and think "Why?" while the young look at it and think "Why not?".

Fiscal Plans for the EU Members?

Although it just recently came to my attention, Angela Merkel had proposed a "Fiscal Plan" for preventing excessive debt burdens since December 2011. An example of her proposals is that each country should limit its fiscal deficit to about 0.5% of its GDP. In the case of deviations from this rule, fines should be imposed to the nation. In response to this, Luxembourg Prime Minister Jean Asselborn gave an interview to Der Spiegel  stating that the plan was a "waste of time and energy."Agreed. However, what is more important here is not that strict rules are imposed. Is what happens when they are not obeyed.

Budget Surpluses or Deficits of PIIGGS. Source: Wikimedia Commons

As many of you may remember, there was (and still is to my knowledge) an agreement between the EU nations called the Stability and Growth Pact. This was implemented in 1998 and it became famous for stating that no fiscal deficit should be greater than 3% and no government debt should be more than 60%. This pact was a German initiative by the mid 1990's. You can guess who were the ones to first break the pact: Germany and France. Yet what happened? Any fines, any rebukes? Nothing whatsoever. 

Earlier this year, the European Commission threatened to suspend subsidies for Hungary. Shortly thereafter, the nationalist Hungarian prime minister, Viktor Orbán, gave in to Brussels' demands, obviously considering the fact that 97 percent of all public investment in his country are financed to a significant degree by the EU. The same situation could happen to Cyprus, Malta, Greece and other small countries. Nevertheless, such measures cannot be implemented in countries like Germany, France, Spain and maybe Italy. Specifically, Germany did nothing over the last month to promote suggestions by the EU for reforming the tax-splitting provision for married couples and Spain has remained obstinate to change its tax policy. Even small countries like Cyprus, Belgium and Luxemburg have opposed to suspending automatic inflation-linked wage increases and Malta has refused raising the retirement age.

The EU now tries to water down Merkel's pact, which, inter alia states that if the European Council, is of the opinion that a debt-ridden member state "has not taken effective action to correct its excessive deficit," it can impose a fine amounting to 0.2 percent of GDP. I would like to see the day when fines are imposed to countries like Germany and France. Yet somehow, given the current situation, I do not believe that it is possible.

Most of the EU leaders proclaim that we need more Europe and more integration rather than less Europe. I couldn't agree more. In an excellent article in The Expositor, Daniel Cohn-Bendit and Guy Verhofstadt have stated that "With a European State, we would have a European government, a European Parliament (2 chambers), a European passport, maybe even a European army (it would enable to cut Defence spending)." These are the issues that have to be addressed by the EU. It is impossible to have a common policy with just common stability pacts and common fiscal policies. European integration is not implemented through economic integration, although hopefully this may lead the way for a whole new spectrum of policies covering not just the economy but the whole of European activity. We have reached a point where we are either united or divided.

P.S. On the same article Daniel Cohn-Bendit has commented that “European enterprises participated in the corruption in Greece: other countries benefited from the high Greek defence spending, so they said nothing”. This brings a whole new perspective to the situation does it not?

Greece's Progress

Many are always accusing the Greeks for the situation their country currently faces and their lack of action for the persistence of financial problems. However, a recent IMF study begs to differ:

As you many see from the above table (it is also in page 93 of the IMF study) Greece's primary deficit is expected to be 1% of GDP this year (i.e. 2012), move to an 1.8% surplus in 2013 and having surpluses until 2030. This would mean that over the next years, Greece will essentially be paying its existing debts, without having any deficits other than the repayments! Gross refinancing needs will drop from 34 billion to 14 billion over the next year meaning that it will essentially take much less money to refinance debt. 

However, the need for debt restructuring may occur, as it is expected to reach 167% of GDP this year. At least this time, I hope that the troika decides better than hair-cutting the debt again! (for an alternative solution to the Greek haircut read this). The Greeks have suffered through severe austerity measures too rapidly, which forced the country's GDP to contract vastly and that is why the debt burden as a percentage of GDP has increased so rapidly (allow me to explain. If debt is 100 and GDP is 100 then debt is 100% of GDP. If the GDP contracts - as is the case with Greece - to 80 then the debt would be 125% of GDP)

The 2.5 billion they are currently requesting is nothing compared to another haircut (or worse a default) which would make financial markets (and especially banking institutions) even more chaotic. European leaders seem like impatient children, who want to see debt reduction and positive growth from one moment to the next instead of thinking that such a procedure requires much more time.