Eurozone Debt Deal – Still Not Enough

The Eurozone have come up with a deal, which will stave off the markets for a few days. Indeed, the markets, led by the Banks, whose shares have soared, has risen very sharply on the news. But, as I have set out previously, the measures announced, and sums of money involved, are nowhere near enough to actually deal with the problem.

The main reason the markets seem to have rallied is that, at least, the core Eurozone politicians appear to have begun to act in, something approaching, a co-ordinated manner, and the main idea, that what is required is the establishment of European fiscal and political union, seems to have been taken on board, and is being discussed openly. The markets realise they cannot bring it about immediately, but seem prepared to give them breathing space, provided this is seen as the first step along the road to it, and the solutions actually required.

The general terms of the deal had been well signalled in advance. There is €450 billion in the EFSF bail-out fund. However, after what has already been committed, only €250 billion of this remains. This is not even adequate to bail-out all of Greece's debt, let alone the debt of Spain and Italy, who are the main concern for EU leaders, fearful that contagion could spread to them.

€2 trillion would be required to cover all of Italy's debt alone. So, what is proposed is to use this €250 billion, essentially as security, against which to borrow additional funds on the world market. Some of the additional borrowing will be provided by EU Government's, but with this security essentially being backed by Germany, the idea is to borrow large sums of money from investors such as China's Sovereign Wealth Fund. There are some weaknesses with this, which I will come to later.

The second part of the plan is for the private Banks and Finance Houses, that lent irresponsibly to Greece, to have to pay the cost for their bad decisions. They have agreed – after Merkel threatened them with losing all their money via a complete collapse of Greece – to write off 50% of the money they lent to Greece, and have also agreed to do this “voluntarily”, thereby not triggering a “credit event”, which would have meant that claims against Credit Default Swap insurance would be made. Although, the Banks, that made the loans, would be able to claim, against any CDS they had taken out, there is an incentive for them not to do so, and to agree to a voluntary haircut. That is because, as was seen with the Sub-Prime Crisis, these CDS are bundled into other investment vehicles, which are traded on Capital Markets.

Indeed, it is possible to buy a CDS even against loans you have not made. In other words to gamble that someone else's loan will go bad, just like betting on a horse race. Consequently, no one really knows what the total value of these CDS, and related derivatives is, who owns them, who will be liable for paying out on them, and so on. So, any Bank or Financial House that has been involved in trading these derivatives could find that it has counter-party risk, or that the Bank that might be due to pay it, will be driven out of business itself. Although, the amount of money written off by the Banks seems astronomical to most people, it is not that large – for Deutsche Bank, equal to only half its profits for last year – and certainly not worth the risks that a full blown global financial crisis would represent. There are also problems with this part of the plan that I will return to later.

The Third part of the plan is that European Banks have to recapitalise themselves, that is they have to increase the ratio of their assets to the amount of loans they make. It is intended that the Banks will do this by selling more of their shares in the market to raise additional capital. They have to raise the amount of their Tier 1 Capital to 9%. Some of the Banks have said they will do this by reinvesting some of their huge profits rather than paying them out as dividends to shareholders. However, it seems that many Banks will achieve the same result not by increasing their Capital, but by reducing the size of their Loan Book i.e. lending less money, and calling some of their existing loans in. This is particularly likely in the case of small Banks such as the Spanish Cajas, or Regional Banks. That is because they do not find it easy to raise Capital by selling shares, and they have already had their credit ratings downgraded. The Spanish Government is trying to bring about mergers amongst the Cajas, but largely without great success. It has also tried to get the Spanish Banks to take them over. The Big Spanish Banks have an incentive to do so, because the Cajas have borrowed large sums from those Banks with which to finance their activities.

The problem is that those activities have almost exclusively been to finance the huge Spanish property and construction bubble of the last 20 years! If the properties, against which these loans were made, were valued at realistic prices, many, if not most, of the Cajas would be insolvent, and the crash in the Spanish property market, so far, would seem like just a small blip, as loans were called in, and properties foreclosed upon. That would then hit the Spanish Banks who were the originators of the finance to the Cajas. So, the Spanish Banks will have an incentive to take over the Cajas if necessary, in order to try to keep that bubble in the air for a while longer.

But, international Capital markets are not completely stupid, which is why the Spanish Banks have themselves been downgraded by the ratings agencies. If they took over a load of bankrupt Cajas, they would see their Credit Rating reduced to junk, and that would inevitably mean the State having to come in to nationalise them. But, Spain has had its credit rating reduced several times. Even with the ECB stepping in several times over recent weeks, to buy up Spanish and Italian Debt, the Spanish 10 Year Bond Yield has risen again to 5.5%, and Italy to 6%. This is where the other problems with the plan become important.

Firstly, France had wanted to ensure that, where any national Banks needed bailing-out, as described above, then the money, to do this, would come from the EFSF directly. France also wanted to ensure that if the EFSF could not raise the necessary funds on international markets, then the ECB could step in to simply print money to cover the difference i.e. Quantitative Easing of the kind already undertaken by the Federal Reserve in the US, and Bank of England.

Germany opposed this. So, the deal currently requires national states to bail-out their own banks, and then, if this state requires a bail-out, the EFSF will provide the funds to the State. You only have to understand the consequence of this to see, why Germany wanted this course.

Most of the Banks, that are likely to need bail-outs, are in countries that themselves are in a weak position. Although, this means primarily Greece, Portugal, Spain, Ireland, and Italy, it also now seems likely to include some very big French Banks, that lent on a large scale to Greece. The problem for France is that for several months the credit rating agencies have been looking at the possibility of withdrawing its Triple A rating.

If it had to bail out one or more of its major banks, it would probably tip it over the edge, causing its sovereign debt to be downgraded. That is not to say that it would be placed in the same position as Greece, or any of the other peripheral economies, but it would mean it had to pay more for its own borrowing – the Yield on the 10 year OAT has already risen sharply – and it would mean that France's standing in the world would be diminished. With a determined move towards a greater centralisation of power within a core Europe, on the way to the establishment of a United States of Europe, this would further strengthen the position of Germany.

But, although its clear why this is in Germany's interest, in the short term, it is not in the interest of providing a longer-term solution for the Eurozone, and, therefore, is not in Germany's longer term interest either. Ultimately, Germany is the back-stop for all this funding, so it is in its interests that the immediate costs of financing are kept to the lowest possible.

Having each country continue to raise money, in the Capital Markets, with the EFSF only acting as a guarantor, does not achieve that. The real solution is for the issuing of Eurobonds, by a central European Debt Management Office, as every other state does. It can then dispense these funds to the member states accordingly. Because this debt would be issued by the whole Eurozone – i.e. directly rather than proximately backed by Germany – the interest rate on it would be much lower than any of the other individual countries could borrow at.

Germany will not currently agree to this for two reasons. Firstly, Merkel might get such a proposal through the Bundestag – because the SDP and Greens support Eurobonds - even if some of her own Party and Coalition partners would vote against it – but would probably face a backlash from the conservative supporters of the Government at the up coming elections. Eurobonds, will be introduced, and Germany will support it, but, she will let the next Government push it through. Secondly, it would be stupid, and very bad negotiating tactics to simply offer it up to other EU countries at the present time. If a new United States of Europe is to be set up, Germany wants to ensure it has a major role within it. Italy is in a weak position, and has a joke for Prime Minister. France remains strong, and has for the last couple of decades been drawing closer to Germany, but it remains in competition. But, France's economy is not as strong as Germany, and if its credit rating is downgraded it will be in a weaker position still. Germany is in the driving seat. Britain, of course, as I wrote the other day, has excluded itself from the proceedings, and is heading towards irrelevance, as even the UK media seems to be recognising.

Germany wants a United States of Europe, and will settle for some measure of fiscal and political union as a step towards that. But, it wants it on its terms, and “he who pays the piper calls the tune”. A small part of the agreement increases the extent to which each country will now oversee, and control the Budgets of other countries. That is an essential element of the conditions that Germany will want. If ultimately, it will produce the deficit funding for a European State, it will want to have control over those Budgets, and to have some say in how the money is used for investment to increase growth in each country, so that the need for such deficit funding is removed.

The basic ideas of the plan have been seen before in some elements. In the 1980's, as the Asian Tigers grew their economies rapidly, they borrowed huge sums of money from western banks and finance houses. So long as they could continue expanding and selling their output, this could continue. Moreover, alongside the economic boom, went a property boom, as easy money went into blowing up asset price bubbles. In fact, the experience of Ireland has been probably closest to this.

When the crisis blew up, the IMF stepped in to provide financing. The Asian economies then used this to clear their debts to the western banks – which was the real reason the IMF had intervened in the first place. Then they pulled out, sending the economies into a major deflationary downturn. However, and again Ireland is similar here, the money that had gone into these economies had not, by any means, all gone into property and other asset bubbles. Real investment, and productive capacity had been created, which then laid the basis for those economies to grow strongly on a sounder financial basis.

That is largely what has happened here. Over the last year or so, large chunks of Greek debt have been transferred out of the hands of private banks, and into the hands of state bodies, including the ECB. That is why the Banks can be persuaded to exchange their worthless Greek Debt for other debt provided to them with only half the face value. In fact, as far as Greece is concerned, the deal goes nowhere near dealing with its problems either in the short or the long term. Even with this write-off, of its debt, its debt to GDP ratio will only fall to 120%, which is impossible to sustain. But, for that reason, it does absolutely nothing to deal with its larger problem, which is the need to restructure its economy, so as to be able to pay its way.

What is required for that is for measures to be undertaken, which are the opposite of austerity, measures which create growth, and encourage investment. But, the measures, demanding the recapitalisation of the Banks, are the opposite of that. At the very least, it means Capital being drawn in to finance the Banks rather than to finance productive investment. Worse, if Banks cut back their lending, it will mean that Capital will become more scarce, the cost of Capital will rise, investment will fall, and economic growth will be reduced. At a time when we are already entering a new Credit Squeeze, which could be worse than 2008/9; that is the opposite of what is required.

In fact, there has been lots of talk about the need for a growth strategy in Europe, but currently, the policies proposed by the right-wing populist parties, in control of much of Europe, are headed in the opposite direction. Under current conditions, you cannot get growth without confidence; confidence of consumers to consume, confidence of businesses to invest. That requires that workers have to be confident that their jobs are safe. It will require additional large scale borrowing. The current measures will paper over the cracks for a few more weeks, and allow the current debts to be covered, but they will do nothing to cover the future debts, or to create the conditions by which economic growth is sufficient to meet the costs of borrowing internally.

As I wrote in my blog Greek Fudge, I estimate the real cost of dealing with the Greek situation would be something of the order of €750 billion over a ten year period.

That would not just cover the cost of financing existing debts, but would enable on going deficits to be covered, whilst a process of investment and restructuring was undertaken to modernise the Greek economy. Applying this across Europe ,to those economies that need a similar restructuring, I estimate that a figure of something like €15 trillion would be required.

For now, this problem can be left on hold, and markets appear happy that some more definitive move has been made to deal with the immediate problem, but EU politicians will need to get ahead of the curve, or the markets will have them scurrying to the next set of crisis meetings before they know it.