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The EU “Fiscal Compact” May Not Work, Argues Martin Feldstein – Bond Markets Already Penalizing Weak EU Members – In the End Greece, Spain, Portugal And Italy May Have To Leave The Euro

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By Paolo von Schirach

April 5, 2012

WASHINGTON – Until yesterday the EU leaders and many international analysts concluded that the European debt crisis had been successfully dealt with. After the admittedly long and painful rescue of Greece and new fiscal austerity measures in Ireland, Portugal, Spain and Italy, (all accompanied by political upheaval), it seemed that the worst was over and that going forward there would be no repeat of the excesses that originated the crisis in the first place. To make sure that this will never, even happen again, the EU countries agreed on a new Fiscal Compact about to come into force that commits member states to fiscal rectitude.

Feldstein: Fiscal Compact may not work

Except that it does not, really, argues Harvard Professor Martin Feldstein in a recent WSJ op-ed piece, (Europe Needs The Bond Vigilantes, April 5, 2012). The Compact commits EU countries to a “cyclically adjusted” budget deficit no larger than 0.5% of GDP. The problem is in interpretation. There is no clear definition of “cyclically adjusted”, and each country will argue whatever it wishes to justify whatever level of spending and whatever deficit there will be, claiming that it is within the rules.

The real issue, as Fedlstein notes, is that most countries at the EU Southern periphery are inherently weak and thus incapable of running at the same speed of stronger and more efficient Germany or Scandinavia. Recent rescue plans may work –for now; but unless these economic laggards learn something new, the reckoning has just been postponed.

Austerity, as Nouriel Roubini and others have noted, is inherently recessionary. Beyond spending cuts, (necessary as they are), countries need growth strategies so that they can grow out of debt and prosper. But the economic outlook for the non competitive South of Europe is not good.

Bond markets already penalizing weak economies

And the bond markets have already taken notice. A recent auction of Spanish bonds was under subscribed. Yields on Spanish 10 year bonds hit 5.81%, the highest rate since last December. Italian bonds are back up to 5.49%, the sharpest rise since last November. In contrast, Germany’s 10 year bonds are at 1.74%. The spread is wide. Quite clearly, investors do not want the bad stuff. Soon enough you will see bond prices of weak countries go further down and yields creep up even more.

Very simply, markets will not be fooled by EU Fiscal Compacts establishing iron rules that will be circumvented. Southern Europe cannot get economic efficiency and real growth through treaties. It needs vibrant economies, and Brussels cannot supply them.

Some countries too weak to stay in the Eurozone

In the end, and may be sooner than any risk averse policy maker would like, the Eurozone stronger economies will have to deal with the simple fact that some of the current members just do not belong. While getting them out of the monetary union would be extremely complicated, keeping them in may just not be viable.




After ECB Liquidity Injections And Fiscal Reform Agreement, Europe Is Looking Much Better – But Systemic Economic Weakness For Greece, Italy And Spain Remains Unchanged

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By Paolo von Schirach

March 3, 2012

WASHINGTON – A European summit without the pressure of another imminent crisis. Now, this is news. The EU leaders just met and they congratulated one another for being there, alive and standing. Indeed, it seems that the liquidity/solvency crisis has been finally stabilized. After untold pain and various twists, there is a deal for Greece. Italian Prime Minister Mario Monti had enough political authority to squeeze some more revenue from the Italians. Higher taxes, combined with more spending cuts, improved the outlook for Italian public spending. And so the “spread” between the interest rate on Italian and German bonds mercifully narrowed down to more acceptable levels.

ECB liquidity injection

But the real magic has been the injection of massive amounts of liquidity into the European banking system engineered by Mario Draghi, the new president of the European Central Bank, ECB. Flooded with the equivalent of about $ 1.3 trillion, even the most rickety European banks now look good. (Remember that these are the same banks that had passed with flying colors various stress tests. Some tests, really).

And finally, now 25 EU members (out of 27) are formally committed to higher standards of fiscal frugality. Even though the agreement they just signed needs to be ratified and then implemented, this step should be interpreted as a good sign.

Brighter outlook?

All in all, therefore, a better picture. No immediate liquidity shortages. No fear of default. And, going forward, improved fiscal policies. But does it mean that all is well? Not really.

While there is no denying that the EU avoided a disaster, Southern Europe is still structurally weak, fiscally and economically. Italy and Greece still have a massive national debt well in excess of 100% of GDP. Spain has far less debt but it is stuck with a very weak economy and very high unemployment. Youth unemployment across Mediterranean countries is still sky high.

Systemic problems in Southern Europe

Unfortunately, the hard issues in Southern Europe are still the same: the welfare state is too expensive, public administration is still bloated and inefficient, there is too much corruption and the broader environment does not invite investments and new enterprise. Hence no growth. On top of that, there are dreadful demographic trends. No babies. Extremely low fertility rates mean a shrinking pool of active workers carrying the burden of a growing senior population. This is bad for financing the welfare state and bad for economic growth. Add to that immigration flows from North Africa that bring into these economies unskilled and difficult to integrate workers who do not help improve productivity.

Stagnating economies

And these large, systemic problems are reflected in stagnating economies that barely grow or do not grow at all. Changing all this may be possible; but it is going to be extremely difficult. It is a matter of changing national psychology and established pattern of behavior. I just do not see Greece transforming itself into a vital society propelled by enthusiastic, risk taking entrepreneurs.

Stop gap measures help, but…

So, this welcome calm is due mostly to the massive liquidity injection provided by the ECB, and to new confidence coming in the wake of the acceptance of the fiscal policy commitments. However, the point is that while more cash helps this is only temporary relief. Good fiscal policies, in turn, while absolutely necessary, are not sufficient. Unless they go together with welfare reform and measures that will ignite economic growth, they will not transform Southern Europe.




Germany Reformed Labor Markets And Created A Pro-Growth Environment

WASHINGTON – In a WSJ op-ed piece, Europe’s Supply-Side Revolution, by Donald L. Luskin and Lorcan Roche Kelly of Trend Macrolytics, (February 17, 2012), make predictions about the future of Europe so bright and so positive that they frankly border on absurdity.

Germany’s example

As the writers put it, following Germany’s example, Europe is bravely starting its own supply side revolution. Italy and Spain will turn into business friendly, market oriented countries. The discipline of debt is driving Europe to closer political integration. If Europe’s countries could finally erase their political boundaries, their debt problems would also vanish. And so on.

Europe is stuck because there is no political will to reform

I must be looking at a different Europe. I see a Europe that is not necessarily doomed; but a Continent that is stuck, precisely because there is no political will to do most of the things that the authors consider either a done deal, or so absolutely necessary that they become inevitable. The implicit assumption in this article is that Europe has had its moment of reckoning. Now it is “do or die”. And Europe chose to live –and live bravely, at that.

No “moment of truth” in Europe, just muddling through

But this is a major fallacy. This notion that Europe had only two choices: disaster and doom or vigorous renaissance, and that it (wisely) chose renaissance is just wrong.

The idea that at this juncture all the Europeans, having just stared into the abyss of the debt crisis, have irrevocably decided to finally do the right thing, is just fanciful. By the way, I really wish that it were so. But there is zero evidence to justify this optimism. My sense is instead that many European countries –and this would include all of Southern Europe– will just muddle through, with enough wisdom to avoid complete disaster, but insufficient political courage to really start the serious reforms the authors assume to be just behind the corner.

Political union a distant dream

As for this irresistible drive towards political unification starting with fiscal union, again, I must be looking at a different Continent. Political union is nobly advocated as a goal by many well-meaning Europeans. But it is a very, very distant goal, without any agreed upon road map and clear set of mile stones.

Sure enough, the Europeans recently agreed in principle to harmonize their fiscal policies in order to avoid a repeat of the debt crisis. But this is no done deal. And nobody has the foggiest idea as to how this generic agreement will become binding and, after that, how it will be implemented and monitored.

Germany succeeded, others will follow?

The op-ed authors premise is that since Germany could see the light at the turn of the millennium and embarked in serious labor market reform through which it regained economic vibrancy, it follows that the rest of Europe will see the value of such a historic change and follow suit.

Well, that would be wonderful. But it would entail a dramatic change of politics, psychology, ethics and business practices that, while possible in principle, cannot be taken for granted only on the basis that it would be the smart thing to do.

In Italy Monti wants reforms, but the country will not follow

Getting into specifics, to say that Italy’s Mario Monti would like to liberalize and open the professions, introducing needed competition and that his heart is in the right place is not the same as saying that Italy is with him and that he will succeed. And, by the way, Monti’s government plans to reform the “Workers Statute” caused the ire of the unions who are absolutely not on board on the critical issue of flexible contracts and more labor mobility –one of the key preconditions to attract investments and generate new enterprise.

Technocrat with no political base

And the authors should also know that Monti is an economics professor and not a politician with an organized following. He did not win any elections. He has no popular mandate. Late last year he was appointed as “chief rescuer”, as a technocratic Prime Minister with the limited (and really unpleasant) job of extricating Italy from the pain of the debt crisis.

Monti came in as the trusted fire man with no political agenda of his own. He has done a good job regarding the stabilization of Italian debt. But, so far, he has done nothing to bring the national debt (now at 120% of GDP) down to the agreed Maastricht levels of 60% of GDP .

Besides, he has a limited mandate. Any serious reform aimed at making Italy a lot more like Germany would require broad and durable political agreement binding the left, the right and the powerful trade unions. Nothing like this ever happened in Italy. That does not make it impossible; but it makes it unlikely.

Corruption

And let me add that other factors do not inspire confidence. Italy has third world level scores regarding corruption, (according to Transparency International) and “easiness of doing business”, (according to the World Bank). Just days ago, Italy’s ”Corte dei Conti’, something like a General Accountability Office, issued a scathing report regarding corruption and lack of ethics throughout Italys’s public administration. According to the report, this creates an environment that discourages investments, enterprise and therefore new growth. (Italy is now in a recession).

Demographic crisis

Add to all this a serious, systemic demographic crisis. Italy has  one of the lowest fertility levels among developed countries, (1.38 children per woman). While the Italians stopped having children, there is the steady arrival of difficult to assimilate, poor and mostly illiterate immigrants from Africa.

Sure enough, all this can and, in fact should, change. But let’s not mix wishful thinking and reality. Monti may like to modernize Italy; but I am not sure that the country’s mood and long-term systemic trends support optimism about success.

If Southern Europe changed its values…

If the Southern Europeans –and that includes Italy, Spain, Portugal Greece and even France– really changed their values, their ethics and their business sense, this revolution envisaged by the op-ed piece authors would take place.

But this is the same as saying that if the Indians were more organized and less corrupt, and if they put together a credible national infrastructure master plan, all kinds of good things would happen to India.

By the same token, if Angola’s leaders were not corrupt, the vast oil and mineral riches of the country could do wonders to finance sustainable development, thereby lifting millions out of poverty.

And we could add that, if the Arab countries would finally understand that they should adopt modern, pro-growth economic policies, this would unleash new economic growth. And so on.

Good outlook for Northern Europe

Yes, Germany reformed labor markets years ago and we can safely assume that the countries of Northern Europe that have a stronger cultural affinity with Germany have already been positively influenced by this pro-business climate.

So we can expect Germany, The Netherlands, Austria, Sweden, Denmark and Finland, and may be a few others to do well. (I am not so sure about France, flirting with the idea of electing a Socialist President).

Southern Europe a different story

But I would not bet on these wise choices to be embraced by the rest of the EU members, whatever Britain may or may not do as the perennial dissenter among the 27 EU members.

Do not count on Southern Europe getting the medicine. And do not tell me that this going go down well in far less developed Romania, Bulgaria or Hungary.

Political union a distant dream

As for Europe finally becoming a federation, with one government, one army, and one foreign policy, this is not impossible; but it is so unlikely that it is indeed peculiar to read in this article that it is sort of a “done deal”, with only a few details to be ironed out.




The Greek Crisis Drags On – Europe Should Cancel Most Of Athens’ Debt – An Insolvent Country Cannot Pay Back A Crushing Debt And Have A Hope To Grow Again

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By Paolo von Schirach

February 5, 2012

WASHINGTON – What is most amazing about the Greek debt crisis is that more than two years into it, (it all started in the Fall of 2009), the European Union has not managed to take care of it. True enough, the Greeks bear full responsibility for getting themselves into this financial abyss and for being recalcitrant counterparts, largely incapable of understanding that the old ways of not working much, not paying taxes and still expecting public services and a good standard of living are gone. Still, it is inconceivable that the other 26 members of the European Union, a grouping of nations with a combined GDP larger than America’s, have been unable to resolve, once and for all, the troubles, deep as they are, of one of its middling to small members.

How big a hair cut?

The issue at hand today is the inability to impose a dramatic loss to private holders of Greek debt. While everybody agrees that there must be a “hair cut”, the sticky issue is how big a hair cut. And this matter that is both financial and political drags on and on. And it is not that everything else is settled. The Greek economy, while benefiting from a variety of lines of credit, is on respirator, while it keeps shrinking, year after year. To get out of this horrible mess, the Greeks need not just some cash to stay afloat. They need some kind of credible pathway to new economic growth. And it is not clear that one has been delineated. Certainly not by the wobbly coalition supporting the recently installed technocratic government headed by Lucas Papademos, himself an economist and a former Central Banker. And the EU partners are not doing any better. They should recognize that the people of a virtually bankrupt country committed to more and more austerity have neither the resources nor the will to go back to work.

Why so difficult for a 15 trillion EU to deal with tiny Greece?

But let’s look at the actual dimension of the problem by considering the larger context. The EU of which Greece is still a proud member has a combined GDP of about 15 trillion dollars, just about the size of the USA. Sure enough the parallel ends here. The EU is not “A Country”. It is an arrangement among many countries. Their combined wealth, while the largest in the world, cannot be mobilized that easily. Still, in comparison, Greece has a GDP of only 300 billion dollars, smaller than Singapore, a tiny city state. And if we look at the EU leading countries, Germany, The United Kingdom and France have respectively the 6th, 9th and 10th largest GDP in the world. Greece is number 41 in the world rankings.

Is it really possible that the EU as an institution and within it its most formidable members, (the UK is not part of the Eurozone, but surely it must have an interest in its stability), have not yet managed to close a two year old problem affecting a relatively minor EU member? Well, yes, it is possible; because the EU has weak institutions, while its key members are not unanimous on anything.

Greece both insolvent and declining. The GM analogy

In the end the Europeans will have to recognize that Greece is an insolvent country trapped in an uncompetitive economy that simply cannot be re-energized while at the same time servicing a gigantic (even if now diluted) debt. As nobody wants to see a Greek bankruptcy, fearing that a disorderly solution would have unpredictable ripple effects, then what do you do? Well, you force all creditors to take a big hit, I mean a really big hit. Forgive me an analogy that may be questionable, but this is what the US Government did with General Motors. Sure enough, in 2009 Uncle Sam stepped in with big money, but the key point here is that a de facto bankruptcy allowed GM to get out of most of its pre-existing obligations, financial, contractual, with the unions, and so on. And so, with Washington’s critically important help, a leaner and unburdened new GM could come to life. And now it seems that a reborn GM will be quite capable to function without government crutches.

EU weakness worse than the Greek crisis

We need the GM equivalent for Greece. Right now, all creditors and most of all all key EU policy makers have to realize that Greece is both insolvent and declining. If bankruptcy is unacceptable because of its messy consequences, then the only hope is to give Greece a truly fresh start. And this means debt forgiveness, just like we used to do with messed up third world countries. No use demanding money that cannot be produced. The never ending negotiations between Greece and its private creditors unfortunately indicate that we are not yet at the point of a realistic political consensus on any of this.

At some point some deal will be struck, I suppose. But the way the never ending Greek Tragedy has been handled is an indication of Europe’s internal confusion and consequent lack of resolve. And this inherent EU weakness may be even worse than Greece’s problems. Europe revealed itself to be nothing more than a turbo-charged Chamber of Commerce, with no idea of how to deal with crises.




Attempts At Injecting New Vigor Into The Atlantic Community Linking America And Europe Will Fail – US Short Of Breath, EU In Serious Trouble – Societies In Decline Are Inward Looking – No Interest In Cooperation

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By Paolo von Schirach

January 31, 2012

WASHINGTON – Wolfgang Ischinger, former German Deputy Foreign Minister, Igor Ivanov, former Russian Foreign Minister, and San Nunn, former US Senator, and once Chairman of the powerful Senate Armed Services Committee, in their current role as co-chairmen of the Euro-Atlantic Security Initiative voice their concern about the future of the Euro-Atlantic community in an op-ed piece in The International Herald Tribune, (Euro-Atlantic Goals, January 31, 2012). The writers lament the lack of policy focus and poor coordination among the key players in this large area encompassing Europe, Russia and North America. At the end of the Cold War, It was hoped that this region could become the driving force for positive change based on new cooperation linking Europe and America, the old partners and a new democratic Russia. But this did not happen. Arguably, Europe and the US are drifting apart, while old enmities with Russia have resurfaced.

Revive the Atlantic Community?

The three former leaders advocate better military to military cooperation, a rethinking about the purpose of missile defense, and a joint, cooperative approch to the exploitation of the vast resources of the Arctic, among other issues. Their underataking is laudable. But the chances of success are dim, mostly because of the profound changes, all for the worse, affecting both Europe and America. Russia is a different story, but not a very good one either.

Impossible dream

Simply put, the old foundations are gone. The Atlantic bond and the NATO Alliance that shaped it were based on both a shared fear of a common foe, the old Soviet Union, and on an underlying optimism about the strength, vitality and moral superiority of Western nations. And look where we are now. Whatever the spats with Putin’s Russia, this is not the old Soviet Union, with armoured divisions stationed in East Germany, just a few miles miles from Hamburg, as former German Chancellor Helmut Schmidt used to remind us, back in the 1980s. Today’s Russia represents no immediate threat to Europe. So, the old glue based on a shared security concern is no longer there, (even though it has not been replaced by a genuine new friendship with a post-Soviet Russia).

Loss of optimism

But the real impediment to the reaffirmation of a spirited and dynamic Atlantic Community is the loss of optimism. Forgive the cliche‘, but the West is in decline and the remedies advocated by politicians will tend to create a more inward looking political climate. Wounded societies will use their diminished resources to try and fix their domestic issues. There is now little spare capacity and even less political will to seriously engage with the outside world on anything that would demand steady commitments. Anything requiring effort and any type of coordination that may entail domestic sacrifices is now politically unwelcome.

In the US, focus on divisive domestic issues of social justice

Look, America, although doing a bit better than Europe, is saddled with a gigantic national debt and year after year enormous budget deficits that are already causing cuts in security spending. But, aside from Pentagon cuts, (in fact the three statesmen are proposing better security coordination, not new and costly security undertakings), the focus of debate in America has shifted away from growth strategies and confidence in globalization, and is now on who should shoulder the bigger burden of the downturn.

President Obama is running for re-election this November on a platform based on how he will guarantee that the rich pay a bigger share of the cost of fixing public finances. This new focus on “fairness” tends to fuel existing and partly justified social and political animosities that will end dividing Americans. Indeed, whatever the objective merit and the justifications for redistributive policies, a nation divided, in which different groups fight to determine who should pay more, will have no energy for foreign matters not considered absolutely vital. So, while we debate about how much the rich should be taxed, there is little interest in new efforts aimed at revitalizing transatlantic bonds with Europe whose value is not immediately apparent. (The fact that the otherwise laughable presidential aspirations of Texas Congressman Ron Paul who proposes complete withdrawal from foreign committments have at least some traction this year, especially among young voters, is evidence of a profound shift in America.)

Europe: the crisis of the welfare state

Well, if this is the new mood in America, in Europe it is much, much worse. Southern Europe is essentially a disaster area, with no one really facing the fact tat the fiscal and debt crises have been caused by costly state run programs and over generous welfare systems that could not be funded by anemic growth in increasingly non competitive economies. And, although right now the focus is still on putting out the fires and eliminating contagion in the banking systems, very few are willing to propose a rejection of the old societal models as a new way forward.

On the contrary, the idea is about doing more of the same, only reapportioning the costs. In the unfolding campaign for the French presidency, Francois Hollande, the Socialist challenger to president Nicolas Sarkozy, would like to keep the old welfare state just as it was. He wants to go back to a lower age of 60 for full pension benefits. At the same time, just like president Obama, he put forward laughable plans to re-industrialize France by bringing back manufacturing that migrated long ago to low cost Asia. The idea is that it may be possible to reassert manufacturing, this time however with more aggressive protection against unfair competitors. And at the same a Socialist President would fight the domestic enemies: the fat cats, the bankers and financiers who have amassed vast fortunes, while the rest of the country suffers.

Populism and protectionism do not mix well with international solidarity

So, in France there is an unhealthy mix of populist class warfare and rising protectionist sentiment. Not a good base for grand new transatlantic initiatives. And do not expect bold new leadership from Germany either. The Germans, while better off economically, right now are mostly concerned with forcing rather recalcitrant Southern EU partners to adopt even more stringent austerity measures, so that there will be no more fiscal crises in the future.

All well and good. But the problem is that austerity without growth strategies will further weaken already weak Southern Europe. Even leaving aside the political fall out of a strong anti-German sentiment –something that does not augur well for intra-European cohesion– I would not count on Greece, Italy, Spain, (more than 20% unemployment), and Portugal to provide a vigorous contribution to any policy aimed at strengthening Euro-Atlantic relations. In the years ahead, they will do their best just to stay alive.

We thought we were better, thus bound to lead

After WWII victorious America and resurgent Europe forged a bond based in large part on the genuine belief that their countries shared the superior foundations of democracy and enterprise. And it was that very self-assurance, that sense of moral superiority that engendered optimism and a willingness to cooperate with other like minded Western nations.

But now that strong belief in Western superiority is gone and with that went the interest in cooperating in the name of the expansion of Western principles. Europe and (even if to a lesser extent) America are now inward looking, unsure and hesitant. Their politics are focused more on fighting over what is left at home rather than on dreaming about an expansive, bright future. The Atlantic Community, for many decades the driving vehicle of Western solidarity, is a major casualty of this new era of reduced expectations and no dreams.




Greek Bonds At 34%, While Default Is Considered Now An Option – EU Failed To Fix A Relatively Small Problem, While Moving Slowly Towards A Fiscal Compact – Are The Europeans Serious?

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By Paolo von Schirach

January 15, 2012

WASHINGTON – A sad but powerful illustration of EU indecisiveness about dealing squarely with the whole sovereign debt mess is that more than two years after the explosion of the Greek crisis, most incredibly, the issue is still wide open. In fact it has gotten much worse. As The Financial Times put it on January 14/15, 2012: ” Talks over Greece’s debt restructuring broke down yesterday, making it increasingly likely that Athens will become the first government of a developed country in more than 60 years to suffer a full scale default on its debt.

Many attempts, no final fix

Bill Gross, who runs Pacific Investment Management, (Pimco), the world’s biggest bond fund, agrees: Greece is heading for default, he says. Now, this is some nice record to be proud of. The first bankruptcy of a “first world” nation in modern history. And Greece, let’s remember, is a country supposedly connected with the European Union, the largest trading block in the world, capable, if it wanted to, to deploy significant fire power to protect one of its own.

No point going through the whole story. But let’s just remember that there was one bail out that did not do the trick, followed by another, bigger one that was supposed to stabilize this unfortunate country. Both the EU and the International Monetary Fund led the effort aimed at rescuing Athens. In the meantime, Greece selected Lucas Papademos, a reputable technocrat, as its new, (and hopefully more credible), Prime Minister.

Small country, easy solution?

At the time, most commentators thought that Greece would be fixed, because it is a relatively small country with a small economy. Indeed Greece in 2010 had a GDP of only $ 318 billion, while the entire 27 member strong EU had $ 14.8 trillion and Germany, its most important economy, had a GDP of 2.9 trillion. Surely mighty Europe could take care of its little brother gone astray. Well, it turned out that it could not. Greek 10 year bonds now have an appalling 34% yield, about 32% above German bonds. This alone should tell you something about how successful the rescue operation has been.

Big EU fiscal coordination master plan ?

Sure enough, the EU is supposedly working now on a new comprehensive compact on fiscal coordination, although we already get rumors of built in loopholes aimed at keeping the spending wiggle room that the new agreement is supposed to eliminate.

These tentative steps towards objectives that may very well be politically unachievable, combined with serial failures to fix the Greek problem, convey one basic impression: lack of seriousness.




S&P Downgraded France, Half The Eurozone, Citing Inadequate EU Policies – In Italy Lack Of A Long Term Growth Strategy, While Corruption And Bad Governance Linger

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By Paolo von Schirach

January 13, 2012

WASHINGTON – Only yesterday the international business media sounded very optimistic about the Eurozone. They reported that Mario Draghi, president of the European Central Bank now thinks that the situation has been stabilized. Auctions for short and medium term Italian and Spanish bonds had gone well. Yields are down. So, is Europe finally out of the woods? Well, not so fast. Today, Standard & Poor’s downgraded half the Eurozone, including (supposedly) recovering Spain and Italy. And France lost its coveted AAA rating.

S&P pesssimistic outlook

Beyond the action that was expected and therefore largely priced in by the markets, it is important to read the motivation provided by this key credit rating agency, because it presents a totally unflattering and pessimistic picture of Europe’s ability to eventually get out of this mess. In other words, this S&P credit downgrading most likely is not going to be the last, unless policy makers change course. And S&P does not believe that they will. Here is an excerpt from a much longer S&P statement:

“….Today’s rating actions are primarily driven by our assessment that the policy initiatives that have been taken by European policymakers in recent weeks may be insufficient to fully address ongoing systemic stresses in the eurozone. In our view, these stresses include: (1) tightening credit conditions, (2) an increase in risk premiums for a widening group of eurozone issuers, (3) a simultaneous attempt to delever by governments and households, (4) weakening economic growth prospects, and (5) an open and prolonged dispute among European policymakers over the proper approach to address challenges.

The outcomes from the EU summit on December 9, 2011, and subsequent statements from policymakers, lead us to believe that the agreement reached has not produced a breakthrough of sufficient size and scope to fully address the eurozone’s financial problems. In our opinion, the political agreement does not supply sufficient additional resources or operational flexibility to bolster European rescue operations, or extend enough support for those eurozone sovereigns subjected to heightened market pressures.

We also believe that the agreement is predicated on only a partial recognition of the source of the crisis: that the current financial turmoil stems primarily from fiscal profligacy at the periphery of the eurozone. In our view, however, the financial problems facing the eurozone are as much a consequence of rising external imbalances and divergences in competitiveness between the eurozone’s core and the so-called “periphery”. As such, we believe that a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand falls in line with consumers’ rising concerns about job security and disposable incomes, eroding national tax revenues…..”

S&P identified systemic flaws, more downgrades to come?

So, according to S&P, despite the great optimism after the latest EU summit, policy measures taken so far are insufficient. Worse yet, there is a failure to recognize that the crisis is largely due to lack of competitiveness resulting in economic weakness. There is lack of understanding that austerity alone, without credible growth policies, makes matters worse because it sucks even more resources from anemic economies.

Beyond the polite formal language, S&P downgraded many Eurozone countries because the EU policies aimed at solving this more than two year long crisis do not add up. Which is to say that the plethora of EU summits and solemn declarations and unity pledges are inadequate and not credible. Amazingly enough, after all this time, the EU has yet to attack the problem in a convincing way. (Translated in simple language: they do not not how, or they are too afraid to take bold steps). Hence this raft of downgrades.

Italy’s outlook is not good

But let’s look at some specifics. Let’s look at Italy as a good illustration of a half baked plan. In the Fall, when the situation was dire, the ethically challenged perennial Prime Minister Silvio Berlusconi was forced out of office, for the good of Italy. In his place comes a dignified non politician: Mario Monti, President of the prestigious Bocconi University in Milan, former EU Commissioner and internationally respected economist. This change at the top alone was supposed to inspire markets as they would finally see a serious person in charge. To his credit, Monti and his technocratic government of non political experts, went to work on some more austerity measures aimed at showing lenders that Italy is serious about cutting spending.

A growth strategy?

But after Monti did that, all observers started asking about his plan to kick start growth in a stagnating Italian economy. Well, there is no real plan. Sure enough, there are some initiatives at liberalizing access to professions and economic activities. But even timid talk about introducing real labor mobility was met with ferocious labor unions’s reactions. No, sir. Our coveted right to life time employment is not for discussion. And liberalization efforts are met with equal resistance from all those who stand to lose equally coveted rent positions based on restricted access.

Corruption lingers

Worse yet, the old and time tested Italian bad habits are still there. As soon as Monti came into office, a major political scandal linking parties, partially state owned corporations Finmeccanica and public contracts exploded. Most recently, Carlo Malinconico, his very own undersecretary to the Prime Minister, (the equivalent of a Cabinet Secretary) , had to resign because of a cloud of suspicion regarding shady past dealing with questionable economic entities. And the Italian Chamber of Deputies just refused to lift the immunity protecting one of its members, Nicola Cosentino, from prosecution for alleged connections with the Casalese clan, part of Camorra, Naples’ most powerful criminal organization.

With all this, no wonder that Italy has very poor ratings on corruption from Transparency International, while it scores badly within the World Bank’s ”Doing Business” tabulations that rank all countries on the easiness to conduct routine economic operations and on the efficiency of public services that should support business activities.

The spread between German and Italian bonds

And, Mario Monti wonders why Italy is forced to pay more than 6.5% interest on its 10 year bonds, while Germany pays less than 2%? The answer is simple. Because Italy has bad governance and low ethical standards. The country is systemically weak and there is no sign that this will improve. Simply put, in the short term the government can raise taxes an d reduce the deficit, as it did. But if this is all the ammunition they’ve got, the battle is lost.

Just a few notches ahead of a Banana Republic

With all due respect for Monti’s personal integrity and skills, he is governing a country just a few notches ahead of a Banana Republic. In order to have meaningful growth, (and that means at least double the miserable 1% that Italy had in the last few years), in this super competitive, globalized world you need good governance, excellent public services, modern policies, first class entrepreneurs and flexible, adaptable labor markets. I see none of that in Italy and, Monti’s reform efforts notwithstanding, a slim chance of making any of this happen. Hence the S&P downgrades and the almost 5% spread between Italian and German 10 year bonds.




Italy and Greece Have A Bad Transparency International Score On Corruption, Matched By Bad “Doing Business” Grades – Poor Public Finances Go Together With Bad Governance, Corruption And Weak Economies

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By Paolo von Schirach

December 6, 2011

WASHINGTON – Bloomberg recently reported that Italy and Greece have the lowest scores within the Eurozone in an international ranking on “corruption perception” compiled by Transparency International, the leading organization in this field . The story tells us that Italy is number 69 in the world and Greece is in the number 80 slot, out of 183 countries, in a ranking in which 183 is the worst score. If one considers that emerging and poor countries get the worst scores, because of inherently weak governance and high corruption levels, Italy and Greece now are sliding into the third world, at least on corruption levels. In fact, Italy is now at the same level of Ghana and worse than Saudi Arabia.

Corruption, bad governance, weak economy

By contrast, the countries with the least amount of corruption world wide are New Zealand, Denmark and Finland. It is no accident that the most honest countries also have efficient governments and relatively prosperous economies.

Is there a connection between large and inefficient public sectors, a weak private sector and corruption? Arguably yes. An efficient, performing private sector would not tolerate corruption. But a weak private sector would be searching for ways to cut corners and obtain special treatments. As I noted in a previous piece on Italy, it is no accident that the Monti Government, instead of focusing immediately on the urgent debt crisis, on day one had on its plate a major corruption scandal about political favors, kickbacks and awards of major public contracts. Finmeccanica, otherwise known as one the best Italian industrial conglomerates, is in the middle of all this.

Bad World Bank “Doing Business” Scores

If we combine the Transparency International scores with the World Bank “Doing Business” rankings, the picture gets even worse. Out of 183 countries, (in a scoring system where 1 is the best and 183 the bottom), Italy is down to 87 from 83 last year. Greece is steady at number 100. And what is worse, if we look at key areas within this ranking, we see that Italy ranks 134 in the “paying taxes” category, 158 in “enforcing contracts” and 109 in the more mundane but equally important category of “getting electricity”. Well, these are third world scores.

Monti Government should deal with governance, beyond the debt crisis

Which is to say that the Monti government would have to do a lot more than just raising taxes to fix Italy’s problems. The emergencies measures just passed may do for the short term. But Italy, just as Greece, would need a fundamental reform of the entire public sector and governance in order to inspire enterprise and investments. And this is what Italy ultimately needs: enterprise and investments to grow the economy. Otherwise, it will be more of the same.

Disaster will be avoided, but Italy will continue to be weak

Sure enough, through a combination of higher taxes, spending cuts and the inevitable helping hand from the European Central Bank that will have to intervene to support Italian bonds, it may be possible to avoid disaster in Italy. This is possible, and I assume that eventually the acute phase of this crisis will be over. But, as these data indicate, the problems are much deeper. No way that a country with third world corruption levels and with a judiciary essentially incapable to enforce contracts will have smooth economic development. There is just no way. And Mario Monti is just one man, a “technocrat” placed there as an emergency care taker, with no political following.




How Can Western Countries Get Out of Debt? Only By Paring Down Unsustainable Entitlement Programs – A New Social Contract

By Paolo von Schirach

May 1, 2010

WASHINGTON – In the case of Greece’s nasty fiscal debacle,  everybody’s focus has been mostly on assessing the unfolding drama. Will this Eurozone-IMF rescue package work? Or will it be the next one, until finally something that would stick is cobbled together? Will Greece precipitate into the bankruptcy abyss; and, if it will precipitate, will this ruinous fall bring about further havoc within the already strained fabric of European monetary cohesion?

A growing debt, not this year’s deficit, is the issue

But, while not unreasonable, this focus on crisis management and related countermeasures takes all observers away from the real systemic problem which is not: “How to stem the hemorrhaging and thus bring down next year’s deficit”; but instead is: “How to reverse the systemic, creeping growth of public debt”. And the creeping debt crisis is by no means confined to Greece. It affects many advanced countries, in fact most of Europe and Japan, among others.

The real issue here is not about how to avoid another Greece; but about recognizing the urgency to reverse established –yet deeply  toxic– public spending trends, so that huge and growing amounts of debt will no longer weigh so heavily on so many countries, eventually crippling their ability to invest and grow, since most resources are devoted to spending or to finance borrowing to be channelled into the same spending. But nobody will act to stop this spending and borrowing until there will be a new, truly shared societal consensus that indeed, however well intentioned they may be, large and growing welfare systems, now a common feature in most advanced societies, force a progressive resources diversion from investments to entitlement spending and debt service; thus crowding out and ultimately smothering new productive investments, new research, innovation and new growth.

British elections: candidates avoid details about spending cuts

However, as things stand now, while everybody wants to avoid Greece’s fate, not many are prepared to take today the steps necessary to get out of a very similar course. Staying on this course does not guarantee becoming a basket case like Greece; but it does guarantee under performance, low growth and ultimately societal stagnation and possibly decline. And yet, as bad as all this is, getting out of this spending trap is politically dangerous, if not outright impossible. 

Indeed, days before critical national elections in Britain, none of the leaders of the three main parties dared to articulate what they would do to cut the monstrous UK debt, in case the voters may not like what they hear and punish at the polls who may tell them the truth about losses of benefits. And so Britain, as The Financial Times recently commented, goes into a critical national election without any idea of what any debt reduction plan may be; with the negative political consequences that whoever will end up governing will have no clear electoral mandate to take the harsh measures that, one way or the other, will have to be taken. (Unless Britain decides to do nothing, thus setting the stage to become the next Greece).

Greece will be fixed, somehow

Greece’s crisis eventually will get under control. Greece is, after all, a small country. Its problems, however dramatic and unprecedented for the Eurozone, are not unmanageable. But the issue of systemic growth of public debt in so many countries: Italy, Spain, Belgium, Britain, Portugal, Japan, and the US, among others, is a different story. The fact that higher and higher debt is eventually unsustainable is now blatantly obvious in Greece’s case. But we do not seem ready to acknowledge that the same disease, albeit in a less acute phase, is everywhere.

Between Greece and the other countries the difference is only about the speed of debt accumulation. All these countries are ailing. But many, for the moment, (and this includes the US), manage to mask the severity of the problem, thanks to the availability of sufficient credit that allows them to finance their chronic fiscal shortfalls.

The real lesson from the Greek crisis

Indeed, the real lesson from Greece is not about how to avoid Athens’ extravagant level of recklessness –this is not that difficult. The real problem is how to get out of the far less obvious trap of creeping higher and higher debt levels that may or may not degenerate into a Greece-like crisis; but that are nonetheless very damaging, in as much as too much debt saps precious energy from the economy. Just like a parasite, without being necessarily lethal, severely weakens the body, debt damages society’s fabric, even though it may not deal a mortal blow. The society somehow survives, just like the human body afflicted by the parasite; but it loses vitality, energy and dynamism.

This is the real problem.

But since it is a problem that grows subtly and incrementally; it is relatively easy to ignore it or to explain it away, in the meantime readjusting goals and expectations down. The Minister of Finance of a leading European power just recently said in Washington that a 1.5% projected growth rate for his country is acceptable. Coming out of a severe recession, 1.5% is fine? Not for people who believe in the need to do all you can to nurture the economy. But if 1.5% is alright now, then may be next year 1% growth will also be acceptable. Lowering goals and thus expectations is not too difficult, apparently.

Debt is like “termites in the basement”

Everybody understands a crisis when we are already in it. But before getting to where Athens is today, there is a long journey featuring, among other things, increased levels of public spending unmatched by corresponding revenue and thus higher borrowing requirements as its key milestones. But the problem with an increased debt level is that its damage is slow and incremental; and so this damage  does not manifest itself all of a sudden, as an immediate crisis.

The crisis comes later, some time much later, once debt has piled up beyond some threshold that convinces some key players that it is too much. With that judgment, warranted or not, comes the creditors’ mad rush to unload the bonds, now deemed to be junk, panic and thus the whole thing just falls apart, just as in the current case of Greece. But until debt can be financed with reasonable rates of interest, the process is fairly painless and thus it is easy to ignore its highly damaging and truly corrosive consequences, not just for public finances, but for the netire economic fabric.

As it has been observed: “Debt is not the wolf at the door; it is more like termites in the basement”. So, growing debt levels are not an imminent, visible threat; but rather a subtle, invisible enemy that literally “eats its way into your home”. If you do not catch it and eliminate it, it will destroy your property.

You can fix the immediate crisis without seriously addressing the debt problem

But if we look at Greece purely as a unique crisis, then we shall evaluate everything purely in terms of the success of a rescue package. If the EU-IMF 60 billion or 100 billion dollars rescue package over so many years comes along, Greece will not go belly up. Somehow, it will manage to cut spending, increase revenue collection, streamline public administration, at least to some degree. And so, everybody, (except the Greeks who will have to live through all this), will be happy. Crisis resolved, let’s all go out and celebrate over dinner.

And yet the larger issue is not Greece’s almost fantastic levels of both private and public irresponsibility. Historic evidence shows that crises brought about by extravagantly bad behavior can be dealt with and managed. However, the real systemic problem is not this year’s or next year’s deficit; but the long term fiscal trajectory created by excessive spending and insufficient revenue growth resulting in high debt. The Wall Street Journal of 1-2 May 2010, (“Athens Confronts Sisyphean Task in Austerity Program”), cites a revealing consideration from a report released by the Brussels based Centre for European Policy Studies: “The goal of the large fiscal adjustments is to make public finances sustainable. However….this goal was rarely achieved”. In plain language, you may avert disaster; but this does not imply successful inoculation against the debt malady. So, in the end you may not die, but you will be chronically ill.

Ad why is that? 

The roots of the debt problem are in the promises of the welfare state

In most western nations a key pillar of public policy is the firm belief that the state is supposed to take care of people. And so, to this end, we have created entitlement programs, ever more complex and ever more onerous, largely based on the fantasy that somehow any level of spending is affordable, that there is enough revenue to finance education, health, pensions and assorted subsidies to more and more constituencies. Policy makers who know that this is not possible, for fear of alienating voters, instead of telling the truth, borrow the difference between what they promised and the actual revenue in hand. Hence growing debt.

But, since borrowing has some limits, policy-makers, as they focus on financing what is politically more important to them, that is social welfare programs, short change discretionary spending, cutting spending in all the sectors that do not have huge, clamoring constituencies. And so they cut defense spending, (now, on average it is about 1% of GDP in Europe and Japan); thus creating the foreign policy of the weak, grounded on crisis avoidance, rather than on meeting threats. And they cut capital investments in infrastructure and in research and development. In so doing, they keep their voters happy, thus gaining confidence that they can face the next election. In all this, there is no concern for the aggregate, long term consequences of a trend that, by privileging social spending while shortchanging investments, objectively weakens the economic foundations and the chances of future growth.

No more babies: welfare spending levels become unsustainable

But other parallel trends will make it harder and harder to sustain this act in the future. Until now, growing debt notwithstanding, it was possible to keep financing this onerous welfare system. Looking ahead, this is going to be more difficult. Indeed, most advanced societies are facing negative fertility rates: well below population replacement levels.

In simple language, this means fewer young tax payers and growing numbers of old people who depend on the state for various costly benefits. A growing number of elderly citizens –and they are those who receive the most in terms of welfare—will have to be supported by the shrinking revenue produced by a dwindling number of younger, active citizens. At some point the mismatch between too many old people receiving benefits and too few active young ones paying into the system will become unsustainable. Recurring to debt will no longer be enough to fix the gap between what has been promised and what is financially possible.

Too late to change course?

What will happen then? Who knows. But we can bet that at that point it will be way too late to reverse the cumulative effects of policies that for decades have privileged social spending over productive investments. Sure enough, some benefits will be curtailed, some may be eliminated altogether, in order to diminish the fiscal imbalance. But I very much doubt that it will be possible to bring before the public and then successfully implement a new public policy philosophy strongly grounded on the basic notion that by far the best way to ensure public welfare is to maintain and safeguard above all else the full functionality of a vibrant economic system; in as much as this is the only engine for wealth generation. If you want to distribute wealth, you have to produce it first.

Until people will be prisoners of the idea that welfare is a basic right and that we can think about how to pay for it later, we shall privilege distribution of benefits and shortchange policies aimed at keeping the economic engine going full force. It should be clear to all that in the end you have to produce some added value in order to be able to distribute it. But the established distortions that make welfare policies untouchable allow most people to overlook this rather basic consideration. And so, we keep on distributing benefits financing the expenditures via borrowed funds.

Strong focus on welfare means less attention for growth

The end game of insisting with these entitlement policies in societies that are becoming less productive, (because the money goes to finance these very entitlements), is that over time there will be less and less to distribute. These societies will be progressively more impoverished, while their standing in the world will be diminished. My hunch is that Europe as a whole is well on its way to economic and societal decline, while I do not see any significant new tendencies that would reverse course. Japan is not too far behind.

What will happen in the US?

In the US it is still a toss up. Certainly there are large, powerful, mostly urban, constituencies located in the large states on the two coasts that aspire to something close to the European model. There are others, witness the spontaneous, if boisterous, anti-government, anti-tax “Tea Party Movement” phenomenon, who instinctively abhor statism and the attendant welfare state public policy approach. Can America find a reasonable balance between maintaining some sort of public safety net and a focus on doing whatever is necessary to keep investments and innovation at the highest possible rate? As of now, because of the impact of the 2008-2009 recession, our debt is  approaching European levels. We can retreat from this bad course and once again emphasize growth, while doing what it takes to keep this economy nimble and competitive. But this benign outcome is not a sure thing. The Obama administration repeatedly stated that high spending is a temporary counter cyclical remedy because of the horrible recession and that it will soon announce a convincing long term decifit and debt reduction strategy. And when will this be? Well…soon. Somehow, I think that we shall have to wait until at least after the November congressional elections. And, after the November elections, we shall be gearing up for the 2012 presidential elections. If, just like other governments, the Obama administration does not want to upset voters by announcing serious spending cuts, there are good chances that we shall not see any bold deficit and debt cutting strategy.

Will we learn anything from the wider debt story highlighted by the Greek crisis?

In the end, the Greek crisis is not an especially useful example of what to avoid, as Greece is clearly an extreme case, whose specific circumstances are not going to be easily replicated. Few other modern countries will accumulate so many distortions and so many inefficiencies.

But the Greek crisis did illuminate in some fashion the debt issue and the cumulative damage brought about by growing and growing public debt. Not as clear, by reading the copious commentary, is whether we are in agreement on the primary cause of structural debt: growing social spending out of sync with revenue. Will anybody, be it in London, Lisbon or Washington DC look at the nasty consequences embedded in spiraling debt and realize that it would be good to change course as fast as possible?