FNB: Brave Sick Europe

22 May.

FNB Comment: Brave Sick Europe.

Over the years we have at times heard about the ‘Sick Man of Europe’, designating so anyone straggling in the European ranks, especially if formerly in the lead.

There is here an element of schadenfreude (malicious enjoyment of others’ misfortune).

So Germany in its day was sick. And France had its turn. And so down the ranks. Today most of the Club Med periphery is beyond the pale.

But the real sick man is Europe overall.

Surprising, perhaps, with Germany growing 6% annualized and France 4% in 1Q2011. But consider the bigger picture.

The bits & pieces that are modern Europe got into bed together not thinking through the consequences (apparently a daily human occurrence the world over, but let that not confuse the greater issues of state here), only focusing on the short-term advantages and blind to what would not fit naturally.

It would all sort itself out in the morning. Supposedly. Disadvantages would fade before the rising sun under the pressure to conform. And only advantages would remain.

Never mind that real fusion is usually only achieved in an act of war. Great Britain getting together wasn’t achieved by a few bureaucrats endlessly talking. The American melting pot and Dream was born out of adventure, rebellion and battle, and kept together (just) at Gettysburg. The Russian State was put together the hard way. So was China a long time ago. And so on.

Europe, on the other hand, apparently has assumed that if it can keep talking long enough, with a little help of lots of mischief, anything can be made to fly. Even Club Med peripherals and sunken banks.

That takes chutzpah (insolent audacity), another favourite term. Without chutzpah you don’t seem to be getting anywhere these days.

But this can lead, as in the case of Europe today, to a truly monumental mess, where clean clearcut decisions are apparently considered unfeasible, and where cloak-and-dagger so beloved in medieval times’ rules.

That makes for a lot of confusion and opportunism. Knowing the difference is a challenge all the time.

Consider five markers to ease the way.

Firstly, Europe got increasingly into bed on the grand scale with each other, finally adhering to one money rule (currency, central bank) overall but mostly refusing giving up sovereignty for its local bits.

There were agreements about preferred good behaviour, but with eyes wide shut at crucial moments, for politics needs to be flexible rather than rigid most of the time to get things done.

Secondly, markets in their utter unwisdom bought this story and allocated to all of the European bits mostly the same Germanic risk standards.

Thus the portals of hell opened before all lowly Europeans suddenly invited to sup at main table with (you guessed it) the Devil (leveraged debt).

Thirdly, with even less wisdom European bankers sensed the whole story hung together AND was guaranteed by all – something like out of Dumas’s Three Musketeers. One for all and all for one. And the utter fearlessness of a D’Artagnan to lead the charge (or a Robin Hood to divide the spoils, but that came later).

Fourthly, this very adventure kicked off while Anglo-Saxons were gorging on subprime debt and generously offered to share the pickings with European and other banks and financial institutions through securitization.

So two Doomsday engines were working overtime in parallel. And they blew in close proximity. Barely a year between them.

This intertwined jungle of financial exposures at its peak involved the larger part of most European banks’ assets (and also at insurers and pension funds).

A solvency problem.

And because mostly everyone became aware of each others’ problems at about the same moment (if fully so only in lazy stages covering a year or two) it was for the time being turned into a liquidity problem, postponing the inevitable, as nobody wanted to deal with anybody (for a while) except with central banks (these being for the time being like Caesar’s wife, beyond suspicion).

The answer was for governments and central banks to interpose themselves between everyone else. Thus unlimited support and liquidity was freely given which could keep the figment of solvency on its feet while “the can was kicked down the road” (lovely expression).

Why try to solve something expensively today if time might bring more and less costly options?

In the process, then, fifthly, recession and private bailouts in the aftermath of crisis created enormous public debts, in many of the peripheral countries not sustainably so.

If this little European tussle was merely between its political elites and the global financial markets, the sense of doom wouldn’t be so complete. Modern governments have a lot of firepower, and big central banks even more.

Between them and financial markets a thing or two can be arranged, as seen to date.

Europe, however, is a modern democracy, with electorates who don’t like free-and-easy life styles by neighbours at their expense, and politicians agreeing to all kinds of costly arrangements.

Electorates apparently mostly think they understand the situation, thinking they have the option to deny bailouts to irresponsible neighbours in the name of a wacky ideal.

What many don’t seem to understand is that their politicians, banks, insurers, pension funds and other fly-by-nights have already lost a trill plus euros.

It just hasn’t been recognized on the books yet.

If this were to be finally acknowledged, Chinese, Japanese and Arab bond holders would lose a bundle on their large holdings of European debt.

European pensions would on average turn out a lot less generous than everybody thought. Insurers would have to increase underwriting fees (for they understand risk a bit better now, at least some of them). And many banks may be underwater and need lots more capital.

The favourite approach of the European political elite is to let all these parties gradually and relatively painlessly provide for these losses out of future income and capital raising exercises.

And so far that has been the case, if with lots of financial market sniping and political infighting.

But as electoral righteousness, especially in Germanic Europe, prevails, the insistence on creditors sharing in future debt default write-offs keeps shining through.

And though this reality will probably only apply post-2013 when the new €500bn ESM (European Stability Mechanism) lifeboat is fully launched, markets fear an early lapse of judgement.

If that happens (early debt restructuring) haircuts will be doled out. This concern has dried up private appetite for peripheral debt. Yet the peripheral Club Med will still need a few hundred billion euros in bridging loans to refund maturing debt these next two years.

If markets don’t want to provide, other governments need to. But their electorates don’t want to, and so neither do their governments (if you follow my drift).

So basically nobody wants to pick up the tab while piously discussing the options facing peripherals. Not surprising, the eventual chorus to the peripherals is “you should do more yourself”.

Reagan had something similarly in mind for Mexico in the early 1980s, telling it to pull itself up by its own bootstraps. Following which a cartoon wanted to know “What are bootstraps, Senor”?

As financial markets keep up the pressure, walking away from more peripheral European country debts, the pressure on political elites grows to provide more bailouts through their common lifeboat, at a time when their electorates are increasingly rebellious.

This at times gives way to apparent farce.

Like last week, for instance. If I understand it correctly, core Europe is threatening to withhold a partial restructuring (soft reprofiling) that would in fact keep peripheral (Greek) debt unsustainable UNLESS Greece commits to greater austerity and more reform (and this eventually also applying to Ireland and Portugal, and even beyond them).

In other words: in return for a few easy changes (increasing debt maturities, lowering interest rates) which will keep these national debts rising and the debt trajectory unsustainable, Greece is expected to turn itself inside out (privatization, austerity, labour, social, bureaucratic reform).

This would buy time, but would it solve anything?

Markets see an ultimate call upon their forgiveness through 40%-70% haircuts. And it makes them jumpy.

The ECB is fighting sovereign debt restructuring in any shape tooth and nail. Actual restructuring would weaken European banks (and increase ECB exposure) while the ECB directly holds the most toxic debt of all (collateral accepted from peripheral banks and sovereign debt bought directly), running the risk of its own default and needed recapitalization by politicians (undermining the ECB’s cherished independence from political interference).

The ECB also doesn’t want a soft sovereign debt reprofiling, for that would simply be dressing up what is still toxic debt, and it would only fan market anxiety about eventual hard restructuring.

The main problem wouldn’t be addressed. The ECB wants everyone to know that it is no longer interested in accepting toxic collateral from banks, as that merely deepens its own problems down the line.

Neither does it want markets more disturb by loose talk.

Instead, the ECB wants governments to take responsibility for their banks (and recapitalize them), INCLUDING the richer Europeans. For the banks remain at the core of the general problem. Once the banks throughout Europe have been adequately addressed, it is possible to address the sovereign debts on everybody’s books.

And the ECB would be able to regain its own health.

But politicians, faced down by their electorates, still don’t dare to face reality and bite bullets. Instead, they keep kicking that can and hope that gradually something less painful turns up.

And it may well work, as it has so far, but more action is needed.

The way of the world is to flexibly seek more wriggle room in every direction. Technically, much can be dressed up (as we have seen to date). Electorates are difficult but politics by its very nature is rarely rigid. And markets are always open to a good offer they can’t refuse (considering the looming alternatives).

This is a game of hide-and-seek between idealistic elites (though realistic about their future global chances if not hanging together, but needing to be cleverer than so far the case), financial markets (forever seeking the easy buck as reward for ‘risk) and intolerant electorates (dreading the common marriage bed even when cerebrally arranged).

The alternative is ignominy (decline and fall, never mind eventually being run over and left for dead like so much road kill in a rapidly changing world).

So much is playing in Europe today, in the process increasing a global sense of danger and risk.

It will probably take years fully resolving, with the eventual outcome as yet murkily hidden in future mists.

But there is always hope, certainly bravery, much cleverness along with much chutzpah, even in the midst of much schadenfreude.

Cees Bruggemans, Chief Economist, FNB

Register for free e-mail articles www.fnb.co.za/economics