Friday, November 4, 2011

Specter of Deflation Haunting the G-20?

Bloomberg's Simon Kennedy and James Neuge report, G-20 Urges EU to End Crisis as Greek Government Teeters:

World leaders expressed impatience and irritation with Europe’s inability to defeat its two-year financial crisis as they urged swift resolution for the sake of the global economy.

With Greece’s debt-ridden government at risk of collapsing as soon as today, Group of 20 chiefs meeting in Cannes, France, yesterday pushed European authorities to flesh out and enact a week-old rescue plan that has already shown signs of unraveling.

“We are grappling with a lack of confidence in markets that leaders will act,” Australian Prime Minister Julia Gillard said in the French seaside resort. “It is therefore very important for leaders to act.”

Such calls -- echoed by the U.S., Britain, China and Russia -- highlight international disappointment that Europe missed the G-20’s deadline of this week to deliver a fix for its fiscal woes. German Chancellor Angela Merkel and French President Nicolas Sarkozy sought to regain the initiative by keeping aid for Greece on ice and demanding Italy accelerate austerity.

“The euro zone must absolutely send a message of credibility to the whole world,” Sarkozy told reporters. “When we take decisions they must be applied, when we set rules they must be respected.”

Confidence Vote

Athens will remain a focal point for policy makers and investors today as Prime Minister George Papandreou faces a confidence vote in parliament. He yesterday yanked his planned referendum on his country’s bailout after it split his party, roiled financial markets and drew unprecedented warnings from euro leaders that it may cost Greece its membership in the 17- nation currency club. Opposition leader Antonis Samaras rejected sharing power with Papandreou and called on the premier to quit.

Whether Greece will need to quit the 12-year-old bloc -- designed by its founders as permanent -- was discussed by the G-20, said Canadian Prime Minister Stephen Harper, who predicted “cooler heads will prevail.” Leaders monitored their BlackBerries through their talks to keep up with fast-moving events in Greece, according to U.K. officials.

As European Central Bank President Mario Draghi cut interest rates and warned a recession is looming, the euro area may find some support after Russian President Dmitry Medvedev said the BRICS group of emerging markets is ready to stump up cash. European policy makers are looking beyond their borders to more than double the spending strength of their 440 billion-euro ($608 billion) rescue fund.

‘Preserving the Euro’

“We have to help preserve one of the world’s leading currencies,” Medvedev said. “We are all interested in preserving the euro.”

Brazil, Russia, India, China and South Africa would contribute to Europe in line with their current voting rights at the International Monetary Fund, Medvedev said. In return, they expect Western powers to give them a bigger say at the Washington-based lender, he said.

The IMF may receive a broader fillip after the U.K. backed an increase in the fund’s $391 billion war chest to give it a bigger crisis-fighting role. Options include raising the amount of Special Drawing Rights, opening a trust fund or not rolling back a 2009 cash increase, an EU official said.

Greek Aid

In a draft of a statement to be released today, officials also pressed the fund to “expedite” a new liquidity line for economies “with strong policies and fundamentals facing” outside shocks.

“When the world is in crisis, it’s right that you consider boosting the IMF,” U.K. Prime Minister David Cameron said.

After browbeating Papandreou on the eve of the talks, Merkel returned to the theme yesterday by saying Europe will withhold 8 billion euros of fresh aid until Greece meets its fiscal promises.

“What counts for us is actions,” Merkel said. “So far, I don’t really see those actions.”

Greece, whose two-year bond yield topped 100 percent yesterday, faces the “real danger” of a disorderly default, risking a run on banks at home and abroad, billionaire investor George Soros said in an speech in Budapest yesterday.

Italian Efforts

Merkel and Sarkozy also teamed up to urge Italian Prime Minister Silvio Berlusconi, who oversees the euro area’s second largest debt load after Greece, to forge ahead with budget cuts. In a sign investors are unimpressed with the emergency steps he has taken so far, they yesterday pushed Italian bond yields to a euro-era record.

The IMF may be tasked with monitoring Italy’s budget- cutting efforts, an EU official said. Berlusconi’s government may first have to request the surveillance.

“For me, Europe is all about Italy right now,” said Jurrien Timmer, who co-manages Fidelity Investments’ $219 million Global Strategies Fund in Boston. “The real issue is contagion, and Italy seems to be the line in the sand. Italy is really too big to fail. It’s the third largest bond market in the world, and it needs to be ring-fenced.”

David Berman of the Globe and Mail agrees, the real concern is Italy:

Stock markets seem to be happy now that Greece’s leader has called off the referendum on the European debt deal. Thing is, though, some observers have been arguing for time – and they continue to assert – that Greece has become a sideshow to the sovereign-debt crisis. The real problem is Italy, where rising bond yields suggest that the country is going to be facing a debt crisis of its own.

As Felix Salmon argues: “Greece is going to default and leave the euro; the only question is when. And when it does, the EU will find that its protections against contagion are about as effective as that $1.6-billion tsunami breakwater in Kamaishi. Greece can fall and the eurozone can still survive. But Italy – which is just as politically dysfunctional as Greece – can’t.” And that could mean the end of the European monetary union.

The Economist sounds almost as bleak: “Should the [Greek] government fall, a snap election will be held, and something will happen. One strongly suspects, based on the almost shocking placidity of markets, that a new government will come in and implement the cuts demanded of the country so that we can all move on to the next phase of the crisis, which is sure to hit any day now, probably about 600 miles to the northwest.”

Shocking is probably the right way to describe the reaction from stock markets. Aren’t stocks supposed to hate uncertainty? Yes, the European Central Bank took its key interest rate down a notch and U.S. initial jobless claims fell below the 400,000-threshold (for whatever significance that has). But with Europe on the brink and leaders scrambling to hold things together at the G20 meeting in Cannes on Thursday, you might think that stock prices would be reflecting some nervousness about the immediate future.

But no: After a mid-morning stumble, the Dow Jones industrial average is up 1 per cent. The CBOE Volatility index, or VIX, which tends to reflect investor anxiety, has fallen 7 per cent from its mid-morning high and is down slightly for the day. And the yield on the 10-year U.S. Treasury bond – one of the key haven investments – has ticked above 2 per cent after falling for four consecutive days.

I wouldn't read too much into yesterday's stock market rally as stocks and other risk assets gyrate wildly on a daily basis. News that Greece was not going to hold a referendum created a relief rally, but Papandreou still has to survive Friday's confidence vote. In what appeared to be a last-ditch attempt to rally dissenting MPs ahead of the confidence vote, Papandreou warned against the risk of bankruptcy for Greece and said his government should press on with its task of pushing through a difficult austerity package aimed at curbing a deepening debt crisis.

Bloomberg reports that as Greece dices with its status in the euro region, Ireland and Portugal say they will do whatever it takes to remain wedded to the single currency:

“We do not want to be confused with what is going on in Greece,” Passos Coelho said in comments broadcast yesterday by television station SIC Noticias.

UBS AG (UBS) estimates a weak nation leaving the currency would cost as much as 11,500 euros ($15,819) for every person in the country, or 50 percent of gross domestic product in the first year alone. It would probably amount to as much as 4,000 per person in subsequent years, the bank said in a Sept. 6 report.

In Portugal, which joined the EU in 1986, income per head has risen about 30 percent since 2000. In Ireland, a member since 1973, it’s up 25 percent in the same time, even after the economy shrank by about 15 percent in the past three years.

“We’re too small a country to stand alone,” Brendan Hanratty, 65, a semi-retired farmer, said in Dublin. “For a small country, I don’t think they would be able to run the country without the euro. If Europe hadn’t given us the cash, we wouldn’t have the roads or the motorways, we’d have nothing.”

I am not so sure that the Irish and Portuguese would agree with this benign assessment of the benefits of remaining in the eurozone. The Irish all accepted deep haircuts in their wages and had their pensions looted to prop up their failed banks. As far as Portugual, to their credit, they have slashed public sector waste but their economy remains weak and hit by the recession, they now want to negotiate more flexible terms for its euro78 billion ($107.5 billion) bailout.

The problem with shoving austerity down everyone's throat is that it will only accelerate the deflationary process that is currently underway, effectively guaranteeing a prolonged period of debt deflation. India's Economic Times reports that Europe's new plan does not address the real issues:

At best, the latest European plan to resolve the continent's debt crisis provides funds to tide over the immediate funding problems of weaker euro zone members. It does little to deal with the euro zone's structural problems.

There is still the risk that Europe enters a prolonged period of low growth or recession. The plan does not address the economic divergences that exist within the euro zone or ease the painful adjustment processes that weaker members will still have to undergo within the constraints of the single currency.

A crucial element of the plan is the ability of Spain and Italy to take action to improve their finances and maintain access to funding at reasonable cost. The EU communique specifically refers to the need for actions by these two members at some length. There is considerable doubt as to whether this will occur.

Spain's economy is weak, with low growth, low productivity and high reliance on debt. As the country has sought to bring its finances under control, Spain's growth has slowed with a rise in the unemployment rate to 21% and youth unemployment above 40%.

Spain's banking sector remains heavily exposed to real estate with the likelihood of more losses. It is difficult to see Italy, weakened by internal political strife, making rapid progress to required structural changes to its economy and cutting public debt. The austerity and balanced budget measures, reinforced and reiterated in the plan, cannot deal with the primary problem, the deflation of the debt-fuelled bubble.

Strict enforcement of limits on deficits and level of debt would prevent counter-cyclical spending by governments undermining economic recovery and lock the euro-zone into a death spiral of budget deficits, further budget cuts and low growth. The problem is compounded by the competitiveness gap between northern and southern countries, estimated at 30% difference in costs.

For many of the weaker countries, the best option would be to devalue its currency in the same way that the US and Britain are debasing dollars and sterling, respectively. The EU's refusal to contemplate a break-up or restructuring of the euro makes dealing with this problem difficult. Unable to devalue or control interest rates, these weaker countries are trapped in a vicious and ultimately self-defeating cycle of cost reduction.

An additional problem is the internal imbalances exemplified by Germany's large intra euro zone trade surplus at the expense of deficit states, especially the Club Med countries like Greece, Portugal, Spain and Italy.

German reluctance to boosting spending and imports makes any chance of resolving the crisis even more remote. German banks lent money to many countries to finance exports, which benefited Germany. It also gained export competitiveness from a weaker euro.

The plan has bought time, though far less than generally assumed. The European debt endgame remains the same: fiscal union (greater integration of finances where Germany and the stronger economies subsidise the weaker economies); debt monetisation ECB prints money); or sovereign defaults.

Finally, I leave you with Andreas Koutras' comment on the Greek referendum's positive shock:
Referendum? What referendum?

Margaret Thatcher once said
"You turn if you want to. The lady's not for turning." (10 Oct 1980). Papandreou on the other hand did a U-turn and took back his Referendum decision. He more or less explained his U-turn as a clever ploy to flush out all those who opposed the agreement both inside and outside his party and to form a consensus. I find that argument very weak and unconvincing. More plausibly this is an attempt to justify his political blunder by laying claim to some higher esoteric and convoluted logic.

Mr Papandreou is a hard nut to crack. Both his father and grandfather were prime-ministers and he was born within an environment of intriguer, chaos and political manipulation. So, it was naturally for him to refuse resignation and dare his timid party to overthrow him. The vote tonight would be pass the bedtime of most markets so we would have plenty of time to reflect on Greece with the Sunday papers. Chances are however, that he would not survive the vote of confidence and a new administration would be formed. If they decide on elections then the most likely date would be the 4th December.

Whether we believe Mr Papandreou’s motives or not the truth is that it has exposed some very inconvenient truths about Greece and the EU.

In Greece
  • Contrary to his repeated claims, the main opposition to the austerity measures came from inside his own party; the union leaders he bred and caressed for so many years, and the socialist utopia which he has promoted with other people’s money (EU subsidies and borrowing). Unfortunately he did not beg forgiveness for promoting the wrong policies all this time
  • It exposed the bipolar policies of the conservative party which tried to capitalize on the popular discontent by suggesting that there is an easier and a more painful way to take the poison pill.
  • It also exposed the double speak of the communist party which for many years advocated exit from the EU.
In Europe

Yesterday’s announcement by Merkel and Sarkozy that any referendum would be taken as YES/NO for Greece’s continuing EU membership was chilling. Merkozy represent individual EU member states NOT the EU. They have no right to issue threats or ultimatums to Greece or to any other state. This is EU democracy and accountability at its worst.

Throughout this crisis the EU tried to force the independent ECB to do their dirty work for them. Then the ECB overruled any default or restructuring of the Greek debt in 2010 (and the Irish in 2009). After that they tried to bend the market and attacked the bad rating agencies and the immoral CDS. Together with the IMF they imposed an austerity package upon Ireland, Portugal and Greece. Talk of fiscal union was brushed aside or was quickly given to Van Rompuy so that they can control it. All this time the people of Europe were never asked for their opinion. Now that the Greeks whispered the offending word “Referendum” the masks were dropped. Greece would be “allowed” to have one only - if the wording is dictated by Merkozy.

Europe needs to wake up. This resolution of this crisis does not lie with a Greek exit from the Eurozone. Greece without wanting it has unmasked many of the serious weakness of this Union and its treaties. The lack of accountability, the democratic deficit, the impotent Europarliament, the lack of fiscal and political union, the ECB’s limited capabilities, the changed relationship to creditor/lender from partner state, all need to be addressed.

I agree, Europe needs to wake up but I fear that they're repeating the same policy mistakes that led the world to the Great Depression decades ago. This crisis has exposed serious weaknesses in the EU and the risk of contagion remains high (see video clips below). Importantly, as policymakers scramble to avert contagion, the specter of deflation is haunting Europe and the G-20.

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