Europe Needs a Real Fiscal Union

The rhetoric is heating up as we head into Monday’s European Union’s summit.  On one hand, we see rumors circulating that a deal in the Greek debt talks is in the works.  Via the Wall Street Journal:

But in Athens, the mood Saturday was upbeat. “We really are one step away from a final agreement [on the debt deal],” Finance Minister Evangelos Venizelos told reporters following a day of hectic talks in the Greek capital. “Next week we will be in a position to complete this procedure along with the talks we are holding on the new loan program.”

Note, however, that these negotiations are just one piece of the puzzle.  Via the New York Times:

Though a debt agreement may spur Greece’s next bailout installment, the deeper loss being inflicted on bondholders carries the risk that many investors, in particular hedge funds that in recent months have loaded up on cheap Greek bonds in hopes of a payday this March, will refuse to participate in the deal.

Greece will try to impose the terms on all investors by writing collective-action clauses into the contracts of its old bonds. By doing this, the hope is that the holdouts, estimated to sit on 10 percent to 15 percent of the 206 billion euros ($272 billion) in outstanding securities, will exchange their old bonds for new bonds — preferring the new discounted bonds to their old ones, which may become worthless.

Some hedge funds that have bought at rock-bottom prices may decide to pursue legal action, although such a process could take years with small certainty of success.

Also undecided is what the European Central Bank, which owns 55 billion euros of Greek bonds, will do. Despite public pressure that it, along with investors, accept a loss on its bonds, the bank has not budged.

It seems to me more accurate to state that one portion of the debt deal may be in place, but in the interest of unity on the eve of the EU summit, we will pretend that the issues of holdouts and the ECB are not relevant.  In any event, given the steady deterioration of the Greek economy, I find it unlikely that this is the last word in the debt story.

More interesting, however, is German demands that Greece cede its budgetary authority to the Troika.  Athens of course was a bit perturbed by the escalation of demands.  Via the Financial Times:

The Greek finance minister has lashed out against a German proposal for its budget to be controlled by a eurozone commissioner as a condition for receiving a second €130bn bail-out, saying the country was already prepared to “implement tough but necessary decisions”…

…The German plan, widely circulated in Athens and dubbed “the document of shame” by a local newspaper, would require Greece to pass legislation making debt repayments a budget priority, and would also give the new commissioner a veto over large-scale spending.

Perhaps the Greeks are not moving ahead swiftly enough with reforms, but consider that they are stuck between a rock and a hard place – anything positive in the long-run looks to be devastating in the short run.  For example:

One main sticking point has been demands by EU and International Monetary Fund negotiators for a 25 per cent cut in the €750 minimum monthly wage and the abolition of an annual bonus paid as 13th and 14th salaries – measures that would improve competitiveness and bring Greece in line with minimum wages in Spain and Portugal.

George Koutromanis, labour minister, argued that the measure would reduce output by about 1.5 percentage points of gross domestic product and prolong the country’s recession, now in its fifth year.

Greece needs more carrots to move forward; Germany offers only the stick.  Speaking of which, Germany subsequently responded to Athens indignation.  Via the Wall Street Journal:

Germany’s finance minister issued an unusually blunt warning that the euro zone might refuse to grant Greece a fresh bailout, pushing Athens into default unless it persuades Europe it can overhaul its state and economy…

…Europe is “prepared to support Greece” with the new loan package, Mr. Schäuble said, but he warned: “Unless Greece implements the necessary decisions and doesn’t just announce them … there’s no amount of money that can solve the problem.”

The options for Greece are narrowing quickly – either willingly accept German rule, or exit the Euro.  And perhaps plans for the latter are already well established.  Via The Examiner (hat tip Ed Harrison):

Greece plans an orderly exit out of the Eurozone according to two sources close to Mr. Papademos, Greek Prime Minister, who spoke on condition of anonymity earlier today.

The sources confirmed that plans are ready to return to a legacy currency given the current circumstances and that such exit would be dealt with, quote “in as orderly a fashion as possible” unquote.

I am starting to wonder if Greece is going through the motions to get one more tranche of aid before they come to the conclusion that they must exit the Eurozone.  Absent real transfers from Germany, staying in the Eurozone now means crushing recession under German rule.  Exiting just means crushing recession.  Germany, however, is playing a dangerous game testing Greek nationalism.  Either outcome is bad for Greece, but I suspect pushing Greece out of the Euro is ultimately bad for Germany as well.

Meanwhile, other nations need to pay attention to how this all plays out, because austerity is just not working anywhere.  Take Spain for example, where unemployment is at a depression-like level of 23%.  A clear symbol of the failure of European economic policy, to be sure.  Spain gets a pass, however, as for now it is playing the German game.  Via the Wall Street Journal:

In an interview this week with Spain’s El Pais newspaper, German Chancellor Angela Merkel noted Spain’s high unemployment rate, and said her country was willing to help the region’s fiscally frail countries, but that they must take steps to solve their own problems.

Soraya Sáenz de Santamaría, spokeswoman for Spain’s new government, repeated that a sweeping overhaul of Spanish labor laws is coming in weeks. “To all those millions of people who are looking for a job, I want to tell them…we are speeding up the reforms that are necessary to turn this situation around,” she told journalists after the weekly cabinet meeting.

The story is that high dismissal costs deter hiring.  To be sure, a real issue.  I would note, however, that this did not seem to be a problem a few years back when the construction boom fostered unemployment rates below 10%.  While structural reforms are important, so to is demand.  And where will that demand come from in the short run?

Even more pressing is the issue of Portugal, which will almost certainly need another bailout.  Moreover, the 15.2% rate of 10 year debt calls into question the EU claim that the Greek PSI was an isolated event.  Via Business Insider:

While on some level it is crucial for the country to sustain the idea that it is meeting its debt obligations until it has more aid in the bag, the truth might be that the gig is up; it’s just unlikely that Portugal will continue to meet its debt and deficit goals amid mounting pressures, even if it complies with the troika plan.

This is much the same psychological development that took place in Greece last summer, as EU politicians realized that a managed default might be the best way to return Greek debt levels to sustainability.

Note that swift passage of an even watered-down commitment to EU-wide fiscal austerity may not be as easy as it sounds.  Perhaps the Irish are no longer willing to suffer in silence, via the Financial Times:

The Irish government faces intense pressure to hold a referendum on the eurozone fiscal treaty after a poll that showed almost three quarters of the public want a vote on the agreement.

Months of uncertainty lie ahead.  That said, perhaps their is some hope that Europe leaders will actually move where they need to go – true fiscal union.  On the eve of the summit, we learned that EU leaders are starting to see the writing on the wall.  Via the New York Times:

Bowing to mounting evidence that  austerity alone cannot solve the debt crisis, European leaders are expected to conclude  this week that what the debt-laden, sclerotic countries of the Continent need are a dose of economic growth.

A draft of the European Union summit meeting communiqué calls for ‘‘growth-friendly consolidation and job-friendly growth,’’ an indication that European leaders  have come to realize that austerity measures, like those being put in countries like Greece and Italy,  risk stoking a recession and plunging fragile economies into a  downward spiral.

But the devil is in the details:

The difficulty, however, is that reaching such a conclusion is not the same as making it happen.

Instead, leaders will discuss long-term structural reforms and better use of E.U. subsidies, while avoiding mention of the one thing that could change the climate: a fiscal stimulus from Germany, the euro currency zone’s undisputed powerhouse.

Easy to say, tough to do given Europe’s political makeup.  At what point will Germany be willing to justify fiscal transfers to the rest of Europe.  For now, the EU appears able to come up with little more than token sums of cash to support growth.  According to Reuters:

The summit is expected to announce that up to 20 billion euros ($26.4 billion) of unused funds from the EU’s 2007-2013 budget will be redirected toward job creation, especially among the young, and will commit to freeing up bank lending to small- and medium-sized companies.

A paltry sum when placed in context of 23 million unemployed in Europe.

Bottom Line:  The European Central Bank’s LTRO dramatically eased financial market tensions throughout Europe, revealing the important role of a lender of last resort.  But underneath those tensions exist some very real and deep economic and political fractures in the European economy.  And unless those fractures are quickly healed via a real fiscal union – not just an agreement to balance budgets, but a union in which rich countries transfer, not lend, resources to poor – the Euro experiment will be torn asunder.

This post originally appeared at Tim Duy’s Fed Watch and is posted with permission.