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The summit to end all summits…until the next one


Another summit, another opportunity lost.

Europe’s leaders gathered in Brussels on December 8th and 9th to discuss plans to save the single currency. Or written more correctly, to discuss Franco-German plans to save the euro. What emerged after intense debate between France, Germany and Great Britain, and after no debate from the rest of the EU, was a plan to amend the Treaty of Lisbon to provide for closer fiscal integration and mechanisms to assure the long-run stability of the euro zone. Unfortunately for the “short-cut” process of treaty emendation, Great Britain decided to exercise her veto. This leaves Britain on the outside of Europe and the rest of the “European 26” wondering how they are going to implement what they so hastily agreed to.

Thus began another round of confusion for Europe which sets new depths of incomprehensibility even for that Byzantine continent.

Markets had been rallying for most of December in the expectation that this summit would finally live up to the hype being generated by the politicians. Statements by Sarkozy (“Europe’s last chance”) and Merkel (“a new Europe”), not to mention Draghi, Monti, Schäuble and others, led even skeptics to believe that Europeans had finally realized the gravity of the crisis they were facing and indicated a willingness to take previously unthinkable steps, like issuing eurobonds or authorizing LOLR status for the ECB. As news of the agreement filtered out Friday morning, there was an initial surge in confidence, especially in equities markets, despite the UK hold-out.

Since then, bond markets have taken a very mixed view. Prices have fallen in the secondary market for most European sovereign bonds, including previously precarious Belgium and Spain. In both cases, the long-term cost of debt has been falling towards the 52 week low.


However, there is another group of key economies who are still facing high or even rising funding costs. Greece and Portugal should come as no surprise to anyone. In fact, Greece hardly belongs on the same planet as the rest of Europe anymore and conditions there cannot be compared to any other market. It is disappointing news for Portugal, where the new conservative government of Pedro Coelho has instituted highly unpopular austerity measures to win back market confidence in his nation’s willingness and ability to repay its debts. He has been unsuccessful so far.

The greater concern comes from the other two economies in this sub par category: Italy and France. Long-term bond prices in Italy fell slightly before the summit; then rose to previous highs after the summit measures were digested; and have now fallen slightly to hover dangerously close to 7%.

The bright spot for Italy is that the price of short-term debt has fallen dramatically and is no longer “inverted”  with respect to 10-year bonds (1). At least investors are no longer predicting an imminent default in Italy.








France has also enjoyed scant benefits from the summit. Her banks have been hammered by the rating agencies, economic data has been generally lackluster, and the new commitments to the European rescue funds leave investors wondering if France is going to have to rescue herself. All this has put pressure on the French budget and caused Moody’s to maintain France’s AAA rating, but only by the hardest. It will undoubtedly be reviewed early next year, leaving investors nervous of a possible French downgrade.

This warning (or threat) apparently hasn’t fazed Mario Draghi or Christian Noyer. These two central bankers have not only discounted the possibility of a downgrade, but have scoffed at the consequences. Mr. Draghi, the new ECB chairman, has stated that a French downgrade shouldn’t be ” a terrible thing” though it would undoubtedly lead to other European nations being downgraded. (2) Last I checked, that was the definition of “contagion”, something everyone has agreed would be catastrophic for Europe.

Mr. Noyer, chairman of the Banque de France, responded to the downgrade warning with what can only be generously described as a fit of piqué:

“Speaking to French regional newspaper Le Telegramme, Mr Noyer said any downgrade should start with Britain ‘which has more deficits, as much debt, more inflation, less growth than us and where credit is slumping’.” (3)

Which is no doubt why Mr. Noyer is not in the Corps Diplomatique. Mr. Noyer nevertheless let his anger override his better judgement in delivering this verdict, since he should know better. The United Kingdom has control over its monetary policy while France does not – it is this lack of control and flexibility that the agencies are punishing, not the relative economic performance of the two nations – which most certainly favors France.

Mr. Bean in Brussels

Meanwhile, the UK has been cast as the villain of this tragi-comedy and excoriated throughout the continental press. A traitor to Europe, short-sighted and blind to its own interests, Judas: yet Bank of England bond yields dropped sharply after the summit and have remained low as investors fled to them from the continent. US Treasury notes have also benefited.

The situation seems a bit fishy as well. Mrs. Merkel and Mr. Sarkozy have made no secret of the direction they were heading, in terms of greater fiscal union of the euro zone nations. David Cameron was in Berlin on November 17th for a meeting with Mrs. Merkel that undoubtedly must have covered these topics and British conditions for accepting them. That meeting ended with Mr. Cameron and Mrs. Merkel agreeing to disagree.

The fact that Germany and France knew the British conditions weeks in advance of the summit, and made no effort to accommodate them or to deal gently with the Tory leader is to me an indication that they were determined to ram their medicine down everyone’s throat, the UK included. It can hardly be surprising that David Cameron, seeing his minimum conditions unmet – blatantly unmet – decided to make a scene. Whether this was a political miscalculation remains to be seen. Markets didn’t think so. Nor did the majority of British voters. And Europe still needs the UK as much as the UK needs Europe…perhaps more.

It seems like much ado about nothing.

The Deal

The main points of the agreement reached on December 9th, if something that was so little discussed by the other participants can be called anything but a diktat, include the following provisions:

  1. A new “fiscal compact” and “significantly stronger coordination of economic policies in areas of common interest”;
  2. Euro zone states’ budgets should be balanced or in surplus; this principle will be deemed respected if, as a rule, the annual structural deficit does not exceed 0.5 percent of GDP;
  3. Such a rule will also be introduced in euro zone member states’ own national legal systems; they must report national debt issuance plans in advance;
  4. As soon as a euro member state is in breach of the three percent deficit ceiling, there will be automatic consequences, including possible sanctions, unless a qualified majority of euro states is opposed;
  5. The European Stability Mechanism (ESM), the euro zone’s permanent bailout fund, is to enter into force in July 2012; the existing European Financial Stability Facility (EFSF) will remain active until mid-2013;
  6. The overall ceiling of the EFSF/ESM of 500 billion euros will be reviewed in March 2012;
  7. Provision of funds to the IMF of up to 200 billion euros to help it deal with the crisis, in the form of bilateral loans from EU states.

Some provisions are good. Some provisions are bad. Most important where the provisions absent from the final agreement:

  1. There was no agreement to modify ECB regulations to permit the European Central Bank to act as a lender of last resort (LOLR);
  2. There was no agreement to create a mechanism for issuing shared liability debt (i.e. eurobonds);

It came as no surprise that Mrs. Merkel set out very tough conditions regarding new fiscal rules and empowered oversight of fiscal compliance, it has been a hallmark of every speech the German Chancellor has made since October. What was disappointing, at least for me, was the failure of any quid pro quo on the ECB or eurobonds. It was my hope and expectation that the Kanzlerin would make these necessary concessions in return for being able to present a new fiscal union regime to the German Parliament. Unfortunately, the Germans have not bent on the two concessions that would have an immediate impact towards resolving the euro crisis. There will be no “financial bazooka”.

Mario Draghi confirmed this when visiting Berlin on December 15th. The Italian central banker out-germaned the Germans:

“The ECB’s purchases of government bonds are ‘neither eternal, nor infinite,’ Mr. Draghi said in a speech in Berlin, stressing it would take “a lot” more than monetary-policy measures to restore market confidence in the euro zone.” (4)

Small wonder that bond investors remain nervous.


The main problem with the new agreement is that it aims to solve the wrong problems and in a remarkably inflexible manner. The first 4 points of the agreement all deal with a new fiscal regime dedicated to Germanic austerity. Europe already has a deficit cap in place, enshrined in the Maastricht Treaty. What’s wrong with a deficit cap? Well, to start with, no one has paid the slightest attention to it, least of all the holier-than-thou Germans and French (5):














It is ironic to note that Ireland and Spain, two of the “profligate” nations, were models of fiscal responsibility until the 2008 crisis derailed their economies. Meanwhile, Germany and France were in the same league as Italy, Slovakia, Portugal and Malta in terms of violating the Growth and Stability Pact. If fiscal austerity didn’t matter over the past decade, why does it matter now? And what makes anyone assume that the new rules will be any more enforceable than the old rules, which also included penalties for non-compliance?

“Ever greater union”. The underlying – and now proven mistaken – hypothesis of the monetary union is that it would force convergence on the economies that joined the euro. The new fiscal union assumes that all of Europe (or at least the euro zone) will now converge on the German model and exhibit German levels of productivity and efficiency. This is living in a dream world. It can only be achieved in one of the following ways:

  1. Germany can end wage restraint and embark on expansionary fiscal policy – i.e. deficit spending – in order to generate inflation and reduce Germany’s relative wage competitiveness vis-a-vis the rest of Europe. NEIN! Probability of this occurring: less than zero. Balanced budgets and wage restraints are codified into German law, and the Bundestag is not about to tamper with these “sacred principles”;
  2. The rest of Europe can attempt to replicate the German model through massive structural reforms. This sounds like a great idea, until one remembers that it took the Germans more than a decade of work during times of economic plenty to arrive at where they are, and that they were already one of the most productive economies in the world when they started. To expect countries like Portugal, Italy or Spain to implement a similar program during a period of severe economic distress, and to stick to it for a decade or more, is unrealistic. And they would have to hit a moving target – there is no reason to expect Germany to stand still, waiting for the rest to catch up. NEIN! Probability of this occurring: around zero. Certainly, some countries will implement important reforms, and countries like the Netherlands, Austria, Sweden, perhaps Poland – are close enough to Germany to achieve convergence. But to expect this to be the pan-European solution is worse than naive;
  3. Uncompetitive countries can regain wage productivity competitiveness through “internal devaluation”. This is a nice way that economists have of saying wages will fall, and fall, and keep falling until labor in, say, Spain becomes cheap enough to compete with German labor. This is achieved through unemployment, through recession, and through misery. Whether Southern European economies can handle the social implications of long-term internal devaluation is an open question. Greece is already in a state of semi-anarchy; Italy and Portugal have seen large-scale strikes and protests with growing frequency. Spain is home to the “indignados” movement that  spread overseas and morphed into “Occupy Wall Street”. On the plus side, this is the least painful option for German voters. JA! Probability of this occurring: near certain.

Option #3 is precisely what Angela Merkel and Nicolas Sarkozy placed before their fellow Europeans on December 9th. Mrs. Merkel at least had the honesty to admit that the course towards fiscal union would be arduous and take many years:

“Member states of the euro zone have set themselves on an ‘irreversible course towards a fiscal union’ to underpin their common currency, even if it may take years to reach that goal.” (6)

Europe may not have years to reach that goal, it may have a few months at most. One reason that bond markets have been steady is that there have been relatively few new debt sales from the distressed economies, and those relatively small. That is not going to be the case come January 2012 (7):











Total debt maturing between January – April 2012 = €353.2 billion
Total emergency funding theoretically available = €500.0 billion (EFSF + EFSM programs)
Total emergency funding actually disbursed to date = €12.5 billion (8)

It remains to be seen come February, whether investors will be willing to rollover €160 billion in Italian debt at reasonable rates of interest. If there is a shortfall in demand for Italian debt, will the EFSF step in big time to save the Italians from default? Up until now, what has been disbursed is small potatoes. We’ll have to see how the Germans react to the reality of saving a big “profligate” via the EFSF rather than through austerity.

The IMF also has a facility dedicated to Europe of €250 billion – but that comes with the always pleasant visits from the IMF “men in black” also known as the “dark princes of austerity”. It is unlikely that Italy, Spain or especially France will want to call on these familiars to save their bacon.

Stay tuned.


(1) Bonds are “inverted” when the price of short-term bonds exceeds those of longer-term debt. Short-term debt is usually priced lower due to the higher uncertainty implied by a maturity date in the far future. Inverted bonds are a very worrying sign that things are seriously wrong with a country’s finances.
(2) http://www.marketwatch.com/story/france-losing-aaa-shouldnt-be-terrible-draghi-2011-12-19
(3) http://www.bbc.co.uk/news/world-europe-16207748
(4) http://online.wsj.com/article/SB10001424052970204026804577099932307341996.html
(5) Eurostat data, courtesy of Jess Jiang and Alyson Hurt, NPR
(6) http://www.ft.com/intl/cms/s/0/a4271df0-2663-11e1-85fb-00144feabdc0.html
(7) Bloomberg data, courtesy of Der Spiegel International edition
(8) EFSF data (http://www.efsf.europa.eu/about/operations/index.htm)

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