Author: Emanuel Arbib

With the first and second LTRO programs the ECB was able to buy precious time to allow the slower workings of politics to solve the problem structurally. Unfortunately, this placebo only worked until a Greek exit from the Euro became a likely outcome rather than a discussion theme for economists.

The excessively pro-cyclical policies imposed by the Germans and the EU on the weaker countries goes against all textbook economics, not only Keynesian. The results, deepening of recessions, deterioration of bank balance sheets, and the beginnings of social unrest, may end up provoking the opposite effects. If Greece leaves the Eurozone, it will be a signal to the markets that they should price in a Portuguese, Spanish, Italian, and who knows, maybe even French exit. That would of course mean the end of the euro.

As with all problems, the later you tackle them, the more aggressive you will need to be to hope to achieve success. Clearly the only body able to fight for the Eurozone survival is the ECB. Its next steps will have to include a strong signal, a double notch rate reduction, and a pragmatic relaxation of collateral rules. Lack of decisive action soon with these tools will only leave it the option of real QE, sometime in the summer months.

It wasn’t difficult to imagine that the Greeks would have voted with anger in their hearts. A fiscal readjustment without currency devaluation is not a pleasant experience. When people’s pensions are cut by 15-20% in nominal terms, the cohesiveness of society is at risk. The inconclusive results of that election and the standoff between a Balkanic and a European Greece are going to keep markets unsettled for another couple of months at least.

The election of the new French president that ran on the platform of ‘we can’t live on rigour alone’ is another, more core-European reaction to the same malaise. Given that Europe without France is an oxymoron, the challenge is now on Mrs Merkel to find the way to square the circle. Absent the ghosts of Weimar, a little inflation would be good for Europe, as a collective mechanism for adjusting their economies in a less painful fashion.

It is too early to tell if Mr.Hollande will be able to use his new mandate to help achieve what Mr.Monti has been arguing for some time, namely that the economies that had spent beyond their means in the good years needed to put their fiscal houses in order, but that this cannot be the only solution at a time where we are still mired in the ‘great recession’ which was initially precipitated by the 2008 banking crisis. Monti is having his own problems in Italy, where the level of taxation is near or beyond the point of diminishing returns. The next three months will be telling for the future of Europe beyond the question of whether Greece is in or out.

Next week we will know who will be responsible for running France for the next five years. If we are to believe the polls, Angela Merkel will have a new partner in the German-French axis, with which she will need to start doing business. At the next French-German-Italian summit, there will be two leaders out of three that are leaning towards a growth strategy, even if nuanced. If until now Monti has politely reminded Sarkozy and especially Merkel, that the problems that Europe is facing cannot be resolved by cuts alone, now he will be joined by an Hollande who has practically ignored the needs for fiscal prudence in his campaign, and has basically insisted on the need to keep and actually reinforce the French welfare state that costs about half of GDP.

Of course Merkel has been there and seen this already, and as the Economist reminds us, all chancellors end up ‘convincing’ French presidents over time. The problem is this time there isn’t much time, and the markets tend to like to test new paradigms or leaders sooner rather than later.

For decades the IMF’s best known recipe for troubled economies was loans in return for a fiscal consolidation commitment. It is now refreshing to see that even the IMF is advising that without growth, there is no practical way out of the European debt crisis. It is a simple question of mathematics. There are two main indicators of a country’s fiscal health: the current account balance, and the stock of debt outstanding. Both these quantities are usually then divided by the gross domestic product to produce the yearly budget deficit ratio and the Debt/GDP ratio. Some European nations have a problem with the first ratio, some with the second, and others are developing a double sickness. Spain, for example has a current account problem; Italy, an inherited huge national debt that stands at well over its GDP. Greece, suffering from a combined problem, had to restructure its debt with IMF and EU help. Fiscal restraint works better in case one, where a few years of low budget deficits can cure the economy. Italy has the second problem, which requires a double cure. The budget deficits haven’t been a problem for several years, and in fact there have been a number of primary surplus years, and this year an overall surplus is expected; however, the Debt/GDP ratio will hardly budge as the economy is expected to once again shrink. The only way for the “Italys” to reduce this ratio is to start growing again, having virtually stopped ten years ago.

Greece, the real life laboratory of fiscal consolidation

Driving in the hectic Athens traffic one could be excused for not noticing that Greece has just defaulted on its obligations. Traffic is slow, the taverns are relatively full, and spring is in the air. However, after a few conversations with the likes of guides, taxi drivers and hotel clerks you get a clear idea of what is going on here. For the first time in a generation in Western Europe people are actually seeing their salary and pension cheques go down, significantly, and since prices are still at European level, this hurts a lot. Coupled with the fact that taxes are going up, disposable incomes are going down very significantly, two observations come to mind: First of all people seem to be devoid of hope in the future, and in particular they don’t trust either side of the current parliament. There will probably be a large proportion of abstentions in the forthcoming elections. Secondly, people seem to be accepting the tough medicine with a limited amount of protest. Of course there are sit-ins in front of parliament and the occasional more aggressive act, but there is no Greek Spring at work here.

It is too early to tell if this brutal fiscal consolidation will work. If it does, it will be a test case that people end up accepting to tighten their belts considerably when they see that there is no alternative, but the Greek ruling class has a heavy responsibility to ensure that the suffering it had to inflict on its citizens will not be for nought, and at the same time it must find ways to ensure that the weakest sector of society is not left without the basic needs of life, food and shelter.

Italy’s PM Mario Monti is in South Korea this week for the nuclear security summit. This marks Monti’s main foray outside the economic arena into the world diplomatic and security scene. Today he has met with President Obama who complimented him for his economic leadership not only of the Italian economy, but also for his contribution to solving the European financial crisis. This is no mean feat. Italy’s two Marios have risen to the top of European policy making in the last six months and have turned Italy from the weak link to a main architect of the resolution of the crisis that at one point had put the entire European integration at risk. We are not surprised that Monti is held in such esteem abroad. What is more surprising and in some ways unique, is the popularity that Monti is enjoying in Italy after less than six months in power, months during which he had to push through some of the most aggressive fiscal and reform packages in Italy’s modern history.

Apart from two fringe populist parties, and possibly the most left leaning union, Monti is enjoying very wide support from the main political parties on the right and the left, from the public, and from the unions and manufacturers associations (in Italy they are called ‘le parti sociali’). It is likely that Monti’s political adventure will be case study material in future decades about the fact that when a political leader has integrity and personal credibility, he can afford to impose bitter medicines to his citizens and remain very popular. It is unlikely that Monti will want to stay past the 2013 elections, but if he wanted to it would be very difficult to beat his quiet, confident style.

Two legged stools are not very stable and Monti’s ascension to European prominence is a good thing for Italy and for Europe as a whole. While Sarkozy is fighting a difficult battle for re-election and Merkel is trying to manage the ideological concern that post-war Germany has over becoming again Europe’s leading nation, not with guns but with money this time, Mr Monti has used his prestige and his impeccable European record to start changing the European discourse towards growth. This will not be an easy battle since Germany’s aversion to easy money is even older than its fear of leading Europe, but it is a beginning.

As a seasoned economist, and as the prime minister of a nation that has practically stopped growing ten years ago, Monti knows full well that fiscal constraints can only do so much to reduce debt. Having done a lot of work on the nominator, it is now time to work on the denominator. The problem with a growth strategy is that in the past nations have abused the concept and the result has been more debt and not a lot of sustainable growth. Italy is trying to square the circle acting along three axes. The first was the emergency budget approved before the turn of the year, which in effect ensured a current account surplus one year ahead of the Berlusconi-Tremonti plans,  which had already done a lot to keep Italy’s finances in better shape than most other economies. The problem was and is growth, the second driver of the plan. Berlusconi had already insisted on a lot of the liberalisation and flexibility measures advocated now by Monti, but wasn’t able to implement them due to Tremonti and his fragmented coalition. Monti has a better shot at it because of his economic credibility and because Italy has now stared into the abyss and presumably the Italians shouldn’t want to go back there. Growth measures are expensive, and achieving a flexible economy is difficult because of the remaining power of Italy’s unions and the ideological difficulty in getting rid of the famous Art.18, which stipulates that companies with over fifteen employees cannot lay off workers. To pay for growth and to show equanimity, Monti is using the tax axe, directing it mainly against ‘the rich’. With newspaper headlines recounting juicy stories about owners of Ferraris and Lamborghinis being caught by the tax police with reported incomes barely enough to pay for the petrol, Monti is achieving two things: first, he should start raising the taxable basis, as Italians learn that they cannot have sports cars and yachts without a demonstrable income; second, he will be able to tell the unions and the working class who is dead scared about labour flexibility, that ‘also the rich cry’, to paraphrase the name of an old Brazilian soap opera.

While every country has its own history and its own particular dynamics (this is the problem with the one size fit all euro area which hasn’t been solved, and may not be solvable…), Italy’s plans can serve as a template for other countries as well. Greece for example, needs a tectonic change in the mind-set of its citizens that need to understand that you cannot have a welfare state without paying substantial amounts of tax. France, on the other hand, and this is also a lesson that other countries, should understand, should be careful with its tendency to over tax to pay for the generous and efficient welfare state that its citizens have come to expect. The continent wide tendency to increase higher rate taxes to over 50% and sometime up to 75% has been proven in the past to backfire. It may serve as a populist tool, but it doesn’t raise tax revenue.

However,  effective this year, new anti-avoidance measures coupled with a new ‘fanatic’ enforcement mentality (which has emptied Italian ski resorts of high end skiers, and ports of super yachts—both types cautiously moving to Switzerland and France, respectively) the time tested pragmatic approach of over taxing knowing that taxpayers will under report, is not working anymore. To adjust, the government will need to aggressively cut taxes to avoid a huge crowding out effect generated by the fiscal tightening, which has increased both the taxable base and some of the actual headline rates. For example, IRAP, the tax that is effectively levied on turnover rather than profits was a temporary measure to circumvent business owners that always reported low incomes or losses. This tax, whose constitutionality and fairness was repeatedly challenged, has been marginally reduced by the government at the end of last year, but it must be scrapped entirely as a first measure to reconcile headline taxes with the need to provide oxygen for growth to the economy.

In addition, the government has promised a lot in terms of liberalising the economy, but to date, apart from the famous war with the taxi drivers, has accomplished quite little. The real test will come with labour market reforms, a very hot subject in Italy. Italian experts in this field are forced to live under police escort, given that their most prominent colleagues have been threatened, shot, and even killed. Italy’s labour laws famously defend only the employed at the expense of the young and the unemployed in general. Unless Italy gathers the force and the courage to make the country a better place to do business where you don’t have to pay taxes on losses, and are not afraid to hire because employees become a catholic marriage partner, no fiscal tightening will help to lower Italy’s high ratio of government debt to GDP which is still hovering well above 100%.

This week I was quoted in an article by Tony Griffiths for HFMWeek about the hedge fund industry’s fee structures. Please visit the article to view my opinion.

Pending the unloading of the real bazooka that the market has been expecting from Angela Merkel, the ECB has decided to fight for time by propping up the banks through the LTRO. This course of action displaces private activity and is producing several distortions. Let’s look at a few of the most significant ones. Firstly, together with the stated QE policy of the Fed and the BOE, it is keeping short rates (and in the US and UK also long rates) very low, amidst a torrent of liquidity. However, the chain of transmission has stopped working, and these banks are not passing on their cheap funding to corporate clients. They are doing two things with the ECB funds; either they hoard it for fears of rainy days, or they use the funds to invest in government bonds that yield many hundreds of basis points more than their funding, even for short term issues, thus pocketing a substantial spread. The problem with this seemingly simple strategy is that if any of these governments were to default or restructure, they would be compounding their problems, given that the very problem that most of these banks are tackling is the high proportion of government bets among their assets.