Month: November 2010

        In 2001 I published “Just Say No:  100 arguments against the Euro”. It is timely to revisit some of  them, to see why the Euro is causing such trouble to economies like Ireland, Greece, Portugal and Spain.

         I pointed out that the Euro was an “Exhange Rate Mechanism you could not get out of”. As so many countries had found it difficult to sustain their currency levels against the DM in the ERM, why did anyone think they could do so from within a single currency? It was locking the door and throwing the key away. That could prove painful if the building caught fire.  The two central arguments were “You cannot make currencies behave in line unless you first bring the economies in line” and “History shows that rigged exchange rates do not work”. Economies would find it more painful to make the adjustments they needed to make against each other if the exchange rates no longer took most of the strain.

               In the chapter on their failure to create a single economic policy that could work for the whole currency zone, I explained that there isn’t one interest rate that is right for Manchester and Marseilles, nor is there one exchange rate that is right for Lisbon and London. “You cannot have a single economic policy without a single budget”. “There will be endless disagreements about how much European government should  spend and where.” “The poorer and richer regions are different. The poorer ones will lose out”. “There is no single political system to take decisions and explain them to electors”.

               I forecast  that there would be pressure to increase taxes, to “harmonise them” in an upwards direction.

               The main analogy I used said that joining a single currency was like sharing a bank account with the neighbours. More people are now beginning to see the force of that comparison. The richer and more prudent neighbours are now being asked to subsidise the overdraft of the poorer or more spendthrift, because they do share a bank account at the European Central Bank.

              Having helped keep the UK out of the Euro by arguing the case and setting out in detail the costs, risks and problems, I see no reason why the UK should now be expected to pick up some of the bills for the predictable stresses within the scheme. If you want a successful single currency first create a successful single country. The Euroland members do need more central economic management and control, but none of that should apply to the UK.  The Euro has for a decade been a single currency in search of a country to love it. The Euro needs a country called Europe if it is to succeed. The Uk should not  be part of that centralising venture.

Just as I feared and forecast, the second phase of the Euro crisis has hit us.  The first phase saw Greece at the centre of the storm. It ended with the announcement of a bail out for Greece, and the provision of general facilities in case any other country got into difficulties. The authorities told us that would end the crisis. Up to a trillion euros were available as loans, guarantees and cash so that would take care of any member state getting into more trouble.
 
         So why didn’t the bail outs work last time? The Greek bond market was not very impressed. Investors wanted to see evidence that the Greek budget deficit was coming down. They seek honest figures showing progress. They wished to see how the Greek economy would recover and grow, as some growth is essential to getting the deficit down more rapidly. Disappointment soon set in, and Greek bond yields have remained very high.
 
         Ireland was  making progress in cutting spending to cut its government deficit. Meanwhile the European Central Bank was quietly making facilities available to various EU banks, including Irish ones, as a Central Bank should at times of difficulty. The German Chancellor decided to float the idea that bondholders who had lent money to Euroland economies under pressure should have to share some of  the costs of sorting out the problem.  She mused that “haircuts” or reductions in interest and capital repayments might be an appropriate way to share the pain of adjustment. This was bound to force up the price of borrowing for the Irish government  and force down Irish government bond prices. Later a partial retraction was issued, saying the haircuts might only apply to future bonds and not to money already lent.
 
        The EU let it be known that they thought Ireland should borrow money under one or more of the facilities on offer given the high cost of direct borrowing and the large borrowing needs. The official Irish position said they did not need to. It was then slipped into the media that the European Central Bank might wish to reduce its support for EU banks, at a time when   Irish banks  might   lose deposits and be in need of extra liquidity. Finally on Thursday it emerged  the Irish government would accept financial help for its banks.
 
           All of the public briefing and comment made the problem worse. Days of negotiation, proposal and denial led to a further loss of confidence in Ireland and its banking system. A Central Bank is  the lender of last resort to ensure sufficient liquidity so no-one need worry about getting their cash back from any bank in the system. The European Central Bank has been performing that role and should continue to do so. The banks should be regulated strongly to ensure they are solvent at all times, that their  total assets exceeed their liabilities. If they have a sudden large withdrawal of money the Central Bank supplies the cash so they can meet it. The bank then should sell as many assets as needed to repay the Central Bank to an agreed timetable which is best kept private.
 
           The European Central Bank appears to want unnamed Irish banks to raise more capital or have access to facilities outside the ECB. This of course involves the Irish Central Bank and government. The sooner they work out their respective responsibilities, the sums involved and issue a detailed package to the markets the better. They have talked themselves into a serious problem, and now need to dig themselves out by their deeds. 
 
          Will this second bail out work, when the first did not last for long? That will depend on what they do and say next.   Now  we want to see the colour of the money, to find out who is paying the bills, and to assess whether it will then work. The truth is arranging facilities is only part of the answer. The Irish government has to continue its work of cutting spending and boosting revenues to cut its own borrowing needs. The Irish banks have to continue selling assets, finding more profitable business and restricting their risks and balance sheet size in the meanwhile. The markets will judge them by results.

         On June 22nd 2010 the new government rightly said they needed to take faster and stronger action to cut the deficit. They proposed  additional state  borrowing to  a total of £461 billion in the five years 2010-2015. This, believe it or not, was a substantial  reduction in the old plans. This was still more than total government borrowing in 1997.

          The spending review of October added £ 8.6 billion to this figure, by increasing capital spending above the June levels, and above the levels inherited from the previous government. If the government now adds another £7 billion of spending to assist Ireland, that means it has added £15.6 billion to spending and borrowing  for the five years within just five months.

           The government needs to observe rigorous spending control in relation to the totals it published last June. The public will find it difficult to understand why certain items are being cut that matter to them, if at the same time the money being spent on EU contributions and  Euro support keeps soaring.

          The argument for the Irish bail out comes from the EU, not from Ireland. Ireland has neither asked the EU nor the UK for a loan. The talks now underway are to persuade the Irish government that it needs to borrow more to deal with the “crisis” in the bond markets which foolish talk by some has created in recent days.

           Two arguments are used. The first is the Irish governemnt will need to borrow more to sustain its own finances. Now that the markets say it will have to pay more than 8% for ten year money, the EU argues  it needs to borrow some money at a lower rate from the rest of the EU/UK to avoid its interest bill getting too high. It is also thought for some unknown reason that borrowing more from the EU will restore bond market confidence. They thought the same about Greece when Greece did apply for EU help, but there is little sign this theory proved correct in that case, as Greek bond yields have remained very high. Indeed, Greece still has to pay the markets more interest for each new  Euro borrowed than Ireland does.

            The truth is each country has to reduce its own deficit in its own best way. Ireland has been bravely trying various methods to do so, and is planning  a new budget. Sensible people from the EU would encourage Ireland to produce a convincing new budget. If Ireland wishes EU officials would be working with Ireland in private to ensure the new budget does the job. Markets will be impressed by seeing the deficit figures coming down in a convincing way. That  will lower rates.

               The second is the argument  that Ireland’s banks need recapitalising, and the EU/UK should help do that. This is strange. The ECB, the EU Regulators and the Irish authorities have been happy with the capital and cash arrangements of the Irish banks and have allowed them to carry on trading. If the Irish banks need extra liquidity that is the job of their Central Bank, the ECB,  to supply it. There is no need or  hurry to run down the general special financial facilities  the ECB has made available for EU banks if that is going to cause new strains. If the Regulators want the Irish banks to have more capital relative to their loan books, then they can work away in private with those banks. Some combination of selling off loans, selling other assets, cutting costs, writing more profitable business and selling companies and businesses from within the banking groups could cut the risks and raise the ratios.

           It is the height of folly to encourage so much speculation about the state of these banks, and to suggest in public that the financing arrangements have to be changed. That is destabilising conduct of the kind that turned a serious problem into a crisis during the peak of the Credit Crunch.If the authorities by public comment trigger withdrawal of too many deposits the ECB simply has to supply more cash to meet the depositor demands, and then has to help with a more rapid run down of the banks’ balance sheets than would otherwise be necessary. Why do modern regulators want to do so much in public, in a way which can  damage confidence in the institutions they are meant to be regulating?

        The fact that RBS and other UK banks have substantial loan books in Ireland is no reason to force UK taxpayers into helping recapitalise Irish banks. The Irish loans of the UK banks will continue regardless, and doubtless they have already made provision against possible losses on this portfolio. If they think they need to make further provision then this will come off the profits they are making elsewhere and should be manageable.

           I see no reason why EU governments  should suddenly buy shares or inject capital into Irish banks.  If the Irish state thinks it needs to inject more capital then it has to provide that from within its own budgets.

          When you are recovering from a serious bout of borrowing too much, borrowing more does not help. Ireland, like many western countries and banking systems, needs a work out or earn out, not a bail out.

            If you are worried about “contagion”, the possibility that other states may also be forced to pay more to borrow, the last thing you should do is to ask those other states to find more public money to bail out a weaker state. The more the stronger states have to borrow, the weaker they become in turn.

PS: We now learn from the Irish Central Bank that their Governor does want to arrange a large facility, as he is concerned about the way deposits have been withdrawn from Irish banks. You can make a crisis out of a problem, and the more you talk down an economy and its banks the more likely that is.

             The last week has seen a gripping struggle for power between the EU and one of the smaller member states. It began when Frau Merkel, probably for German political reasons, undermined confidence in Greek and Irish bonds by saying that Euroland “sovereigns” might have to cut the interest or capital they owed to bondholders. It continued with strenuous efforts by the EUauthorities and leading member states to get Ireland to discuss a refinancing package for the country. Ireland protested loudly and in public that it did not need any money, and had its finance arranged through to the middle of next year.  Despite this the EU continued with its deliberations, leaks and press statements in a way which was bound to destabilise markets further pending an outcome. Now we learn that Ireland is being persuaded that it  needs money from the EU to help it to recapitalise its banks more rapidly.

Why would members of Euroland want to do this, as all the public debate about crisis and the need for emergency  responses is bound in the short term to make things worse.? All the talk of contagion just puts the idea into the market that the problems might not end with Ireland.  Either the Euro powers that be are incompetent, and do not understand how they can induce falling markets by saying too much and doing too much, or they are out to ensnare Ireland into new controls and conditions, to strengthen the EU’s hand in economic governance. The EU has never liked Ireland’s attractive low Corporation Tax rate, and would dearly love to be able to force that up.

The UK should make it clear that we are not part of any Euroland rescue or facility. We should say we do not think they can use EU disaster relief provisions to offer Ireland more cash. If Ireland does not wish to take any EU money, the UK should be Ireland’s ally. The stated Irish wish to see their own way through their own deficit problem is wholly admirable. Let us hope the EU does not make it unrealistic, by their market destabilising statements.

You do not make a currency area stronger  by taking money from the heavily borrowed to give to the overborrowed. The heavily borrowed have to borrow more themselves to prop up the overborrowed.  If done on a large scale,  that migth weaken them dangerously. You do instead need to bring deficits and in due course the debt down. You do not do that by borrowing more collectively.

The EU spin suggests Ireland is being selfish by refusing the money. They argue that if Ireland does a deal soon it will remove the risk of the problem spreading to other Euroland states. This argument ignores the fact they told us that when Greece accepted a deal. Markets sometimes take a hint – if pushing hard produces a subsidy or favourable borrowings for one country, why not push on another weaker country and do the same all over again?

              There is no perfect answer. In practice, in any democracy, independent arrangements only last for as long as they have broad politcal and public support. If the independent bodies  do the wrong things or if the public loses confidence, then the elected authorities will change them.

              I do not favour relying on the chance that the electoral and political party system may just happen to put in the right senior office someone who understands the intricacies of monetary policy and is capable of making good judgements. The senior elected official can at any time override or make the important calls. Mr Darling, after all, seemed to take a very leading  role in cutting interest rates and loosening policy at the height of the banking crisis, when there was concerted action by the leading Finance Ministries of the world. It would be better to find a system where good official advice and delegated powers  can usually be operated without detailed reference to the senior elected official.

              In system with fiat currencies and single Central Banks it makes sense to delegate substantial power to the Governor and senior executives of such a Bank. Under the older UK system the Governor held regular talks with PM and with Chancellor. Differences could be ironed out in private, and a common view reached between the Bank and the government over correct interest rate and monetary policies in the light of the government’s tax and spending policies. Under the newer system the Bank has more authority to settle interest rates on its own, and to conduct more of the dialogue with government in public, by publishing forecasts and warnings about economic developments in the light of the government’s published decisions on tax and spend. The newer system does not, however, preclude private discussion about  the intersection of fiscal and monetary policy.

               What the public wants is for Bank and Treasury to follow policies which promote low inflation and good rates of growth. Within reason they do not much mind how that is done. The record shows that no  political party has avoided some boom/bust cycles. The record also shows that the two worst boom/bust cycles of recent years came about under regimes based on so called independent action designed to avoid political interference in key decisions.

                The truth is that an independent Central Bank is only a good idea if it is led by people with great judgement about the cycle. In 1989 we needed Central bankers to withdraw their enthusiasm for the ERM on the obvious grounds that the pound was going up and trying to keep it down would damage monetary and anti inflation policy. We needed a Bank which in 2005-6 made sensible adjustments to avoid excessive credit expansion, and a Bank who from the middle of 2007 made enough money available to markets and cut interest rates fast enough to avoid a run on banks. The fact that we did not get this shows that finding good Central Bank leadership is not easy, and the task itself is not easy for those charged with it.

                  In many other walks of life democratic government  is based on the theory that the generalist, the Minister answerable to the public, takes decisions based on best professional advice, but has the last word in cases of disagreement or difficulty. It is, after all, the politican who has to defend the decisions to the public, and who keeps or loses his job based on the success or failure of the decisions.

                          Some element of this needs to be included again in our approach to the newly strengthened Bank of England which will emerge from the latest reforms. I welcome the return of bank regulatory powers to the Bank of England. They need to understand bank balance sheets day by day and be able to control them to control the money supply. They should also act in the markets to raise money for the government. Armed with these substantial powers, they need from time to time to  confirm they have the support of the government. This could be done through a formal and public process, or through an informal one as used to happen. The senior elected official has to keep his confidence in the Governor, and satisfy himself that Governors in future are more likely to read cycles well than has happened in recent years.

                  In the end it comes down to people. The Chancellor has to carry the can and make any final or difficult decison. He is best equipped to do this if he has chosen a good Central Bank Governor with judgement and knowledge of the markets. He can then trust him and interfere little if at all.  If he has a Governor who is not good at judging he has to find ways of bringing better advice to bear on the problem, or he needs to change the Governor.

                    Angela Merkel started the latest phase of the rolling Euro crisis. She warned that Europe’s taxpayers could not be expected to carry the whole burden of bailing out countries that had borrowed too much. She felt that the bondholders, people and institutions who had lent money to the likes of Greece and Ireland, should lose some of their money. She favoured the heavily borrowed countries scaling back the interest and or capital they repay to their lenders. She also wished to clarify and settle more of the details of the bail out funds, announced in haste during the first phase of the crisis.

                          This may have been popular with German taxpayers who are very nervous about how much they might have to contribute, but it did not go down well in the bond markets. Irish bond prices fell sharply, forcing up the interest rate Ireland will have to pay for new debt and replacement debt  when it wishes to borrow again. Other senior people in the EU realised this was hastening the crisis they were trying to avoid, and eventually put out a statement saying any reneging on the terms of debt would only apply to new debt. It would not apply to debt people,funds and banks already owned

            That was a curious way of “reassuring” people. Why would savers want to buy Irish or Greek debt in the future if it no longer has an effective  sovereign guarantee that you will be paid all your interest pr0mptly and will get your capital back on the due date? How is it reassuring to current investors to know that when Ireland or Greece comes to borrow again to repay you, they may have to offer much higher interest rate coupons because people will fear the “haircuts” in the interest and  capital to come?  You can reach the point where the interest rate they need to pay to renew their borrowings is simply not sustainable from their tax revenues.

             To many readers the idea that the bondholders should take a hit may seem attractive. After all, they could have worked out what the rest of us worked out, that some Euro area sovereign debt is high risk.   There is a simple answer to Mrs Merkel and her theory of bond cuts. If the Euro sovereign renege on their debts people’s pension funds, saving funds, and the banks will lose this money. The Euro sovereign bonds are not all owned by rich people who could afford the losses. The UK taxpayer will be one of the bigger losers, thanks to the Irish holdings in RBS, the state owned bank.

               It’s in all our interests that they find a way of avoiding reneging on debt. It is also in our interest for our government to make sure UK taxpayers do not have to subsidise Euro area governments that have borrowed too much. The answer is of course stronger economic growth and a lower proportion of GDP being borrowed by the state. The problem is, to achieve that they probably need a lower Euro as well, something Germany is none too keen on. Maybe if Mrs Merkel makes some more unfortunate remarks it will lower the Euro anyway.