France can't afford Francois Hollande

The people of France will choose their next president on May 12th. 

While presidential elections are always important in France (because the right/left policy divide is so pronounced), this time it is particularly consequential. France will be choosing between market credibility and “social justice”. 

Sarkozy, on the right, represents the policy of fiscal austerity and bond market credibility, while Hollande offers greater social welfare spending and confiscatory taxes on “the rich”. There is nothing new about such a debate, and normally this election would be business as usual.

But it isn’t business as usual, because of France’s decision in 1999 to ditch the franc and adopt a foreign currency, the euro. France has committed what economists call “original sin”: she has financed her national debt in foreign currency. Like a Latin American country in 1982 or an Asian country in 1997, she has placed herself at the mercy of foreign creditors.

France sacrificed her monetary sovereignty to get greater European unity. Now, instead of worrying about the external price of the franc, she must worry about the attractiveness of her debt to eurobond investors. A weak currency is a problem; unmarketable debt is a catastrophe.

If, in the midst of the euro crisis, the people of France demonstrate that they prefer more social welfare to bond market credibility, they will soon have neither. The consensus view among the punditocracy is that either candidate will have to pursue austerity and that, should Hollande take a step down the socialist road, the markets will push him back.

But markets have memories, and once a new yield plateau is set for French bonds, it could prove quite difficult to convince the market that France = Germany as a credit. Should the people elect Hollande, at this conjuncture in history, no rational investor would ever again view France as the same as Germany. (Even the German socialists are austere.)

So, as a thought experiment, let’s think about what it would mean for the world if France became a “story credit”, a name that appeals to some investors’ tastes but not others. First of all, it would be bad news for the rest of Club Med, since they are even worse credits. It would make it harder for Portugal, Spain and Italy to market their debt. it would probably force Europe and the IMF to rescue Portugal and Spain. No one can rescue Italy (too big), and the cost of rescuing the entire Club Med (France, Italy, Spain and Portugal) staggers the mind.

There is only one way to avoid a Second Great Depression, and that is for each member of Club Med to do its part in building bond market confidence, and for the ECB to do its part as the lender of last resort. At present, the signals coming from the borrowers are mixed, and the ECB continues to engage in metaphysical debates about its mandate. Germany and the Bundesbank continue to insist upon austerity from all eurozone members.

We are looking at a multi-piece orchestra in which each player must be flawless. For France, of all European countries, to be the one that blows the false note, would be a very negative event. We’ll know in a couple of weeks.

Final terms of the Greek bailout

Below is the partial text of the statement issued by the Eurogroup concerning the conditions required of Greece in order to obtain its second bailout. As you will see, this document is unprecedented in the modern era in its degree of intrusiveness. It reads very much like a document handed by a victorious government to a defeated one, providing “terms” for surrender.

In essence, Greece has been placed in receivership, with the Eurogroup Task Force acting as receiver. Greece is requited to change laws, to admit “observers”, to submit its finances to external inspection, to give priority to debt servicing over all other uses of revenue, and to change its constitution in order to enshrine this priority in perpetuity.

It is hoped that such Draconian terms will be sufficient to persuade the parliaments of the Northern League (Germany, Finland, Netherlands) to pass the bailout legislation.

This document will only have curiosity value a year from now, when it has long been forgotten by everyone involved. But it is worth reading now, nonetheless.

Greece must achieve the ambitious but realistic fiscal consolidation targets so as to return to a primary surplus as from 2013, carry out fully the privatisation plans and implement the bold structural reform agenda, in both the labour market and product and service markets, in order to promote competitiveness, employment and sustainable growth.

To this end, we deem essential a further strengthening of Greece's institutional capacity. We therefore invite the Commission to significantly strengthen its Task Force for Greece, in particular through an enhanced and permanent presence on the ground in Greece, in order to bolster its capacity to provide and coordinate technical assistance.

Euro area Member States stand ready to provide experts to be integrated into the Task Force. The Eurogroup also welcomes the stronger on site-monitoring capacity by the Commission to work in close and continuous cooperation with the Greek government in order to assist the Troika in assessing the conformity of measures that will be taken by the Greek government, thereby ensuring the timely and full implementation of the programme.

The Eurogroup also welcomes Greece's intention to put in place a mechanism that allows better tracing and monitoring of the official borrowing and internally-generated funds destined to service Greece's debt by, under monitoring of the troika, paying an amount corresponding to the coming quarter's debt service directly to a segregated account of Greece's paying agent.

Finally, the Eurogroup in this context welcomes the intention of the Greek authorities to introduce over the next two months in the Greek legal framework a provision ensuring that priority is granted to debt servicing payments. This provision will be introduced in the Greek constitution as soon as possible.

Greece is standing on the trap-door

The media is filled with stories about the coming Greek depression, supposedly unprecedented in the modern era. This would come as news to millions of central and eastern Europeans who lived through the painful transition from communism to capitalism only twenty years ago.

What sets Greece apart is not the degree of economic adjustment required to resume growth, which is certainly less than was required in eastern Europe. What distinguishes Greece is the degree of mental adjustment required. Unlike the eastern Europeans, the Greek people have no desire to make the transition from socialism to capitalism. This transition is being forced upon the Greek electorate by Greece’s total loss of credit market access. Greece’s credit cards are maxed out and it needs to find a real job making things that foreigners will pay for, not subsidize.

It is instructive to observe the Greek public reaction to national bankruptcy. Anger, disbelief, bargaining, denial, and, of course!, destructive rioting. No comprehension that the government has run out of money, only loud demands for “social justice”. Not one politician is advocating structural reform on the lines of what Poland implemented in the nineties. They seem to think that there is an alternative to radical change.

Either Greece will accept and implement the austere terms of the EU bailout, or the government will be unable to pay its bills next month. Either way, the Greeks will be forced to change their way of life, and pronto.

Greece is currently running twin fiscal and current account deficits of 10%, which are being financed by the ECB (via the banks). One year from now, perforce, both of these numbers will be zero (excluding foreign charity). Greece’s budget and current account will both be balanced, because it will have no one left to borrow from. The ECB window will be closed by then.

This adjustment will occur because of a collapse in aggregate demand. (The adjustment will necessitate a collapse in aggregate demand.) Government, businesses and households will be forced to reduce spending due to “hard budget constraints”. The prices of domestic nontradables will fall, especially real estate values which will probably fall by 90%. (There will be no privatizations in the absence of a legal system). Wages not controlled by the government or labor contracts will fall as the safety net is removed and the necessities of life force people to emigrate or find work. Unemployment will approach 40%, while unemployment benefits are reduced or eliminated. The defense budget will be cut, with the obvious implications for domestic stability: it is hard to fire colonels in countries like Greece.

What I have outlined is not a risk; it is a certainty.

One would have to believe that such an object lesson would be a major blow to European social democracy and a boost for austerity-minded politicians such as Merkel, Sarkozy, Monti, and Cameron. It will be interesting to see which comes first: Greek collapse or the French presidential election. If Hollande wins, he will have a memorable presidency.

Germany plays with Greece

If you believe what you read in the paper, Europe is on the verge of yet another Greek rescue package intended to prevent default next month when EUR ~14 billion in Greek government bonds become due.

The deal has the following elements:

1. Greece (all parties) agrees to an austerity diktat issued by the Eurogroup (formerly known as the Troika). The parties must sign and parliament must pass enabling legislation this weekend. No dawdling this time.

2. Private-sector bondholders agree to a debt swap in which they receive worthless paper in exchange for worthless paper with a higher fictitious face value. All bondolders must agree or else holdouts will be forced to exchange, resulting in an involuntary default. This deal has been “almost done” for weeks. The deadline is Monday.

3. The Eurogroup will lend Greece either EUR 130 or 145 billion in order to keep it afloat for the rest of 2012 (if you believe in the Easter Bunny).

The psychology here is interesting. The Germans are in an emotionally conflicted position. Bailing out Greece is a small price to pay for European financial stability. But the whole exercise sticks in the German craw, especially since the Greeks will sign anything and do nothing. One part of the German mind wants to get the bailout over with and move on, while the other part wants to push the Greeks over the cliff and watch their well-deserved demise.

This conflict is visible in the prescriptive language of the diktat. The exasperated tone is reminiscent of Austria’s ultimatum to Serbia in 1914 (another case of German frustration with the crafty Balkan mentality). It is a kind of Prussian wishlist of Greek good government reforms, with a utopian flavor:

* A reduction of 22 percent to the minimum wage, currently at 751 euros per month gross, with an additional 10 percent reduction to the basic salary for young people aged under 25.
* A freeze on the minimum wage of three years.
* A freeze on all salary raises until the unemployment level is reduced from its current 19 percent to under 10 percent.
* A reduction in the pensions of employees of state companies OTE telecoms and Public Power Corporation by 15 percent, as well as of seamen by 7 percent.
* Placing in the labor reserve scheme 15,000 state employees by the end of 2012, with the target of reducing general government employment by 150,000 by the end of 2015.
* The reduction from six months to three of the period over which collective sectoral labor agreements continue to be in effect after their expiration. If a new labor agreement is not drawn up in this period, the sector in question will be bound by the basic national standard, without, however, forfeiting benefits for years of service, job hazard, children and education.
* Collective sectoral agreements will have a limited duration of three years, while existing contracts with a 24-month duration will expire in one year from now.
* A reduction in contributions to the IKA Social Security Foundation of 2 percent effective immediately, and an additional 3 percent in 2013.
* A review by end-June of the special salary status of judicial employees, state doctors, diplomats, and police and military personnel.
* The sale by end-June of scheduled share packages in the following state-owned companies: Public Gas Corporation (DEPA), gas distributor DESFA, Hellenic Petroleum (ELPE), betting agency OPAP, the Attica and Thessaloniki water and sewerage companies (EYDAP and EYATH), and the International Broadcasting Center.
* The abolition of permanency for employees at state-owned companies and banks.
* The restriction of tax exemptions, simplification of the value added tax and property tax structure.
* The closure of 200 tax offices across the country by the end of the year.
* The hiring of 1,000 more tax auditors, to bring their total number by the end of April to 2,000.
* Eliminating the extension of payment terms for overdue taxes and social security contributions.
* A further reduction in military spending by 0.15 percent of GDP.
* The recapitalization of Greek banks through common shares with limited voting rights and through contingent convertible bonds.

Quite a list, no? All that’s missing are German gendarmes stationed at Greek customs posts. Does the list bear any relation to Greece’s future budgetary policy? No.


None of this will happen. The Greeks know this and the Germans know this. But it is intended to provide sufficient political cover for the Bundestag to pass the bailout legislation, which Merkel's coalition will ensure.

The bailout will go through and the Greek saga will last a bit longer. To the extent that any aspects of the diktat are implemented in fact, we will have more ITV footage of the usual riots, etc. I would not expect the Papademos government to fall, because the parties and the army want to have nothing to do with these measures. The parties want to return after the explosion, not before.

Clowns at play

Is there anything that the EU could have done or could yet do to make the euro crisis worse?

• Begin by stating that an obviously insolvent Greece is actually just fine and those who disagree don’t understand Europe;
• When Greece can no longer borrow in the market, admit that it has a temporary problem that can be fixed by a touch of austerity plus a generous portion of Brussels happy talk;
• Concede that, in addition to pinch of austerity, Greece may need substantial official loans to finance its huge deficits “until it regains market credibility”;
• Make sure that such loans are small, late, and contingent on ever-tighter austerity targets;
• “Restore” market confidence by asserting that default by a eurozone member is unthinkable and that such bonds are risk-free;
• Announce that any further bailouts must include partial bond default (“private sector involvement”) and that no one should have ever seen them as risk-free;
• When Italian and Spanish yields rise to junk-bond levels, announce that future bailouts will not require public sector involvement, adding that neither Italy nor Spain actually require bailouts;
• As eurozone government bond pricing becomes increasingly affected by market-access and credit-risk concerns, denounce market participants who raise these issues;
• As eurozone government bond prices steadily fall, invent accounting schemes that prevent eurozone banks from having to show mark-to-market losses

Which brings us to the latest, and most humorous development: the assault upon the rating agencies for beginning to reflect in their ratings the scale of the stresses facing eurozone governments and banks.

There are three prongs to this assault:
1. Accusations of incompetence, irresponsibility, and “foreign influence”;
2. Another attempt to create a “European” rating agency to counter the malign anglosaxonism of the Big Three; and
3. The push for regulations to prohibit the publication of irresponsible and/or disruptive ratings.

The first prong (jawboning) is the usual Brussels Orewellianism, which market participants ignore. The second (a European rating agency) is a 25-year old chestnut that has reared its head many times. The idea is that a tame house-agency would produce different market outcomes than the current system. A good analogy is that by controlling the weather bureau one can control the weather. It also ignores the continued existence of the Big Three and their uncontrolled opinions.

The third prong, ratings blackouts, would reduce market disruption during periods of sovereign stress:

“Some members of the [European] parliament are in favour of banning publication of negative ratings," Wolf Klinz, a German Liberal member of the European Parliament said. "Some of the socialists and conservatives say it's a good thing to have the option to ban the publishing of ratings if they do come at the wrong moment," Klinz told Reuters.
The original blackout proposal was intended to cover only publication of negative ratings of countries receiving bailouts. But some politicians could now go further and ask for publication to be banned if it comes at an 'awkward' moment for the country concerned.  (Reuters, 2/17/12)

This is the option that I find most humorous. I very much doubt that this proposal will ever actually be implemented, but I wish that it would be, as an object lesson in market behavior.

The idea is that, when a country is in negotiations for a bailout or is otherwise under stress, the EU would promulgate a decree temporarily banning the publication of any rating opinion on the country. Thus, the agencies would issue press releases stating:

The government bond rating of France has been temporarily suspended in accordance with the EU’s blackout order. Until such time as the blackout period is lifted, we will have no rating opinion with respect to France’s government bonds.

During the blackout, French bonds would, by law, be unrated by any recognized agency. Since many institutional investors are not permitted by their clients’ guidelines to hold unrated bonds, the blackout directive would cause market chaos.

I do not mean to imply that the EU has exhausted its options with respect to further exacerbating the euro crisis. Within the next month, as the Greek bond default negotiations proceed and as Italy seeks to issue billions in bonds, we will entertained with many more such gaffes, blunders and magic tricks.

The EU summit will fail

This week’s EU summit meeting will fail. The purpose of the meeting is to agree to a fiscal stability plan that will persuade the ECB to rescue Italy and Spain. This will fail for two reasons.

First, there is considerable daylight between what Germany wants and what the EU or the  eurozone can agree to. Germany wants a new treaty with binding constraints. A new treaty requires all 27 countries to sign on because every country has a veto. A number of EU countries that are not in the eurozone lack enthusiasm for this idea. It is unclear if European law contemplates a treaty that leaves out a number of members. There could be a eurozne-only agreement, but not a treaty. It is hard to see how the leaders can emerge on Saturday with anything like what Merkel wants.

Second, there is little reason to believe that there is anything that can persuade the Bundesbank to reverse its position on rescuing Italy and Spain. While Draghi has made hopeful noises, the president of the Bundesbank, Jens Weidmann, has not. His position is that this is a matter for the EU to solve via eurobonds, which Merkel has ruled out. Draghi cannot rescue Italy and Spain without the Bundesbank’s consent.

It will be interesting to see how the leaders, who are staring into the abyss, can construct a communique that will obscure the summit’s failure. 
Many European leaders have said that a failure to rescue Italy and Spain will lead to catastrophe. But standing in their way is Germany, which won’t agree to guarantee other countries’ debt, and the Bundesbank, which will not allow the Bundesbank to become the eurozone’s bond buyer of last resort. 
Without either eurobonds or an ECB rescue, Italy and Spain are doomed.

In the event of their default and/or redenomination, the rest of Europe will have to recapitalize their banks. This will place strains on everyone, especially France and Germany. In the end, I would expect the ECB to capitulate and embark upon an unprecedented campaign of quantitative easing.

Should it fail to capitulate (soon), the outlook for the eurozone is dire. Those of us outside the eurozone (UK, Canada, US, Australia, Japan) will be able to lean against the deflationary forces blowing over from Europe.

The major economy most at risk now, besides Italy and Spain, is France. France may lose its AAA, will have to bailout its banks, and will have to remain credible in the bond market. This will force a level of austerity that could lead to civil unrest.

Draghi's speech to the European Parliament: a breakthrough?

Mario Draghi, head of the ECB, gave a somewhat dovish speech today to the European parliament. As the NYT reports:

He seemed to be saying that the bank would use its virtually unlimited resources to keep financial markets at bay, if government leaders in the euro region agreed to do their part by addressing the structural flaws that had allowed the debt problems of Greece to mutate into a threat to the global economy.

“What I believe our economic and monetary union needs is a new fiscal compact,” Mr. Draghi said. “It is time to adapt the euro area design with a set of institutions, rules and processes that is commensurate with the requirements of monetary union.” After government leaders take steps to improve the way the euro area is managed, “other elements might follow,” Mr. Draghi said.

I can’t imagine Draghi would make such a statement without the consent of the ECB’s governing board, including the Bundesbankers. He seemed to be saying that if the “Merkel Plan” is adopted, the ECB would intervene more forcefully in the government bond market.

The Merkel Plan would change the eurozone from a monetary union into a fiscal union, with Brussels in charge of national fiscal policy. It has not yet been fully embraced by Sarkozy, and it leaves unanswered what would happen to the 10 EU members who are not part of the eurozone.

I won’t say that the ECB’s independence has been compromised de jure, because it certainly hasn’t. But the ECB has found itself in the awkward position of either leaving its “price stability” comfort zone, or else standing by while the eurozone (its raisson d’etre) goes away. It would be understandable if certain board members did not wish to preside over the dissolution of the eurozone.

“Who will rescue the eurozone?” is a hot potato that has been tossed back and forth between the ECB and the eurozone governments for a number of weeks. It would seem that they have begun to inch toward a joint plan:
the eurozone will impose a fiscal strait-jacket upon itself, in return for which the ECB will intervene forcefully in the bond market, thus rescuing Italy and Spain.

There are two big ifs here: (1) Will all 17 members agree to the Merkel Plan; and (2) if they do, can Draghi really deliver the ECB in force? Previously, the ECB had demanded that the eurozone issue guaranteed eurobonds. Now it would appear that it is prepared to buy national bonds without any guarantees on the basis of the “fiscal pact”. As always, I am skeptical. But this latest news suggests that all is not yet lost, and there may indeed be light at the end of the tunnel.

If so, this is very bullish news, the best news in months if not years.

France should ring-fence its banks now

There are two ways that Italy and Spain can be rescued from collapse: either the eurozone agrees to issue eurobonds which are guaranteed on a joint-and-several basis by all 17 members, which would be used to refinance maturing debt; or the ECB agrees to act as bond buyer of last resort and establishes a standing bid for Italian and Spanish bonds at an agreed yield.

If either of these events occur, Italy and Spain will be able to continue to repay maturing debt. If neither of these events occur, then at some point the bond market will close to Italy and Spain, as it did to Greece. (The bond market may have already closed, since the ECB does not disclose its purchases by individual country.)

Under the bad scenario, Italy and Spain will have to restructure their debt and/or leave the euro. Either way, banks will be faced with substantial writedowns.

Which brings us to France. France is a strong credit (somewhere in the AA category) despite its banking system’s exposures to Italy and Spain. Its banks, however, are not strong credits on a standalone basis, because of their eurozone exposures as well as general unprofitability.

The weakness of France’s banks (especially BNP) is contaminating France’s own credit, such that France is having to pay yields as much as 2% above Germany. It is time for France to bailout its banks, and thus demonstrate its ability to withstand defaults by Italy and Spain.

There are a number of ways for France to bailout its banks, but here is a pretty common method: Establish a state owned entity (or use an existing state institution such as CDC) to buy marketable assets (i.e., sovereign bonds) at current market prices (below their current accounting value) and make up the losses with new equity. That way, the banks would no longer be at risk of further writedowns on this paper, and should thus regain their credibility in the debt market. There is much less of a problem with exposures to Italian and Spanish banks; these are manageable and declining, with the ECB taking up the slack.

For reasons that I can’t fully understand, the rating agencies have said that if France incurs additional indebtedness in order to bailout its banks, it is likely to lose its AAA rating. Since these costs are known contingent liabilities, this threat suggests that the agencies are using mechanical debt ratios, as opposed to taking into account contingent liabilities. This is particularly peculiar for S&P, which has been saying for over a decade that it takes into account the contingent liability posed by the banking system when analyzing sovereigns.

In any case, France has already lost its AAA in the bond market, partly in anticipation of a downgrade, and partly due to the weakness of its banks. In my opinion, France should bite the bullet now, take the downgrade, and move on. This would give the bond market one less thing to worry about.

Today's announcements mean nothing

So, the Dow index is up by over 700 points this week. This is certainly a market that has been impatient for good news. What was the good news?
1. Reports of a Paris/Berlin plan to organize a fiscal stability pact for the eurozone without the need for a treaty.
2. Reports of an $800 billion IMF bailout plan for Italy, since denied.
3. Establishment of large dollar swap lines between the Fed and the ECB.
4. Lower collateral haircuts at the ECB.

The Paris/Berlin plan is intended to lure the ECB into bailing out Italy; that won’t happen. The IMF bailout of Italy was a false rumor. The Fed/ECB moves announced today are plumbing adjustments which mirror their actions after the Lehman bankruptcy. They are routine and easily predicted.

The dollar run on the eurozone has squeezed the banks; these steps should make it easier for eurozone banks to meet their creditors’ demands. It won’t stop the run. There is nothing in this package for Italy itself, only its banks. So, as the police like to say, nothing to see here folks.

I would venture to say that, later this week, the harsh reality will sink in, and the markets will lose their euphoria and give up their gains. At present, there is nothing standing in the way of a major Italian funding crisis.

Thoughts about Greek redenomination

Let’s assume that Greece manages to run out of money in the next few months (which is up to the EU/ECB/IMF troika). Assume that the troika says no to the next tranche or the one after that, and Greece can’t pay its bills. (Note that its bills don’t include maturing bonds because it is in the process of repudiating them). Then what?

Greece will have two choices: stay on the euro and default domestically (stop paying government wages), or redenominate into drachma. They will opt for the latter, redenomination.

How would this work? I can't think of any exact precedents, but the closest I can come up with would be Argentina’s 2001 move from the dollar currency board into the New Peso or whatever they called it. Here is my scenario for Greece:

1. By presidential decree, freeze all deposits, debts and financial contracts, foreign and domestic.
2. Impose currency and capital controls prohibiting any movement of financial assets out of the country.
3. Temporarily close all land, sea and air borders to prevent the smuggling of euro notes.
4. Announce the redenomination of all deposits, debts, contracts, and currency notes into drachma on a one-to-one basis. This would include all foreign debts, claims and contracts with the possible exception of the ECB.
5. Require that all euronotes be exchanged for drachma.
5. Allow the drachma’s external value to float (since the Bank of Greece will have no international reserves and no international credit, assuming that the ECB does not make credit available).
6. Sell drachma bonds to the Bank of Greece in order to pay the state’s bills.
7. Nationalize and recapitalize the banking system with government bonds.
8. Impose permanent capital and exchange controls to prevent capital flight and speculative attacks on the drachma.

Debts incurred under foreign (i.e., English) law will have to be litigated. There is ample legal precedent for successful repudiation of such debts and contracts (Peru, Ecuador, Argentina, Russia, China, Cuba, etc.).

Once this exercise has been completed, Greece will be effectively debt free, will be able to pay its bills, will have a solvent and liquid banking system, and will have a very competitive currency. However, its international trade lines will be temporarily eliminated, until it is able to accumulate enough foreign currency to finance its imports on a cash basis.

The terms of trade will shift dramatically in favor of Greek exports and against imports. The importation of oil (which requires dollars) will be a particular problem, unless exporters are willing to extend credit. This could prove to be a big problem, although Greece would not be the first country in such a fix. Over time, as Greek exports grow, foreign currency receipts would be able to finance imports. (Currency controls will allow the Bank of Greece to prioritize imports.)

The standard of living in real terms would decline as inflation would exceed nominal wage growth. The real price of domestic tradeable goods will rise with the real cost of imports. The need for fiscal austerity will be a function of the regime’s willingness to tolerate inflation. Given the Greek social model, the government will choose inflation over the alternative, and there will be no external pressure to do otherwise. We have already seen this in Russia, Yugoslavia, Ukraine and elsewhere. While it is true that the middle class’s domestic savings will be wiped out, most Greeks have their savings elsewhere, so the social impact may be muted.

The foregoing is my best estimate of what we are likely to see next year. Because Greece is small, the international impact would be negligible, as would be the case with Portugal. The same would not be true for Spain or Italy.