Reply to George Soros' June 26 FT article

In his Financial Times article of June 26 (How to shift Germany out of its cant do mode, June 26), George Soros explained that avoiding a euro meltdown was just a matter for Spain and Italy to agree to structural reforms in return for which Germany would agree to a mutualisation of a “significant portion of their outstanding stock of debt”, such German agreement having been withheld so far mostly because of domestic politics.  This remains to be seen.

In Italy, Prime Minister Monti has been keen to push through reforms, yet has found great resistance from a variety of Italian vested interests.  In Spain, reining in the discretionary powers of provincial governments has proven difficult.  Although they were not mentioned by Mr. Soros, Greece has done very little to reform its bloated public sector while France has rejected the German economic model.

Structural reforms on the scale that is needed take years to be debated, approved and finally implemented.  And this is when populations are not dead set against them.  Therefore, a debt mutualisation today would have to rely on promises (couched in the form of laws which can be later amended) which will become reality, at best, over a much long time-frame.

There is a say that if you owe little, it is your problem, but if you owe a lot it becomes your creditor’s problem.  As a creditor, Germany is fast approaching this point of no return.  Given that hundreds of billions of debt are in the balance, it is very doubtful that the threat of fines or penalties would sway delinquent countries or compensate Germany for the financial burden it would assume.

A larger issue is whether such reforms would be successful in securing the place of the weaker countries alongside Germany in the eurozone over the long-term.  I would love to swim a relay with Lochte, Phelps and Adrian, but, however hard I train, our team wouldn’t make the Olympic cut.

Finally, it remains to be seen whether Europeans truly want a federal system, one where pensions will be determined in Brussels and be based on the German system, or where the size of national public sectors will be shrunk to converge with that of the best performing countries.

In my view, Germany will not accept an early mutualisation of European debts for the above reasons.  Nor will Austria, Finland and the Netherlands.  If push comes to shove, they may consider exiting the euro; yes, the strong deutsche mark would make German exports less competitive, but it would also make the repayment of euro-denominated debts a bargain.

Rather than forcing a decision that won’t be accepted and will resolve little, it might be better to focus on what can be preserved: a Europe of 27 countries where the weakest will be helped to the extent they help themselves.  One option suggested by the economist Richard Koo would be to ensure that a large portion of new sovereign debts be issued to domestic investors and remain in their hands; this may raise the financing cost but in return it would ensure greater financial stability.  It would also preserve greater strategic flexibility. 

Another would be to accelerate privatizations in Italy, Spain and Greece.  Vast resources could be freed in the process which would help reduce the size of sovereign debts.  Greece has over €300 billion in public assets which could be sold; it committed to sell €50 billion; so far it has sold a minute fraction of the latter number.  If a country declines to sell public assets, why should its euro partners guarantee its debts?  Why should the IMF and financial markets agree to a rescheduling, or even a restructuring? 

Other measures to foster growth and employment include reforming labor laws.  Yes this takes time, but then all reforms do.  There is no shortcut.  Some will argue that markets won’t wait.  Perhaps.  But historynshows that markets tend to look ahead, and it is likely that a credible reform program will elicit a favorable reaction in the form of greater investor interest and creditor cooperation.

In the end, some more countries may have to reschedule or restructure their sovereign debts.  But contrary to what is often written, this does not signify the death knell of economies; only the absence of coherent policies and the capricious application of laws do.  One only has to look at the example of Chile in the 1980s when it received no international financial aid yet engineered the longest lasting economic recovery in Latin America.  Indeed, even though debt-to-equity terms were more onerous than in neighboring countries, investor interest was much higher.  Or take Brazil under the leadership of F. H. Cardoso, first as minister of finance and then as president.

Debt mutualisation, as Mr. Soros advocates, sounds great and stirs the right emotional cords of generosity, European solidarity and immediate relief.  In my opinion though, it is unrealistic and insufficient.

Contrary to what European politicians would want us to believe, this is not the first time that countries, large and small, have had to face debt and spending difficulties.  The ways out are well known and they work.  But they are not quick or painless.

“Allo, Don Enrique?”

Two weeks, Robert Zoellick, the outgoing president of the World Bank, advised European leaders to “break the glass” and get into emergency salvage mode.  A less violent option, but one that would likely be just as effective, would be to make a single phone call.

By that I mean calling former Tresaury Secretary Hank Paulson, granting him dual US and Spanish citizenship and offering him the job of Secretario de Hacienda of the Kingdom of Spain.

The latest saga of the Spanish banking sector bailout was in line with previous efforts: vague, not definitive and indefinite as to the timeline. 

The Spanish government hired two consultants to assess the banking sector’s capital needs.  Two scenarios were considered, a central one and a stressed one.  This move was precipitated by the very poor handling of the Bankia bailout so far. 

The results are in.  Under the base scenario, the banking system would need €16 to €25 billion; under the stressed one it would need €51- €62 billion.  This is to compare with the IMF estimate of at least €40 billion and the Eurozone members agreement to make available of up to €100 billion. Oh, one last point, Spanish sovereign debt was to be a non factor in this study, a pretty big fudge if there was one.

So, what then?  Well, not much really.  The two government officials presenting the results repeatedly referred to the consultants'  as an “exercise” and pointed out that under the central scenario there was no need for capital injection.   Put it another way, if the sun keeps shining, there is no need to buy an umbrella.  Later, and confusingly, Bankia announced that it would not need any public money even under the stressed scenario (presumably, non-Spanish governments' money is not public money).

There was also no immediate call for action.  The top three banks, BBVA, Santander and la Caixa, didn’t need more capital under either scenario according to one of the consultants.  The Spanish government stated that the problems were limited to the banks it had seized, that their auction would be postponed and that there likely would be no bank closing as this was deemed too expensive an option.  The recapitalization numbers were not broken up by bank.  Bank-specific audits would be released by September 30.  Then banks would submit their recapitalization plans, and those that could access the markets (in whose judgment?) would be given up to one year to comply.  In other words, the sector recapitalization could extend into late 2013 before it was completed!

If this feels like a trip to Alice in Wonderland, it is because it is.  It is also an accident waiting to happen.

Knowing what they know today, I am sure that Secretary Paulson (and the Fed) would handle the Lehman crisis differently.  But one weakness that Sec. Paulson doesn’t have is being wishy-washy.  In 2008, as panic gripped the US markets, he swiftly convinced the President and Congress to recapitalize our tops banks with government money.  He then proceeded to impose his decision on bank managements in one afternoon.

A few months later under the Obama Administration, credible stress tests were conducted on the top US banks, the individual results were made public and the banks wasted no time announcing voluntary recapitalizations.  Over the 2008-2009 period, several very large banks were closed and/or sold to financially solid competitors.

Having waited too long, Spain is now in a difficult position and needs outside help to shore up its banks.  However, having admitted to weakness, Spain should take prompt and forceful action.  Such decisiveness might even improve the terms of the bank bail out, making it more convincing and effective.  I don’t know how good Sec. Paulson’s Spanish is, but I think it is good enough.  Make the call!

European hieroglyphics

You can find anything on the Internet, even a site that translates English into hieroglyphics.  According to Quizland.com, the tablet at left says “We do not understand financial markets”, and it could be the motto of the Eurozone leaders.

In its rejection of Anglo-saxon free markets, Europe has been under the delusion that these can be willed away or bent to the wishes of political and other leaders.  One can recall Mr. Trichet, then president of the European Central Bank, flatly stating that Greece would not restructure its sovereign debt, and his “ruling” being repeated by a large chorus of European politicians; or President Sarkozy, after each summit with Chancellor Merkel, declaring that the debt problems had been solved by the negotiation of a new memorandum of understanding and that markets would thus have to fall in line.

When this didn’t work, several futile ideas were proposed, like creating local credit rating agencies (presumably under close scrutiny from eurozone governments) to write credible reports yet refrain from calling for unwanted debt downgrades.  As pressure kept mounting, intricate rescue plans were offered, which had the principal merit of multiplying euros earmarked for intervention funds as if they were fish and loaves of bread.

This state of mind isn’t unique to politicians and bureaucrats; it is shared by bankers as well.  For years, the top banks of Europe have operated under the guidance and protection of their governments.  In so doing, they ended up believing the messages delivered to the “gullible masses”, that the state always gets it way, and that, by staying in the governmental wake, so would they.  This led many banks to rely excessively on wholesale funding, to under-reserve, to feel comfortable with lopsided loans-to-deposits ratios and to be undercapitalized. 

Eurozone banks believed that they could bluff their way through the current crisis.  Indeed, only one, Unicredito from Italy, had the courage to raise $10 billion of fresh capital at a huge discount to market price.  But markets quickly wised up, forcing a liquidity crisis at the same time as a solvency one was worsening.  By then, the most exposed Spanish banks couldn’t access the markets.

The solution to the latest Iberic crisis is true to form, so far: opaque, uncertain as to timing and bound to close markets further.  Opaque because such terms as interest rate, final maturity and conditions have not been disclosed; uncertain as it is not clear whether Spain has formally asked for a rescue package for its banks and what the trigger for recapitalization would be; finally, the recapitalization will be funded by loans to a Spanish agency, thereby increasing that country’s debt burden, and will be chanelled through the ESM to assure seniority over private creditors; this will make future access to the markets that much more difficult. 

The causes of Greece and Spain’s financial troubles are different, but in both cases the eurozone rescue packages, while clearly designed to reduce risks for the institutions that provide help, in effect raise them.  Greece private creditors were handed a 75% effective loss (which has risen to 80% since) to insulate official creditors, and official creditors gained preferred status on the money they lent to Greece.  The private creditors’ loss is greater than the 75% one forced a decade ago by Argentina which was (rightly) characterized as an effective spoliation. Greece abandonned a very reasonable €50 billion privatization program.  Sovereign  bond contracts were retroactively amended by the state.  Net net, financial markets have no rational motivation to return to Greece any time soon and eurozone states are now ‘it”.

In Spain, the sovereign debt will be raised by some 12% to fund the bank rescue, it is not clear what reforms will be required of the recipients, whether the bad banks will be liquidated and how much further help will be needed by the government.  If the bank rescue loans rank ahead of regular sovereign bonds, it is pretty clear that any holder of Spanish, or maybe even Italian, government bonds better sell them in a hurry.  This will leave the eurozone countries to hold the bag, except that their bag of tricks will soon be too small.  At the end of the day, a lack of capital in Spanish banks was remedied with an increase in debts of the Spanish state.

As the eurozone dithers, risks of implosion are rising.  When one country after the other receives financial assistance, it drops out from the pool that will fund the next sovereign borrower in need.  Clearly, Germany, being the last one in line, is on the hook to fund everybody unless the process is changed. 

Spain is make-or-break for the eurozone.  If it fails, Italy gets into the line of fire and, in my opinion, Germany leaves the eurozone because it would have neither the means nor the desire to mortgage its future to save everybody in the eurozone.

What can be done?  If I were head of government in the eurozone, I would try to prepare for the day when Germany refuses to help out.  This means controlling public spending in a way that is politically acceptable: means testing programs, reducing civil servant headcount through attrition and, inevitably, across the board spending cuts as well as some tax increases.  More controversial would be labor laws reform to foster hiring of the young and, yes, pension reform.  These last two issues are hazardous to a president job security, but the payoff is worth a try.  Mr. Hollande has demanded that the CEOs of public sector companies limit their salaries to 20 times that of their employees and that the CEOs in the private sector likewise restrain themselves.  This may be nothing more than demagoguery, or it may be the necessary first step to ask everybody to share in the pain. 

Finally, the deleveraging pain could be alleviated by privatizing public assets.  According to Mr. Stark, ex-board member of the ECB, Greece has over €300 billion in public assets it could sell.  It was supposed to sell €50 billion.  Spain, Italy and France have much more to sell.  Markets can be of great use in gathering funds and setting fair prices for public assets.  Argentina, Brazil, Chile and the UK did it not so many years ago.  It could and should be done today. 

Perhaps another reason why I think that it is crucial that European countries accelerate reforms on their own NOW is that I have real doubts about the future of the eurozone: I am pretty sure that if it survives it will be as a reduced group of more homogeneous countries. Even then, I wonder if ”deep integration is possible”. 

Are most of the eurozone inhabitants willing to let Brussels bureaucrats run their lives?

Are the French willing to align their labor laws and retirement age and benefits on those of Germany?


Short of a full federation US-style, how much, or little, integration do you need to run a common currency alliance on a sustainable basis?  The truth is that we don’t know. 

There is a big world out there, and if it is that big it is thanks to free markets.  Europe's mistake has been to be built to keep the barbarians out, so to speak.  Relatively less effort was dedicated to pool resources and compete on the world stage.  If the eurozone is to succeed, it needs to be redesigned to make a core Europe as competitive as it can be on the world stage.

By the way, the Tweety Bird standing over the English lawn means “no” in hieroglyphics. 

“We are not on the edge of a precipice”

Thus spoke Mariano Rajoy, the Spanish prime minister, this weekend.  As Wile-e-Coyote often demonstrates, our senses can easily be fooled; once a country enters the danger zone, circumstances can change very rapidly, so rapidly that reasonable plans are rendered obsolete and rational expectations turn to panic.

Unlike the US, Spain avoided the CDO and off-balance sheet madness.  Unlike Greece or Italy, Spain didn’t suffer from excessive sovereign indebtedness.  However, it built a huge real estate bubble financed with bank loans.  When the bubble popped, loans soured and banks became undercapitalized. 

Crucially, Spain let the problem fester for more than two years, failing to merge or close underperforming banks or to force the viable ones to recapitalize.  In that it was not alone in Europe; to this day, the only large bank that has had the courage to go to the markets for a large capital raising exercise at a huge discount to market price was Unicredit from Italy.  That share offering took place earlier this year, when markets were very difficult but still open at a (steep) price.

Having failed to recapitalize to absorb the impact of deteriorating real estate portfolios, the Spanish banks entered 2012 facing a new challenge:  sharply falling prices of their sovereign bond holdings (over 8% year-to-date) against which they had not been required to carry any capital.  By now, markets are closed and the capacity of the State to implement, on its own, a large forced recapitalization is doubtful.  ECB assistance alleviated the Spanish banks funding difficulties and gave Spain some time to prepare a new plan, but it didn’t improve solvency.

The problem is that markets may be slow to grasp what is actually going on, but once they do, they are likely to overreact.  As if this were not enough, it has transpired that some €97 billion of bank deposits left the country during the first quarter.  If the situation doesn’t improve quickly, that number is likely to rise much higher.  I remember a Brazilian lawyer I worked with, back in the 1980s, telling me that he kept essentially all of his money abroad in US dollars save for some minimum in local currency.  Right now, and unlike Brazil in the 1980s, it is perfectly legal for Spanish locals and multinationals operating there to transfer or hold money outside the country.  It is also much easier for individuals to drive across the French-Spanish border if need be.

Faced with this crisis, the Spanish government has made the surprising decision that it wouldn’t let any bank fail.  Why shouldn’t unviable banks be closed after paying off their depositors?  How does the government expect to keep all afloat when it doesn’t have the necessary money?  And if it needs to get funds from fellow eurozone members or the ECB, how can it expect to do so without signing a formal agreement carrying tough conditions?  Even if it is a partial simplification, I don’t think that German or French taxpayers will advance money to Spanish banks to, in effect, fund capital flight.

Clearly, the Spanish government has to do some thinking and needs to act quickly and decisively.  In my view, to be credible, it cannot maintain its stance of blanket support for its banking sector: it doesn’t have the money to back it up, is not likely to get it, and I don’t think that it should either: not all banks are systemically important and some examples must be made of the most egregious abuses.

Other European governments are also in the line of fire.  By now, an exit by Greece from the eurozone would likely be greeted with relief by the markets IF it were handled properly, meaning decisively and credibly.  For the eurozone to survive, the line has to be drawn somewhere, which means exercising solidarity.  If it is drawn to include Spain, Spain has to convince the likes of Germany, France, Italy and Benelux that it means business.  The firewall built by the core countries must also be credible.  This means that France in particular must provide a clear set of spending controls as well as growth-inducing policies.  And Italy needs to convince that it can take care of its own debts as well as shouldering its share of firewall building.

I am not convinced that the euro is viable long-term, whether its member count is reduced or not, but I think that a disorderly breakdown can be avoided. 

Back in the 1980s, faced with a mounting financial crisis, a well known Mexican finance minister said that the country was on the edge of the precipice but that it would overcome by taking a decisive step forward.  That particularly step was not taken, thank God, but Mexico did much to transform itself into a successful economy; the EU would benefit from studying how Mexico overcame its crises, in particular the so called tequila crisis of 1994.