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Edward Hugh is only able to update this blog from time to time, but he does run a lively Twitter account with plenty of Spain related comment. He also maintains a collection of constantly updated Spain charts with short updates on a Storify dedicated page Spain's Economic Recovery - Glass Half Full or Glass Half Empty?

Monday, October 13, 2008

Europe's Leaders Agree To A Common Front In Fighting The Banking Crisis

Well, Europe's leaders have finally bitten the bullet. Faced with what IMF head Dominique Strauss Kahn warned could turn into a global financial meltdown, our leaders have risen to the challenge, at least to a certain extent. The details of what has been agreed continue to remain vague, but obviously I think it is a good FIRST move. More will now almost inevitably follow, but our reluctant leaders have finally got their feet wet, and the bathing costume is on. Now it is only left for them to dive into the ocean which lies in front.

And, of course, the situation was not without its theatricals. Initially billed as a "eurozone only" meet-up, Gordon Brown was ultimately summoned, a move which was not totally essential, but since he was the only one with a real "going plan" on the table, the invitation made sense. Of course Brown himself has been relishing it all, proudly proclaining that Britain will "lead the way" out of the credit crunch, and adding in true Churchilian style that "I've seen in the cities and towns I've visited a calm, determined British spirit; that, while this is a world financial crisis that has started from America, Britain will lead the way in pulling through."

Well, we will see.

While the details at present remain vague the important point would seem to be that Europe's leaders have made a commitment not to allow any systemic bank - in Western Europe (the guarantee does not extent to Hungary which today had to turn to the IMF for support) - to go bust, and it will now be hard for them to go back on this without losing all credibility. The deposit guarantees - which may be useful in terms of reassuring the general public - would now seem to be largely redundant, since if the large banks, and their debts, are to be guaranteed, then logically the deposits themselves are safe. And while Europe itself will underwrite the systemic banks, the national governments will be able to handle the smaller ones (Spain's regional cajas etc) at local level.

So government finances will guarantee the banks, but who will guarantee the government finances? This, at this stage may seem to be an idle question, since none are under direct threat, but I think we need to be clear here, the money which will now need to be spent - and it is way too early to start trying to put precise numbers - will have to come from somewhere, and by and large this will mean the national governments issuing debt, but if we come to individual national governments like Greece or Italy - where debt to GDP ratios are already over 100% - it is not clear how much paper they can actually issue without seeing what is know as the "spread" on their bonds increasing significantly. So while it is certainly time to breath a sigh of relief, we we far from being able to whistle the all clear. And of course the real economy consequences of what has just happened are pretty serious, and the funds which will be spent propping up the banks will not be available for fiscal stimulas packages, so the bottom line is that we, in the OECD world, may well be in for one of the longest and deepest recessions since WWII.

The Package Itself

Now, as I say, the details we have to date of what has been agreed are far from clear. What is clear is that the EU collectively has agreed to guarantee new bank debt in the eurozone (and possibly elsewhere, but this point still awaits clarification, since as I say the guarantee evidently doesn't apply to Hungary, and that should give us some sort of idea about just how strained everything is at the moment). They are also committed to the use of taxpayers money to keep any systemic banks which get into distress afloat, and by implication they are prepared to pool resources to do this (maybe by injecting funds into the ECB as the UK has pledged to do for the Bank of England). This is also a very important precedent: since the European institutional structure is something of a patchwork quilt at this point, it is clearly make, mend and improvise time.

Wolfgang Munchau clearly seems to catch the spirit of the times in a long and thoughtful article in the Financial Times this morning:

"I had a better feeling about Sunday’s eurozone summit. It produced a detailed and co-ordinated national response to recapitalise the banking system, and to provide insurance to revive the inter-banking market. But as far as I could ascertain, this was still agreement on ground rules for national plans, and it is not clear how well this agreement would cover the numerous cross-border issues that have arisen. There is no doubt that, in the eurozone at least, we have come a long way since Friday. It is an okay policy response, but I wonder whether this is going far enough at a time when global investors are pondering whether to pull the big plug."

Well look Wolfgang, my favourite phrase these days is "sufficient unto the day", we have come as far as we are able to come in one weekend. There will still be next weekend, and the one after. Clearly we have not come far enough yet, but as Paul Newman discovered in a once famous film, there are only so many hard boiled eggs you can eat in one sitting.

The key measures announced at the weekend were: a pledge to guarantee until the end of 2009 bank debt issues with maturities up to five years; permission for governments to buy bank stakes; and a commitment to recapitalize what the statement called `"systemically'' critical banks in distress. The statement gave no indication of how much governments were willing to spend or the size of bank assets deemed to be at risk, and European officials refused to estimate the price tag of the measures. Some indication of the numbers involved will start to emerge today, when France, Germany, Italy and others begin to announce their national measures.

"What has been done over the last three days should provide elements of reassurance,'' Dominique Strauss-Kahn, chief of the International Monetary Fund said on French radio Europe 1 today. The worst of the financial crisis ``may be behind us.''

Often criticized for its preoccupation with inflation, the European Central Bank abruptly reversed course last week, cutting interest rates for the first time since 2003 in a move coordinated with the U.S. Federal Reserve and four other central banks. The ECB doesn't have the legal power at the moment to follow the Federal Reserve and buy commercial paper to unblock a financing tool that drives everyday commerce for many businesses, according President Jean-Claude Trichet, who also participated in yesterday's Paris meeting.

``We are looking at our entire system of guarantees and we can imagine new measures to enlarge access to our system of guarantees,'' Trichet said.

As Wolfgang Munchau points out, there is now an almost unanimous consensus among economists about the need for a recapitalisation of the banking system, and for the provision of some form of public-sector insurance for the money markets, even if there is no consensus about how exactly to do this. We should not forget, of course, that it was precisely the practice of offering guarantees - via instruments like credit default swaps - for what appeared at the outset to be investment grade lending but which later turned out to be extremely risky that has produced the current "near meltdown", and we therefore need to be extremely careful about the kind of guarantees we are offering, since what we do not want to happen is to see public finances meltdown in the future in just the way bank finances have.

What Wolfgang doesn't draw too much attention to - perhaps he is too modest - is how few of us there actually are who have been who have been arguing systematically and repeatedly for just this kind of package of measures since the very start. Wolfgang is one of a very select company here, and I, if I may be so presumptious, am another. Back on July the 18th - in a post for RGE Europe EconMonitor - I said the following (the numbers were pretty rule of thumb, but in the light of what is now coming out they don't look that far off):

So what does all this add up to? Well, to do some simple rule of thumb arithmetic, just to soak up the builders debts and handle the cedulas mess, we are talking of quantities in the region of 500 to 600 billion euros, or more than half of one years Spanish GDP. Of course, not every builder is going to go bust, and not every cedula cannot be refinanced, but the weight of all this on the Spanish banking system is going to be enormous...............So it is either inject a lot of money now - more than Spain itslelf can afford alone - or have several percentage points of GDP contraction over several years and very large price deflation - ie a rather big slump - in my very humble opinion. And it is just at this point that we hit a major structural, and hitherto I think, unforeseen problem in the eurosystem (although Marty Feldstein was scratching around in the right area from the start). The question really we need an answer to is this one: if there is to be a massive cash injection into Spain's economy, who is going to do the injecting? Spain alone will surely simply crumble under the weight, and it is evident that the problem has arisen not as the result of bad decisions on the part of the Spanish government, but as a result of institutional policies administered in Brussels and monetary policy formulated over at the ECB. And yet, the Commission and the ECB are not the United States Treasury and the Federal Reserve, no amount of talk about European countries being similar to Florida and Nebraska is going to get us out of this one: and it is going to be step up to the plate and put your money where your mouth is time soon enough.

Well, getting through to the put your money where your mouth is stage didn't take that long, now did it? Twelve weeks and two days to be exact.

My central point at this stage would be that all of this is going to have, among other things, important implications for the real economy, since it is the degree of all that leveraging which we have been busy doing which is now going to have to be reduced, and while we are all busy "deleveraging", our real economies will notice a significant drop in demand. I wouldn't like to dwell too much on the point at this stage, but this was, of course, precisely what happened in the 1930s.

Basically, one economy after another in the developed world is now going to become export dependent. If I take Spain as an example, perhaps things will be clearer. Spanish households are now in debt to the tune of around 90% of GDP. Spanish companies owe something like 120% of GDP, and the government, which is just about to start accumulating more debt, owes about 50% of GDP. Adding that up, Spain incorporated owes about 260% of GDP at the present time. But the situation is worse than that, since debts continue to mount.

Back in the good old days of Q2 2007, when Spain's economy was busy growing at a rate of about 4% per annum, corporate and household debts were increasing at a rate of about 20% per annum. 4% growth for a 20% rise in indebtedness (or an increase of about 30% in debts to GDP) doesn't seem like that good value for money when you come to think about it - and in the meantime Spain Incorporated's indebtedness to the rest of the world (via the current account deficit) was growing at a rate of 10% per annum. Fast forward to Q2 2008, and household and corporate debts were rising at a mere 10% per annum (and government debt had also started to rise, at this point at a rate of around 2% of GDP per annum, or 4% of accumulated debt), but Spain's economy had reached a virtual standstill (true it was still growing at 1% rate year on year, but quarter on quarter it was virtually stationary). So not only is this a horrible "bang for the buck" ratio, it is also totally unsustainable. Indebtedness has to be reduced, not increased, and this can be done in one of two ways, either by ramping up GDP growth (which in the present environment is out of the question in the short term) or by burning down the debt by paying (or writing) it off.

This harsh but unavoidable reality has two important implications. The first of these is that Spain is going to need external help, and the second is that while the level of indebtedness is being reduced, Spain will not get GDP growth from internal demand, and any headline GDP growth there is will need to come from exports.

And of course Spain is just one (extreme) case. There will be a whole company of others who need to make this transition (the UK, Greece, Denmark, Ireland at least, and probably virtually all of Eastern Europe - now what was that football song I used to sing back then in the old days, over there on the Spion Kop... "when you walk through a storm...").

So the question is, while a host of new countries are suddenly struggling to export, who is going to do all the importing? No mean topic this one. The only person who seems to have even the inkling of a proposal here is World Bank head Robert Zoellick, who came right out with it on Sunday: we need a new multilateral structure. The global financial crisis underscores the need for a coordinated action to build a better system, he said on Sunday. "We need to modernize multilateralism for a new global economy....We need concerted action now to ... build a better system for the future." Never better said, and never was the fact that we live in an interconnected world placed under such a stern spotlight.

And just what will this system look like? Well, the details will all need working out, but in broad brushstroke terms, my strong feeling is that we need to bring-in the large developing economies like India, Brazil, Egypt, the Philippines etc en-bloc, and create a Marshall-Plan-type structure were all those newly created developed world savings can be put to good (and safe) use in facilitating the emergence of those long suffering emerging and frontier markets, and in so doing these countries will play their part by helping provide the customers which our own "export dependent" economies will all now so badly need. But, as I say above, sufficient unto the day......


Anonymous said...

Hello Edward,

Yes in deed, finally we have a plan. But the more I look at it, the less I like it. I suppose it is still fuzzy and will be refined as we go along, and I am no expert.
1.From the FT:"“The state will act as insurer for the commitments of the financial sector in exchange for a fee,” Angela Merkel, chancellor, said".
They will charge 2% for this. So we now have a super AIG or the states creating a huge Credit Default Swap mechanism. So much for critisizing Wall Street. 2% !!!! That is huge, add that to euribor for the banks...
2. From FT: Mr Steinbrück will be able to draw up to euro 10bn to acquire assets.
Spain is making available euro 50bn. So spanish cedulas are more of a problem!! Now what is interesting is that the spanish plan makes euro 100bn "aval" available until the end of 2008. So we will probably need more for 2009. Unlike France, Britain or germany it is not specifying the full amount to be made available. Why would that be? (let's not scare everybody.) Have I misunderstood something?
3. We have seen as you say how the superinsurers of wall street have ended up, and Italy with close to 100% debt does not dare to say how much money it will make available. Lets hope all this debt will not make the interest rates go up in a time when we are already in full recession. Anyway we do not have much more alternatives...
4. I am not sure as you are that the plan is global. In the sense that if for example a big spanish bank would default, that the german will use their taxpayer money to refloat it. The plans seems to me to be national. Each country will look after it's own. I hope that I am wrong, but it is not explicitly specified. I supose they would rather stay vague about this, until it happens, so that they can sell this plan to their own people.
Well I am not a big fan of Gordon, but he did a hat tip job on this. So in a sense we spanish are lucky to be in the EU, as with good leadership (Brown, Sarkozy and Merkel) we are able to mitigate the shortcomings of ZP and Solbes...
There was an interesting debate in the week-end edition of elmundo "Mercados". Several spanish economists were debating the first part of the plan (50bn for buying assets). The major diference in point of views: some thougth the spanish banks had only a liquidity problem, others insisted on a solvency problem.

Edward Hugh said...


"But the more I look at it, the less I like it."

Well I have also been sleeping on it, which is a good think to do about anything before taking a decision I feel. And while I still think (obviously) that this had to be done, the weaknesses in what they have decided - some of which you have pointed out above - are now becoming clearer to me (although probably they couldn't have done much more at this point, as I say in the post).

To take just one immediate example, Banco Santander have announced this morning that they are taking over the 75% they still don't own of the US based Philadelphia-based thrift Sovereign Bancorp - for some $1.9 billion. They already had a 25 percent stake in Sovereign and will now buy the rest with their own stock. Sovereign Bancorp has received a drubbing in the stockmarkets due to rising mortgage delinquencies as the US housing market has tumbled. Its stock has lost nearly two-thirds of its value in the year to date.

Now.... the point is, with loans and debts guaranteed at home, and Spanish property prices set to take a beating, why not buy up cheap US banks where the house prices are probably already near their bottom? But this is hardly what the average Spanish taxpayer thought they were giving the green light to. However, once you give a blanket underwrite to the banking sector, there is really little you can do to stop this, since banks are commercial enterprises, and have to do what is best for them and their shareholders. All of this has already come up in the context of the notorious Irish "excesses" in accessing ECB funding, and in - for example - the McQuarrie proposal (subsequently dropped)to take paper backed by Australian car loans over for presentation at the Irish central bank.

So let us be clear, this is a "lesser evil" situation. The greater evil would be a banking sector which went bust, with all the attendant consequences.

But, we need to be clear, this is just a first move. The banks are now "as safe as houses", which frees us up to address the problems in the real economy, which are going to be large. Spain is about to go into the most serious recession in living memomry, and there are two important groups of people who are not protected at this point: the builders and the private mortgage holders.

Both groups are now going to find themselves flooded with unsupportable demands on their finances. The former since there is now less than half the market there was for their product, and the latter because the value of what they own is going to fall, while their debt isn't. Added to which, in the two-earner households which are supporting a great deal of this, one or other of the parties is likely to find him- or herself out of work in a not too distant future, and while the INEM payments may help for a year or so, what happens after that? I mean, we need to be clear, we are digging in for a long winter here.

So the next steps need to be a plan for downsizing permanently the construction industry, and some provision for "distressed" mortgage holders, just like we have been seeing in the US really.

So, the big question is that all of this will cost money, and money is going to be in short supply in Spain over the next few years - especially if we are thinking of paying down the external debt, which we have to be really - and so we wend our way back upstream to the banks, and to the European support.

"I am not sure as you are that the plan is global. In the sense that if for example a big spanish bank would default, that the german will use their taxpayer money to refloat it."

Well look, I think people are going to end up playing "chicken" here. I mean by this that Spain will end up threatening that a systemic bank is about to go, all the way up to the brink, and up to the point that the others feel they have no alternative. Actually, Spanish politicians seem to me to be particularly adept at this kind of game (they are much better at this than they are at addressing the real underlying issues), so they are in their element here.

I think any going back on the committment not to let a systemic bank fail would have important consequences for the whole eurozone, and I will not say more than that at this point.

"Spain is making available euro 50bn. So spanish cedulas are more of a problem!! Now what is interesting is that the spanish plan makes euro 100bn "aval" available until the end of 2008. So we will probably need more for 2009."

Well, yes, this is about the size of the problem. What they are hoping is that they can "restart" the economy in 2009, but I think this is a pipedream. We may well need this sort of funding as the securities are rolled over all the way through to 2012 and beyond. I doubt there is going to be any important wholesale market in Spanish RMBS-type paper before the correction is over, and this has all the hallmarks now of being a very long drawn out affair.

One of the main advantages of a Schumpeter-style "creative destruction" process, is that it is nasty, brutish, but short, and after everything has crashed you can begin the rebound. Spain's process is likely to be much longer than in either the US or Ireland, since property prices are much slower to fall, and builders are not being allowed to go bust in any sizeable numbers, yet.

So we won't "bottom" here until much later, and there will be no significant RMBS market till we do bottom. I mean, I think people have missed the very important point that the German Pfandebriefe, on which the cedulas were modelled, were introduced as part of the POST 1995 rescue package and bank bailout, AFTER property prices had already dropped, thus, since prices had already fallen (and they have stuck more or less at this level since) these securities were "safe as houses" since the underlying asset was stable.

"The major diference in point of views: some thougth the spanish banks had only a liquidity problem, others insisted on a solvency problem."

Well personally I would say that the two points of view are valid, in the sense that what we have now (and have had since Sept 2007) is a liquidity problem. But what we will have when property prices drop and builders go bust is a solvency problem. So both views are correct, and the only thing they need to get straight is the timing.

On the numbers which are being bandied about, I agree with you: they do seem to be huge, and they do make all the earlier smug comments about the situation in the US seem ridiculous. I also think no one is really clear at this point just how much will be needed, so they may even be quoting numbers on the "upside", just to demonstrate that they will go as far as it needs. The number for Germany amounts to around 20% of GDP, and given their fiscal position, I don't see how even they can do this without, for example, reducing pension and health commitments. So nothing from now on is going to be easy.

Well, good luck, and keep the comments coming. I am just about to update the original post with a big slice of these arguments.