EU Summit Notes

Posted in Economics, Financial Markets, Politics and Policy at 8:52 am

US stock markets rallied 2-3% and crude oil jumped over 9% yesterday in reaction to the latest “plan to have a plan” and “agreement to agree on what has already been agreed” coming out of the EU.

I’m not convinced that this will amount to much more than another short term attempt to boost market confidence that rapidly deteriorates.

Everyone ought to just read the official statement (which is just slightly longer than one page in length) and ignore the speculation from the financial press.

Here are my key concerns:

  1. Debt subordination. The financial press keeps saying that the EU agreed that the Spanish bailout would be an exception that would not subordinate existing debt.  That seems to be true, but if you read the actual statement, it’s an artifact of the EU simply re-affirming that any assistance provided by the EFSF and then transferred to the ESM will not involve subordination.  This is an important point, for reasons that will become clear in a moment.
  2. ESM.  I have a number of concerns here.  First and foremost, the ESM was supposed to go into effect July 1.  That’s tomorrow.  It appears the new target date is July 9.  Is that realistic?  They need to get to a point where the countries providing 90% of capital contributions ratify it in order for it to become operational.  Progress has been quite slow.  Another concern is the size of the ESM – with approximately €500 billion in credit to be available it will not be nearly large enough.
  3. Direct injection of ESM funds into banks. This is the big one.  The question, again, is timing.  It can’t happen until the new single bank regulator is in place, currently targeted for January 1, 2013 (and we know how target dates slip in the EU).  Furthermore, each individual ESM bank bailout will require UNANIMOUS approval.  Is the thinking that no banks will get in trouble over the next 6 months, and that when they do get in trouble there will be ample time to get unanimous approval on terms?

Given the timing of the ESM itself as well as the timing of its power to provide direct assistance to banks along with the subordination issue, I think there is going to be enormous pressure over the next few months to expand both the duration and size of the EFSF while backburnering the ESM.  Alternatively, some new “medium term solution” may emerge to fill the gap between the EFSF and ESM.  It’s unlikely that matters will proceed along the lines currently proposed, with a smooth and seamless transition between the EFSF and ESM.


Spain becomes the 4th EU country to get bailed out

Posted in Economics, Financial Markets, General Musings, Politics and Policy at 7:41 am

Yesterday, the EU agreed to provide Spain with a 100 billion Euro ($125 billion) rescue package.

The money will go into a fund called FROB (Fund for Orderly Bank Restructuring) modeled loosely after the US TARP prgram.  The Spanish government will be responsible for paying back the loan, but they are constrained in how they can use the money; essentially, it has to be used to recapitalize their banks.

It appears this will calm the markets, but for how long?

Why is “calming the markets” always the proximate (and often the ultimate) goal?  Spain has an overall unemployment rate over 24%, with unemployment levels hovering around 50% for the young.  GDP growth was negative in 2009 and 2010, barely positive in 2011, and now has gone negative again for the first half of 2012 with consensus estimates for all of 2012 coming in around -1.5%.  The housing market is in shambles after a boom and bust.  Where are the plans to address crisis-level unemployment and jump start economic growth?  Where are the plans to fix the housing market?

It’s interesting to note the similarities between Spain and Ireland, both of which pursued fiscally responsible policies prior to the financial crisis.  Spain ran budget surpluses in 2006, 2007, and 2008.  In 2009, Spain’s public debt was under 60% of GDP, well below the EU average.   Even now, after the crisis, it only stands at around 68% of GDP.  Like Ireland, Spain is not a tale of fiscal profligacy, it’s a story of a country that experienced the collapse of an asset price bubble followed by a banking crisis.  Awhile back, Paul Krugman noted that Rogoff and Reinhart got the correlation between public debt as a % of GDP and economic crisis correct, but they had the causation reversed.  An economic crisis causes public debt to skyrocket, not vice versa.  Spain is a perfect example.

Where do we go from here?   What will the political repercussions be, both in Spain and in the rest of the EU?  Will Ireland and others demand a renegotiation of their bailouts to remove or reduce the austerity measures attached to them?  What impact will this have on the Greek elections?  Will the contagion spread to Italy next?