French-German divide prolongs Greece’s woes

Even by the EU’s sad standards, eurozone finance ministers’ display of unity on Monday over the Greek crisis proved particularly short-lived. But a deep divide between France and Germany over how and whether to help Greece is accentuating the crisis and increasing the chances for worst case scenarios.

The ministers agreed on Monday at their monthly dinner meeting in Brussels on the broad outline for how the eurozone would extend bilateral loans to Greece if Athens were forced into needing them. However, the ink was barely dry on the communique before the agreement began unravelling with Germany raising the possibility of calling in the IMF and even the possibility that countries could be kicked out of the 16-nation shared currency union.

Germany’s reluctance to pony up any cash for Greece is more about domestic politics than anything else. With an election later this year, German politicians don’t want to be seen sacrificing German taxpayers’ cash to prop up a corrupt and profligate Greek benefits system after Germans worked hard to keep down their deficit levels. Therefore, Chancellor Angela Merkel and her Finance Minister Wolfgang Schauble have been doing everything possible to stall any firm and precise commitments to support Greece with cash. That’s why Schauble pushed the idea of a European Monetary Fund two weeks ago and why Merkel has opened the door to the possibility of calling in the IMF. They are hoping that stall-tactics will be enough to keep Greece solvent until it gets over a key debt rollover hump running through April.

Meanwhile, Nicolas Sarkozy’s France has been pushing for stronger eurozone commitment to Greece. The last thing he wants is for the IMF to have to come in and pick up the pieces in the Greek crisis as it just so happens that his biggest political rival heads the IMF. Shortly after he was elected, Sarkozy exiled Dominique Strauss-Kahn in Washington with the plump job of running the IMF in hope of keeping sharp and respected Socialist out of domestic French politics. However, the move has largely backfired because Strauss-Kahn’s absence in Paris has done little to hurt his ratings, with French opinion polls now ranking him as the most popular French politician. That makes him a formidable rival for Sarkozy if he decides to run in the 2012 presidential elections. That point is likely to borne home as soon as Sunday when Sarkozy’s ruling UMP party is due for a drubbing in regional elections, the last vote before the presidential election.

With Germany and France busy playing domestic politics, Greece is left wondering where its going to get the cash to pay its bills over the next six weeks. That’s why Prime Minister George Papandreou tried to force Germany and France to get serious and come up with coherent positions in time for a summit of EU leaders in Brussels next Thursday and Friday. If they don’t then the markets are probably going to drive up Greek bond yields and ultimately there may be little choice but calling in the IMF for an emergency rescue. And that will be sorry sign that the eurozone is not mature enough to sort out its most pressing problems.

China will not be bullied into revaluing the yuan

China will eventually let the yuan rise, but not because its trade partners told Beijing to do it. When China’s leaders let the yuan rise it will be because they perceive it to be in the interest of the political establishment.

With the US Treasury due to issue its annual report on currency manipulators soon and elections around the corner, a new rash of China bashing has broken out in Washington. But China insists as much as ever that the yuan is not undervalued. As a result, a dangerous game of brinkmanship has emerged at the heart of the most important economic relationship in the world, raising the chances of a nasty trade war.

The new push in Washington for sanctions against China is more about domestic politics than anything else, with China an easy target for politicians eager to build up political capital ahead of the mid-term elections amid high unemployment and general anxiety about China’s rise. But likewise, China’s refusal to revalue the yuan is also driven by Chinese politics. Chinese leaders don’t want to be perceived by the population as kowtowing to the United States or other western countries, which would undermine their credibility and make cracks in their power.

It is frequently said of China that the Chinese have a much longer sense of history than in the West, which makes them see the world through the prism of history. Therefore, the Chinese consider it vital to put the last 200 years of foreign domination behind them and restore China’s position as one of the world’s pre-eminent powers — a position China enjoyed for millenia until the Europeans arrived. Prior to the arrival of Europeans, the Chinese leadership considered it to be at the centre of the world, literally the Middle Kingdom. However, a student of Chinese history will quickly see that the central powers have long struggled to maintain authority over the country and surrounding territories, causing the imperial leadership to frequently collapse and uprisings to break out.

The current Chinese leadership know that to retain authority, and therefore credibility, with the population they must firstly deliver prosperity through rapid economic development and secondly they must be perceived as restoring China to its former glory as a pre-eminent power. And, as Americans themselves know perfectly well, pre-eminent powers do not let their policies be dictated by foreigners.

That is why the Chinese leadership are refusing to re-value the yuan even as it increasingly makes sense for the Chinese economy. With inflation in China becoming a problem and asset bubbles getting bigger every day, relaxing the yuan’s exchange rate makes good economic sense. But it does not yet make good political sense. It will make political sense when the economic damage from the yuan’s overvaluation becomes more of a domestic threat to the Chinese leaderships credibility than the perception in China that revaluing the yuan is kowtowing to Washington and other foreign powers.

In the mean time, bullying China to revalue the yuan can only be counterproductive because it would only make the Chinese leadership look weak if they actually did it.

Is Germany the China of Europe?

It’s an international economic powerhouse sporting a trade surplus the envy of most other nations. It’s workers are industrious and it’s consumers are thrifty. And it’s trade strategy is getting on the nerves of its major trade partners.

The parallels between the German and Chinese economies stop there. But French Finance Minister Christine hit on a something when she very undiplomatically attacked Germany in an interview with the Financial Times for building its huge trade surplus on holding down wage costs. Such criticism is certainly familiar to the Chinese.

For Germany, an export driven economy coupled with high savings and stagnant wage growth would not be so irritating for other countries except that Germany is in a currency union with 15 other countries. And if Germany runs a big trade surplus, it means that its main trade partners, who are mostly in the eurozone, must run a big trade deficit. And if Germans save everything they can, that’s money they don’t spend on consumption of imports from the rest of the eurozone or vacations in Greece, Spain or Portugal. And when German employers keep wages from growing year after year, they become much more attractive than their competitors in erstwhile poorer eurozone countries like Greece, Spain and Portugal.

Of course, divergences between countries are normal. After all the southern Europeans could have done more to make their economies more competitive. However, such divergences become a problem in a shared currency union such as the eurozone. For instance, they explain how Germany has been able to run its public finances much better over the last five years than southern European countries. Such divergences also mean that smaller countries on the fringes of the eurozone were stuck with interest rates more appropriate for Germany, helping to create housing bubbles in Spain and Ireland.

Of course, the real target of Lagarde’s criticism in the FT interview is Germany’s stubborn budget discipline. What she wants is Berlin to do like Paris and worry less about its budget deficit and do more to kick start domestic consumption, which would benefit not only Germans but people in other eurozone countries. In other words, give Germans a raise if you want to help Greece.

How long can stocks defy gravity?

What a difference a year makes. It was barely a year ago and armageddon seemed to be upon the investing world. A year later doom is a distant memory and the stock market is behaving like there never was any financial crisis. More dangerously, stocks are not reflecting the huge economic and political risks that will eventually undermine the rally.

While stocks probably went too far down a year ago, now they are going to far up. The Federal Reserve’s Flow of Funds data last week showed that already in the fourth quarter of last year that the equity of US companies was trading nearly at their net worth, which is well above the long term average. The Fed report showed the ratio of equity of US companies to their net worth, a stock market valuation measure known as Tobin’s q, was at 0.98 while the long-term average is about 0.63.

US stocks are also trading well above their average earnings over the long term. At 21, the price/earnings ratio is getting pretty far from the long-term average of 16.

Generously valued stocks might be a reasonable scenario if the economy was on an undisputed and unambiguous path of rapid recovery, profits were soaring, taxes low, politics working. But that’s hardly the case. Uncertainties abound on all these fronts. Indeed, we are facing just as many macro, fiscal, political and regulatory risks as before the crisis if not more.

But risk is being priced at the complacent levels that so recklessly abounded before the financial crisis. The equity risk premium, which measures the premium investors are demanding to own risky stocks instead of risk-free government bonds, has fallen to 4.25 percent, the lowest its been since about September 2008, back when markets still had a long way to go before pricing in the worst recession in generations.

While investors seem comfortable with risk given how much they are willing to pay for stocks, the companies themselves seem much less at ease. Managers are acutely aware of the risks they face and are letting their cash pile up despite the paltry interest rates they get on it now. Concern about risk is why companies are bullet-proofing their balance sheets rather than splurging on new investments, raising dividends, making buybacks or pursuing mergers.

Despite being clearly overvalued, the stock market could still go higher be a nasty bout of mean reversion sets in. The main reason is low interest rates, which makes the alternatives of cash and bonds unappealing and makes liquidity abundant. But one thing that is certain is that interest rates will rise, the liquidity will to be mopped up and stocks will fall. The timing, as always, will be key.

Greece and the speculator witch-hunt

A financial crisis is just not the real thing unless the authorities conduct a witch-hunt against speculators. During the global crisis of 2008, the powers that be went after short sellers, that perfidious lot who, horror of horrors, try to make money when everybody else is losing their shirts. And now Greece has gotten itself in trouble and on cue Europe’s leaders are following the time honored-tradition of blaming the speculators for the debt-crippled country’s woes.

The wave of short-selling bans that many countries put in place during the heat of the 2008 crisis ended up having quite nefarious effects, according to two academics here at Voxeu.com. They find that the bans hurt liquidity and price discovery — two things that are nice to have in the darkest moments of a full-flung financial crisis.

Now European politicians, with Germany’s Angela Merkel leading the charge, have convinced themselves that credit default swaps are making Greece’s woes worse. But no politician, to my knowledge, has bothered to explain exactly how CDS contracts are making things worse for the Greeks. One can’t help but think that maybe just maybe those wise leader sare mixing up their causes and effects. After all it was the Greeks who contracted their debt lying outright about their previous indebtedness. The speculators came afterwards. The cause was the Greek debt and effect was speculation on just how bad that debt situation is or is not.

If there is a problem with credit default swaps in the Greek case it may be that both people who owned Greek debt and people who did not own Greek debt but saw an opportunity in the situation (ie, speculators) rushed into CDS contracts when it became apparent how weak Greek finances were, blowing out the spread and ultimately causing the yield on Greek bonds to play catch up. But even then, it’s not certain that Greek bond yields would not have been forced higher in light of the Greek finances if there were no such thing as CDS.

Banning naked CDS contracts, as Merkel is keen, would at best do little to improve the situation for the Greeks. If the EU pushes through legislation against CDS, which would take time anyway, then speculators could still short Greek bonds or they could short Greek stocks, especially Greek banks. The EU would make a better use of its time with a serious effort to set up a single clearing-house for CDS contracts which would help reduce counterparty risk and make the market more transparent. Such plans have been in the air since 2008, but have been left neglected in the absence of political will in Brussels to do something.

But as is often the case with practical reforms that address real problems, they do not earn much political capital and they cost a lot of energy. And politicians, just like speculators, want to get as much return on the capital as possible. Only the game is different.

Too much debt is just the beginning of southern Europe’s woes

Will the eurozone break up as its southern members splinter off under the burden of  crippling debt? Probably not. But even if the bloc’s richer northern members don’t snub their profligate southern brethern in their hour of need, the eurozone faces unsettling cracks that have long been emerging in the club’s economic foundation.

Southern European countries have not only failed to manage their finances wisely. They have also failed to keep their economies competitive in recent years, which could prove to be just as much of a burden on their economies in the future as their crushing debt.  Greece, Italy and Spain have all seen their unit labor costs run well ahead of the eurozone average since the beginning of the decade, according to calculations from OECD data. Greek unit labor costs rose on average 1.7 percent annually since 2000 while in Italy the figure rose 2.3 percent and Spain 2.6 percent — all well in excess of the euro area average of 0.4 percent.

The increases in the three countries could just seem to be evidence of relatively poorer European countries catching up to standards in the richer north, except that in the mean time unit labor costs in eurozone economic powerhouse Germany actually fell on average by 0.7 percent. Therefore, the workers in Greece, Italy and Spain have been getting more expensive while German workers have become cheaper. Since German exports are generally known for their quality and high level of added value, the sole advantage that exporters from Greece, Italy and Spain had was their cheapness. But that advantage has dwindled away while at the same time the three Mediterranean countries have not been able to establish themselves in the markets for top quality, high valued added goods.

Eurozone politicians are not ignorant of this and indeed such divergences were one of the more common subjects finance minsters fretted over at dinner during the monthly Eurogroup meetings before the economic crisis hit. But they should start fretting again because the trend is only likely to diverge even more in the years ahead as taxes go up in southern Europe too pay down debt, leaving less cash for businesses and consumers to spend.

Of course, one easy solution would be for German companies not to be so tight-fisted and give a raise to their workers. But don’t count on it. German companies seem to understand much better than their southern brethern that they have to keep pushing the value they can add to their goods while keep costs under control to keep Chinese competitors at bay.

China not dumping dollars… yet

The press has made much out of US Treasury data last week indicating China’s holding of US treasury bonds fell by 34.2 billion dollars in December, suggesting either openly or by implication that Beijing is dumping the dollar. While the drop in Chinese holdings does raise many questions, such speculation ignores the basic facts about why China purchase’s treasury bonds in the first place.

China buys US treasury bonds in order to keep the value of the yuan to the dollar fixed. Therefore, if the Chinese suddenly got cold feet about the dollar and dumped a chunk of their holdings then the yuan’s exchange rate to the dollar should have changed in December. That clearly did not happen as it would have been huge news. The yuan is just as fixed to the dollar as ever although there are good reasons to expect that to change in the coming months.

There are other explanations for the fall in Chinese holdings. One possibility is that the Chinese central bank chose to purchase treasuries indirectly through US or foreign banks, which would keep the purchase from showing up in the Treasuries data for direct purchases by China. Indeed, holdings of US treasuries by Britain — with London the home of many international banks — rose by 24.9 billion dollars in December, which would offset a big chunk of the fall in Chinese holdings.

The question then arises why would the Chinese opt for a more roundabout way to manage their US holdings, especially since it would increase the transaction costs for them. Perhaps, it is a new way of sending Washington a message. Chinese officials have been voicing concern about the dollar and the spiraling US deficit for sometime. So maybe this is a way of putting their money where their mouths are, both figuratively and literally, since actually dumping the dollar is not possible without relaxing the yuan’s peg to the dollar. Moreover, tensions between China and Washington have been high and rising, getting in fact substantially worse since the December period covered  by the data.

But there is also another more mysterious possible reason for the fall in Chinese holdings of US treasuries. Since the Chinese have to buy dollar assets in order to keep the yuan pegged, perhaps they have bought US assets other than low-yielding treasury bonds. In which case, what did they buy? Corporate bonds, stocks… One can hardly blame the Chinese for trying to get a better return on their investments in US assets given the rock-bottom rates on offer from the Treasury. Indeed, even in regard to its treasury holdings, China has been cutting down on low-yielding treasury bills in favor of higher-yielding, longer term notes. That can also be said of all foreign holders of US government debt.

While sharp for one month, the drop in Chinese holdings also has to be put into context of the trend over several months. Chinese holdings peaked in May 2009 at 801.5 billion dollars and have been drifting down since then although December’s fall was bigger than previous months. However, that fall in Chinese holdings has easily been offset in increases by Britain and Japan, which regained its title as the US government’s biggest foreign creditor from China in December.

Therefore, the US is still having no problem attracting the foreign capital it needs to finance its vast current account deficit.

Greek crisis kills off Europe’s nascent reserve currency ambitions

European hopes that the euro could rival the dollar in the coming years as a new reserve were effectively killed off by the current crisis engulfing Greece, which has shown that the euro is by no means ready for such a role.

One may very well lament Washington’s poor management of its finances, but the Greek crisis has shown a light on just how weak Europe’s management of its finances are in the absence of a “federal” structure to impose spending limits on the eurozone member countries. The Stability and Growth Pact, which is supposed to impose fiscal discipline, has proven far too weak during the last two recessions, allowing countries  to run up unsustainable deficits with utter impunity.

While fears that the Greek crisis might threaten the very survival of the eurozone are excessive, their existence shows that the euro is by no means ready to take up a role as an international reserve currency. Why would authorities want to seriously stockpile a currency if they considered that there was even a vague risk that the country or country it belongs to might break up? One might fear for the fiscal state of the United States, but nobodies worries that it might break up, which helps underpin the dollar’s status as a reserve currency.

The case for a new reserve currency has been driven more by the logic of international relations than the logic of international economics. China, Russia and France have pursued the idea mainly because it suits their aims of diluting American dominance. In China’s case, it has also served as a way to put pressure of Washington to better manage the dollar, which Beijing has a vital interest in on account of China’s vast assets in dollars.

Since a G8 meeting last summer in Italy, France’s Sarkozy has been the main proponent in Europe of an alternative to the dollar as a reserve currency. However, he has apparently failed to recognize that if ever the euro were to serve that role then central banks around the world would have to buy up vast amounts of euros, driving up the currency’s value and killing off the eurozone’s exports. It’s surprisingly that this fact has escaped Sarkozy, who has also decried their euro’s strength in the past because of the impact on exports.

Perhaps one day in the distant future, Europe will have more mature and sound fiscal management and the euro will be ready for a role as a reserve currency of choice. But that is unlikely to happen for many years and by then the Chinese yuan would probably be a better contender for such a role anyway.

Stability and Growth Pact: Act III

Nobody ever said that using one currency in a bunch of eclectic European countries would be easy. Before the euro’s birth, there was no shortage of critics, many in America, who bet that the endeavor would fail. With Greece now agonizing over how to pay its debts and Spain and Portugal increasingly jittery, critics predicting that the great euro project is bound to end in tears are once again popping out of the woodwork.

The current generation of European leaders has shown little will for grand EU projects since the demise of the bloc’s constitution in 2005, when French and Dutch voters gave the thumbs down for the proposed charter out of anger with their governments and a general lack of understanding of the EU’s merits (or functioning for that matter). However, in the moment of truth, should or when it comes, we believe that the current crop of EU leaders will summon the courage to ride to the euro’s rescue by propping up Greece’s public finances and possibly Spain and Portugal’s as well with a little help from the good ol’ German checkbook. But when the dust settles, it’s clear that the EU’s fiscal rulebook, the hapless Stability and Growth Pact, will no longer be standing, not at least in its present form.

The Stability and Growth Pact

Act I : France’s Faustian bargain

Since the credibility of government policies is the lynchpin of stability in a post-gold standard world, the success of the euro has from the start required a fiscal framework commanding almost transcendental reverence. While Germany, which largely authored the original Stability and Growth Pact in the 1997 Treaty of Amsterdam, was in the start happy to pray at its altar, the French were alway suspicious that it was just a way to impose German pyscho-rigide (as the French say) budget discipline on the rest of Europe. And indeed it was. But the French were happy to pretend they had found religion if that was necessary to get the Germans on board.

Act II: Goethe has second thoughts

Well, following a painful recession in the wake of the tech bubble, even the Germans changed their minds after running up a budget deficit along with the French (and others) in excess of the sacrosanct 3 percent of GDP enshrined in the Pact. Brushing aside the concerns of the (French) ECB chief Jean-Claude Trichet and others, EU nations rewrote the fiscal rulebook to insert a little Keneysian commonsense where before there was only dogmatic commands of thou shalt not spend more than 3 percent of GDP.

Act Three: Here we go again

Once economic growth was firmly restored, eurozone countries went to work (in vastly varying degrees) on balancing their budgets by 2010 (whoops!), only to see their well-intentioned efforts violently derailed by the financial-cum-economic crisis in 2008. Those countries that took balancing their budgets seriously during those halcyon days before the crisis, such as Germany, are now forced to ponder bailing out those countries that ran up their deficits with utter disregard for how they would be paid for. On top of things, Greece has been a serial liar about its deficit, although it is far from being alone in its deviousness. Spain was actually quite reasonable before the crisis, but the bursting of a housing bubble has triggered a particularly painful recession there that chewed up the public finances there and spit out a gaping deficit. Britain, which, granted, is not a euro member but is nonetheless bound by the Pact’s rules as an EU member, was particularly indignant of the 3 percent deficit bar during pre-recession times and now finds Her Majesty’s taxpayer liable for one of the biggest deficits in the free world.

…which is all to say that the rulebook that was supposed to infuse the eurozone with the credibility to survive over the long term has proved painfully insufficient. Once Greece’s less indebted eurozone, EU and possibly IMF partners have decided to pull the country and any of its ilk back from the brink, then EU leaders are going to have to sit down — again —  and rewrite the Stability and Growth Pact. While this time they probably won’t water it down into oblivion, they will have to ponder how to make monetary union more harmonious without political union. Given the EU’s general lack of ambition towards grand new European political projects, leaders will opt for more technocratic innovations (always the EU’s stronghand), such as allowing EU auditors to pick over a given country’s books. Still even that will be highly controversial, because such intrusion into how governments toss around taxpayers’ money will ultimately impinge on their sovereignty. And given the general mood in the EU in recent years, nobody’s ready for that any time soon.

Europe reaps what it sows with Obama snub

The European press and various officials anonymous and otherwise quoted by it were up in arms this week about US President Barack Obama’s decision not to attend an upcoming EU-US summit in Spain, which they saw as a humiliating snub from a man they expected to be much more, well, European after eight years of the reviled George Bush. The only question is why are the Europeans surprised by Obama’s indifference towards Europe.

Europe's odd couple

Obama’s first EU-US summit in Prague last spring was not only tedious and a waste of time, coming on the tail end of a whistle-stop tour of Europe including G20 and NATO summits. But the 27 European leaders ridiculed themselves trying to bask in his glory. Obama’s head must have been spinning when the leaders of the Czech Republic, Sweden and Spain (the successive holders of the bloc’s rotating presidency) jostled to represent the EU in the (very brief) final press conference.

The beleaguered Lisbon Treaty was supposed to put an end to such spotlight pageantry with the naming of a permanent president of the European Council and foreign policy chief. But by naming such political lightweights as Herman Van Rompuy to the former and Catherine Ashton to the latter EU leaders have utterly neutered the treaty’s capacity to give a more coherent political profile to the EU internationally. Prior to getting the job, Van Rompuy was a reluctant Belgian prime minister who took up that post because his predecessor was forced out by scandal and there were few other candidates to satisfy the delicate balance of Belgium’s wildly complex politics. Ashton also was widely unknown outside of Britain before she was parachuted into Brussels as trade commissioner when Peter Mandelson was recalled back to London. Thus, Europe has thrust two people largely unknown outside of their home countries into the supposedly most prominent positions in Europe.

But more high profile personalities such as Tony Blair proved too controversial for EU leaders to agree on and in any case bigger countries probably preferred to keep the top EU brass weak in order to protect their clout on the international stage. The two positions were supposed to be some of the most visible innovations of the treaty, which also includes a host of more technical changes to the wildly complicated EU decision-making process. But unfortunately, the naming of two weak personalities to the positions has become yet another example of EU leaders watering down their originally high and noble ambitions. One may recall the travails of the Lisbon agenda, the original Stability and  Growth Pact, the EU’s carbon emissions targets and emission trading not to mention the bloc’s short-lived constitution.

If European leaders do not take the EU’s projects seriously, then they should hardly be surprised when the rest of the world does not take the EU seriously.