Thursday, 13 October 2011

Yet another comprehensive plan to fix Europe

Today, the European Commission announced a comprehensive plan to decisively deal with the euro zone sovereign debt crisis.

Haven't we been here before? Over the last three years, the Commission bravely spoke on several occasions of ambitious rescue plans only to discover that those plans were not sufficient to stabilize the European financial system or resolve the growing public sector funding issues in southern Europe.

This latest plan comes in five parts.

  • Decisive action on Greece so that "all doubt is removed" about the country's economic sustainability.
  • Increasing the size of the EFSF to €440 billion and accelerating the launch of its permanent successor, the European Stability Mechanism.
  • Co-ordinated action on strengthening Europe's banks. Banks should set aside more assets to cover losses through private funding or national governments if necessary. If this is still not adequate, they can tap into the EFSF, but if they do they will not be allowed to pay dividends of bonuses
  • Speeding up policies to enhance growth and stability, such as free trade agreements
  • Building greater integration for economic governance across the euro zone.

Let us start from the bottom of this list and work our way to the top.

Building greater economic integration will do nothing to eliminate the crisis. The problem is about funding and not European governance structures. Unless someone somewhere is willing to put more money into southern European governments then the crisis will continue.  Integration or disintegration - it is a question that isn't being asked right now.

Likewise, free trade agreements will not help. In the long run, more free-trade might boost growth, but the best, the effect will be marginal. Again, it won't put any money on the table for Greece or Italy.

The next three measures illustrate the limited options available at this late stage of the crisis. European banks are under capitalized. Somewhat surprisingly, banks and continue to pay dividends and large bonuses despite the fact that they were short of capital. This speaks volumes about modern Europe and the shortsighted nature of those who run its financial system.

Be that as it may, the penny is finally dropped, and policymakers now realize that a devastating European banking crisis could be on the horizon. To avoid this crisis, the European Commission would like national governments to recapitalize banks. This will increase indebtedness of European governments, making them more vulnerable to funding crises. The plan will replace one problem with another.  This illustrates the great lesson of the early 21st century - financial engineering can move risk around, but it cannot eliminate it.

The Commission also suggests that the European bailout fund - the EFSF - could be used to recapitalize banks. The problem here is that money cannot be spent twice. If the bailout fund is used to sort out the banks, it can't be used to bail out governments.

The European Commission is aware of this rather obvious constraint. They would like to increase the size of the bailout fund from its current underfunded level of €440 billion. Since all European governments are out of money, the only institution that can bring new cash to the table is the European Central Bank. There are, however, powerful legal restrictions on the ECB that prevents it from bailing out governments.

Realizing this conundrum, European Commission has played around with some vocabulary. The bailout fund will be renamed and in future it will be known as the European Stability Mechanism. Whatever it might be called, bailout fund remains at €440 billion. This more or less guarantees that the crisis will linger on.

Finally, there is the promise of decisive action on Greece. This can only mean one thing- a default. The only remaining issue is the size of the haircut that great creditors will have to accept.

Overall, it isn't much of a plan. In the coming weeks and months, the European Commission will be announcing further comprehensive plans to stabilize Europe.

So what is the answer to Europe's economic crisis?  Alice Cook's plan to save Europe can be encapsulated in one word - honesty.

European Policy makers need to be brutally honest with their electorates. Welfare systems are unsustainable and without reform, it is inevitable that they will collapse. European workers are overpaid and uncompetitive. Public sectors are too large and need to be reduced in order to make room for the wealth creating private sector. Financial systems have become too bloated and need to be downsized. Europe is ageing rapidly. 

Europe should have produced more children but didn't. It put aside the family as an institution and focused on personal consumption and debt accumulation. It was a big mistake, but there isn't much that Europe can do now after four decades of neglect.  However, this unfortunate choice has a consequence; those public pensions, that we thought we would receive when we retired, were illusory. Europeans need to understand the appalling consequences of poor demographic decision-making. 

Europeans also need to hear that printing money doesn't create wealth and increasing government debt cannot get Europe out of a debt crisis. 

Above all, Europeans need to hear that they are about to get much poorer. They may demonstrate in the city square if they want, but it won't change anything. However, with honesty comes genuine change and reform.


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Vodka drinker said...

I'm confused. How would the EU turn 440 billion into two trillion? Is it something I can do?

Anonymous said...

Alice, as a long time follower of your blog, this post really speaks to me and the point about honesty is just well, so honest... and that is what depresses me.

Realistically, I and I suspect many other readers of this blog know it ain't gonna happen, ergo we will continue on this path to ruin and the political classes will continue to repeat the orchestrated mantra that they can fix it.

My own personal thought is that Honesty as a principle has become nigh on extinct. As you identify, protesting is not really going to cut it either. The only viable way that I can see a correction to be made would be via some large catastrophic natural event. A financial catastrophe just provides more fuel for the politicos.

Much as I hate to say it, we need a 'reset' at the human population level for Western and parts of Eastern society if we continue with this model of society.

Electro-Kevin said...

For those of us who think we're safe out of the Euro think again.

We're paying for bailouts via the IMF and Ireland.

Stevie b. said...

Alice - nice idea, but can someone please tell who the last successful honest politician was...?

....and would the electorate be honest enough to recognise and elect such a politician if he could be conjured (cos that's the only way he/she could get there) into existence today as the leader of a mainstream political party?

davidb said...


Easy. Fractional reserve banking. That may be the cunning smoke and mirrors plan. If they give the 440 billion to banks then they in turn can lend 10 or more times that and presto, they are keeping to their BASEL 3 capital requirement, but the magic trillions are conjured up out of fresh air.

The banks should be left to go bust. The banksters made lots of money out of this system over the years, and now all the bad debts are coming home to roost its taxpayers - many not earning massive bonuses - who are being saddled with the bill. This is a scandal.

I see Iceland is growing again.