“Sovereign debt”, update on Stan and Ollie

Update, Dec 10, 2011.

Ok, we have 26 of the 27 European Union countries signing off on precisely the sort of greater central economic control outlined below (on Nov 24).  They did not agree to a Euro bond, in part, I would suggest, because no such bond can exist until the controls are actually in place.  Have they actually solved the key problem?  No.  Have they saved the Euro?  No.

What is the key immediate problem?  Italian debt.  Several weeks ago (10 Nov), the NY Times ran a lovely series of charts on who holds which debt in Europe.  French banks held over $400 billion in Italian debt.  (German banks own a lot less Italian debt.  Italy’s state debt is the second highest in the Euro zone, after Germany, which has a much, much larger GNP.) Little wonder that Moody’s yesterday dropped their rating of three of the largest French banks.   Moody’s assessment of BNP’s standalone strength (BFSR) dropped to level “C”, meaning “may be in default”. (http://www.moodys.com/research/Moodys-downgrades-BNP-Paribass-long-term-ratings-to-Aa3-concluding–PR_232989)

In plain English, that would seem to mean Moody’s believes BNP is in big trouble.  They  highlight its high exposure to Italian debt ($12.2 billion); BNP has already written down $2.6 billion in Greek debt (and holds $1.6 billion more, as well as $1.4 billion of Portuguese debt). It somehow managed to shed $10+ billion of its $23 billion of Italian debt in a very short period, to get down to current levels.  {The buyer?  The European Central Bank, which purchased $65 billion in sovereign bonds in the first 9 months of 2011, and, to judge from the BNP figures, much more in Oct and Nov. }

German banks don’t get a free lunch, because they own $200+ billion of French debt (and over $100 billion in Italian debt); European banks collectively own close to $1 trillion in French debt.  Not good for the European banking system, not good at all.

Here’s what the British newspaper The Telegraph had to say, in an article on the Eurozone banking system:

“If anyone thinks things are getting better then they simply don’t understand how severe the problems are. I think a major bank could fail within weeks,” said one London-based executive at a major global bank.

Many banks, including some French, Italian and Spanish lenders, have already run out of many of the acceptable forms of collateral such as US Treasuries and other liquid securities used to finance short-term loans and have been forced to resort to lending out their gold reserves to maintain access to dollar funding.

“The system is creaking. There is a large amount of stress,” said Anthony Peters, a strategist at Swissinvest, pointing to soaring interbank lending rates.

Ok, let’s swing over to the British Left, and the Guardian’s (www.guardian.co.uk/) economics editor, L. Elliott:

“Europe is sleepwalking into a prolonged depression. The prospect of 2012 seeing the start of the break-up of the eurozone is a real one. Financial markets are already starting to pick apart what looks like the latest, if more sophisticated, attempt to kick the can down the road. Britain has isolated itself on the fringes of the European Union, perhaps the most significant development at a summit that assuredly did not draw a line under the crisis in the single currency. But at least the interests of the City of London were defended. For now.

In short, the summit that was supposed to save monetary union has been little short of disastrous. Going into the talks, the markets hoped for a happy ending to the sovereign debt saga: a deal to pave the way for the European Central Bank to ride to the rescue of Italy and Spain, under siege from the bond vigilantes. What they got instead was political schism, half-baked reforms and the complete absence of any fresh economic thinking.”

Now, over on the Right, at the Financial Times, the headline suggests the deal won’t last until Christmas, full article at:

Short excerpt:

“Jonathan Loynes of London’s Capital Economics, who accused Mr Draghi of “clumsy communication,” said: “The bottom line is that even our low expectations for last week’s supposedly critical advancements in the eurozone debt crisis appear to have been undershot.” He described further debt writedowns that would affect the private sector as “virtually inevitable”.

The muted market moves on Friday may be misleading. The euro rose against the dollar – but this may have been driven by banks repatriating assets.

European bank shares, while above their lows, trade at half their book value, implying grave fears that some of their assets will be written down.”

Little wonder that 26 of 27 agreed to a general solution.

Le Monde gives two different views, suggesting in one article that the worst is over and that the three “vices” of Maastricht were addressed:  1) letting Britain opt out of the euro – Le Monde argues that the 26 kicked the UK out of Europe;  2) lack of economic central governance (see below, original posting); and 3) lack of a stabilization mechanism.  Le Monde argues that Draghi, head of the ECB, has agreed to “unlimited” funding of banks, at 1% interest, for 3 years.

A second article, “L’Eurozone n’agit pas, mais cause”, takes an entirely skeptical approach.  On the key issue of the 26:

“Les chefs d’Etat et de gouvernement de la Bulgarie, du Danemark, de la Hongrie, de la République tchèque, de la Lettonie, de la Lituanie, de la Pologne, de la Roumanie et de la Suède ont évoqué la possibilité de rejoindre ce processus après consultation de leur Parlement le cas échéant”.

In other words, they gave tentative assent, but have to get approval from their parliaments.  Nice way to pretend to go along. The article points out that this agreement is not a treaty, but a statement of principles, a declaration, not legally binding on anyone, not agreed to by any elected body, even the European Parliament.

So far, the geniuses (led by Chancellor Merkel) managing this crisis have allowed Greece to go bankrupt, have waited until Spain, Portugal, and Italy are lined up to do the same (Ireland, too), and are fiddling while the banking system burns to the ground.

China’s Dagong Credit Rating Agency yesterday lowered its rating of France’s “sovereign” debt (down from one of the three levels in the upper medium grade, to a level in lower medium grade), following up its reduction of Italy’s rating from A- to BBB (second category of lower medium grade, just a short hop from junk bond status).  Dagong believes France will have to intervene to save its big three banks, the ones Moody’s just downgraded: they refer to potential partial nationalization of those banks.

Western observers may belittle Dagong, which is an obvious effort to remove Western monopoly on credit ratings, but it’s worth remember that most of the Western countries, especially the USA, borrow lots of money from China.  If the Chinese government and other Chinese investors start to place high credence in Dagong’s ratings (which, it should be noted, rate the US as lower than many European countries), then Western borrowers may have to pay higher rates of interest to Chinese investors.

One poster on Le Monde compared the summit to putting up three bags of sand against a tsunami.  Nice.

And I love Sec’y Geithner, channeling Oliver Hardy, telling Sarkozy (in the role of poor Stanley),  “and this is another fine mess you’ve gotten us into.”

Original post of 24 Nov, unmodified:

European political leaders seem to be facing the obvious reality pointed out in the earlier post: “sovereign” debt of Euro zone countries is an oxymoron.  We hear now that they are finally discussing the only possible solution:  creating real European sovereign debt, by means of a common bond issue, guaranteed by all member states.  Alas, as my father used to say, all solutions create new problems:  this one makes no sense absent a more unified sovereignty within the Euro zone.  Creating a common Euro bond cannot take place in a situation in which key elements of sovereignty remain in national hands.

Tax collection offers a simple example.  If published estimates are correct, roughly 15-20% of Italy’s economy is in the black market: that would mean $300-400 billion escapes taxation.  Italy’s VAT is 20% (much less on necessities like most foods), so the Italian government loses $60-80 billion a year in VAT revenues alone.  Add to that the lost revenue from income taxes and you probably get something like $100 billion in annual losses due to the black market.  That $100 billion would close Italy’s budget gap to zero, with no need for tax hikes or service cuts.

Italian non-compliance has many causes, but we need not fall into the facile generalization that it’s all the fault of the Mafia and Camorra, or a simple reflection of Italian cultural norms.  Italian companies have powerful economic incentives for non-compliance:  corporate total tax rates (TTR) in Italy are 68.6%  as against 41.2% in the EU.  France, which also has compliance issues, ranks close by, at 67%, and Spain is also high, at 56%, whereas the TTR is far lower in the other large European economies:  Germany, 48%; the Netherlands, 40.5%; UK, 37%.   (TTR, from World Bank, IFC, Paying Taxes 2011.  The Global Picture, figure 2.17).  The key difference is  labor taxes, which are vastly higher in France and Italy:  they make up 3/4ths of the corporate tax burden in France, about 2/3rds in Italy, only half in Germany, about 40% in the Netherlands, a third in the UK, and only 1/5th in the US.  Italy has a ridiculously complicated corporate tax system, to judge from compliance hours:  285 hours per year, as against only 110 in the UK, 132 France, 134 in the Netherlands, and, surprisingly, 215 in Germany.  Unsurprisingly, most of this time goes toward figuring out and paying labor taxes (shares of social security, unemployment tax, etc.).

As someone who has worked a great deal on tax systems, I would suggest that the Italian system is deliberately complex to enable fraud;  many less-developed countries have a similar situation. Any time you have an obvious crook like Berlusconi (who has been prosecuted for tax evasion) running your country, you can be sure that the tax system will be set up in a way so complicated as to assure that business tycoons, like Berlusconi, can practice non-compliance with a high level of impunity.

Can there be Euro bonds when one of the main economies (Italy) has a tax system that, in performance, resembles the systems in the African Union far more than it does those in the European Union?

The only possible way to get to Euro zone bonds is for the countries in that zone, perhaps through the European Central Bank, to get centralized control of economic policy and fiscal administration (in terms of oversight) throughout the 17 states.  Angela Merkel made that clear when she vetoed the idea of a plebiscite in Greece.  This fiscal crisis, among its other elements, marks the end of representative democracy in the 17 member states, if those states go to a Euro zone bond and to the sort of economic controls that can make such a bond work.

The Euro zone countries would then look like the US in economic and borrowing policy.  The Euro zone would issue “sovereign debt” bonds, like US bonds; the member states would issue bonds similar to those of US states, like New York or Alabama.  Member states would generally have to pay higher rates of interest than the Euro zone as a whole.  Euro zone bonds would have to be limited to specific purposes and some sort of central governing authority (drawn not from elected bodies, but from technocrats) would have to regulate who got which share of the Euro bond issues.  Bonds issued by individual states would be like bonds issued by US states or even municipalities; they would likely be guaranteed by given tax revenues (a system widely practiced, btw, in 16th-century Europe). The rise of a genuine public debt (in the 18th and 19th centuries) lowered central government borrowing costs, which in that earlier system had been generally higher than those of regional or local governments.  Right down to 1788, the King of France regularly borrowed money through such intermediaries because they paid much lower risk premiums than the central government.

The danger is that such a pattern will repeat itself, that Germany will borrow at a lower rate of interest than the Euro zone bond.  If that turns out to be true, as one would suspect, then the Euro zone bond will essentially be nothing more than a way for the suspect economies (like Italy) to borrow ostensibly through a central agency, but, in reality, through the intermediary of a more solvent regional government (i.e., the German or Dutch one).  You would then have the dangerous situation that a large German bank (or another investor, like China) could play the spread between the two.  Markets may already be anticipating such an outcome: Germany could not sell its bonds yesterday, because the interest rate is so low.  What investor would want to buy a German bond  at 1.98% (yesterday’s rate), when s/he could buy a Euro bond, also guaranteed by Germany, at 3% or even 4%?  Those willing to buy at 1.98% are betting that the Euro bond will not become a reality.


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