IREF - Institute for Research in Economic and Fiscal issues
Fiscal competition and economic freedom
The crisis is not over and doubts about the virtues of the EU and the euro abound. It may therefore seem surprising that not only are more countries seeking to join the EU, but also that some are joining the currency union. Croatia accedes on July 1 and its central bank Governor Boris Vujcic has indicated that it is only a matter of time before the currency peg is abandoned and the euro embraced. Latvia, subject to EC approval, will adopt the euro Jan 1st, 2014. On May 27, Serbia abandoned its longstanding territorial claims to Kosovo; this is openly part of Serbia’s own EU application process. Bulgaria has a new government and may well choose to abandon its currency board link and join the euro as a full member.
The search for prestige and international status is part of the explanation for the enthusiasm. More importantly from the economic standpoint, however, these new EU or euro members are likely to find it easier to borrow and attract private investments once they are fully fledged eurozone members. Should we also expect them to issue more public debt and engage in higher public expenditure?
Yes and no. Yes, because in the past, EU/euro membership has usually generated a drop in interest rates for the borrowing countries, as a consequence of reduced exchange-rate risk and possible EU guarantees against default. No, because rating agencies and markets in general have become skittish and default is no longer perceived as a remote possibility. For example, despite a relatively modest debt/GDP ratio of under 70%, Slovenia’s debt was downgraded by Moody’s to junk at the beginning of May, and Fitch followed suit with a cut to the verge of junk on May 17. The urgency shown by the Bratusek government was initially respected by markets as yields on the 2022 government bond dropped to 5.4%, but as we go to press this yield has crept back to 6.3%, and the road ahead seems bumpy.
Consensus among the regulators seems to be weakening. In particular, the EC/ECB deeply resented the IMF’s June 4th report of errors that all three limbs of the Troika made in the various bailouts of Greece, starting in 2010. The IMF has claimed that the EU was fixated with saving the euro, and insufficiently focussed on identifying ‘growth friendly’ reforms. The IMF now says that Greece should have had an agreed default package in 2010, not two years later. Both Brussels and the ECB immediately rejected the report, calling it ‘hindsight biased’. More tensions can be expected.
Progress on European banking is also straining alliances. Germany and the ECB agree on two of the three ‘pillars’ of the eventual banking union – single supervisor and single resolution authority. However, they strongly differ on the third – a single ‘safety net’ to protect bank depositors. Bundesbank head Jens Weidmann publicly stated that only the first two pillars should exist, putting him in direct conflict with Irish Finance Minister Michael Noonan who at the Dublin summit called for progress on deposit guarantees. Germany argues that Cyprus has shown that large depositors can be ‘bailed in’; and that provided banks are properly scrutinised before qualifying for the remit of the single supervisory authority, small depositors can look to their national government insurer.
To add to the confusion, the Commission in Brussels has just published a position paper declaring that it is “the best placed institution” to take all decisions regarding resolution of a failing bank, with powers to overrule home country objections and use funds from a central pot. The German government was not pleased. Is there a compromise? Perhaps the astute Mrs Merkel has found one; at the end of the month she seemed to have persuaded France’s President Hollande to withdraw support for Brussels’ self assertive position and favour the establishment of a “Resolution Board” consisting of national institutions rather than a single EC one. In due course, the Resolution Board could be merged with the ESM fund. But this compromise resolves to a position to which the Bundesbank itself is strongly opposed, with Germany as the funder of last resort to a common fund which may be asked to directly recapitalise banks.
In the second half of May, volatility in the world of banking also increased. Markets have come to realize that bankers’ present nirvana — ultra cheap central bank money funding large scale market gambles such as carry trades backed by explicit or implicit government support — is under pressure. The bankers’ claim to be fixing economies is undermined by widely held concerns: lending to small and medium-size companies is minimal, unemployment is rising steadily, the US subprime mortgage market is awash with hedge fund activity, and worries that asset price bubbles are at crisis tipping point levels intensify.
Even in the US, where the turnaround narrative is strongest, banking stewards are coming around to our view that the Basel supervisory edifice of rules is unworkable. At the end of April, Senators Brown and Vitter, responding to concerns that the Dodd-Frank Act has achieved little, introduced legislation directly targeting bank size. Since JP Morgan’s total of supervised assets has grown from $1.32 trillion end 2007 to $1.9 trillion end 2012, there can be little argument that if the main concern is size, then Dodd-Frank is not working. Brown-Vitter would compel banks with over $500 million of such assets to demonstrate compliance with equity capital to asset ratios of 15% (compared to 4% under Basel 2 and 5% or 6% under Basel 3 proposals). Six major banks rebutted the proposals, claiming they would undermine the US economy. Again, they advanced the false argument that a dollar raised in capital is a dollar less available for lending. This is clearly untrue, however, since capital in banks is not ‘held’ as a ringfenced reserve to support the bank in times of trouble, but employed in the day-to-day lending of the bank. The big six also claim that the proposal would force them to sell assets. But this is also untrue if their business models are sound. To sum up, it is difficult to escape the conclusion that the managers of these banks know that there is little market appetite for fresh equity in them. At the other end of the size scale, concerns about smaller US banks’ health were hardly eased by data released May 29 by the Federal Deposit Insurance Corporation; there were 612 banks classified as ‘in danger of failing’, down from 651 at the start of the year but 11 times as many as the 2007 figure of 53.
Last, but not least, one should keep an eye on Liborgate, which is still on the table despite its manifest obsolescence. As a matter of fact, this debate is a classic example of international banking crisis authorities never ending efforts to fix the stable door after the horse has bolted. Not only has the lack of prosecutions made it difficult to define the mischief which the replacement of LIBOR is supposed to address, but there is simply no market need. Customers have a choice of benchmarks, and few will have failed to grow suspicious of LIBOR’s integrity. Banks on the other hand stopped using LIBOR for interbank trades time ago, because they all knew what was going on as the copious embarrassing email trails now reveal. For dollar trades, the interbank benchmark has for years been the Fed Funds rate, for most other currencies the Overnight Indexed Swap rates have been used. What do these two have in common? They are traded rates, not ‘submitted’ ones.