This summit will really be decisive

The European Council of June 28-29th may well be decisive for the future of the euro. Other summits since the beginning of the euro zone crisis two and a half years ago have taken measures to deal with the immediate crisis—measures which have required considerable commitments from the countries backing  financial rescue mechanisms, and from the recipient countries in terms of measures to cut their government deficits. They have not, however, been sufficient to prevent the sovereign debt and banking crises from gradually deteriorating. Temporary improvements such as those after the well-regarded technocrat Mario Monti was selected as Italian prime minister in November 2011, have always been subsequently reversed. Whatever the reasons may be, two large countries, Spain and Italy, are now being charged market interest rates on government debt which if continued will force them into insolvency. There is, as the post below points out, room for criticism of some of the non-fiscal reform programmes in Italy.  However, the fiscal austerity programme of Italy is a credible one and so is that of Spain’s central government, while  concerns about the deficits of Spanish regional governments are being addressed. In both countries the fiscal tightening has brought about a new recession this year. This in turn reduces government revenue and so makes the process of deficit reduction more difficult.

There is an invidious choice that government policy makers have to make between allowing the recession to cause deficit reduction targets to be missed or further fiscal tightening which will make the recession even deeper and so  may make the attempt to reach fiscal targets self-defeating. In the situation, both the Italian and Spanish governments can justifiably point out that they are doing everything that can reasonable be expected to address fiscal deficits. Moreover Germany and the creditor nations have obtained their objective of a new fiscal treaty which puts in place irrevocable commitments by all euro zone countries to eliminating deficits by 2016 and bringing down debt.

The situation is a vicious circle of fiscal tightening causing recession, which itself leads to a decline in investor confidence and higher interest rates causing the need for further fiscal tightening and ever deeper recession. The only way for this vicious circle to be broken is for Germany and other creditor nations to act to support Spain and Italy in an effective way at the summit.  This could be done through short-term commitments of up to two years which ensure that pressure for continued fiscal prudence is maintained. The alternative is political disillusion with austerity in Italy and Spain and movement towards a break-up of the euro zone involving sovereign debt defaults and bank collapses whose cost directly and indirectly to the public finances of all euro zone countries, including Germany, would be catastrophic.

A week to save the euro says Monti, but it is also up to him

Mario Monti has said there is a week to save the euro. He may be right. But saving the euro needs action by both sets of countries: those currently seen as strong by the financial markets, like Germany and those seen as weak, including Italy. There is much that he needs to do back home and, if he is right that the action has to be taken in a week, he has left himself little time. His government came to office in November and over the next two months did not disappoint the hopes that had been put in him and his government. He brought in a series of deficit cutting measures  and the beginnings of an effort to boost growth and employment, notably in a Decree-Law of December 6th, 2011, entitled Urgent Dispositions for Growth, Equity and the Consolidation of Public Accounts.  This was followed by a major pension reform, introducing substantial cuts in entitlements. Although the government should be providing more information and analysis on its fiscal programme, there can be little doubt that the public finance measures, including pension reform, has had an impact and there is still the a reasonable chance that the government deficit should fall this year to under 2% of GDP and of reaching balance in 2013. In annual budget balance terms, this puts Italy in a favourable position compared not only to other vulnerable euro zone countries, like Spain, Ireland and Portugal but also compared with France and the UK. However, such improvement is the minimum necessary because Italy’s public debt is the highest in the EU in absolute terms and the second highest after Greece relative to the size of its economy.

Given Italy’s record in fiscal management, there can be no complacency, but even assuming that expenditure is kept under tight control and tax collection improved, Italy like most of its EU partners other than Germany is in a trap whereby it is required by financial markets, the EU fiscal compact and simple financial prudence to take “pro-cyclical” measures that exacerbate the downturn in demand, leading to recession and rising unemployment. For that reason, the government rightly launched a reform strategy designed to create the conditions for growth and particularly to create opportunities for young people, many of which continue to see better opportunities outside than inside Italy. One of the most innovative was the creation of a legally recognized “Simplified Company with Limited Responsabilities” designed to enable those under the age of 35 to start companies with a minimum capital of one euro and with no need to pay notaries’ fees for bureaucratic requirements. This was part of a package of reforms presented on January 24th, which became law on March 23rd, entitled Cresci-Italia.

However, after its impressive first three months, the Monti government entered a period of drift. Mr Monti has remained active in a European and international context but has no longer exercised the driving force for reform domestically that he did early in his government, nor have other ministers stepped in. What should have been a major element in the reform programme, a wide-ranging reform of the overall labour market, has fallen flat. This in large part reflects a failure of representatives of business and the trade unions to set aside their longstanding differences and work together but it might have been hoped that the government would knock heads together. At present the bill, 130 pages in length, is being debated in parliament. The debate has become weighed down by detail which has caused a loss of focus on the objective of fostering job creation while providing basic legal protections for employees which safeguard rights at a cost which does not inhibit job creation.  The drive to open up access to individual trades and professions where incumbents have set up barriers on new entrants is one to which the government is in principle committed but one which also has lost momentum.

The government urgently needs to reclaim the initiative in driving an agenda for business formation and growth and job creation. Good initiatives such as the one on simple companies established by young people should be followed up, to analyse their success or failure, and the obstacles encountered by those trying to build up small businesses.

Mr Monti is right to argue for more intervention by the European Financial Stability Facility (EFSF) and the new European Stability Mechanism (ESM), which should come into operation in July. But he also has to show that Italy is acting with vigour to boost its economic performance so as to find a way out of the trap of fiscal consolidation exacerbating recession which itself then threatens the success of the process. Italy may be helped by bond purchases by the EFSF or ESM but in the last resort Italy is the country that is too big to save.  It has to save itself. The government cannot revive the economy in a week but it needs to show that it has a plan and the determination to make major progress in the nine months which remains before the next election falls due.

The future of the Greek economy remains a deep concern in and outside Greece

Following the June 17thelection, six weeks after the previous one,  the Greek economy is in its third year of severe austerity and fifth year of economic decline, with no evidence that the trend is likely to be reversed this year, next year or even subsequently.

In terms of length and severity of the economic decline and the lack of any apparent light at the end of the tunnel the situation in Greece might be compared with that of European countries at the time of the great slump, which started in the late 1920s. Employee in the public sector, and many in the private sector, have seen wages reduced dramatically sometimes by as much as 50%. With the situation in Greece being even worse than in other vulnerable countries like Portugal and Spain, and with debts that have become unmanageable, it has been portrayed abroad particularly in Germany in terms which caricature its weaknesses, leading to a potential feeling in Greece that the country is being punished and humiliated rather than helped by its EU partners. In January this feeling was given justification by the leaking of a German government memorandum calling for a regime being imposed on Greece which would give priority to repayment of debt over all domestic Greek public expenditure (see Why Greece still matters, InsightEU post on March 30th below). There are some commentators who still argue that Greece has not stuck to its commitments on austerity. But wage and pension cuts, unprecedented in any of Greece’s euro zone partners since the Second World war, together with rows of empty shops and the expansion of soup kitchens run by NGOs in Athens, should be evidence that such an interpretation is nonsense. Where Greece may be failing is in the implementation of reforms intended to make the economy more flexible and increase prospects for growth.

In 2011 Greece had an overall government deficit of 9.1% of its diminished GDP, and a primary deficit (i.e. excluding the cost of servicing the debt) of 3.6%, or just under €10bn. What is done about Greece’s government debt of still about 150% of GDP after the write-down by private sector creditors of half the nominal debt finally agreed on in March 2012 (and about 70% in net present value) is not a matter that can be immediately sorted but whatever happens the primary deficit must be converted into a primary surplus. Since no EU member state would be willing to sharply increase the ongoing transfers provided for by the EU budget on a permanent basis, the need to eliminate the primary deficit seems unavoidable. Is there anything that can be done to break the vicious circle in which further austerity leads to further economic decline?

On April 18th, the Commission released a communication, entitled Growth for Greece. Most of the communication was a re-inforcement of existing pressure on the Greek government to make effective reforms that have in theory been passed to open up competition within the Greek economy and improve administrative procedures to release businesses from the entanglement of red tape. The arguments are valid and should be acted on but the trouble is that they consist of preparing the ground for potential business growth but do not directly lead to that growth.

Business growth is inhibited by the fact that Greek banks, which have lost heavily in the government debt restructuring, need to deleverage and therefore can do little or nothing to extend new loans. In this situation the Greek authorities should actively seek out potential for new businesses and business growth particularly where there is opportunity for export earnings and secondly to compete with imports. Greece should press EU institutions to do more to help. Significant resources are potentially available. An amount of €20bn of structural funds were budgeted for Greece in the 2007-13 Community Support Framework in the form of non-repayable grants, of which–according to the Communication–half has so far been spent. With half to spend in the last two out of the seven years, there could be a relatively big boost to provision but obstacles to the money being well spent are still large. Although the proportion going to businesses is supposed to increase, the majority of the funding still goes to infrastructure, which cannot directly support business expansion or boost exports. The grants can be supplemented by low-interest loans from the European Investment Bank and the European Investment Fund[1]. This is supposed to be happening already but on a much smaller scale than is possible. Successful business  investments should be publicized as examples that others might follow. Growth will have to come from the private sector but there is much more EU and Greek policy makers and institutions working together could achieve.


[1] Including Joint Resources for Micro to Medium Enterprises (JEREMIE) an initiative in which the European Investment Fund (EIF) uses structural funds along with loans.

Spain: the need to separate the sovereign debt and banking crises

The rescue for Spanish banks by the euro zone announced on June 10th may succeed in rescuing Spain’s weaker banks, such as Bankia, but it has failed to halt the deterioration of confidence of investors in Spain’s sovereign debt position. The latter should not be an insuperable concern, given that debt at the end of the first quarter was still lower than that of Germany, France or the UK in relation to its GDP. However, Spain is now threatened with a repeat of what happened in Ireland, where a deterioration in public finance due to severe recession has been hugely exacerbated by the costs of bailing out banks. In the case of Ireland the cost relative to the country’s economy has been considerably higher than is likely to be the case for Spain since virtually the whole of the Irish banking sector became insolvent whereas in Spain only about a third of the sector is threatened by insolvency without external support. Nevertheless the additional amount has, rightly or wrongly, been deemed by rating agencies as highly significant, causing them to severely downgrade their assessments of Spain’s creditworthiness. The sum allowed for in the new loan facility of €100bn, which should be far more than is needed, has instead of giving confidence, undermined confidence because it has been seen as the actual figure that will be added to Spanish sovereign debt because, crucially, the rescue of the banking sector is not a direct one but an indirect one through the Spanish state, thus adding to sovereign debt and moreover probably doing so in a way which gives the new loan seniority to private lenders so increasing the risk to the latter

What is needed is a serious attempt to separate the sovereign debt and banking crises. It should be recognized that Spain like Ireland in fact managed their public sector finances well up to the economic crisis, which was caused by mistakes made by banks. Banks in other euro zone countries should never have provided the finance for Spain which led to the construction and property bubble that proved so disastrous. The problem in Spain’s banking sector is a result of private sector and euro zone policy mistakes across the euro zone and not just in Spain. It is not therefore just that all the cost should be carried by Spain. Policy makers in the stronger euro zone countries, such as Germany and the Netherlands, should be willing to acknowledge that the current situation has come about as a result of mistakes made by banks in these countries and policy makers in the euro zone as a whole. If they did so it would have followed naturally that the rescue should have been carried out by the new European Stability Mechanism directly so not adding to Spain’s sovereign debt. This could have been a first move to a European banking union. Such a move would not have been a first step towards a “transfer union” in which German taxpayers subsidise public expenditure in southern economies since the money would not be used by the government but would rather be a fair sharing of risk in tackling the banking crisis, which is at present is causing most concern in Spain but which affects the whole euro zone and indeed countries like the UK outside the euro zone.

Little known, the European Investment Fund is active, even in Greece

In a landscape of austerity, the search is on for ways to bring about a revival of growth in the euro area as a whole and particularly in the countries where excessive public and private sector debts and deficits have given policy makers little choice but to impose austerity programmes on public sector finances while much of the private sector also deleverages. One of the main proposals being discussed is to increase the capital of the European Investment Bank (EIB) which has triple A credit status and can therefore lend much more cheaply than local banks in the vulnerable countries. Much less has been said about the European Investment Fund (EIF), which is 60% owned by the EIB but is a separate institution and focuses on investing in and guaranteeing the loans of small and medium sized businesses through financial intermediaries. SMEs are the largest provider of employment in the EU and are the main vehicle through which economic recovery can feasibly take place.

The EIF acts primarily in two ways. First it works through locally active banks helping them to provide increased funding to SMEs by sharing the risk. It can also help to protect their capital ratios as is being required by EU legislation at a time when such ratios are under pressure from losses on non-performing loans. Secondly the EIF acts as a fund of funds for venture capital providing capital for risky start-ups and fast growing SMEs including those involved in investment in technology emerging from research bodies and universities

Two fields in which the EIF has been rapidly expanding its activity include promoting the provision of microfinance. This is supported by European Commission funds and has developed within a year into a substantial activity

Another example is the development of a risk sharing Guarantee Instrument for lending to Innovative SMEs across Europe, working with the European Commission’s Directorate-General for Research.

The EIF is also increasingly working to facilitate and co-operate in the use of structural funds (for poorer regions of the EU) for investment in SMEs. This money from the EU budget can be used for equity or loans for risky investments. If the investment fails, then the budget is used up but if it succeeds, the money is returned and can be used again in due course.

A great example of the power of this type of recycling of funds  is the fact that some EIF investment activity is still financed  by funds originating from the European Recovery Programme (ERP) dating back to the post-Second World War period.

The EIF has currently committed €6bn to over 350 European Venture and Growth funds, which is on average 25% of the final fund sizes, the remainder being made by private sector investors ‘catalysed’ by the EIF investment thus leading to total investment of €24bn.  Approximately 4,500 companies have benefitted from this investment. The EIF guarantees portfolios of loans totalling EUR 26billion.

The activity of the EIF is spread throughout the EU not just in its economically weaker countries reflecting the gaps that exist in the access to finance for SMEs across the EU. It is highly active as is right in the new member states and there is a clear desire for its activity in the vulnerable euro zone countries to increase in view of the fact that these countries are now in recession and face poor prospects of recovery. The problem is that their own financial institutions through which the EIB has to work have in some cases been weakened by the economic setbacks since 2008.

Nevertheless, significant activity is taking place in these countries including Greece for which there is a €250m programme through three locally-active financial institutions.  €50m of this has been allocated to Venture Capital funds, with up to €15m to a fund for the utilization of research carried out in Greece.