Eurogroup and how to prevent a repeat of the Cyprus bailout debacle

Eurogroup sounds like a name for a rock band or a multidivisional conglomerate.  It is actually the grouping of Eurozone finance ministers, but perhaps it is appropriate to compare it to the other two given how dysfunctional its members work with each other.

In the case of Cyprus, the finance ministers in the Eurogroup ended up bickering over the details of how to save money in the bailout.  They first tried to do this by breaking two key principals in banking, one the guarantee on small depositors’ money (the government ensures that depositors always get their money back), and the other the seniority of depositors over bondholders and other claimants on the bank (depositors always get paid back before creditors do).  This needlessly caused panic amongst savers and hurt whatever trust and confidence is left in the banks (how can you trust the financial system if you don’t have confidence that your money is safe in your bank?).  The financial system inherently works on a system of confidence and trust.  Banks need confidence because they are lending out most of the deposits they take in; the bank by default does not have the ability to pay if all depositors suddenly want their money back, as is the case when they lose confidence.

So though the Eurogroup of ministers had to change their bailout proposal after protests (rightly so) from Cypriots, but they had already eroded confidence to such an extent that many depositors, not just Cypriot banks but elsewhere as well, will now withdraw money out of their banks and stuff it under a mattress (or elsewhere where it is not as economically productive).  Then Jeroen Djsselbloem, the Dutch finance minister and current head of the Eurogroup (his name sounds remarkably close to DimWitBloem in German), had the gumption to say that this new bailout plan can be the new template for how bailouts will work in the future.  He further compounded his faux-pas by saying that Luxembourg, Malta and other countries with big banking sectors should fix their problems too.  I guess no one bothering to tell him that the more he scares people in a financial crisis, the higher the costs of the bailout.   By trying to save a few pennies (the Cypriot bailout was only supposed to cost Eurozone countries EUR 10bn, which in the whole scheme of things is miniscule), the Eurogroup has now made the problem much worse.  Sure enough, the estimated costs of the Cypriot bailout has increased by EUR 6bn, simply because of the Eurogroup's idiotic actions.  They may have been right in their sentiments that creditors should bear losses in a bank bailout, but they should have done this in an orderly structure where everyone understands the process.  The Eurogroup is actually tasked with drawing up rules for orderly structuring bank recapitalisations, but has been taking its time with doing so, which makes one wonder why other people have to agree to its terms in haste while the Eurogroup doesn't have to abide by its own rules.

DimWitBloem also committed a potentially even bigger sin, repudiating his commitment to a common rescue fund for the Eurozone, once a Eurozone banking regulator is in place.  I actually have some sympathy for this point of view, but for a different reason.  The collective rescue fund and banking regulator is supposed to break the ability of governments to get their banks to support them (mainly by buying government bonds).  But knowing how EU countries always water down the regulations, I'm very skeptical that this tie can be broken under the proposed structure.  In fact, as it stands, EU regulations have already sown the seeds for another disaster.  Solvency 2 (new regulations for insurance companies and soon to apply to pension funds) gives government debt a risk weighting of 0% in those investors’ portfolios, i.e. government debt is deemed to be riskless!!!  Now, does anyone out there think that debt of the likes of Italy and Spain is riskless???  Nuts...  But my point is that the EU can't be trusted to get the rules right, so having a unified rescue fund will likely only cause weaker countries to find ways to dump their troubled assets into the rescue fund.  Also, banks tend to use the government bonds of their home country as a means to take care of simple cash needs.  So unless a Eurozone-wide government bond is issued, it will be effectively impossible to break the link between weak countries and their banks.  I, for one, am actually in favour of a Eurozone bond as long as it can be structured to be senior to each country's own bonds.  That way, governments can default on their own bonds without the significant destabilising effect on the rest of the Eurozone, as the default would be more contained and have a much smaller impact on the banking sector.  This is similar to how it is difficult for the US federal government to default but relatively easy for individual US states to do so (and they have done so in the past).

So the Eurogroup has been so dysfunctional in its actions that one has to wonder whether it is craven cowardice in facing up to reality or whether any of them know anything about economics and how a financial system works.  The lack of forward thinking is shocking.  Being reactionary is not a plan; it impairs the ability of the EU to make the necessary reforms to grow out of the current crisis.  The lack of a plan causes people to focus on nitpicking the bailout’s details rather than focusing on the greater goal.  A plan to recover from a debt-induced economic crisis is fairly straightforward; it has been done several times in the past (so what’s taking so long in figuring out what to do this time?).  It comes in three stages:

1) First, you must implement and explain the need for austerity.  This is not as what northern Eurozone countries such as the Netherlands and Germany demand, i.e. simply cutting spending.  Instead, it means explaining why the current system is not sustainable (overall spending needs to be shifted from consumption to more economically productive uses) and to chart an inevitable course for why change is needed.  People don’t like this idea but they get it.  Some will probably fight tooth and nail to keep their benefits, but overall, they see sense in the reasoning.  And you have to stick to the plan.  Maggie Thatcher said it best, “The lady is not for turning”.

2) But you have to give people an out.  This is step two.  You have to implement the changes needed to reform the system.  People have to know that there is a clear direction towards a brighter future, otherwise they won’t work for it.  Again referring back to Maggie Thatcher, she definitely changed people's attitudes towards entrepreneurship, aspiration and working to get ahead.  The UK is a much more dynamic culture that what it was before because of this.

3) But Thatcher only got it two thirds right.  There is a third step (and unfortunately, most reformers miss step three…Sweden is probably one of the better examples of how step three works). Generations of people are often left behind by reforms, e.g. coal miners by Thatcher, and they are never able to recover without help from the state.  Not everyone is an entrepreneur who's willing to risk their livelihoods in a competitive world...most people actually aren't, so the trick is to give them a bit of confidence but more importantly the skills and opportunities needed to adapt to the changed world.  Thatcher failed to do this, and the devastation to the economy in the north of the country (not to mention Tory prospects for being electorally competitive in these regions) was the result.  The current UK government has done stage one but has not done a good job moving on to step two, a growth plan which is necessary to make step one work, and hasn’t given much thought to a step three.  Unfortunately, the Eurogroup and Eurozone leaders are in even worse shape; they don’t seem to have a credible plan for even step one, much less the other two.

Note, people should not view the assistance with adjusting to reforms in step three as welfare.  It is a necessary investment to help the economy better adapt to changing market environments and should be quick and temporary.  The minute it becomes permanent, then it is merely a transfer of wealth from the economically productive to the unproductive.  The objective is to assist the unproductive to become productive again to support themselves, not to give them money in order to placate them that they are "getting their fair share".

Ideally, one should not take disproportionately more money from the economically productive to subsidise this process.  However, that just doesn't work in reality.  The economically productive are by definition generating more income, so in order to be able to pay for the adjustment programmes, it is necessary to get a greater contribution from them (e.g. Germany, Netherlands, the rich, etc).  But again, people need to get away from this mentality that these payments are to allow them "to get their fair share".  They are not.  It's just that this is the most efficient way of raising the funds for such programmes.  This is an important distinction that people need to set in their minds.

So the framework for a Eurozone recovery is fairly straightforward.  It is the same one used by Sweden to recover from its financial crisis in the 1990s and by Germany roughly 10 years ago when the country was highly uncompetitive.  But the advantage that those countries had was that they stopped talking and whining about the problem and got on with implementing the solutions.  In the present crisis, the EU countries which have already starting implementing reforms in a substantial way like Ireland, Latvia and Estonia, are already well on their way to recovery.  The problem with the rest of the Eurozone right now is that they are still having a bunch of useless discussions without a long-term plan.  So it's tough to see how the Eurozone is going to get itself out of the current malaise.  But everyone should know that the problem is the lack of political will, not the lack of a viable economic solution.  Maggie Thatcher, the Eurozone could use someone like you right now...