8th September 2011 – European Confederation – TIPSTER’s “European Consolidation Treaty”

Rethinking the Stability and Growth Pact

Quote of the Day:

Fragmentation of the Euro would incur political costs. Europe’s “soft power” influence internationally would cease (as the concept of “Europe” as an integrated polity becomes meaningless). It is also worth observing that almost no modern fiat currency monetary unions have broken up without some form of authoritarian or military government, or civil war.

Stephane Deo, Paul Donovan, Larry Hatheway – UBS Economist Team.

Macro Overview

• War? YIKES!! I’ve always been a fan of Paul Donovan, back in 2008/2009 he and David Rosenberg were pretty much the only mainstream Street economists playing down the inflation threat to treasuries. Discouraging investors from dumping US Treasuries – he felt there was always going to be support for prices. A highly contentious and contrarian call at the time, but it doesn’t look so bad now does it?
• Here’s UBS’s latest report – of which I’m sure Paul is a large part: Euro-break up – the consequences. It is creating such a stir around the World I’ve had to include a link to it (courtesy of Paul Kedrosky’s blog site). As a hard-wired skeptic I’m not 100% sure about the credibility of the message, though: “don’t break up the Euro or we’ll all descend into financial chaos and civil war”. Indeed, ZeroHedge take a more satirical line to it in their comment, Bring out your Dead, quoting extensively from UBS’s piece:

“Were a stronger country such as Germany to leave the Euro, the consequences would include corporate default, recapitalisation of the banking system and collapse of international trade. If Germany were to leave, we believe the cost to be around EUR6,000 to EUR8,000 for every German adult and child in the first year, and a range of EUR3,500 to EUR4,500 per person per year thereafter. That is the equivalent of 20% to 25% of GDP in the first year. ” It also would mean the end of UBS, but we digress. Where it gets even more scary is when UBS, like many other banks to come, succumbs to the Mutual Assured Destruction trope made so popular by ole’ Hank Paulson : “The economic cost is, in many ways, the least of the concerns investors should have about a break-up. Fragmentation of the Euro would incur political costs. Europe’s “soft power” influence internationally would cease (as the concept of “Europe” as an integrated polity becomes meaningless). It is also worth observing that almost no modern fiat currency monetary unions have broken up without some form of authoritarian or military government, or civil war.” So you see: save the euro for the children, so we can avoid all out war (and UBS can continue to exist). The scariest thing, however, by far, is that for this report to have been issued, it means that Germany is now actively considering dumping the euro.

• I think the UBS report sensationalizes the scenario a little as it implies that a Euro would be allowed to “freely collapse” in an uncontrolled manner – I simply cannot see this happening under any scenario unless we see parabolic escalation of geopolitical tensions withinEurope. So yeah, if we have a war, then the probability of war is high! In fact, one thing I agree with ZeroHedge on is the most concerning thing about the report is the fact UBS felt it necessary to issue it at all. What does this say about the fragility of the Eurozone – or indeed the fragility of UBS?
• That said the detail of the report highlights the probabilistic outcome for the Eurozone, in my opinion. Most people talk either of the Eurozone muddling through under its current form with the Germans reluctantly agreeing to provide huge contributions (either by Eurobonds or through EFSF) where as others think that the Euro will simply disintegrate.
• They’re missing the most obvious solution in my opinion which is what Donovan calls the confederation of Europe. I’ll go one stage further and say I think the best solution would be to reform the Maastricht Treaty and Stability and Growth Pact. Let’s call it “The Eurozone Consolidation Treaty”.
• Remember as I mentioned in another comment the old Treaty and SGP had the two main criteria for convergence:

…Member States were required to do stick to the following two fundamental economic criteria:

1. Deficits of less than 3% to GDP
2. Debt to GDP of less than 60%

• The Eurozone Consolidation Treaty would be an evolution of this where:

• The absolute targets (level 2 criteria) are revised to more realistic levels in this crisis:
• Deficits less than 5%
• Debt to GDP less than 100%
• Additional confederative oversight – structured into the Treaty. Where, if deficits approach the level 1 criteria of: 4% or Debt 80% of GDP then the following occur:
• Government must seek approval from other 17 member states before executing the fiscal budget. Voting is weighted pro-rata among members according to size of economy (a measure of GDP)* or risk collectively enforced austerity (loss of independent political power).
• The member state immediately loses its confederative voting rights in the event of level 1 criteria being triggered.
• These initial targets are then ratcheted back to closer to their original levels over 5 years after 2013.
• LEVEL 1: 2.5% GDP Deficits, 55% Debt to GDP
• LEVEL 2: 3% GDP Deficits, 60% Debt to GDP

Benefits:

• These measures would act as a severe deterrent for member states to stray beyond their fiscal responsibilities toward convergence.
• The political structure would literally force member states to take an active and political interest in each others fiscal agenda. Much more coherence and collectivism within the Eurozone.
• There would be collective responsibility among member governments for failing Euro members.
• Greater cultural and social cohesion between populations.
• Greater credibility to the Euro and fiscal union of the Eurozone.
• Greater independence of the ECB as this would purely be inter-state legislation.

* I put GDP weightings although this could be contentious. But it’s my view that, if, during a Sovereign debt crisis, member states are expected to contribute towards bailouts (EFSF) with pro-rata weightings in accordance with their GDP, then they should be awarded confederative voting rights in this respect too. This could be made into a more sophisticated weighting (e.g. I personally favour (GDP – Debt) measure which would place significant additional encouragement towards the convergence of fiscal prudence. If you get your sovereign balance sheet in order, you’ll get more regional confederative powers.

• Listen, lots of flaws with what I’ve just suggested, perhaps it’s too complicated or too rigid or just too politically unrealistic… but it’s just a suggestion. A new European Consolidation Treaty along these lines may just work. Let’s face it, there are many positive things about a currency union in Europe– in fact Stephane Collignon of The Guardian came up with an interesting alternative solution yesterday which has many similarities with mine.

I therefore propose to abolish the SGP and to replace it by a new framework with the following features:

1. A European macroeconomic framework law is voted every year under theLisbontreaty art. 294 on the ordinary legislative procedure, which determines what the appropriate aggregate fiscal deficit is for the euro area as a whole. This law takes into account the economic environment, growth and employment, the accumulated debt levels, and the world business cycle. The macroeconomic framework law replaces the rigid deficit limits of the SGP, which were never kept, and establishes a framework with greater (vertical) flexibility that an efficient macroeconomic policy in a single currency area requires.

2. The European commission then issues deficit permits against the authorised amount of the aggregate deficit.

3. These deficit permits are allocated to member states according to their GDP shares. Modifications according to the relative debt ratios (above or below 60%) are possible.

4. Deficit permits are transferable. If one member state needs to borrow more, it can obtain additional permits from other member states that do not use them. The transfer could be subject to deals between governments in the European council, or one could set up a market where deficits are traded like pollution permits. The transfer mechanism allows for the necessary horizontal flexibility that responds to asymmetric shock in member states.

5. A banking regulation that prohibits financial institutions from lending or helping raise euros for public authorities unless the borrower can present the equivalent amount of deficit permits. In other words, member states’ capacity to issue debt is controlled at source; no need for complicated bureaucratic surveillance and punishment mechanisms.

• The point I’m trying to make is that Europefaces a political problem – there are political solutions.