Friday, August 07, 2020

Will the Pandemic Bring Down the Eurozone?

 Published on U.S. National Review Online

As the coronavirus crisis subsides in Europe, another crisis may rear its ugly head again: the crisis surrounding the EU’s common currency, the euro. The euro crisis, which came to a head when Greece nearly defaulted in 2009-10, never really went away, and it could have profound consequences for the United States.

No eurozone government has openly declared insolvency during the coronavirus pandemic, but the European Central Bank has undertaken massive financial injections to avoid just that.

On top of this money printing, European governments have been spending like drunken sailors. Germany alone has committed €1.2 trillion in spending and guarantees, more than any other individual EU country. There is a real danger that German support for domestic firms undermines fair competition in the European Union, which its executive, the European Commission, is supposed to guarantee, although in this case it has remained silent.

Recently, European governments agreed to an additional €750 billion in COVID-related stimulus spending, dubbed “Next Generation EU,” which will add yet more to the burden already imposed on hard-pressed European taxpayers. The €750 billion will be borrowed on international markets — perhaps even from China —and jointly guaranteed by European governments, a development of considerable political significance in that it effectively represents a degree of debt mutualization that has thus far been resisted by the EU’s “north.” To pay back the jointly issued loans, the European Commission will be levying taxes directly, an encroachment on powers previously reserved to the members. With a “tax on non-recycled plastic waste” already levied on January 1, a “carbon border adjustment mechanism and a digital levy” may follow.

In Northern Europe, opposition to this spending scheme was firm, as governments realized the extra burden it would put on their national budgets already stretched by the measures taken in response to the pandemic.

The so-called “frugal four” — the fiscally responsible Netherlands, Austria, Sweden, and Denmark — are hesitant to put themselves on the hook for decades of financial mismanagement elsewhere. It should be noted that the latter two opted to stay out of the eurozone and are therefore even more hostile to the idea of underwriting transfers designed in reality to sustain that shaky monetary union. At the European summit, they put up a good fight but basically lost out, having to accept that €390 billion of the €750 billion would consist in grants to European governments as opposed to loans.

An agreement was already reached that the new multiannual EU budget, not including the €750 billion special “coronavirus” stimulus, would once again amount to more than €1 trillion euro over seven years, despite the loss of the UK, which was the EU budget’s second biggest net contributor.

It is not as if the EU spends the money it already has as well as it might.

For a start, it devotes more than €400 billion to agricultural subsidies, irrespective of production, which amount to huge transfers of public resources to industrial conglomerates as well as to landholders, some of whose land just happens to be classifiable as agricultural, including (prior to Brexit) the Queen of England. The system emerged after EU agricultural subsidies had led to massive overproduction, so instead of axing the handouts all together, it was decided to merely decouple them from output. As was noted in a detailed 2019 report in the New York Times, allegedly:

across Hungary and much of Central and Eastern Europe, the bulk goes to a connected and powerful few. The prime minister of the Czech Republic collected tens of millions of dollars in subsidies just last year. Subsidies have underwritten Mafia-style land grabs in Slovakia and Bulgaria.

In the Times’ view, “few leaders have attempted such widespread, brazen exploitation of the subsidy system as [prime minister Victor] Orban in Hungary”. The paper’s reporters argue that he “uses European subsidies as a patronage system that enriches his friends and family, protects his political interests and punishes his rivals.”

“Regional funds” are the EU’s second-largest area of spending. These are supposed to help Europe’s poorer regions catch up, but they have ended up supporting organized crime and the mafia in Southern Italy, according to Italy’s Central Bank. Most economic research has concluded that these funds do not help to close the economic gap, and one study even alleges the funds bring more harm than benefits to regions that are net recipients of this largesse.

Germany, and ultimately the frugal four, are likely to back down in the end when it comes to both regular and post-COVID EU spending. The waste (and worse) associated with EU funds is no secret, but it is often considered as some kind of a “bribe to sustain the EU’s “single market,” which enables businesses to trade across borders more smoothly in Europe.

The single market is a good thing, even if its focus has moved from scrapping national protectionism to harmonizing rules at the European level. Discontent about the latter, along with perennially wasteful EU spending, were two of the reasons behind Brexit. We can already see rising discontent in the more “frugal” countries like the Netherlands or Sweden over the EU’s seemingly never-ending appetite for spending, but that discontent does not foreshadow an exodus from the union, an idea with only minority support in those parts of Europe. In Italy, by contrast, support for leaving the EU and the euro zone was higher in April — at around 50 and 40 percent, respectively — but Italy is financially dependent on euro zone membership. An exit would wreak havoc on its troubled banks.

None of this was properly considered. With the UK’s departure, the voices of those arguing in favor of responsible financial management have been weakened. The COVID crisis helped those pushing for more EU spending to almost double it, while also financing part of it via joint lending, and no longer only, as was the case, bottom-up, via payments to the EU. Also in the future, the EU could decide to cover any shortage of cash via a joint lending program. Importantly, however, the EU Commission’s authority to issue joint debt is time limited. Every EU member state is able to veto any future program similar to the 2010 joint lending program to finance Eurozone emergency loans to Ireland and Portugal, which can serve as the first precedent of joint EU borrowing.

In the end, the 750 billion euro of the new joint borrowing program is still relatively small. Ultimately, it is the European Central Bank (ECB) which is preventing a euro zone break-up.

Taxes are already excruciatingly high in financially weaker countries like France, Belgium, Greece, Italy, Portugal and Spain. The economic damage of Covid is now crushing tax revenue. If those countries’ governments want to avoid big spending cuts, which is a “no go” in Europe, where a social-democratic mindset is mainstream, they need to increase borrowing. That’s where the ECB comes in.

The combined budget deficits of euro zone governments this year amount to an estimated €1.4 trillion, roughly equal to as the extra money the European Central Bank has pledged to inject into the system by the end of this year. By the end of 2021, the ECB’s monetary expansion will, according to conservative estimatesexceed €1.6 trillion , which is a lot more than the €340 billion stimulus the EU Commission intends to dole out until the end of next year.

The ECB has become a crucial source of funding to many euro zone governments. It does this by drastically expanding the supply of money, either buying government bonds on the secondary market or distributing newly printed cash to European banks. This all happens through seemingly endless programs usually identified only in abbreviation: LTRO, TLTRO, PEPP and PSPP. As for the money lent by the ECB to banks, much of it is spent on bonds issued by the euro zone’s governments. In 2011, French President Sarkozy  that the real purpose of the LTRO program was to fund governments: “This means that each state can turn to its banks, which will have liquidity at their disposal.” When it is buying bonds directly, the ECB moreover disproportionately purchases those of the financially shakier member states, meaning it is not just engaged in banana republic–style monetary financing of government spending but also effectively organizing transfers between eurozone member states, and not in a direction appreciated by the eurozone’s north

There are legal constraints in the eurozone aimed at preventing monetary financing, which is rightly seen as undemocratic (it’s a way of increasing government spending that bypasses parliamentary scrutiny), but they don’t amount to much. Recently, Germany’s Constitutional Court ruled that the EU’s “Supreme Court,” the European Court of Justice, had violated the distribution of competences laid down in the EU’s founding treaties by allowing the ECB to conduct its very own “quantitative easing” program, PSPP, without sufficient motivation of the reasons why it’s necessary. The German judges have a history of daring to bark but not to bite, so another fudge was found, with Germany’s central bank simply delivering an explanatory note.

For a long time, German political opposition to the ECB’s monetary activism, stemming from the trauma of 20th century hyperinflation, acted as a brake, but memories are fading.

Complacency over inflation has also been helped by stable consumer prices, despite clear sign of asset-price inflation. One explanation for this is that much of the money created by the ECB and lent to banks has simply stayed put in the banking system. Banks are not lending it out, because they cannot identify enough good projects to fund . Meanwhile, European savers aware that their savings are being slowly eroded remain wary of more active investment strategies, apprehensive that a stock-market or real-estate correction may be around the corner. That interest rates have been driven into negative territory has not changed their mind to any significant degree.

The next stop may therefore be “helicopter money” — sending money to citizens rather than banks. In theory, this ought to drive up the “velocity of money,” as the newly created cash would no longer sit idle in the banking system, but could be used by citizens right away. That’s the theory, but it is possible that many people would still not indulge in a spending spree, and might merely keep the extra money in their savings accounts. Nevertheless, if enough people did start spending right away, consumer prices would go up, “forcing” people to join the spending spree, so as not to lose out. This would all end in runaway inflation.

The euro does not enjoy the reserve-currency status of the U.S. dollar. Its credibility as a store of value is considerably less. The ECB can control how many euros it inserts into the system, but not the degree of trust people have in the single currency. It’s possible to foresee a situation in which the ECB may be forced to increase interest rates to stem capital flight, a phenomenon familiar in those emerging markets where money has been printed a little too enthusiastically.

In the eurozone, higher interest rates would not simply be a matter of political and economic pain. They could threaten the single currency’s survival. Southern European politicians may simply refuse the demands for stricter budgetary controls insisted upon by their Northern counterparts in return for fiscal support. Or Northern European politicians may no longer be able to persuade their voters to head off a sovereign default by one or more of the eurozone’s southern members, such as Italy. We should never underestimate how far Germany’s political establishment is willing to go to save the monetary union, but perhaps COVID-19’s economic fallout of will exceed the capacity of German politicians to agree to transfers.

To be sure, even if no solution can be found within the eurozone, there’s always the possibility that the United States will bail Europe out.

At the worst moments of the eurozone crisis, the U.S. Federal Reserve was there to provide “swap lines” to European banks in need of dollars. The U.S. typically does this for friendly nations, but here more was at stake. During those years, Obama’s Treasury Secretary Tim Geithner had to travel to Berlin to convince the German government to bail out other eurozone countries. A Greek default would have struck a blow to troubled U.S. banks. Back then, it was in the interest of the U.S. to bail out the eurozone.

Will Washington still hold the bag for Europe in the age of “America first” and when, in the event of capital flight, European banks’ needs for U.S. dollars would be even greater? It’s hard to say, but the administration needs to start focusing on the economic news coming out of Europe.

As much as President Trump’s instincts may rebel against support for the EU’s shaky common currency, there will be massive pressure on him to do so, amid calls for “safeguarding global financial stability.” But America should resist the temptation to prop up a wobbly structure.

Italy’s economy is now smaller than before it entered the eurozone, in 1999. Despite years of budgetary surpluses (before interest payments), the Italian government has been unable to jumpstart proper economic growth. Nominal interest rates may be low, but the absolute sums (now repayable in a “hard” currency since Italy gave up the lira for the euro) left over for from terrible financial mismanagement in the 1980s require high taxes, and high taxes are not a recipe for growth. Moreover, the greater the role of the ECB in Italian government financing, the less incentive there is for the Italian government to introduce structural reforms.

The unpleasant reality is that Italy’s public-debt mountain is simply too high to ever be brought down to a manageable size. Even years of “primary budget surpluses,” which exclude interest rate payments, were not sufficient to generate proper economic growth in Italy. Policymakers should accept that an Italian default is the only way out. True, this would hurt investors, pensioners, and the ECB, which holds about 20 percent of Italian debt, but it’s better to deal with the pain now than face even worse damage further down the line.

Would an Italian default lead to the break-up of the eurozone? Perhaps, but if the alternative is preserving a structure that can only be sustained by ever greater debt and transfer payments, perhaps that’s not the worst thing.

To be fair, the potential damage from an Italian default may already be so great that hopes of an orderly debt restructuring and a managed unwinding of the eurozone are nothing more than a pipe dream. In that case, the best option is for European governments to have a “plan B” ready for a disorderly eurozone break-up. According to retired Dutch policy makers close to the decision making at the time, this was something that the Dutch and German governments had in place in 2012.

There is, of course, also always a chance that real economic growth — engendered by the many remarkable technological innovations we are witnessing today — will facilitate enough growth to overcome Italy’s debt mountain, but it would be dangerous to count on it. At its current debt levels, it would take massive growth rates to dig Italy out of its financial hole. And the more difficult it becomes the greater the likelihood of the first, more pessimistic scenario: a disorderly eurozone break-up There may be a rough ride ahead.

Thursday, August 06, 2020

Euronews interview for July EU Summit in Brussels

Podcast interview

In a podcast interview with monetary expert Paul Buitink, I  I discuss the euro, eurozone politics as well as the recent EU Summit deal for another 750 billion euro Covid "stimulus" on top of the EU's highly deficient 1.000 billion euro budget:

Europe is finally coming to terms with Brexit

Published in The Spectator

In article in the Dutch, left-leaning newspaper Het Parool led with the headline ‘Despite Brexit, multinationals prefer London over Amsterdam or Paris’ this week. The piece reports that ‘the feared exit [of companies] from Great Britain is not happening’ as expected, and highlights the fact that Unilever decided to:

Become fully British, scrapping its dual [Anglo-Dutch] structure [which has been in place for 90 years]. Its headquarters will be London and not Rotterdam, despite the avid attempts of Prime Minister Mark Rutte.

Reportedly, the opportunity offered by London’s capital markets trumps any risks resulting from Brexit, an element that could also play a role in Shell possibly moving its headquarters from the Netherlands to the UK.

The article goes on to point out that despite relocations by some major companies (such as Dyson, Honda and Panasonic) firms have not rushed to leave Britain. At least 1,441 companies have even recently moved to the UK, according to official statistics published in November.

Goldman Sachs has recently decided to build a new £1 billion headquarters in London and city firms are less worried about Brexit, ‘having spent millions of pounds on precautions for any negative consequences’. Before the pandemic, the IMF issued a prediction that the UK economy would outpace the eurozone for the first two years after Brexit, concluding that despite the risk of no deal, ‘Great Britain remains a magnet for capital, even in the eye of a storm.’

Notably, the article adds that:

The presence of Prime Minister Boris Johnson is reassuring, despite his actions during the pandemic that are a cause for concern. As opposed to his predecessor, Theresa May, he does get along with business. He is opposed to regulation and for free trade. Multinationals now also fear the Labour party less, since the moderate Keir Starmer was chosen as its leader.

Analyses like this demonstrate that mainland Europe is now finally coming to terms with Brexit, based on facts on the ground.

There is, however, an import caveat: it still matters what kind of trade arrangement the UK agrees with the EU before 1 January. Will the UK manage to reconcile regulatory and trade sovereignty with maintaining access to Continental markets? Will it manage to compensate the unavoidable loss of a degree of market access with competitive measures, such as the creation of freeports? We need to wait to find out.

An outstanding question in the ongoing negotiations is to what extent the EU will drop its insistence on ‘level playing field’ minimum standards for UK regulations, in return for continued market access to UK businesses. A ban on state aid is part of the ‘level playing field’, but the EU has just signaled some flexibility on this.

Given the way the EU Commission often reinterprets tax breaks as ‘state aid’, this is a welcome development. A compromise could be the creation of a ‘dispute resolution mechanism’ on any state aid granted to UK companies, instead of obliging London to follow EU rules straight away. This concept should perhaps also be applied to market access more generally. The UK could agree that after December, it will continue maintaining all EU rules it has taken over in domestic legislation, but pledge to notify the EU every time it intends to issue divergent regulation. This concession should of course depend on the EU granting a lot more market access than it has offered so far.

In this way, cliff edges, tariffs and economic damage could be avoided at the end of the year. Involving the EU in the British legislative process could also help inform UK lawmakers about how they can minimise the loss of market access when diverging from EU regulation. When it comes to chemicals, the UK government may simply opt to shy away from different standards for chemical products, due to the importance of the EU market. While on digital innovation, the UK may decide it isn’t worth constraining British innovators with GDPR and other similar innovation-killing regulatory straitjackets, and diverge from the EU.

In July, the UK compromised by accepting an overall governance framework, rather than a patchwork of sector-by-sector deals, and the EU side moved – at least according to Brexit negotiator David Frost – on the role of the European Court of Justice. If the two sides manage to sort their ‘level playing field’ issues, only fisheries access remains as the last big sticking point. An EU diplomat has told Reuters that ‘fisheries won't wreck the whole thing’, which is probably right, if only because the UK wouldn’t be able to consume all the fish it is entitled to catch in its own waters.

With all of this out of the way, both the EU and the UK can then focus on recovering from the massive and ongoing damage inflicted by the pandemic.

Now that Europeans are finally coming around to the idea that Brexit won’t be the complete disaster many of them originally predicted and that post-Brexit Britain won’t be the desperately dependent and helpless island they envisioned, they should be more willing to engage in the talks.

Tuesday, July 28, 2020

Freeports : a major benefit of Brexit

 Published on Reaction Life

With the coronavirus crisis subsiding, the UK government is now focusing on how to kick the British economy back into gear. Agreeing a good deal with the EU on future trade access when the UK recovers its regulatory and trade freedom from January 1 is obviously very important in the short run, but in the longer run, there is more to do.

An absolute priority should be the creation of so-called “freeports”, which has now been announced by Chancellor Rishi Sunak. The UK government is planning to create 10 of those, by introduce sweeping tax cuts and an overhaul of planning laws in selected areas, so they would be fully operational by April 2022.

Labour has dismissed the plan out of hand, pointing to problems at some of the EUs freeports, but this is shortsighted. The UK has an opportunity to learn from continental mistakes and build a bespoke freeport model that brings tens of thousands of jobs to disadvantaged areas in the UK.

As International Trade Secretary Liz Truss has put it: “freedoms transformed London’s Docklands in the 1980s, and free ports will do the same for towns and cities across the UK. They will onshore enterprise and manufacturing as the gateway to our future prosperity, creating thousands of jobs.”

Freeports are already widespread—there are around 80 freeports in the European Union and some 3,500 worldwide. The UK once had seven of the facilities, including in Liverpool and the Port of Tilbury, but all had closed down by 2012.

The crux of a freeports economic potential is its special customs status. When goods arrive at a freeport from abroad, no tariffs or taxes are collected on them, unless they leave the facility. Some freeports also contain factories, which produce goods mainly meant for export, taking advantage of the fact that tariffs are often higher on raw materials than on finished products.

The EUs freeports have been restricted by the blocstate aid rules, which consider the tax or tariff exemptions granted to freeports to a large degree to be an unfair subsidy” to businesses. Such an interpretation may be considered a violation of the spirit of state aid rules, and on occasion, the European Commission has been overruled by EU judges for its tendency to qualify tax breaks as state aid”, most notably in the recent case regarding Apple and Ireland.  In any case, once the UK regains its regulatory independence, it will be free to create freeports under more lenient WTO rules.

Opponents have suggested that the free trade zones could open the UK up to financial crime. According to Labour MP Peter Dowd, the EUs existing freeports serve as tax-free warehouses used to hoard art, wine and gold”.

Freeports on the continent have indeed been the subject of repeated allegations that theyre havens for money laundering and tax evasion. Opponents often single out the one in Luxembourg, called Le Freeport Luxembourg”. It is owned by Yves Bouvier, a Swiss art dealer, who has been investigated in his home country for evading hundreds of million of Swiss francs in taxes and was once accused of cheating a former client out of $1 billion. Bouviers Luxembourg freeport claims to strictly respect all anti-money laundering rules and to have three customs officials stationed permanently at the complex.

Members of European Parliament who visited the facility, however, were sceptical of these claims. One described it as a black hole”, while another suggested that customs checks were extremely perfunctory”.  

In addition to drawing policymakers’ ire, the freeport model popularised by Yves Bouvier doesnt appear very profitable. The chairman of the board of the Freeport Luxembourg, a former socialist MEP, recently stepped down as the facility faces millions of euros in losses. The former editor-in-chief of a newspaper which extensively covered the facility, Fabien Grasser, has even claimed that he was fired because of his newspapers critical take on the freeport.

In their haste to demonise the UKs freeport plan, however, detractors have failed to recognise that its very different from the flawed facilities abroad. Rather than emulating Yves Bouviers freeports in Luxembourg and Singapore, the post-Brexit UK will seek to establish something closer to the original idea of a freeport, replicating in Europe some of the success of Shenzen in China or the Jebel Ali Free Zone” in Dubai. This is in line with suggestions made by former MEP Ana Gomes, who urged the Commons to introduce a so-called “Bouvier rule”, forbidding the storage and sale of artworks above a certain value.

The facilities would not become boltholes for priceless art. In fact, the UK government has clearly stated it does not intend to designate freeports for the purposes of High Value Luxury Storage”, such as art works. Instead, the focus will be on creating an attractive business environment in disadvantaged areas. 

Some arguments against freeports are that these would not fulfill that aim, as the facilities would merely drive away business from other parts of a country and not create any new economic activity in net terms.

There are two responses to this. First, even if this were true, it would surely not be the end of the world to see more jobs growth in less well-off parts of the UK, like the North. Secondly, its factually incorrect to claim that there wouldnt be extra business opportunities if the effective tax and tariff burdens are also lower, meaning that both London and the North would reap gains.

The UK is already in a good position to make sure that the economic benefits of freeports are evenly distributed. As Chancellor Rishi Sunak wrote in a 2016 policy paper:

Unlike many other countries with often just a single (taxpayer-funded) super port, the UK contains dozens of successful, large-sized ports; all privately financed. These are spread around the country and are already home to manufacturing clusters.”

While the plan to establish ten freeports across the UK is still in the consultation phase, several applications have already arrived. One is from Tees Valley in the North East of England, whose Mayor calls it a fantastic opportunity to turbocharge our local economy and bring much-needed jobs, growth and investment”.

Tees Valley is already an enterprise zone”, meaning it enjoys certain tax concessions, infrastructure incentives, and reduced regulations. Combining the benefits of such an enterprise zone and a freeport would let businesses import, process and export goods without costly customs bureaucracy. 

The benefits for regions like Tees Valley could be substantial. Consultancy and construction group Mace has estimated that creating seven supercharged freeports” could boost UK international trade by £12bn annually, as it would also add £9bn to UK GDP after 20 years and lead to 150,000 extra jobs.

While establishing freeports, the UK government should continue with the strategy to turn them into areas with minimal customs duties, import VAT, and national insurance contributions, rather than warehouses for luxury goods. In this way, the initiative could turn into the United Kingdoms prime benefit derived from Brexit. Perhaps Europe might even be inspired.