Domestic battles of Slovakia threatening euro

Slovakia is the last member of the eurozone to agree to expanding the powers of EFSF (European Financial Stability Facility). Slovakia's prime minister Iveta Radicova (left on the picture) is finding it hard to reach an agreement with her coalition partners who oppose EFSF. Richard Sulik (right on the picture), leader of Slovakia’s libertarian Freedom and Solidarity (SaS) party last week agreed to supporting the EFSF only if Slovakia would not participate in ESM (future substitute of EFSF) and only if Slovakia would have a veto of how the funds would be used in EFSF. The prime minister refused the offer.

Slovaks have publicly opposed helping heavy borrowers and those who don't follow eurozone rules. Let's see how Slovaks themselves manage in that area.

Slovakia has been running a huge budget deficit for the last two years (-8% in 2009 and -7,9% in 2010 - Eurostat). Maastricht criteria require it to be under 3% of GDP. In former years Slovakia has done well in that area. Slovakia plans to run a 4,9% deficit this year and has a budget drafted for 2012 which foresees a 3,8% deficit.

Slovakia doesn't have as much debt as the problematic countries in the eurozone do. It had a debt burden of 41% of GDP in 2010 which is bound to increase in current and next year.

Slovakia isn't the best performing country in the euro area. Yet it is possible that it will be the only one not supporting the EFSF legislation. And it is not because Slovakia has a lesson to teach to rest of the Europe about how to balance the budget but it's because Slovakia has power-hungry politicians not willing to do the right thing.

Against EFSF? Really?

Estonia's parliament will vote on expanding the powers of EFSF tomorrow together with Germany. As always media and politics have managed to develop a circus out of the discussion preceeding the vote. Polls show that Estonian people are mostly against expanding EFSF (also those supporting our current right-liberal government). Some of the people shout out arguments like "Greece should go bankrupt" or "Why do we have to feed banks". This was followed by a statement from our centre (populist) opposition party that they also don't support joining the EFSF probably hoping to get some votes. Since people are getting very emotional on this subject I will lay out some most important facts about EFSF. (Check these out yourself HERE)

1) First and foremost - EFSF was created with an intention to preserve financial stability in the eurozone by providing temporary financial assistance to governments or banks in difficulty. In other words it is supposed to AVOID crises like we are in now.
2) EFSF finances itself by issuing bonds that are guaranteed by all 17 eurozone countries up to 440 billion euros. Countries participating in EFSF do not pay any additional funds to EFSF, it is backed by guarantees.
3) EFSF is only a temporary measure to handle the current crisis and its permanent follower will be ESM or European Stabilisation Mechanism.

Q: What happens if a country doesn't participate in the EFSF?
A: There's a risk that other countries don't want to particpate as well, who will finance the EFSF then?

Q: Why do we need EFSF at all?
A: To avoid uncontrolled bankruptcies of banks and countries

Q: Why do we need to avoid their bankruptcies if they have overspent?
A: Since if we don't borrowing costs for countries like Italy, Spain, France, Belgium etc will rise significantly leading to other bankruptcies. Banking system as we know it might fall because of the losses that these banks will have (the banks are holding the bonds that are worthless after a bankruptcy of a country). There will be no more euro.

Q: What happens if euro goes?
A: Countries like Germany, Estonia, Finland, Netherlands etc that are financially sound will get currencies that will rise significantly in value causing our exports to fall greatly (it is then more expensive for other countries to buy our products). This will bring massive unemployment and loss in economic welfare. It has been estimated that the effects of such an event would lead to 20-40% fall in GDP in first year. For countries like Spain, Italy and Greece this might even leed to civil war since their currency would devalue so greatly that the people of these countries are unable to pay off their loans. There would be massive unemployment since there is no funding for investments (who would borrow to a bankrupt country in civil war?). GDP of these countries could even fall 50% or more. (Analysis is done by UBS).

The total loss of these events will surpass trillions of euros (if you look at European GDP of about 12 trillion EUR). The countries going through tough austerity measures including budget cuts and reforms will hopefully turn to growth in a couple of years. It is not like regular people of these countries aren't suffering enough already. Hasn't Europe learned anything from its history just 70 years ago? It's not like we are not on the edge of a cliff..

Europe needs a vision, not just doing something

Imagine a football match without goals and goalkeepers, everybody are just trotting around anxiously. Imagine a ship on the sea without a compass or any other navigation system. Imagine a doctor treating you for symptoms even though you haven't agreed that you want to get better. This is what Europe is doing right now with the eurozone crisis.

In strategic management a vision is defined as the way an organization should look like in the future, what is the state of things. In the same manner we could (and most definitely should!) have a vision for Europe. What is the future of Europe? Do we want an economic union, a political union or even more integrated Europe? If we knew that it would be awfully easy to find a solution for the crisis.

If we wanted tight economic cooperation amongst countries we should let Greece suffer for their own overspending and throw them out of the euro. If we wanted United States of Europe we should introduce bazookas like eurobonds or unlimited supply of liquidity, bond buying and loans from ECB.

A clear vision of Europe is making it so difficult to find a solution to the crisis since everybody has their own vision for Europe. Again - imagine a football match where everybody would have their own rules for the game.. It is not too late yet. Even though the project of Europe should have began with a common understanding of the ultimate goal, it is not too late to agree upon one right now. The markets don't need a bazooka per se, they need a clear understanding of how Europe is going to tackle the crisis.

What about Maastricht criteria?

Every country part of the eurozone has to fulfill certain economic conditions (referred to as Maastricht criteria). The country that is not obeying these criteria can be punished by the ECB. The criteria go as follows:

1. Price stability. The inflation rate should be no more than 1.5 percentage points above the rate for the three EU countries with the lowest inflation over the previous year; 
2. Budget deficit. This must generally be below 3% of gross domestic product (GDP);
3. Government debt. The national debt should not exceed 60% of GDP, but a country with a higher level of debt can still adopt the euro provided its debt level are falling steadily;
4. Exchange rate. The national currency's exchange rate should have stayed within certain pre-set margins of fluctuation for two years (no re- or devaluation of currency);
5. Interest rates. The long-term rate should be no more than two percentage points above the rate in the three EU countries with the lowest inflation over the previous year;

Maastricht criteria were the reason why my home country Estonia didn't join the euro in 2007 as planned because of the inflation criteria was not fulfilled even though Estonia is fiscally the toughest and best performing country in Europe (Estonia is part of the eurozone from 2011). That's OK because rules are rules... or are they? Greece, Italy and Belgium (the heart of EU - really?) joined the euro even though their debt was exceeding 100% of GDP. Greece was running the biggest budget deficit with one of the highest inflation rates. Check the following graphs.

So far the criteria have been important for countries willing to adopt euro since it's a precondition for joining (this statement is conditional itself as seen from history). For joining countries it is a good motivational exercise to get their finances in order. Once already in the eurozone motivation quickly disappears.

So how should we deal with that? Shall we fine the countries that are not capable of cut their spending (read: living within their means)? That's like asking for money from a beggar so it probably wouldn't work. There are still couple of things that could be tried.

Make it political! The main reason for not cutting spending or increasing spending for politicians is the support of their voters. Political promises can often lead to overspending so there is motivation for politicians to spend more than possible. So why couldn't it be possible to force the government step down if two out of five criteria are broken for example?

Another idea is to keep away the cookies. Today a lot of countries are receiving structural funds and richer countries are participating in other mechanisms like Framework Programme. Would it make sense to cut funding for countries that aren't fulfilling their duties? Since all of the EU countries aren't in the eurozone it would be impossible, but approach as such would serve its course (as can be seen in Greece today).

I would prefer stabilizing the eurozone with political measures which reduces populism, the mother of all wrongdoings. We should remove the motivation to behave badly, fines and nagging doesn't work here!

Finland vs Greece vs Europe

No, it's not a football match I'm going to write about, even though Greece would have a much bigger chance succeeding there. Finland has gained much attention recently since their prime minister announced that Finland has gotten monetary collateral for supporting Greece. This means that Finland agreed to support the second bail-out package to Greece only if Greece would deposit equal amount of money as a collateral for Finland. If Greece would go bankrupt, Finland would keep the money.

For Finland this is mainly a domestic political campaign. Finnish voters are turning anti-euro and the government had to do something in order to win some votes back. For Greece, guaranteeing collateral was one way of securing the votes of all countries, including Finland.
Other countries in the eurozone though are (rightfully so) upset because if one country gets collateral, why shouldn't others? This would eventually lead to a situation where all the money borrowed to Greece would be deposited somewhere as collateral and there would be no money left for Greece to cover its costs. Is there any solution for this?

Seeking collateral for the money borrowed to Greece would be a good idea since this would discipline Greece as well. What could be used as a collateral though? One possibility could be natural resources. In 1992 my home country Estonia successfully carried out a monetary reform which substituted Russian ruble with Estonian krona. Estonia initially used our national forest and gold reserves as collateral for the krona. So let's look at Greece's natural resources and other reserves (from CIA World Fact Book):

• 991 million cubic meters of natural gas with a market value of around 138 billion USD (Bloomberg)
• 6,37 billion USD in gold reserves
• 10  million barrels of oil with a market value of around with a market value of around 1,1 billion USD (Bloomberg)

In addition to that Greece has deposits of bauxite, asbestos, nickel, magnesite and marble. So Greece just might have enough natural resources to at least partially put out a collateral for money received from other eurozone countries and the IMF. As a matter of fact natural gas, gold and oil reserves add about up to the total amount of the most recent bail-out package of 110 billion euros.

Crisis escalated (and managed) by ECB

I came across a blog (link) where Rebecca Wilder pointed out that hiking of interest rates in Europe has worsen the crisis in Europe. Take a look at this graph.

ECB (European Central Bank) has risen interest rates twice this year. In both cases the yields of 10-year government bonds of the most problematic countries (Yes, Belgium is not one of the hawks) has risen considerably. This means that these countries have to pay much bigger interest costs on their debt thus worsening situation with their budgets.

Now ECB has started buying government bonds of Italy and Spain in additon to Greek, Portuguese and Irish bonds. ECB now holds more than 100 billion of debt of these countries. While the ECB is terrified of inflation (reason for hiking interest rates) their colleagues from USA have speculated that inflation might be temporary. Maybe that's what ECB should do now - lower the interest rates so the euro would weaken supporting export and possibly lowering yields of problematic countries as well. Of course, maybe the ECB knows something we don't. Or maybe Jean-Claude Trichet (president of ECB) is busy buying all the bonds. We will know more maybe even on Friday when the ECB publishes their opinion on monetary developments in Europe. If not then, we will here more on the 8th of September when the Governing Council will meet in Frankfurt to discuss economic environment in the eurozone.