On the Brussels’ Agreement: Europe’s Reverse Alchemy in full throttle

Yanis Varoufakis

The official unveiling of a systemic crisis
One knows that there is something rotten in the world economy when the fate of a Greek PM makes headlines all over the world and for a whole week. Greece is not, and ought not to be, that important. But Italy is. And so is, from a global perspective, Europe. For some time now, Europe has been hiding its ills behind its (Hellenic) little finger. At long last, the truth (which I have been at pains to shout from the rooftops for more than 18 months) is now out: This is a systemic crisis that threatens not only the euro but the world economy in its entirety. While Greece is insignificant, the eurozone, lest we forget, is the globe’s largest economy; a block that accounts for China’s single largest slice of exports, for one fifth of America’s exports, for more than $120 billion of Latin America’s exports, not to mention up to half of emerging Africa’s money-spinning trade (from fresh fruit and flowers to minerals). A deep recession in Northern Europe (which will surely result from the euro’s demise) is, thus, bound to unleash deflationary winds that will destabilise an already imbalanced global economy.
It is for this reason that all eyes have been, of recent, on the 27th October EU Brussels’ Agreement. For, as we all know, this is the Agreement that was meant to avert the euro-system’s collapse; a collapse that will force Germany to forge a new currency whose immediate appreciation will be the trigger of the recessionary forces mentioned just above. Alas, while the world is looking, it is failing to see. Judging by the headlines, the world’s media, markets, political leaders and opinion makers were biting their nails until word came from Greece that a national unity government will be formed so that the Brussels’ Agreement can be implemented. It is as if the whole wide world was praying for the Greeks to give the Brussels Agreement a chance. And since Silvio Berlusconi announced that he will go Mr Papandreou’s way, similar hopes have been raised about Italy. It is the purpose of this article to argue that the world’s prayers have been misplaced. That the anxiety to see Greece and Italy return to the Brussels’ Agreement fold is a sign of the calamity to befall the global economy. For this Agreement, as I shall be arguing below, is most likely to prove the euro-system’s greatest foe, rather than its cure. If I am right, the sights and sounds of a world agonising over the fate of the Brussels’ Agreement will be followed by the sights and sounds of a world readying itself for a major new twist in an already devastating Crisis.
 
On the pre-history and the three aims of the Brussels’ Agreement
This particular phase of the Euro Crisis saga began on 21st July when, in the midst of joyous celebrations, the last ‘final solution’ was touted. As some of us had indicated almost instantly, that agreement was doomed as it tried reluctantly to acknowledge one relatively minor problem (Greece’s insolvency) by putting so much of a burden on the shoulders of the problematic EFSF that a much greater problem was created (Italy’s and Spain’s liquidity-cum-solvency crisis). Lo and behold, the Italian and Spanish sovereigns were thrown in sharp turmoil two days later. During the summer, while on their holidays, Europe’s leaders knew they would have to go back to the drawing table come September. Indeed, by the time the leaves had turned brown, not only were Italy and Spain in the sin bin but, to boot, Dexia’s collapse had heralded the beginning of the unfolding of the eurozone’s banking sector. And when Secretary Tim Geithner and President Obama, aided and abetted by the rest of the G20, put it to the Europeans that they had a week to get their act together, Europe got into gear to produce what we now know as the Brussels’ Agreement. Their task was to deal at once with three related problems: Europe’s collapsing banking sector, the problem with Italian and Spanish sovereign debt (and their potentially catastrophic effects on France’s triple-A rating which would, in turn, wreck the EFSF), and the derelict Greek economy. After days and nights of deliberations, the Brussels Agreement was patched together. On that night, after having read the preliminary document, this was my verdict: Not one of these [nb.the eurozone's three problems] was even remotely tackled last night. The banking sector required aggressive, compulsory recapitalisation at a central European level. It will not happen. (Not only is the sum set aside to feeble but, primarily, the bankers will be given multitude chances to wriggle out of losing control over their bankrupt banks through various means that will render recapitalisation a dead letter.) The EFSF-on-anabolic-steroids (which is what its private capital leveraged version will turn it into) that has been announced will neither lessen the burden on Italy (nor remove the dark clouds over France). Lastly, the Greek haircut is a mere empty shell of a number (50% is the rule of thumb agreed on in the early hours of the morning, just in order to have a number) since it is predicated upon a series of ludicrous assumptions and deals that deals with the bankers that politicians are nowhere near completing. Now that the dust has settled, and new governments are emerging in Greece and in Italy, with the express purpose of endorsing the Brussels Agreement, it is time to take a closer look at what this Agreement is meant to do to tackle each of these three problems.

The Agreement’s First Aim: To re-capitalise Europe’s banking sector
After having, at long last, acknowledged, that Europe’s banks are in desperate need of recapitalisation, the Brussels Agreement allegedly set aside up to €110 billion for the purpose. This sounds reasonably encouraging, despite the low sum (which according to the IMF ought to be at least €200 billion; or three times that if we take into consideration the special vehicles that our wise bankers have created since 2009 and which multiply by a factor of around 5 the banks’ exposure to bad debts and assorted losses). Ignoring for the moment the low sum allocated in the Brussels Agreement to the banks, the real cause of concern lies elsewhere. First, it lies in the stated target and, secondly, in the proposed means (by which the recapitalisation will be implemented). So, let’s begin with the objective of the exercise. It is, reportedly, to raise the banks’ capitalisation ratio to 9% over their assets/exposure. This constitutes a tragedy in the making. Let me explain. Ratios sport a numerator and a denominator. If one wants to bring a ratio closer to a certain figure, it is possible to do it either by adjusting the numerator or the denominator (or, of course, both). Sometimes, grand failure results when the policy or decision maker adjusts one assuming falsely that the other will remain constant. [For example, in recessionary environments, governments trying to reduce the debt-toGDP ratio find that austerian attempts to shrink the numerator lead to faster diminution of the denominator (as the recession takes its toll), the result being a stubborn debt-to GDP ratio.] In the case of Europe’s banks, the repercussion of using the capitalisation ratio as the policy target is bound to be detrimental to the real economy. Bankers have already warned us: They will do all they can to avoid taking on new public capital. Which means, naturally, that (since the private sector will not give them any capital, courtesy of their parlous state), the only way they can achieve the 9% capitalisation ratio is by shrinking the… denominator. What does this mean? It means that they will try to sell their loans, their derivatives, their paper assets in general to whomever wants to buy. At the same time, they will avoid issuing of new loans like the plague (since loans increase the denominator). The effect of these moves will be massively to reduce liquidity in the marketplace at a time when the eurozone is entering a new recessionary phase. In short, if the Devil wanted to push Europe into a sea of even greater troubles, he could not have chosen a policy target (regarding the banking sector) better than that we find in the Brussels’ Agreement. But there is more grief where the above came from: It appears once we delve into the means by which the 9% capitalisation ratio will be achieved. According to the Brussels Agreement, there will be three stages which must be completed by next summer. First, banks will be asked to seek more capital from private investors. [This is absurd, since no sensible private investor will ever invest in insolvent banks - unless they get a controlling stake that the current bankers will not want to part with.] Secondly, if the banks cannot secure private capital injections [which they will not!], then they must turn to their national governments for capital. And, thirdly, if the latter are bankrupt or fiscally strained themselves (as all of them are), the last port of call is the EFSF. The problem with this process is twofold. First, in the hypothetical scenario that the bankers accept public money, even EFSF money, these sums will be added to the already strained public accounts of the relevant member-state. Yet another migration of the same problem that keeps toing and froing between the private and the public sector. Secondly, as mentioned before, bankers will fight tooth and nail to avoid public capital which will dilute their own control over the banks preferring instead to reduce their assets’ book. So, the three step process envisaged by the Brussels Agreement will give bankers the excuse they need to delay any talk of taking on new capital. In effect, they were given around ten months during which to shrink their loan and assets’ book while taking on only a minimum amount of public capital. Verdict: The Brussels Agreement will lead banks to take steps which reduce liquidity, fan the fires of recession throughout an already euro-system and, crucially, prevent any serious re-capitalisation of our ailing banking sector.

The Agreement’s Second Aim: To revive comatose Greece
The centrepiece of the Brussels Agreement is, just like that of the 21st July Agreement, its proposed Greek rescue. Much of it centres around the 50% haircut of pre-May 2010 bonds that have not matured yet – and which have not already been bought by the ECB (which somehow places itself over and above other bondholders of Greek debt). As we all know, Mrs Merkel burnt the midnight oil, with Mr Sarkozy and the bankers shop steward, a certain Mr Dallara, in negotiations the purpose of which were to lean on the latter to accept that the haircut be declared ‘voluntary’ (so as to prevent the triggering of the CDS’ issued in the past couple of years on Greek debt). Mrs Merkel’s negotiating strategy was simple: “Consent to a 50% haircut or take the blast of a full 100% insolvency.” Unsurprisingly, Mr Dallara relented. There are a number of unresolved issues here but, nevertheless, we already know enough to reach a rather depressing verdict on the chances of the Greek economy even if the Brussels Agreement is implemented to the full and even if the accompanying (exuberant assumptions) are confirmed in practice. To cut a long story short, the agreed haircut will prove an insignificant relief for Greece (another case of too little too late) while the extra austerity that will be traded for it (and imposed on the new government in return for the haircut-loan package) will eat further into Greece’s GDP. In short, it is my estimate that, even if all goes according to the Brussels Agreement plan, Greece’s debt-to-GDP ratio will remain well above 140% by 2020 while the much needed GDP growth will be nowhere to be seen. Soon, perhaps within six months, another Crisis Summit will have to be convened to find yet another ‘final solution’ to the Greek debt debacle. Ironically, the only reason why such a Summit may prove unnecessary is that the euro-system may have imploded for reasons to be found in its other constituent parts. But even under less dramatic circumstances, the Greek part of the Brussels Agreement will be neither here nor there if the other two planks (bank recapitalisation, see above, and the EFSF’s makeover, see below) fail. Just like the Greek part of the 21st July Agreement meant nothing once Italian and Spanish debt blew up, so with the Brussels Agreement the whole deal on Greece will be confined to the dustbin of history if something similar obtains in the banking sector, in the EFSF’s finances, in France’s triple-A rating, in Italy’s and Spain’s refinancing efforts etc. But let’s, for argument’s sake, concentrate on the Greek situation alone, assuming that which we cannot, wisely, assume: that the other two parts of the Brussels Agreement hold together. What would the Greek haircut plus the new loans achieve? The official story is that it will shave off around €100 billion of the Greek outstanding debt. Sounds impressive? Yes, but wait. Things appear quite different upon closer scrutiny. For in order to entice Mr Dallara, Mrs Merkel threw in a ‘sweetener’, in the form of around €30 billion. Of this, €15 will be produced by the Greek state through privatisations [which with every day that goes by require flogging harder the dying horse of Greece's public assets] and another €15 billion which will be borrowed by… Greece (from the EFSF). The sum of €30 billion will then be invested in the usual kitty of AAA-rated assets to be held aside as collateral (in case the Greek state fails to repay even the remaining 50% of the bonds’ value). In short, the haircut is going to reduce Greece’s public debt, at best, by €70 billion. That is an effective debt reduction of less than 19%, in terms of Greece’s debt-to-GDP ratio (the overall €380 billion outstanding debt will shrink, at best, to €310 billion while GDP, already down to €217 will have shrunk to €206 in 2012). In short, a pittance. Much ado about nothing. All this commotion, and the late night negotiations, in order to reduce Greece’s debt-to-GDP ratio to… 140%. While the meekness of the proposed haircut is, obviously, a problem, it is not the only one. The main source of concern is the insistence that the haircut be pronounced voluntary. Securing the consent of the bankers means that the haircut is not sufficiently deep (see previous paragraph). Far more worrying however is the following: Since the Brussels Agreement was announced, a number of hedge funds have been purchasing Greek government bonds (especially those that will be maturing in 2012 and 2013). Why? Because they are planning to call the Europeans’ bluff. If, indeed, the haircut is to be declared voluntary, there is nothing to stop the hedge funds that have just purchased Greek bonds at 35% of their face value from demanding full payment, threatening to go to the IDSA to have the haircut declared involuntary (thus triggering the feared CDSs) if their demand for full payment is not met. If their stratagem works (And it will work if the Brussels Agreement is implemented successfully) Greece’s debt relief will fall much below the €70 billion sum! The idea of suppressing the CDSs’ triggering, by leaning on the banks, undermines well and truly the Brussels Agreement strategy for dealing with the Italian and Spanish debt crisis – see below. Lastly, while it is clear from the above that the haircut is woefully inadequate as a means of dealing with the Greek debt, the new round of austerity measures that are part and parcel of the Brussels Agreement, especially in the absence of any tangible commitment on the investment front, border on the criminally negligent. To put it bluntly, they shall guarantee an acceleration of the freefall of Greek GDP to a level that may well fall below €200 billion, at a time when public debt will be floating above €350 billion (once the new loans, the sweeteners for the banks aand the full repayment of several hedge funds are taken into account). In short, the international (and Greek) press tell their readers/audience that Greece’s ‘salvation’ is predicated upon accepting and implementing the Brussels Agreement. I beg to differ. In view of the above, a Greek consent to the Brussels Agreement strategy for dealing with the Greek debt crisis is equivalent to a nation’s suicide. The obvious alternative is to default within the eurozone (a 100% haircut on pre-May 2010 issued bonds), to utilise all proceeds from privatisations internally, and to cut all sector pay in a top-down fashion till the government’s accounts are balanced. Verdict: The Brussels Agreement will lead Greece further into the mire, wrecking not only what is left of the Greek social economy but, perhaps more significantly from a N. European perspective, destroying the remnants of Europe’s policy-making credibility both with electorates and markets.

The Agreement’s Third Aim: To prevent Italy’s and Spain’s exit from markets 
This was always going to be the greater of the three tasks, in view of Germany’s steadfast objection to having the ECB monetise any part of these countries’ debt, either directly or indirectly (via leveraging the EFSF). The question is: How can the remaining €240 billion of EFSF guarantees stretch to plug a €3000 billion hole without the ECB’s involvement? The answer, of course, is that it cannot happen credibly and the evidence comes in the form of the skyrocketing spreads ever since the Brussels Agreement was signed and announced. According to the Brussels Agreement, the EFSF will try to fulfil this Herculian task in two ways. First, by offering ‘first loss’ insurance to investors buying Italian and Spanish bonds up to and including a haircut of 20%. In other words, anyone purchasing a fresh issue of such bonds will be insured by the EFSF for a loss of up to 20% of the face value. In effect, this amounts to a digital CDS insurance contract (digital in the sense that they either pay the full loss or nothing) to be offered free of charge by the EFSF, on behalf of the eurozone, to anyone purchasing these unwanted bonds. The hope is that these bonds will, all of a sudden, become desirable. Secondly, the EFSF, a Special Purpose Vehicle (SPV) set up by the EU in May 2010, will set up… another SPV which will attract (or try to attract, more like it) private funds which, in conjunction with some of the EFSF’s own capital, will be used to re-capitalise the banks, assist Greece, continue lending to Ireland and Portugal etc. Here are some reasons why this pig will not fly: Investors are being asked to assist the eurozone twice: First, to provide capital to the EFSF so that the EFSF can issue the digital CDSs for fresh Italian and Spanish bonds. And, secondly, to buy these same bonds! Investors are being asked to behave foolishly: On the one hand to accept the idea that holders of Greek debt are forced by the EU to accept a 50% haircut without the benefit of the payouts they were expecting from the CDSs they purchased together with the Greek bonds while, at the same time, trusting the EU’s own issue of digital CDSs on future Italian and Spanish bond issues. The world in general, and China in particular, is expected to turn a blind eye to the toxic nature of the EFSF which means that either it is too small to deal with the capital black holes facing the eurozone (both its sovereigns and its banks) or its impact will be too toxic if it is given a large sum to play with. Verdict: The Brussels Agreement comes hot on the heels of the 21st July Agreement which pushed, unwittingly, Italy and Spain off the proverbial cliff. And instead of pulling them out of the ravine, the Brussels Agreement amounts to an official declaration that Europe cannot help these two countries. The very allusion to potential help from China and the IMF amounts to a declaration of failure. What followed in the Italian bond auctions after the announcement of the Brussels Agreement was a foregone conclusion. 


Concluding remark - Greece and Italy are in the process of acquiring technocratic governments the stated purpose of which is to ensure that the Brussels Agreement is implemented. If my analysis above is right, their task is hopeless. Technocrats may serve a purpose when working from a rational engineering plan. But when the plan is of the sort discussed here, they are bound to oversee the collapse of the very euro edifice that they were summoned to save. They will then be remembered as Europe’s reverse alchemists (who started with a nugget of gold which they then, almost mysteriously, turned into a piece of lead.).