Based on the latest discoveries, such as the recent pictures from the European Space Agency, scientists are concluding that the universe is not inflating quite as fast as they previously thought. And so too, back here in on Earth, we are finding things are not quite as they may have appeared. The attempt to reflate the world economy is proving more difficult.
Many European officials had recently been congratulating themselves that the European crisis had passed. The Outright Market Operation facility, brandished but not triggered, and forbearance by EU officials appeared to have turned the corner. Yet this was just another swing of the European pendulum. Each time unresolved issues flare up, officials put it out and in doing so think they have put the fire out. They have not.
After relatively easily absorbing the inconclusive Italian elections and the rejection of the terms of the first aid offer to Cyprus and the brokering of another deal, the markets had a more dramatic reaction to the suggestion that Cyprus may be a template for future aid packages. This spooked market participants who sent Italian and Spanish equities, and especially bank shares, sharply lower. European peripheral bond markets sold off. The euro fell to new five month lows against the dollar.
1. Many observers continue to under-estimate the political will of the European elite for EMU to succeed. As Fed Chairman Bernanke observed, there are no ideologues in a crisis. European officials are willing to sacrifice many sacred cows on the altar of EMU. It is an evolving situation, and as more institutional capacity is innovated, the range of the policy response can be enlarged. There remains among the commentariat class a profound skepticism of the EMU's viability, especially it seems in the Anglo-American traditional and social media. Many thought Greece was going to be jettisoned in 2011 and 2012. Some gave it weeks or months to survive a year ago. They greet each problem and official misstep with a cry that the end is nigh. Yet there is no Plan B and without a compelling alternative vision, Plan A persists.
2. In order for the EMU to survive, it will be shaped by the most powerful interest, which is Germany. As the US pivots toward Asia and the UK threatens to leave the EU, the centuries-old balance-of-power politics is giving way to a German-led block. Its ideology of ordo-liberalism advocates a strong state and strong markets, as opposed to the Anglo-American neo-liberalism, which allows for a smaller role for the state. There is a sense in some of the local press that Germany is fatigue of aid and it is not coincidental that the Bundesbank just made public a report that has been available for several weeks showing that, due to home ownership rates, many Europeans, include Spaniards on average, are richer than Germans. Of course, political sensibilities are running high as the national election draws nearer (in September), and the first German party to officially advocate leaving EMU, has been launched. At the same time, the cost to Germany has thus far been quite limited and what de minimis funds it has had to raise has been more than offset by the government's lowering borrowing costs and interest on its loans.
3. We have been arguing for some time that the Troika is not the united front it previously was. The Cypriot crisis has brought this issue to the surface and many now share our insight The EC would seemingly be content for Europe to deal with the issue alone, which is easy enough after the IMF has generally assumed the funding of roughly a third of the aid packages. Germany, which initially did not want to include the IMF, now sees it as an ally. The ECB has shown itself to be willing to use the leverage it has (such as granting Emergency Lending Aid by the national central banks and definition of acceptable collateral) to pursue its interests.
4. Germany and the IMF have long wanted to increase the private sector burden sharing when aid is needed. Brussels has been a reluctant party. Germany and the IMF are winning that fight. There is an established order of seniority (in practice if not in law) for cases of insolvency. In Cyprus, the initial plan, proposed by the newly elected Cypriot President, and agreed to by the Troika and Germany, was a violation of this by taxing small depositors while equity investors and unsecured creditors were kept whole. However, the new plan exempts small depositors and hits shareholders, bondholders and uninsured depositors. European officials seem to have greater confidence increasing the role of the private sector aid programs.
5. It is not yet clear the extent or duration of the capital controls. Some observers are arguing that capital controls are a violation of the governing treaties, and because one cannot take unlimited amount of funds out of Cyprus at the moment, it means that this marks the end of the monetary union. They suggest that now the euro in Cyprus is worth less than the euro elsewhere. We do not find that logic compelling, based on what we currently know about the controls. We accept that there may be unintended consequences and the situation can evolve into something different, but presently, we do not see these administrative measures, as inconvenient as they are, to be tantamount to the introduction of a Cypriot euro.
6. Cyprus is going to face a deep and prolonged adjustment process. In the global division of labor it was an entrepot, providing commercial and financial services. Broadly understood to include finance and insurance (9.2% of GDP), real estate and construction (17.8%) and wholesale and retail trade (23.2%), it accounted for nearly half of the Cypriot economy in 2012. Manufacturing only accounted for 5.9% of the value-add of the economy, which is down from 9.5% in 2000 and 7.2% before the financial crisis. It simply does not mean that manufacturing capacity can export its way to growth. This suggests that whether inside EMU or out, there is a painful restructuring process ahead. What ails Cyprus is not that its currency is too high. It is that its developmental model, which leaves aside whether it is a low tax jurisdiction (complying with the global standard for tax cooperation and fully aligned with Code of Conduct for Business Taxation of the EU and the OECD) or a tax haven, as the German narrative suggests.
7. As has been the case since the crisis first erupted, European officials, the IMF (and many private sector economists) have over-estimated growth in the stricken countries. This has serious implications for trying to stabilize the debt/GDP ratio, which seems the official goal - putting countries back on sustainable fiscal trajectories. The risk is that adjustment in the Cypriot economy is so severe that the economy contracts sharper than officials forecast. The bottom line is the downside risks to the economy mean that this aid package may not be the last for Cyprus.
8. What appears to be large natural gas and oil fields on its continental shelf suggests the way forward. However, this may prove more mirage than reality for years to come. The problem is arguably more about politics than economics. One of the strategic errors of European officials was allowing Cyprus to join its clubs (EU and EMU) without uniting the island. That should have been one of the prerequisites but that would have forced European officials into compromising with Turkey, perhaps over EU membership, which it was not prepared to do. In addition, getting the gas to market is more difficult and costly (relative to the size of the Cypriot economy) than often acknowledged.
9. Cyprus 2.0 was constructed in a way that allows an end-run around parliament. This is a shame and ultimately counter-productive. The lack of democratic legitimacy means that it will always taste like foreign imposition. It means that parliament will not take ownership for the program. It also shows that European officials to be still tone deaf, seemingly failing to realize monetary union is an elitist project and without strong public support is vulnerable to various populist movements from both the right and left.