Eurozone Populism Wins Even As It Loses

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Includes: ADRU, DBEU, DBEZ, DEZU, EEA, EPV, EURL, EZU, FEEU, FEP, FEU, FEUZ, FEZ, FIEE, FIEU, GSEU, HEDJ, HEZU, HFEZ, HFXE, HGEU, IEUR, IEV, PTEU, RFEU, SBEU, UPV, VGK
by: Adam Whitehead

Summary

Mario Draghi temporarily resists German attempts to accelerate the discussion about the removal of ECB monetary stimulus.

The case of Montei dei Paschi sets a moral hazard precedent for the Eurozone bank bailout process and exposes the conflicted and compromised ECB.

Progress on deeper economic union remains elusive so that the shaky economic status quo remains the best possible outcome.

Corruption and nepotism in economic policy making are being exposed at a time when the Eurozone Project is going through a mandatory personnel change.

Positive perceptions of the Eurozone political and economic landscape do not discount the probability that European Populism is only in its early stages.

(Source: Bloomberg)

Speculators and policy makers in the Eurozone are mutually reinforcing the view that Populism is in retreat and all is well. It may be better to travel than to arrive at these conclusions which may be premature.

The Bundesbank has now moved from a position of accepting the need for continued ECB monetary policy expansion to calling for it to be scaled back. In a recent comment, Bundesbank President Jens Weidmann did not mince words and stated that: "I would like to see a less expansive stance". ECB Executive Board member Sabine Lautenschlaeger immediately endorsed Weidmann's call, but tempered her enthusiasm by saying that whilst it is currently premature to reverse the stimulus it should be done as soon as is practicable. The Bundesbank's position was echoed by the Netherland's central bank, when ECB Governing Council member Klaas Knot suggested that, when the stimulus ends in December 2017, it should immediately be followed by the beginning of withdrawal from QE.

The German led attack on QE was swiftly countered by Governing Council member Jan Smets, who dismissively referred to it as a dissonant "minority" view whilst affirming that the ECB will stick to its guidance on expanded monetary policy this year. Smets was supported by Governing Council member Erkki Liikanen, who insisted upon staying with the current policy commitment and guidance; in order to remain consistent with the current low inflation economic conditions. Governing Council member Ewald Nowotny then joined this growing chorus when he said that: "The strategy for 2017 has largely been set and from my point of view there is no reason to depart from this." Just as German pressure for a scaling back of monetary stimulus was rising, the latest incoming Eurozone inflation data provided support for Mario Draghi's position. This deceleration in inflation was highlighted by Governing Council member Bostjan Jazbec as justification for the ECB's commitment to retain an expansionary policy.

ECB Executive Board member Benoit Coeure chose his German putdown rhetorical words more carefully than his Dovish Governing Council colleagues. As an Executive Board member he can afford to be more conciliatory, since this position does not set monetary policy. He was also careful to evince some kind of objectivity, in order to preserve the charade of corporate governance best practice at the ECB. Accordingly, he therefore said that the German raising of concerns is "legitimate" however premature.

Mario Draghi tried to effectively draw a line under the debate, with his latest communication that inflation is not yet strong enough to warrant any change in monetary policy for the foreseeable future. Within hours of Draghi speaking, the defiant Weidmann responded that a discussion over the end of QE is still "legitimate" in his view. ECB Vice President then tried to further downplay the controversy, by stating that "There is a wide consensus around the policies that we have been pursuing." The issue is remains unresolved and will drag on.

The debate may still roll on, not just because of Weidmann but, also because of the technicalities of the current bond buying programme. ECB Chief Economist Peter Praet has identified this new risk to the expanded monetary policy story from the ECB's own market operations. In the near future, the incremental size of the latest QE security purchases will be stepped down from 80 to 60 Billion Euros. Praet was swift to opine that this incremental contraction does not signal a reduction in QE. This message will need to be emphasized in the future, when the incremental reduction in buying occurs.

The last report observed the unfolding plan to deal with Eurozone banking sector's non-performing loan (NPL) problems. This plan was contrasted with Mario Draghi's warning to European nations not to game the system, by rolling back economic reform in this year of national elections. It was concluded that, given his prime directive to save the Eurozone at all costs, Draghi's bluff will be called and the ECB will willingly get abused.

Italy may be the first example of this abuse. In addition to an upcoming unorthodox bank recapitalization process, the government has now hinted that it is backtracking on its privatization commitments. The budget deficit will therefore get pushed even further into the red by a state bailout of the banking system which is not balanced by the shedding of some state liabilities through the privatization process.

Elke Koenig, the head of the Single Resolution Board (SRB), which will oversee the process of dealing with the NPL issue, recently gave some interesting signals on where the process is currently at. Consistent with the ECB's blanket assessment, that there are no insolvency issues, she affirmed the general health of the banking sector; whilst admitting that there are still legacy issues to be dealt with. These legacies were also identified by European Commission Vice President Valdis Dombrovskis rather than new signs of crisis. In her opinion, the best way to address these legacies is through cross border mergers and acquisitions. What she is therefore advocating is that the strong Northern European banks, buy their weaker Southern brethren. Populism and national interests will however pushback against this mechanism. It is therefore likely that national taxpayers will be used to bail out their banks, thus strongly vitiating against the prime Eurozone directive to deepen economic union. Once again it can be seen, as Draghi warned against, that Eurozone countries are only capable of preserving the shaky economic status quo. A deeper integration that consolidates and strengthens the economic foundations of the project remains as elusive as ever.

Evidence from Italy, regarding the intended state bailout of Montei dei Paschi di Siena recently provided a classic example of how this ritual abuse of the ECB will occur, throughout the process of dealing with the banking sector's bad debt problem. The ECB Supervisory Board ruled that the bank is solvent, after performing stress tests. This ruling was however qualified with the big disclaimer that the solvency was predicated on an overly optimistic valuation of the bank's non-performing loans. The ECB may also have perjured itself however, thus leaving it open to manipulation, because it failed to opine on the fact that Montei dei Paschi then used the clean bill of solvency health to jam inappropriately structured and valued junior bonds into retail investor accounts to bolster its capital position. A systemic fraud may have occurred with the ECB complicit in the scam.

If the bank were insolvent, then the ECB would have to announce this and then put the bank through a recapitalization process that would involve the bail-in of private creditors. At this point, the retail junior bondholders would no doubt contact their lawyers and scream fraud. A disingenuous compromise has therefore resulted in which the bank has been classified by the government as deserving of a state bailout, even though the ECB opines that it is solvent. The over-valued bad loans at the heart of the potential fraud are the common denominator that underpin this compromise. This method of bank capital casuistry rather than adequacy was then replicated by the ECB, for Banca Popolare di Vicenza SpA and Veneto Banca SpA in order to receive the same preferential taxpayer support treatment; suggesting that this is the model that will be rolled out in Italy and the wider Eurozone if and when needed.

Evidently, the ECB is feeling very uneasy about the way it has been fooled into enabling the bailout of the Italian banking system that is not officially a bailout. Executive Board member Yves Mersch tried to exonerate the ECB by opining that: "This is a process that is still underway," and also that "The ECB is involved from the point of view of supervision but we have a strict separation between the supervisory side and the monetary policy side." Perhaps he should have said "fool me once shame on you, fool me twice shame on ECB"!

(Source: Bloomberg)

The options market is now starting to discount a positive outcome, for the resolution of the Eurozone banking sector's bad debt problems, in addition to the potential for healthier lending margins when the ECB finally normalizes. The risk of Populism is also being gradually taken out of risk premiums. Looked at from another perspective, one could also say that the options market may also be starting to discount the probability that the Eurozone banking sector is too big to fail; and will therefore be saved by a combination of the Eurozone taxpayer and the ECB.

(Source: Seeking Alpha)

The ECB Supervisory Board is compromised and can only opine its dissatisfaction with the state aid process. This process thus serves a template for the ritual abuse of the ECB and national taxpayers that will be rolled out across the Eurozone banking sector. A previous report explained in detail the broken governance structure within the ECB. This broken governance structure allows for the Governing Council to drive policy crafted subjectively by Mario Draghi. In relation to the resolution of the banking sector's bad loan problems, this broken governance has allowed for national governments to game the rules on capital adequacy.

(Source: Handelsblatt)

Moral hazard in monetary policy and macroprudential regulation is endemic and institutionalized at the ECB, as a consequence of the prime directive to save the Eurozone at all costs. As with all similar episodes of moral hazard, taxpayers ultimately pay the final price for bailouts in relation to macro-prudential moral hazard. In relation to monetary policy moral hazard, the same taxpayers pick up the bill as consumers and holders of debased currency. The ECB's embrace of poor governance, has enabled the rise of Populism which may ultimately be the central bank's undoing as Handelsblatt recently warned.

An ECB staff survey conducted in 2015 showed 65 per cent of respondents chose "knowing the 'right people'" as a way of getting ahead at the central bank a higher proportion than any other factor. The problem of poor governance is well known by the ECB's own staff, even if is ignored by its own executives and Eurozone policy makers. It is therefore not hard to identify the source of the culture that enables the moral hazards opined previously.

(Source: Globe and Mail)

A new scandal is already unfolding at the Executive Board level. It should be remembered that both the Executive Board and Governing Council are chaired by Mario Draghi. The latest scandal exposes how rampant nepotism has replaced core competences in the hiring and promotion of ECB personnel in Brussels. Opining on this scandal, the Global Watchdog Transparency International recently stated that the ECB needs to become more transparent and accountable, including by overhauling its "outdated" framework for whistleblowers to denounce conflicts of interest, corruption and other wrongdoing. Perhaps the cause of Eurozone reform that Mario Draghi proselytizes in earnest should begin a little closer to home.

This expose of nepotism and corruption at the heart of economic policy making comes at an awkward time for the Eurozone. The national elections this year will be an opportunity for Populists to exploit the negative headlines. In addition, the process which institutionalizes these nefarious practices is also up for a renewal of personnel. A continuation of arcane corrupt practices, during this personnel change, in the spotlight of the recent scandals would be ill considered.

At the Eurogroup level the current leader Jeroen Dijsselbloem may lose his job, by nature of the trouncing his own party received at the Dutch polls in addition to the inflammatory comments he made about how Southern Europeans spend their money. His continued membership of the policy making executive in any formal capacity would evince the kind of nepotism from Core Europe, that it complains about in Southern Europe. The bigger picture of hypocrisy would not be lost on the Populists.

The presidency of the European Investment Bank (EIB) becomes vacant in May 2018. France's Daniele Nouy will leave her position as chair of ECB's Single Supervisory Mechanism at the end of 2018. The ECB will lose its arguably three most influential members of its six-person Executive Board in 2019. Chief Economist Peter Praet of Belgium leaves at the end of May, Mario Draghi retires five months later, and France's Benoit Coeure goes at year-end. Both Southern and Eastern Europe have demanded representation in these vacant positions, in rather the same way that emerging market nations wish to have greater representation at the IMF. Failure to recognize the legitimate demands for a policy making voice from these nations, would weaken the cohesion of the Eurozone.

The political centre of Eurozone gravity, which then influences how the unelected policy executive is composed, will therefore be in a state of flux between now and 2019. The timing is awful, given the new challenges of Brexit and President Trump in addition to home grown Populism. At the same time, the opaque methods by which Eurozone governance is created and executed are under a brightening spotlight, that is exposing some of the more suspicious practices.

Currently, observers are discounting the defeat of Populism after the Dutch elections and extrapolating this into the French elections and across the Eurozone in general. In practice however, Populism is in fact not being defeated but rather it is being embraced by the Eurozone political establishment in order for them to survive. Even though Populists may lose at the polls, Populism has in fact won at the institutional policy making level. If markets believe that Populism is bad for the global economy, they are not currently expressing this view in their trading and investing behavior.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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