August 5, 2012 8:18 pm

The silent Rajoy is deaf to the Spanish emergency

Man with shovel, pfeatures©Matt Kenyon

About this time two years ago in Dublin, it was hard to escape the talk of bondspreads” and “yields”, as the soaring cost of Ireland’s borrowing entered the twilight zone beyond which lay an autumn rescue package from the International Monetary Fund and the EU. So it is now in a hot and febrile Madrid, where seemingly everyone is fixated by the prima de riesgo or risk premium on Spanish government bonds over German Bunds. Spain looks to be in a similar fix to Ireland, stumbling towards some sort of EU bailout this autumn.

The extent to which the government of Mariano Rajoy – or any Spanish government in these circumstances – can be considered master of its own fate is limited. As Spanish borrowing costs reach euro-era highs, the markets are not just placing bets on Spain (or Italy) but on the survival of the euro. This administration, in power for a little more than seven months, already has the feel of a government approaching the end of its term.

Since winning an absolute majority last year, Mr Rajoy’s Partido Popular has liberalised rigid hire-and-fire laws, started (albeit belatedly) to clean up regional savings banks crippled by overexposure to the burst housing bubble, slashed public spending and raised taxes. While all this has won plaudits in Brussels and Berlin, it clearly does not feel like a viable programme for recovery to a surprisingly broad spectrum of Spaniards. Among the middle classes of Madrid, Barcelona and Bilbao, there is a pervasive sense of a government losing control. Even though so much about Spain’s future depends on its eurozone partners, this is an odd situation to be in for a newly elected, majority government.

One distressed PP insider says of Mr Rajoy: “He is the wrong man, in the wrong place at the wrong time.”

There have been policy mistakes and errors of judgment. The handling of the now nationalised Bankia, a botched merger of savings banks laden with toxic property loans, has been disastrous. The consequent €100bn EU package Spain needed to recapitalise its stricken savings banks was then sold to the public as soft loans Mr Rajoy artfully negotiated to break the blockade of the markets, rather than a strictly conditional, if partial, rescue scheme.

Indeed, an increasingly alarming feature of the Rajoy government is its inability to grasp that the world is listening to what it says as well as watching what it does. One sometimes gets the impression that Rajoy speaks in public as if he was addressing a parish where the internet has yet to arrive,” Jesus Ceberio, a former editor of the daily El País, wrote last week.

On top of the prima de riesgo, the government has taken to inflicting on itself gratuitous additional premiums. Cristobal Montoro, finance minister, said last month the government would not be able to meet the public sector wage bill – on the eve of what would turn out to be a very expensive bond issue. José Manuel García-Margallo, foreign minister, followed this by rubbishing the European Central Bank, an institution standing between Spain and the abyss, as “a clandestine bank”. To round it off, Valencia, a rickety regional government ruled by the PP, further panicked investors by announcing it was broke – while the markets were still open.

Mr Rajoy himself speaks rarely, in parliament, in public, or to the press. When he does, it is of itself top news, independent of anything he actually says. Some of the coverage of his performance at a press conference last week alongside Mario Monti, the Italian prime minister, read like theatre reviews.

When the government rammed through by decree last month’s €65bn austerity package, Mr Rajoy was absent from parliament. When he announced the measures earlier, each cut was rapturously applauded by government MPs, one of whom greeted benefit cuts for Spain’s legions of unemployed by saying que se jodan (let them screw themselves).

While few question the democratic legitimacy of a government with a majority in parliament, many do question its democratic sensibility – and it surprised no one, except perhaps the PP, that within hours this contemptuous epithet turned into a slogan rallying protesters against the cuts all over the country.

Mr Rajoy’s style of government is another problem. Despite his absolute majority in parliament, he prefers to rule by decree. Oddly, for someone who favours centralised and secretive control, he has three competing voices on the economy: Mr Montoro at the treasury, former Lehman’s banker Luis de Guindos at the economy ministry and Alvaro Nadal, his German-speaking adviser.

Yet it is his failure to even try to rally the countrytrapped in a downward spiral of debt and deflation – that is really damaging. Last Friday, Mr Rajoy made his first appearance since taking office at the government’s weekly press conference, but he recoils from addressing the nation.

He seems deaf to growing calls for a national pact to confront the economic emergency, analogous to the 1977 Moncloa Pacts that helped chart Spain’s path to democracy, but to include unions and employers as well as all parties including Basque and Catalan nationalists.

Also for the first time on Friday, Mr Rajoy openly contemplated the possibility of a full EU rescue. If that is what is on the cards, then it is time for a multi-party national pact, which the government should treat not as a sign of weakness, but as vital ballast to steady Spain through the storm.

Copyright The Financial Times Limited 2012.


Why Eurobonds are Un-American

Daniel Gros
03 August 2012

BRUSSELS – The emerging consensus in Europe nowadays is that onlydebt mutualization” in the form of Eurobonds can resolve the euro crisis, with advocates frequently citing the early United States, when Alexander Hamilton, President George Washington’s treasury secretary, successfully pressed the new federal government to assume the Revolutionary War debts of America’s states. But a closer look reveals that this early US experience provides neither a useful analogy nor an encouraging precedent for Eurobonds.

First, taking over a stock of existing state debt at the federal level is very different from allowing individual member states to issue bonds with “joint and severalliability underwritten by all member states collectively. Hamilton did not have to worry about moral hazard, because the federal government did not guarantee any new debt incurred by the states.

Second, it is seldom mentioned that US federal debt at the time (around $40 million) was much larger than that of the states (about $18 million). Thus, assuming state debt was not central to the success of post-war financial stabilization in the new country; rather, it was a natural corollary of the fact that most of the debt had been incurred fighting for a common cause.

Moreover, the most efficient sources of government revenues at the time were tariffs and taxes collected at the external border. Even from an efficiency point of view, it made sense to have the federal government service public debt.

Federal assumption of the states’ war debts also yielded an advantage in terms of economic development: once states no longer had any debt, they had no need to raise any revenues through direct taxation, which might have impeded the growth of America’s internal market. Indeed, after the federal government assumed the states’ debt (already a small part of the total), state revenues fell by 80-90%. The states then became for some time fiscally irrelevant.

Finally, the key to the success of financial stabilization was a profound restructuring. Hamilton estimated that the federal government could raise enough revenues to pay approximately 4% interest on the total amount of debt to be servicedsignificantly less than the 6% yield on the existing obligations.

Holders of both state and federal bonds were thus offered a basket of long-dated bonds, some with an interest rate of 3%, and others with 6 % (with a ten-year grace period). The basket was designed in such a way as to result in an average debt-service cost of 4%. In modern terms, the “net present value” of the total debt (federal and state) was reduced by about one-half if one were to apply the usual exit yield of 9%.

Moreover, the new federal bonds’ very long maturities meant that there was no rollover risk. It would have been very dangerous to expose the federal government to this danger, given that the operation was rightly perceived at the outset as extremely risky.

For the country’s first few years, debt service swallowed more than 80% of all federal revenues. The slightest negative shock could have bankrupted the new federal government. Fortunately, the opposite happened: federal revenues tripled under the impact of a rapid post-war reconstruction boom, and continued to grow rapidly, aided by the country’s ability to remain neutral while wars ravaged the European continent.

By contrast, growth prospects in Europe today are rather dim, and interest payments, even for Greece or Italy, account for less than 20% of total revenues. The real problem is the rollover of existing debt in a stagnating economy. For example, Italy will soon have a balanced budget in structural terms, but must still face the problem of refinancing old debt as it matures each year.

Assuaging doubt about the sustainability of public debt in the eurozone would thus probably require a deep restructuring as well. The eurozone crisis could certainly be resolved if all existing public debt were transformed into 20-year Eurobonds with a yield of 3%, and a five-year grace period on debt service. One can easily anticipate the impact that this would have on financial markets.

More interesting in view of the current situation in the eurozone is what followed roughly a half-century after Hamilton acted. In the 1830’s and 1840’s, a number of states had over-invested in the leading transport technology of the timecanals. When the canal-building boom ended, eight states and the Territory of Florida (accounting for about 10% of the entire US population at the time) were unable to service their debt and defaulted on their, mostly British, loans.

British bankers threatened that they would never again invest in these untrustworthy Americans. They could point to the precedent set by Hamilton, and had probably invested on the implicit understanding that, if necessary, the federal government would bail out the states again.

But, despite foreign creditors’ threats, the federal government did not come to the rescue. The bailout request did not succeed because it could not muster a simple majority of the states (represented by the Senate) and the population (represented by the House of Representatives) under the normal decision-making procedure (the “Community method,” in European Union jargon).

The defaults proved to be costly. The 1840’s were a period of slow growth, and continued pressure from foreign creditors forced most of the official debtors to resume payments after a while. Default was not an easy way out, and all US states (with the exception of Vermont) have since embraced balanced-budget amendments to their constitutions as a way to shore up their fiscal credibility. Are EU members prepared to take a similar step?

Daniel Gros is Director of the Brussels-based Center for European Policy Studies. He has worked for the International Monetary Fund, and served as an economic adviser to the European Commission, the European Parliament, and the French prime minister and finance minister. He is the editor of Economie Internationale and International Finance.

Draghi breaks the ultimate euro taboo
August 5, 2012 4:14 pm
by Gavyn Davies


When Mario Draghi said on 26 July that a “convertibility risk” was preventing the smooth functioning of the ECB’s monetary policy across national borders inside the eurozone, he was breaking a taboo which has been stubbornly followed by all of his predecessors in the project to create a durable single currency. (See Alphaville here.) That taboo is that no-one in the ECB should ever admit that the euro might break apart. The objective of the taboo (which admittedly has previously been broken in the “special case” of Greece) has always been to ensure that markets should not feel the need to reflect any concerns about possible foreign exchange risk among the member states which comprise the euro.

By admitting that this “convertibility risk” now exists, the ECB president has implicitly acknowledged that the permanence of the single currency is not fully credible in the financial markets. The recognition of redenomination risk after a potential devaluation is one reason, he implies, why sovereign bond yields are now so high in Spain and Italy. He has said that this prevents the ECB from transmitting its intended monetary stance into those economies, which gives the ECB the right to take direct action to reduce these bond yields.

After last Thursday’s ECB meeting, it appears that this direct action will be to purchase short dated government bonds in Spain and Italy, provided that these governments have previously applied for support from the EFSF/ESM mechanism, and have accepted any conditions attached. The question is whether this action will be enough to put the convertibility genie back into the bottle.

Until Mr Draghi’s recent remarks, the ECB’s line on convertibility risk was that the different members of the eurozone should be treated like the different districts of the Federal Reserve system in the US.

In other words, they should be seen as the component parts of a single payments union, where the value of the euro is guaranteed to be the same throughout the eurozone. The bedrock of this guarantee is our old friend the ECB’s Target 2 payments system, which ensures that payments made in euros by solvent and liquid entities will always clear, wherever they are made within the eurozone. By this means, the ECB ensures that the market does not need to worry that a Greek or Spanish euro will ever be worth less than a German euro.

What lies behind this guarantee is, however, an obscure mechanism which in effect means that the national central banks of the strong economies (eg the Bundesbank) are offering to extend a potentially unlimited amount of credit to the central banks of the weaker economies (eg the Bank of Spain) in order to ensure that the monetary union stays intact.

They in fact do this via the ECB balance sheet, which stands between the Bundesbank and the Bank of Spain. But this does not alter the basic fact that the original design of the euro did not take into account the strains which would be placed on this mechanism if a country like Spain were to run a large and persistent balance of payments deficit (on current and private capital account) against Germany, which is what has been happening.

A balance of payments deficit means that Spanish residents are making larger outgoing payments to (say) Germany than German residents are making to them. Since 2008, the outflow has been driven by private sector capital flows, not by a current account deficit, but it still needs to be financed. So how does this outflow of private money actually get financed? It gets financed by an equal and opposite flow between the central banks. As a result, the Bank of Spain builds up a debit and the Bundesbank builds up a credit.

In the case of two completely independent countries, these debits and credits would get settled by a payments flow of between the relevant central banks. Under the Gold Standard, this flow would be in gold itself.

Under the Bretton Woods system, it would be in dollars. In either case, the outflow of official reserves would force Spain to take steps to eliminate its balance of payments deficit by tightening monetary policy or allowing the exchange rate to depreciate, so the problem would, in principle, be self correcting.

The key difference between these situations and the euro mechanism is that the the debits of the Bank of Spain never get settled at all; they just get larger and larger, for as long as the Spanish balance of payments imbalance persists. And the same applies to the “credits” of the Bundesbank. This is why the Target 2 imbalances inside the ECB balance sheet have grown so large in recent years. As long as the national central banks are willing to allow these imbalances passively to rise, then the single currency simply cannot break up. That is what makes it a single currency.

However, as Mr Draghi has now implicitly acknowledged, the markets are no longer convinced that the Target 2 imbalances will be allowed to rise without limit. Although the Bundesbank has pointed out many times that Germany’s credits under this system are against the ECB, and not against any individual country, potential Target 2 losses after a euro break up have become a political issue within Germany, undermining market confidence in the ultimate stability of the euro.

It is risky for a central banker to acknowledge that the payments system on which the currency stands may not be fully credible. Mr Draghi could simply have repeated the old line that the operation of the Target 2 system is enough to ensure that the euro can never fall apart. By admitting the reality that the system is no longer 100 per cent credible in the eyes of the market, the ECB president has invited investors to ask whether his proposed interventions are powerful enough to deal with problem he has raised.

This question requires a more complete analysis at a later date. However, it is worth noting that Mr Draghi’s latest ideaECB purchases of short dated bonds under a reactivated Securities’ Market Programme – will not increase the scale of official capital inflows into Spain, since they will (mostly) be undetaken by a Spanish entity, the Bank of Spain*. This means that reactivation of the SMP will not eliminate the need for Target 2 imbalances to continue rising, which ultimately could undermine confidence in the single currency still further. In order to prevent that, more drastic action to raise official capital flows into Spain, like providing a banking licence for the ESM, would be required.


* The exact impact of the SMP on capital flows, and therefore on the need for further increases in Target 2 imbalances, is not a straightforward or transparent matter. After consulting several macro-economists on this (Martin Brookes and Juan Antolin-Diaz at Fulcrum, Huw Pill at Goldman Sachs and David Mackie at J.P.Morgan), I have concluded that most SMP purchases have been made by national central banks from entities within their own countries, so that no cross border flows have been involved. I assume this pattern continues under SMP2.

Updated August 3, 2012, 7:03 p.m. ET
.Donald Boudreaux: Was Milton Friedman a Secret Admirer of Keynes?
Liberals misread the great free-market scholar in order to hijack his legacy.

With the possible exception of Adam Smith, no person in history is more widely recognized as ably championing free markets than Milton Friedman. Justly so: For more than 60 years until his death in 2006, he pressed the case for capitalism and freedom with impeccable scholarship, good cheer, impressive vigor and unmatched clarity.

Despite his clarity, there are a handful of people whose inability or unwillingness to grasp Friedman's arguments leads them to misrepresent his writings and policy recommendations.

Consider British journalist Nicholas Wapshott. He used the occasion of the 100th anniversary of Friedman's birth (July 31) to claim, in the Daily Beast, that Friedman's attitude toward government was much closer to that of pro-interventionist John Maynard Keynes than to that of Keynes's famous free-market opponent, Friedrich A. Hayek.

Mr. Wapshott says that Friedman really was quite sanguine about a large and constitutionally unrestrained state, based on the alleged contents of a supposedly "lost" essay by Friedman. Contrary to the naive Hayek—who worried that power concentrated in big government inevitably corrupts politicians and invites its own misuseMr. Wapshott says, the essay (which was originally published in 1989) shows Friedman believed "that big government is not evil so long as it is honestly administered." He adds that the essay "calls into question whether those today who rail against the size of the state are blaming the system when they should be rooting out corrupt politicians and public officials instead."

So Milton Friedman was really a good-government progressive? No.

Friedman's essay, "John Maynard Keynes," was never lost. The original article, first published in German translation in a volume of commentaries on Keynes's "General Theory," was translated and republished in 1997 by the Richmond Federal Reserve Bank in its quarterly magazine, and it is readily available on the bank's website.

The essay shows beyond a shadow of doubt what Friedman really thought about Keynes's views on government: "I conclude that Keynes's political bequest has done far more harm than his economic bequest and this for two reasons. First, whatever the economic analysis, benevolent dictatorship is likely sooner or later to lead to a totalitarian society. Second, Keynes's economic theories appealed to a group far broader than economists primarily because of their link to his political approach."

Friedman here articulates concerns long expressed by Hayek in the latter's 1944 book, "The Road to Serfdom," that big government of the sort that Keynes demanded is poisonous to freedom and prosperity. He saw clearly that Keynes's "political bequest" was so dangerous that no amount of rooting out of corrupt officials would prevent a government armed with unlimited discretionary economic power from becoming tyrannical.

There's an even more egregious misrepresentation of Friedman, this one by Paul Krugman, the economist and New York Times columnist. A few months after Friedman's death in November 2006, Mr. Krugman penned an essay in the New York Review of Books, "Who Was Milton Friedman," accusing him of being "intellectually dishonest." He doubled down on this charge in a letter to the editor of the New York Review responding to critics of the essay.
The dishonesty, in Mr. Krugman's telling, consists in an alleged contradiction. On one hand, Friedman the scholar claimed in his famous "Monetary History of the United States" that the Great Depression was worsened by the Fed's failure to keep the money supply from falling. But, on the other hand, Friedman the public figure claimed that the Depression likely would have been far less severe in the absence of the Fed. "I'm sorry," Mr. Krugman wrote in the letter, "but those are contradictory positions."

Mr. Krugman's charge is silly. Friedman understood that, without the Federal Reserve, private bank-clearinghouse associationsmarket institutions that were displaced by the Fed—would likely have prevented the money supply from collapsing and, hence, might well have kept the depression from becoming "great." But Friedman also understood that the Fed, having substituted its own technocratic discretion for the market adjustments of clearinghouses, then had a responsibility to manage the money supply properly. It failed to do so. Friedman (and his co-author Anna Schwartz) properly criticized the Fed for this terrible failure.

Friedman's argument here is no more contradictory or dishonest than would be the argument of, say, a physician who, having unsuccessfully warned a patient not to rely for medical care upon a witch doctor, points to the witch doctor's failure to administer appropriate mouth-to-mouth resuscitation as the cause of the patient's death.


Milton Friedman combined soaring academic credentials with a remarkable virtuosity at explaining to the public why free markets are economically and ethically superior to even well-intentioned government plans and regulations. He was throughout his long life and career a special target of those who would preserve what he and his wife, Rose, called "the tyranny of the status quo."

This status quo consists of interest groups, bureaucrats and politicians who—with help from cheerleaders in the media and the academyuse government to enlarge their own pocketbooks and to stroke their own egos, all at the expense of the general public.


If Friedman was secretly upbeat about powerful government or, worse, misleading the public, then the voice of one of history's greatest advocates of free markets would be silenced. In fact, Milton Friedman's advocacy of free markets was as principled, consistent and honest as it was brilliant.

Mr. Boudreaux is professor of economics at George Mason University and author of "Hypocrites and Half-Wits" (Free To Choose Press, 2012).

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