18 July 2022
What Scholz wants from the EU
Ask what you can do for the EU, and not what the EU can do for you. That would be our response to Olaf Scholz. He demanded in a newspaper article this morning that the EU abolishes the national veto on foreign policy.
Smaller EU countries would be mad to give up the veto in foreign policy in our view unless Germany commits to a shift towards a more EU-compatible economic model. The two are toxically intertwined. There was not a word on this from Scholz, no grand bargain on offer. Right now Germany needs a strong EU to further its own interests. But that wasn't always so, and won't be always so in the future.
The fundamental problem we see is the complete lack of awareness inside Germany of how its own political choices affect other EU countries. The dominating narrative about the euro area's sovereign debt crisis remains one of profligate southern European government and of rule-abiding Germans, generous in their support for southern Europe. The Merkel government could not care less about objections from east European countries and the US to the Nord Stream 2 pipeline. There is also no hint in discussions that structurally high export surpluses are the mirror image of structural savings surpluses and financial imbalances within the euro area.
Writing in FAZ this morning, Scholz is framing Germany's problem as one of overdependence on Russia. But it goes deeper. The dependence on Russian gas is intertwined with a gas-guzzling economic model that requires large export surpluses simply to stay afloat. The times when Germany's current account is in balance, as it is now, are the times when the country is in economic crisis. Germany dependence on Russia and China was not an accident. It was part of a wider strategy.
If you harmonise EU foreign policy without addressing this imbalance, all you do is making foreign policy more potent, but without changing the actual policy itself. We are elevating national neo-Mercantilism to a European neo-Mercantilism.
Others should respond to Scholz' proposals not by rejecting them outright, but by making demands of their own. The most important would be, in our view, to complete the banking and capital markets union, which would leverage the EU's ability to impose economic sanctions on third countries. We would even go further and insist on a full fiscal union, if only to prevent a situation where a common EU foreign policy is subjected to sectarian German and French economic interests.
Whatever you do, do not follow the old adage to integrate first, and think about the consequences later. This is what brought the euro's perma-crises. This is the time to widen the debate to the goals of foreign policy itself, rather than focus just on voting rights.
15 July 2022
Putin, a rational agent from the textbook
Microeconomic thinking can sometimes be very useful to cut through the fog of political discourse. Olivier Blanchard got the Russian gas policies spot on with his comment that Russia is a gas monopolist who faces inelastic European demand, meaning that Europe is dependent on it and has no alternative suppliers. Blanchard goes on to say we are in the rare situation where the monopolist has a reason to raise the price of his commodity to near infinity. The reason is that we announced to the world our intention to get out of Russian gas permanently once we have found alternative energy sources. The only thing that keeps a monopolist sweet is the expectation of further business in the future. We have taken that expectation away. The rational agent from the economics textbook would thus behave like the meanest monopolist. Raise the price until the pips squeak.
A short while later, the Russia foreign ministry essentially followed up on Blanchard. It said that the further operation of the Nord Stream 1 pipeline will depend on economic sanctions. We expect the Germans to take Russia’s blackmail very seriously. Despite official denials, we believe that there is intense pressure within the government for a dirty deal with Putin: you, the Russians, keep the gas flowing. We, the Germans, commit to buying your gas at least 10 years. But we won't tell anyone now. Nobody will care anymore when this becomes clear in two years time.
This is not what the Germans will ever admit. Not even privately. We may be wrong on this. We may underestimate Olaf Scholz' determination to make Germany, and his party, independent from Russia. The Germans won’t blame Scholz and his government for gas shortages. Everybody knows that the dependency on Russian gas was the work of Gerhard Schröder and Angela Merkel, not of Scholz, Robert Habeck or Christian Lindner.
It would be a triumph of hope over experience. Our experience has been that Germany goes to the most extreme length to preserve its gas-dependent business model. A dirty deal with Putin would go a long way also to defuse the biggest conflict inside the coalition. The FDP is currently putting pressure on Habeck to keep the three nuclear power stations running. Spiegel reports that this issue is now on the verge of turning into a first-order government crisis. The Greens are saying that the nuclear exit will happen, no matter what. If the gas flows, Lindner can stick to his fiscal deficit reduction plan, on which he staked his credibility. And the SPD is off the hook too. The fate of heavy industry and that of the SPD are closely intertwined.
The Greens hold all the cards. The FDP can’t really afford to walk out of the coalition over this issue. It has no alternative political power options and the polls look dismal for them. If Putin keeps the gas flowing, this conflict won’t boil over. Also, we should not underestimate the pressure Scholz is under from German industry. They tell him every day that the German industrial model depends for its survival on the kindness of dictators. They are right. German industry has a very long tradition of coddling dictators, domestic and foreign. Like Berney Ecclestone, they, too, would take a bullet for Putin.
If the gas miraculously comes back at the end of next week, we know for sure that Putin received iron-clad assurances from his German friends. This will not be made official. Scholz seems comfortable with sending conflicting messages, like when he promised weapons deliveries to Ukraine, and then frustrated them administratively. He may play the same game on energy sanctions. Say one thing, and do another. This is how Germany has been playing its variance alliances in the past. It would constitute in policy if they changed this.
We already saw that the Scholz administration was willing to break sanctions just for the sake of the gas. They put pressure on the Canadian government, presumably with some heavy pushing from the Biden administration, to send a turbine to Gazprom that was apparently needed for the maintenance work. The idea was, as Habeck said, not to give Putin an excuse to cut off the gas. It is rather naive, but very typical of the German discourse, to think that Putin needs excuses.
We look at Putin as that elusive rational agent from an mciroeconomics textbook. And he is confronted by customers who have never read economic textbooks. We are just adding one and one together.
14 July 2022
Too clever by half
Elimination competitions like the Conservative leadership elections have their own rules and their own dynamic. The best way to describe the dynamic of the preselection process is the old adage about French presidential elections. People vote for their preferred candidate in the beginning, and for the least objectionable one in the end. This is going to happen here too.
Forget all this idle talk about momentum, or tactical voting, and remember that journalists are paid to create stories even if there aren’t any. We also had a laugh when we heard that supporters of Rishi Sunak would vote tactically in favour of the two candidates he would be sure to beat in the final round. This was too clever by half, if only because the two candidates he was certain to defeat were both eliminated in round one.
Tactical voting at that level of sophistication is almost impossible because the vote is secret, and you have no way of knowing how the others are voting. It is a version of the prisoners' dilemma in game theory.
In an election like this one, the initial rounds broadly reflect first preferences across a wide range of candidates. Since the final vote is cast by a different group, Conservative party members, tactical voting is certain to become dominant. Instead of voting for your first best choice, you are voting against your least favourite one. In the final round of voting next week, where three candidates get whittled down to two, this is the moment to watch out for. If this will be a contest between Sunak, the fiscal responsibility and anti-Johnson candidate, Penny Mordaunt, who combines social reform with a hard line on defence, and Liz Truss, who ticks all the Thatcherite boxes, it is quite possible that Mordaunt prevails because she is less hated, and also less known, than the other two big beasts.
Voting is always about both what you like and what you hate. As with everything Tory, it is easier to know what they hate than what they want. So that in the final round of the preselection contest, it is quite possible that negative sentiments outweigh the positive ones. The most hated candidates are Sunak and Truss. It is not a pro-Brexit or anti-Brexit thing, at least not directly. It is true that nobody talks about Brexit. What they are talking about is even older: Thatcherite supply-side policies. Should you consolidate your finances first, and then cut taxes, or do it the other way round? And it is about defence spending. Sunak is least enthusiastic about defence spending if only because he knows that high defence spending kills your budget. Just ask Christian Lindner.
The most interesting of all the candidate is Kemi Badenoch, who came out with the astonishing proposal to break up the UK treasury. This is exactly what we would propose too. If you were to embark on a strategy to produce an alternative post-Brexit economic model, this is where you would have to start. With Sunak-vs-Truss, this is not going to happen. Or with Sunak-vs-Starmer. Badenoch is the first UK politician we have encountered who talks about post-Brexit regime shifts with clarity. We suppose she could be the leader one day.
Our baseline case is this. The Tories will go for Truss, Sunak or Mordaunt now. Then go on to lose the next elections. The leadership contest that is going to be really interesting is the one that happens then.
13 July 2022
So much for the rule of law
Whether over foreign policy, as was the case with the Russian oil sanctions, or tax, as we discussed yesterday, Viktor Orbán has a knack for frustrating the rest of the EU’s best-laid plans. While there’s always some nominal, usually economic performance-related excuse, it’s not hard to figure out that the real motivator behind Hungary’s moves is EU recovery money. The European Commission has yet to approve €7.2bn worth of grants for Hungary, and is exercising the recovery fund’s conditionality mechanism because it has concerns over potential misuse of public funds.
Orbán has more than enough incentive to kick over a fuss over the funds. His government’s fiscal solidity, and Hungary’s wider economy, is in serious trouble. Hungary’s budget deficit for the first half of the year is virtually the same as the value of its EU recovery grants, and is 92% of its full-year target. Lavish pre-election spending and inflation-shielding measures inflated the figure, which the government risks overshooting.
Hungary’s budgetary position has eased somewhat through May and June, but that’s thanks to an even bigger problem: inflation is not going away. Core inflation hit 13.8% year-on-year in June, the highest it’s been in 24 years, well before Hungarian EU membership began. Hungary’s central bank raised its base rate by 200bps yesterday, after a 185bps hike two weeks ago, to try and stave off a collapse in the forint. As of this morning, the forint is down 9.6% year-to-date against the euro.
This leaves Orbán with a tricky economic problem to solve, one that would be easier to deal with if he had access to EU funding. His carrot-and-stick approach to the dispute with the Commission was initially stick-heavy. First, there was the standoff over oil, which lasted almost a month. Then more recently, blocking corporate tax harmonisation in line with OECD guidelines. But there has, more recently been some carrot, and he has promised to make a few changes to how funds are disbursed by the government in an attempt to appease the Commission.
These changes are, however, cosmetic. As Kim Lane Scheppele argues, while they address the procedural side of the issue, they do not tackle the fundamental cause of the Commission’s concerns: institutional capture. Orbán’s Hungary suffers from a serious lack of administrative, prosecutorial, and judicial oversight. So long as government officials, businesses, functionaries, prosecutors and courts are caught up in the same nexus, an environment exists in which corruption can thrive.
But handling these issues could raise a consistency question for the Commission. They recently struck a deal with Poland over recovery funding after the PiS-led government agreed to rule-of-law concessions. These were, however, also cosmetic, and did not fully address the issue at the heart of that particular dispute: the government’s ability to unduly influence the judiciary.
For various reasons, the Commission has clearly made their peace with Poland, and is taking a different tack with Hungary. Poland’s rule-of-law problems are not explicitly related to the funds themselves, unlike Hungary’s. The Polish government is also much more popular within the EU after their strident response to Russia’s invasion of Ukraine. Hungary, by contrast, is isolated. Crucially, Poland’s backing for Hungary is more tenuous now.
The Commission could continue to take a hard line against Orbán, having already picked their battles. But Hungary can still wield its veto. The Commission’s battle with Budapest could also be complicated by the largest anti-corruption party in Bulgaria’s parliament failing to form a government last week. An election before the end of the year would potentially return Boyko Borissov’s scandal-wracked Gerb party to government, piling more on the Commission’s plate.
12 July 2022
Thatcherism was not about tax, but reforms
Among the three leading contenders for the Conservative Party leaders, one, Rishi Sunak, is an old-fashioned fiscal conservative; one, Liz Truss, is a fiscal earth-scorcher; and another one, Penny Mordaunt, focuses on wider economic reform. Mordaunt is a former defence secretary, and also happens to be the favourite among Conservative grassroot activists, not that this group is necessarily representative of the membership at large. She is campaigning with an argument that is close to one we have been making independently: Brexit requires structural economic reform to offset the losses from trade with the EU. This is a debate perpendicular to the standard economic discourse in the UK about taxes and spending. What we believe will be the factor that makes or brakes Brexit is innovation, or the lack of it. The biggest obstacles to innovation are not corporate taxes, or the lack of fast trains, but business regulation, immigration and education.
Mordaunt and Sunak have the largest number of MPs that support them. But we doubt that the final shortlist likely to emerge by the end of the next week will consist of two relative moderates. It looks as though Truss is emerging as the unity candidate on the right, and that Sunak will be the unity candidate of the centrists. We expect that the various other candidates will ultimately line up behind one of them. We would treat the ultimate choice by the membership as wide open.
It is a sign of modern Conservatism that it is strangely stuck in the debates of the 1980s, while failing to comprehend the innate logic of Thatcherite economics. Thatcherism was about economic reform that generated tax revenues, which in turn allowed them to lower taxes. It was not the other way round. In that sense, Sunak’s more conservative position on tax cuts is much more in tune with Thatcherism than the blind advocacy of supply-side tax cuts, proposed by the majority of the other contenders. Macroeconomics was never the strong point of Thatcherism. It was business regulation, urban planning and education reform.
The modern Tory party consists of crude supply-siders. The crudest of them all is the current chancellor, Nadhim Zahawi, who promises dramatic cuts in the basic rate of income tax and corporation tax to be funded by a generalised 20% staff cut in every government department. Anyone who has ever dealt with fiscal policy knows that it is what politicians do when they have they have reached the end of the rope. They go for some blanket spending cuts across the board: health, defence, education, no matter what.
Since the Labour Party under Sir Keir Starmer has no Brexit policy whatsoever, this Conservative leadership election will be decisive for Brexit. The new leader will have two years, in which to bring structural reforms. Or prioritise populist tax cuts. It’s a choice. If the opportunity is missed, our base-case scenario, it will be safe to conclude that the UK will end up incurring all the costs of Brexit, but reap few of the potential opportunities. In that case, it will only be a matter of time until the Brexit debate itself reopens.
11 July 2022
When stablecoins fail
Economists avoid thinking hard about crypto currencies because the whole idea of money not under the control of a central bank offends them. It is easy to dismiss what you don’t know. And your prejudices are confirmed when there is a market crash.
A noted exception to this rule is this article by Russell Wong, an economist at the Richmond Federal Reserve, who tried to understand, in forensic detail, why the Terra-Luna-UST stablecoin triangle blew up in May. We cannot summarise the entirety of Wong’s article, but the gist of it is that the stablecoin itself was not the main problem in this particular case. What blew up was a platform called Anchor which promised holders of the UST stablecoin a risk-free annual deposit rate of 19.5%. That high rate created the imbalance that led to the de-anchoring of the UST and the collapse of the system.
To unpack this information, one needs to understand the basic infrastructure of the system. The UST ecosystem was comprised of the following components. UST itself was an algorithmic stablecoin, pegged to the dollar at a one-to-one rate. Terra was the name of the blockchain, the technology behind this particular crypto universe. Luna was the coin of the system, like bitcoin or ether. If the price of Luna is $0.25, then a trader can sacrifice one UST to mint four Luna. Conversely, if the price of Luna is $3, a trader can mint one UST by burning one third Luna. Price equilibrium is restored in either case. Whenever the price of UST deviated from $1, investors had an interest to arbitrage out the gap buy by minting or burning Luna. But as any arbitrageur knows, it is the liquidity that can kill you.
It is hard to compare the various elements of the crypto-verse to existing financial structures. Anchor had some similarities to a mutual money market fund, except that investors in a MMMF would never see such high returns. The short story is that those high returns induced people to burn Luna to deposit USTs, thus creating an imbalance that led to the system losing its natural equilibrium.
Wong’s main conclusion is that the system collapsed due to rookie design flaws, but it was not a Ponzi scheme. Ponzi schemes work by defrauding new investors, to the benefit of existing investors. That was clearly not the case here.
This passage in Wong’s article captures the dynamic, and draws comparison with other financial crises:
“UST was backed by Luna but the price of Luna was backed by its option value of converting to UST. When the confidence of this circular backing is shaken, the liquidity of algorithmic stablecoin becomes flighty...When market liquidity evaporated, UST and Luna ultimately relied on the issuer’s equity to support the prices, similar to the backing of a more traditional currency as seen in the Asian financial crisis. It is the part of economics cannot be replaced by technology.”
We have previously warned economists to take this technology seriously because it is the technology of the future, and it has characteristics that traditional money lacks. Likewise, the crypto-fanboys should learn lessons from traditional economics, not so much to dissuade them, but to understand how to design crypto-systems properly. As students of financial crises, we know that for all their specific differences there are elements common to all, including the high-tech 21st century variants. The most important ones are exuberance, together with a denial of intruding dynamic effects.
8 July 2022
Sinn Féin seizing the moment
The Irish government is likely to face a no confidence vote next week, brought forward either from Sinn Féin or the People before Profit party in the last week before the summer recess.
Sinn Féin, the party that surprisingly won the 2020 elections in percentage terms but not in seats, will decide today whether to table a motion of no confidence, and urges independent MPs not to support the government in votes anymore.
The coalition of Fianna Fail, Fine Gael and the Greens lost its majority in parliament yesterday after one of its MPs voted against its bill. The coalition government is still operational, as it is also supported by independents. But its own majority has been dwindling, down from an initial 84 out of 160 MPs to 79. It is this trend which Sinn Féin is riding on.
Will Sinn Féin get a motion of confidence through? This still looks unlikely based on the number of opposition votes. But not doing anything in an occasion like this is simply not an option. Under Mary MacDonald, the party is building up on its momentum since the last elections, broadening its appeal and shaking off its militant past, a legacy of the Troubles in Northern Ireland. Sinn Féin has been vocal on the failure of the government in education and housing, in a country where house prices are soaring, putting tenants and first-time house buyers into difficulties. This is a popular theme.
The numbers do not add up to sink the government. But let’s go to the unlikely scenario where a no confidence vote is won. This does not automatically mean new elections. In Ireland it is the president who decides whether the dissolution of parliament will warrant new elections or not. He may ask instead parliament to come up with a new government proposal.
The more likely scenario is for the coalition to stay on for now and muddle through. Governing without a majority will become more difficult, with further troubles in autumn when it needs parliament supply for its spending budget. In this context we note a warning from the Irish Central bank saying that structural public spending plans are too dependent on 10 multinational companies that bring in half of the country's corporate tax revenues. Just to get a sense of the magnitude: the government predicts a budget surplus of €2bn this year due to excess corporate tax receipts. Without those, the government would run a €7bn budget deficit. The central bank has called on the government to put money into the rainy day fund, which they repeatedly deferred, writes the Irish Times. With Sinn Féin breathing down their neck, we also would not hold our breath that it is going to happen for the 2023 budget.
7 July 2022
Energy in the food chain
Two years of the pandemic and the war in Ukraine revealed our supply chains exposure to global shocks. After the financial crisis in 2008 revealed the interconnectedness in the world of finance, it is now the production sector that has discovered its own version.
The food industry, for example, depends on gas and diesel for its fertilisers, tractors and irrigation. Energy costs can represent up to 50% of its variable costs. Add to this the price hikes for grains, packaging, and transport, and food producers are now facing a cost increase of 60%, according to Ania, the French food industry association. Nitrogen fertilisers also depend crucially on gas. Some fertiliser plants have announced temporary closures, citing spiralling natural gas costs as the cause.
Exploding prices for containers, energy, fertilisers, raw materials and food prompted calls to bringing production back home. But this is easier said than done. It requires a rethink in production and logistics on an unprecedented scale. New plants and warehouses have to be built, and new energy sources have to be sourced and developed for the production of fertilisers and transport. These are long-term decisions with immediate cost implications. Governments are designing policies that replace fossil fuels in the food chain. Poorer households will need some support, while care is to be taken at least not to worsen the market conditions for those countries in Africa that are much poorer and more dependent on grain imports than Europe.
The three years of various crisis highlighted interdependencies in the manufacturing sector and the food supply chain. As much as this is a challenge it is also an opportunity to explore new ways of doing things in farming or manufacturing. It is an opportunity to use the savings glut in Europe to create a different future. But the process is likely to be chaotic, especially if every EU country is doing its own thing. It is the combined effect of the different measures that counts, and this also takes time to work its way through.
6 July 2022
Next comes the drought
One crisis is often followed by another. In Europe, we experienced the Covid-19 pandemic and its lockdowns, the war in Ukraine and its ramifications for migration as well as supply chains for energy and grains. And climate change has produced a severe drought not only in India and Africa, but in southern Europe too.
In Italy the government announced a state of emergency in five regions over water shortages until the end of this year. Scarce winter rain and spring droughts lowered the water level of the Dora Baltea and the Po, the largest river in Italy, down to eight times lower than usual. Both rivers feed one of the most important agricultural regions in Europe, with 30% of production currently threatened by drought. In about 100 cities water use is restricted to reserve enough for drinking.
Portugal is small by comparison and comes better prepared for water shortages. They already started preparing for a dry season in the winter, restricting the use of hydroelectric power plants to two hours per week, thus saving water reserves. The drought hit in May, when 97% of the country was affected. Local farmers' organisations also rolled out emergency plans to limit irrigation of some crops.
Spain is the third largest producer of agricultural products in the EU. At least 70% of all fresh water is used for agriculture. Some communes have been restricting the use of water since February, after the second driest winter since 1961. At risk of desertification, the country still needs to come up with a plan on how to preserve its water reserves.
This drought is certainly nothing compared to east Africa, which has barely had any rain for four years. Millions of people face dire water shortages. Food prices have risen rapidly, worsened with the fallout of grain imports from Ukraine.
Those different crises have taught us to live with constraints. The pandemic restricted our social interactions, and the war in Ukraine triggered an energy and grain shortage, both flagging up supply chain shortages for our industries. There are restrictions on how people use water in their daily lives, and how farmers are using it.
Those crisis have redistributional effects: young people who had to stay in under lockdown to save the lives of the more fragile in society; poorer households affected most by the rise in energy and food prices as measured in proportion to their income; a south afflicted by drought, heatwaves and wildfires versus the green northern EU countries.
The upshot is that these serial crises are forcing a big rethink about solutions. It could, for example, force European farmers to learn techniques usually applied in Africa to adapt to new climate patterns and become more resilient in the long term. Crises often come in clusters, but so do policies and technologies to overcome them.
5 July 2022
Three reasons to distrust Sir Keir on Brexit
Sir Keir Starmer last night pledged pledged that a Labour government would not return to the EU, or try to re-enter the single market or customs union. It was as clear and unambiguous as such a pledge can be. We have three reasons to distrust it.
The first is that he shifted his policy position on Brexit before. Labour-supporting Brexiteers still remember this vividly. The Labour Party went from an official position of accepting the referendum result during the 2017 election campaign to open advocacy of a second referendum in 2019. Sir Keir, then Labour’s Brexit shadow secretary, was the most prominent voice in the second referendum movement, and instrumental in persuading Jeremy Corbyn to accept it as the party’s official campaign promise. Yesterday’s news broadcasts were full of pictures with him on pro-second-referendum demonstrations.
We recall the flimsy argument on which that shift was based: the Conservative government had not delivered a viable withdrawal agreement. The argument was dishonest because Sir Keir was instrumental in frustrating a compromise offer by Theresa May, shortly before her downfall. We recall this period vividly, and argued at the time that the Labour party should have kept to its previous pro-customs-union position. The second referendum crowd entered a period of delirious delusion that they could win. When the situation changed, Sir Keir changed his mind. And we all know that situations keep changing all the time.
The second reason to distrust the statement is that Labour, like the Conservatives, does not have a strategy for Brexit Britain. We don’t mean a good strategy. We mean any strategy at all. A strategy would require a focus on new sources of economic growth to compensate for the fall in trade. All the trade shocks currently recorded in the statistics are not due to Brexit. Oil price shocks and the global supply chain crises, and transitional Brexit-related red tape shocks are muddying the picture. But there can be no doubt that Brexit will have a lasting impact on trade. A promise not to reopen the Brexit debate would have been more credible had it been accompanied by a strategy for a post-Brexit growth model. There are interesting parallels between the UK’s paralysis on this issue and Germany’s failure to deliver an alternative business model, as discussed in our lead story. Old instincts are kicking in. The Labour Party, once in power, will realise that the only source of an economic recovery will be the only one they have ever known.
The third reason we distrust the pledge is that it might not survive a coalition or confidence and supply agreement. Sir Keir also recently stated categorically that he would not enter into a formal agreement with the SNP. It is possible, but unlikely based on current polling, that Labour would win an absolute majority outright. The Liberal Democrats would be mad if they supported a Labour government programme without ironclad guarantees for proportional representation, and possibly a second referendum. The SNP will ultimately also want a second referendum, either if they don’t get a Scottish independence referendum, or if they get one and lose it. From an opposition perspectives, Sir Keir’s new found clarity on Brexit is as understandable as it is not credible.