Merkel Won’t Let Euro Split, May Cause Dark Age, Rifkin Says

Bloomberg has an interesting angle on the European debt fiasco - if only Jeremy Rifkin would give up the hydrogen thing and focus on more practical energy solutions - Merkel Won’t Let Euro Split, May Cause Dark Age, Rifkin Says.

Angela Merkel won’t allow the euro region to split because she understands that could cause “a dark age" by wrecking the bloc’s energy markets as oil supplies dwindle, said an adviser to the German chancellor.

Europe’s 500 million residents, the wealthiest market on Earth, have led the development of technologies in clean energy, transport and communications that can drive global growth that doesn’t rely on oil, said Jeremy Rifkin, a Wharton Business School professor who has advised Merkel for six years.

“I hope they pull this off, there’s no one else," he said yesterday in Madrid of Merkel’s struggle to boost growth as part of Europe’s rescue strategy and preserve the single currency area. “If it splits up, we’re into a dark age."

Rifkin argues that record oil prices in 2008 pushing up the costs of everything from food to clothing rather than the collapse of Lehman Brothers Holdings Inc. was the main cause of the financial crisis. The global economy won’t return to its pre-crisis growth until it moves away from fossil fuels because rising oil prices will continually hold down expansion, he said.

The global economy sputtered again this year after oil prices surged. The European Central Bank started buying Italian and Spanish government bonds to control the sovereign debt crisis on Aug. 8, three months after oil prices reached their highest since 2008. Stock markets slumped this summer, with the S&P 500 losing 17 percent from July 22 to Aug. 8.

Germany’s deployment of renewable energy, intelligent power grids and electric vehicles leaves it best-placed to lead the world economy beyond its reliance on fossil fuels, Rifkin said. His vision involves creating an “energy Internet."

The EU has led the global battle to limit the greenhouse gas emissions that scientists say are almost certainly the cause of global warming, establishing the world’s biggest market for carbon-dioxide emission permits in 2005. That infrastructure, as well as the bloc’s targets for transforming its energy networks over the next 30 years, would likely be wrecked if the single currency area split, Rifkin said …

Global crude output likely peaked in 2006, the International Energy Agency says. Oil companies will have to spend trillions of dollars drilling in increasingly hostile environments such as deep waters in the Gulf of Mexico or the Arctic to meet demand, it said in its 2011 World Energy Outlook.

Rifkin, in the Spanish capital to speak today at a Rafael del Pino Foundation conference, has advised Merkel, French Premier Nicolas Sarkozy and Spain’s Jose Luis Rodriguez Zapatero that the global economy’s fundamental problem stems from the end of a growth model based on fossil fuels.

Sustainable expansion will only return when officials and executives can produce “the third industrial revolution," the University of Pennsylvania’s Wharton School professor argues in a book of the same title due to be published next month.

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Europe's moment of truth

The Business Spectator has a few unconventional rants about the teetering European financial system . I wonder when it will once again become conventional wisdom that keeping commercial banking and investment banking separate is kind of a good idea.

First Robert Gottliebsen floats the radical idea that voters should be consulted about bank bailouts and austerity plans (as well as creating a federal European government or effectively abandoning the idea of a continent wide currency) - Europe's moment of truth.

The current orthodoxy among world politicians is that voters should not be trusted to make a decision and that only on rare occasions should voters be told the truth. Papandreou, whose family has been involved in Greek politics for three generations, this week suddenly woke up that the only way Greece can implement the austerity program that the other Europeans leaders are demanding is that the voters agree with it and are told the truth.

What a breath of fresh air.

Papandreou is under huge pressure to go back to concealing the truth and not letting voters decide. But the world will be a better place if he holds his ground.

Here are three other ‘truths’ that should be flushed out:

– The big French and German banks have lost their capital (and a lot more) and need massive capital raisings plus government money to restore solvency. Voters are entitled to decide whether it is worth saving them. My guess is that the cost of not saving them is much higher than saving them. Yet given the banks broke every rule in the banking book, they do not deserve saving and shareholders of companies that lose their capital normally get very little.

– Italy, Spain and Portugal have deep problems. Their voters have every right to be told the truth and to decide which way to go.

– In the US the massive money printing exercise went into the pockets of the major global banks that used it to fund global speculation when they should have used it to lend for housing and business development. The US politicians need to have the courage to tell the people that these banks fund both parties so it’s hard to take action against them by separating their gambling activities from traditional banking.

Back to Greece: Papandreou is under huge pressure to reverse his referendum decision, but once he has announced a referendum it will be impossible to implement the austerity program without it. There is a good chance the austerity program will win voter support if the Greeks are told the truth that they must choose between the horrible immediate consequences of a balanced budget (about a quarter to half of the public servants may lose their jobs) and the austerity program where the Europeans are still pumping money in.

There are only two long-term solutions to the European problem – a movement towards a United States of Europe or alternatively a situation where countries that do not want to (or can’t) make the financial sacrifices leave the euro currency (or a perhaps the euro is left to the weak countries and the strong ones go their own way).

Voters must be part of those decisions or they can’t be implemented.

Alan Kohler follows up with a call for changes to the way banks are governed - Time for radical bank reform.

The debt crisis in Europe is the fault of bankers, yet the people are the ones who pay. The current mess is simply yet another earth-shaking collision between those who reap the returns from banking (shareholders and management) and those who bear the risks (everyone else). …

Andrew Haldane, the executive director of the Bank of England in charge of financial stability, gave a speech recently in which he showed as clearly as I have ever seen how the changes to banking over 200 years have contributed to the crises we have endured since 2007.

His last paragraph sums it up: “the risks from banking have been widely spread socially. But the returns to bankers have been narrowly kept privately. That risk/return imbalance has grown over the past century. Shareholder incentives lie at its heart. It is the ultimate irony that an asset calling itself equity could have contributed to such inequity. Righting that wrong needs investors, bankers and regulators to act on wonky risk-taking incentives at source."

Haldane explains that in the first half of the 19th century, when banking still existed in its original form, the capital put in by the owners of banks usually matched the amount of deposits – that is, bank gearing was 50/50.

Not only that, there was no such thing as limited liability as we have today: liability was unlimited and directors had the power to vet share transfers to ensure that the new owners had sufficiently deep pockets. As Andrew Haldane said: “This put shareholders firmly on the hook, a hook they then used to hold in check managers."

But during the industrial revolution, countries became hungry for more capital. The supply of credit was restricted by unlimited liability on bank shareholders, so it was progressively removed by governments, starting with Connecticut and Massachusetts in the United States in 1817 and concluding with the Companies Act of 1879 in Britain.

Shareholder vetting remained at first, and although liability was limited, a pool of uncalled capital was created that could be called on in an emergency – a sort of hybrid unlimited liability. That seemed like a good idea, but of course managers found that the act of calling on that capital merely worsened a crisis.

It was the first example of what Haldane calls the “time-inconsistency problem". That is, bankers do not exercise their available capital insurance because they fear – rightly – it would make a bad liquidity situation worse. The issue becomes even more acute when an institution is “too big to fail".

Eventually, the vetting of bank shareholders was dropped as well and “ownership and control were amicably divorced", as Haldane puts it.

The controllers (managers) soon learnt that taking bigger and bigger risks increased their returns without increasing the risks either to them or their shareholders. As a result, the ratio of bank assets to GDP all over the world has risen exponentially.

There was another incentive to increase bank gearing – tax. Interest on debt is tax-deductible but dividends paid to the providers of equity are not.

Moreover, managers are paid bonuses according to returns on equity, not on the returns they make on the total assets they manage.

Andrew Haldane suggests switching banker remuneration from ROE to ROA (return on assets). “Imagine if the chief executives of the seven largest US banks had in 1989 agreed to index their salaries not to ROE, but to ROA. By 2007, their compensation would not have grown tenfold. Instead it would have risen from $2.8 million to $3.4 million. Rather than rising to 500 times median US household income, it would have fallen to around 68 times."

He also suggests that voting rights be extended to a wider set of stakeholders in the bank. For example, depositors could be given a vote, albeit a smaller one than shareholders.

“The advantage is that governance and control would then be distributed across the whole balance sheet. Some of the rent-seeking incentives of the equity-dictatorship model would be curbed."

At the very least, although Haldane does not mention this, banks should be forced to return to their basic function of taking deposits and making loans.

This is the core recommendation of Sir John Vickers’ Independent Commission on Banking. He said that basic banking should be structurally “ring-fenced" from the other activities, specifically proprietary trading. Naturally bankers are howling about this.

It is time for governments to listen to Haldane and Vickers and get on with radically reforming the way banks operate and bankers are rewarded, and they should not waste time discussing it with banks.

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Unravelling the Greek basket case

While I don't normally quote ideologoues from conservative thinktanks, this bit of history highlighted in The Business Spectator caught my eye - it seems the Greeks quite enjoy milking a monetary union - Unravelling the Greek basket case.

You may agree or disagree with Georg Wilhelm Friedrich Hegel’s deterministic world view, but it is hard to argue with the philosopher’s grim assessment of governments’ ability to learn: “What experience and history teach is this — that nations and governments have never learned anything from history, or acted upon any lessons they might have drawn from it.”

Since these words were written 180 years ago Europe’s dealings with Greece have proved Hegel right time and again. Greece is not a country with temporary economic, fiscal and monetary problems. It is a permanent basket case. Despite this, Europe has never found a way to deal with it.

Since Greece gained independence from Turkey after its war of independence (1821-29), the country has been plagued by recurrent budget crises, frequent state defaults and long periods of being cut off from international capital markets. There was no shortage of attempts to put Greece on a more stable trajectory by integrating it into international monetary arrangements. And yet they all failed eventually.

The first attempt to give modern Greece a convertible silver currency was in 1828. It was suspended only four years later when the budget deficit was so high that the government resorted to printing paper money to pay for the ongoing conflict with Turkey. A return to the silver standard began a few years later but the Greek government continued to borrow heavily from the central bank for its expenditure – hardly a sustainable fiscal arrangement.

After more tumultuous years with yet another departure from silver to paper and back, Greece in 1867 sought refuge in the Latin Monetary Union, one of the forerunners of today’s euro currency.

Effectively, LMU was a gold and silver-backed monetary union with the French franc at the centre, and Greece hoped to benefit from the monetary stability it offered. Being part of a big monetary union with many other European nations also gave it access to deeper capital markets.

From a Greek point of view, it was perfectly understandable why they were so keen to join the club. The only question is why the other members of LMU admitted Greece despite its poor economic structures.

Not even observers closer to the historic events could see the point of Greek membership. In his ‘History of the Latin Monetary Union’ report, University of Chicago economist Henry Parker Willis summed it up nicely, and it is worth quoting at length:

“It is hard to see why the admission of Greece to the Latin Union should have been desired or allowed by that body. In no sense was she a desirable member of the league. Economically unsound, convulsed by political struggles, and financially rotten, her condition was pitiable. Struggling with a burden of debt, Greece was also endeavouring to maintain in circulation a large amount of inconvertible paper. She was not territorially a desirable adjunct to the Latin Union, and her commercial and financial importance was small. Nevertheless her nominal admission was secured, and we may credit the obscure political influences … with being able to effect what economic and financial considerations could not. Certainly it would be hard to understand on what other grounds her membership was attained.”

Replace ‘Latin Union’ with ‘European Monetary Union’ and the paragraph quoted above could have been published today. In fact, it was published in 1901. Already back then, Willis came to the conclusion that monetary union in Europe did not work, which again sounds like a prophecy of things to come:

“The Latin Union as an experiment in international monetary action has proved a failure. Its history serves merely to throw some light upon the difficulties which are likely to be encountered in any international attempt to regulate monetary systems in common. From whatever point of view the Latin Union is studied, it will be seen that it has resulted only in loss to the countries involved.”

One of LMU’s problems was Greece. The country had introduced paper money that was only valid domestically and it also reduced the gold and silver content of its coins in violation of international agreements. No wonder that other LMU members became increasingly frustrated by Greece’s refusal to play by the rules.

The Swiss ambassador to Paris allegedly once complained that monetary union with Greece was an ‘unhappy marriage’ from which there was no easy escape. Eventually, however, the other LMU countries lost patience and ordered Greek coins retired in 1908. Effectively, they kicked Greece out of the union because they were fed up with it.

Greece then had to readjust its monetary policy and managed to return to LMU in 1910 under a gold standard, but by then the LMU was already fragile. Four years later, the union was effectively abandoned at the start of World War I and formally dissolved in 1927.

After LMU, Greece’s monetary history remained a roller-coaster. The drachma devalued and became pegged to the sterling in 1928. It devalued again before being pegged to the US dollar in 1953. In 1975 it was floated and devalued immediately, followed by big devaluations in 1983 and 1985. Only in preparation for the euro did the Bank of Greece eventually announce a ‘hard drachma’ policy in 1995, but its entry into the European Exchange Rate Mechanism required yet another devaluation.

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A Greek Energy Sell-off ?

The FT has a report on the possibility of Greece defaulting on its debt payments, noting the government is considering selling a number of energy projects - Greece vows to avoid default at all cost

The plans include offering licences for undersea oil and gas exploration in the Ionian Sea off the west coast and also south of Crete. They are also looking for investment in solar installations that would export electricity to northern Europe and in offshore wind parks in the eastern Aegean.

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