Monday, 9 July 2012

The Enarque-in-Chief Strikes Again

Hollande Government Raises Taxes: Faced with the gaping maw of a growing budget deficit and a towering cumulative pubic debt, the government of Francois Hollande continues to attempt to square the circle. Among Hollande's election promises there was inter alia a mad-cap plan to hire 150,000 new civil servants. This immediately prompts the question how France was able to cope without these 150,000 additional bureaucrats up until now. Why hasn't it fallen into administrative chaos yet? You'd think that with 150,000 bureaucrats fewer than are necessary to achieve perfection, things must be really bad in that regard.

France's public debt amounts to over € 1.8 trillion, or about € 63,000 per household. At 89% of GDP and growing, it is a far cry from the Maastricht treaty limits.

In order to pay for the trick to artificially lower the country's embarrassingly high institutional unemployment (unemployment is at 10.1% and growing, and that's according to official statistics) by letting the government hire people no-one needs, Hollande has put in place one his other election promises – or rather, election threats. On Wednesday last week, he raised taxes, aiming to bring an additional € 7.2 billion into the government's coffers.

France's new Socialist government announced tax rises worth 7.2 billion euros on Wednesday, including heavy one-off levies on wealthy households and big corporations, to plug a revenue shortfall this year caused by flagging economic growth.
In the first major raft of economic measures since Francois Hollande was elected president in May promising to avoid the painful austerity seen elsewhere in Europe, the government singled out large companies and the rich.
An extraordinary levy of 2.3 billion euros ($2.90 billion) on wealthy households and 1.1 billion euros in one-off taxes on large banks and energy firms were central parts of an amended 2012 budget presented to parliament.
The law, which includes tax increases on stock options and dividends and the scrapping of an exemption on overtime, should easily receive approval by a July 31 deadline after the Socialists won a comfortable parliamentary majority at elections last month. Hollande says the rich must pay their share as France battles to cut its public deficit from 5.2 percent of GDP last year to an EU limit of 3 percent in 2013 despite a stagnant economy and rising debt.
"We are in an extremely difficult economic and financial situation," Finance Minister Pierre Moscovici told a news conference. "In 2012 and 2013, the effort will be particularly large. The wealthiest households and big companies will have to contribute." The budget followed a grim assessment of public finances on Monday by the state auditor, which warned that 6-10 billion euros of deficit cuts were needed in 2012 and a hefty 33 billion in 2013 for France to avoid a surge in public debt dragging it into the centre of the euro crisis.
One of the highest state spending levels in the world has raised France's debt by 800 billion euros in the last 10 years to 1.8 trillion – equivalent to 90 percent of GDP, the level at which economists say debt starts to hinder economic growth.
Budget Minister Jerome Cahuzac said that, while the initial focus this year was on tax rises for the wealthy, the government would progressively rein in its expenditure from 2013 onwards. "Cutting spending is like slowing down a supertanker: it takes time," he told Reuters. [yeah, sure. ed.]
Having promised to freeze central government spending without cutting staffing levels, Hollande will now face the difficult task of convincing France's powerful public sector unions to accept a cap on pay rises and promotions. This is likely to figure on the agenda of a "social conference" next week with unions and employers.
"I think the unions accept this idea of rigor," Civil Service Minister Marylise Lebranchu told RTL radio, insisting that the measures would not amount to draconian austerity.
The Socialists accused the previous government of President Nicolas Sarkozy of deliberately overestimating economic growth and tax revenues by several billion euros to improve his chances in presidential elections in April and May. [the French version of 'it's all Bush's fault', ed.]
Prime Minister Jean-Marc Ayrault on Tuesday slashed this year's official GDP growth forecast to 0.3 percent from a previous estimate of 0.7 percent, and to 1.2 percent in 2013 from 1.75 percent previously.
The amended budget eliminated a number of reforms introduced by Sarkozy, such as the tax exemption on overtime for companies with more than 20 employees. Scrapping that measure should raise 980 million euros this year, the Socialists said. Repealing a law which shifted labor charges onto a rise in VAT sales tax will also have a net positive effect of 800 million euros, and a doubling of a tax on financial transactions to 0.2 percent will bring in 170 million euros.
"There's a sharp break, politically and to a lesser extent economically, with Mr Sarkozy's more business-friendly fiscal policies," said Nicholas Spiro of Spiro Sovereign Strategy.
"As long as there's no pressure on France's bond market, the government is unlikely to pursue the kind of product and labor market reforms which France requires."
"We are sorry to see an increase in corporate taxes at a time when they need to be lowered, as the only way to make our economy more competitive," said Medef chief Laurence Parisot.
Some 300,000 people are likely to be affected by the one-off rise in wealth tax on households with net worth of more than 1.3 million euros, which rolls back a tax shield on the rich introduced by Sarkozy, officials said.
The conservative UMP party said that measures such as the end of the overtime tax exemption would hurt ordinary French.
"It is completely false to say that the tax increases will just hit the rich," said Gilles Carrez, president of the National Assembly's finance commission. "The bulk of the new taxes will hit the middle class and today we have the proof."

(emphasis added)
Well, what did people expect? That the 300,000 rich people would be able to finance such a huge hole in the deficit all on their own? Allow us to briefly reflect on this astonishing statistic by the way. What, there are only 300,000 truly wealthy people in France?
Note here that apart from destroying all incentive for those who are not yet rich to ever want to become so, this mix of taxation policies ends up lowering taxes on consumption, while raising them on capital, labor and businesses. It couldn't be more wrong-way if they tried.
The problem is that as in the rest of Europe, Hollande wants to bring his country's deficit to heel without shrinking the size of the State at all – on the contrary, he plans to expand the State still further.
This will not and cannot work. The most likely outcome of this plan is that capital will flee, investments will be withheld, and tax revenues, instead of rising, will fall still further as the economic contraction gathers pace. A brain drain has already been underway for quite some time, with London today considered the 6th largest French city. It will likely accelerate further now – why should entrepreneurs, creative people, and wheelers and dealers of all types want to stick around and wait for the blood-letting like a herd of sheep? Let Hollande find out on his own if the country can restore a condition of fiscal probity with the help of 150,000 additional bureaucrats.
We confidently predict that it won't be possible by retaining or even enlarging the size of government while concurrently shrinking everything else. This only works with socialist mathematics (according to Karl Marx, 'proletarian logic' is different from 'bourgeois logic', so presumably the same holds true for proletarian mathematics).
As to the French bond market, which market participants have seemingly erroneously lumped with the 'safe havens' of this world, it may well be that bond traders have a certain appreciation for the highway robber qualities of France's new government. After all, a government bond is based on the promise that the citizenry's wealth will be expropriated successfully to pay off the bondholders. It is only in cases such as Greece and Spain where evidently no more blood can be squeezed from turnips that bond market investors have fled.
France's biggest problem was previously held to consist of the overly large balance sheets of its banks, which together hold assets worth more than 400% of the country's GDP (with the three largest banks accounting for assets worth approximately 240% of GDP). The ECB's LTRO's and the Fed-ECB dollar swap window have postponed a funding crisis for the big French banks, which in turn has postponed the moment in time when the government will be called upon to bail them out.
Indeed, looking at France's 10 year government bond yield in isolation, one would think everything is perfectly fine. However, a bond investor doing so is likely doing himself a disservice. For one thing, 5 year CDS on France's government debt have spent the past several months trading between 170 and 245 basis points – currently they reside near the lower end of this range at 185 basis points. This makes France at the moment as creditworthy as Indonesia and a good deal less creditworthy than e.g. Panama (137 basis points).
185 basis points means that there is an implied cumulative 5 year default probability of 13%. No reason to panic just yet, but surely an astonishing level for a developed economy as large as France's – even if it is no longer rated 'triple A'.

5 year CDS on France (orange line), Belgium, Ireland and Japan. Note that the scales are different for each chart.

France's 10 year government bond yield – by itself, it appears as though everything were fine. Indeed, the recent low in yields was a 260 year low!

France's 10 year yield since 1746 (via Merrill Lynch). This shows that the recent low was a 260 year low. In the late 1780's/early 1790's there was the revolutionary assembly's 'assignat/mandat' hyperinflation spike in yields.

However, as we have already pointed out on a previous occasion, since November of last year the spread between French and German yields has widened and has never really closed again. This must be regarded as a not too subtle warning sign:

French 10 year yields compared to German Bund yields. Since the flaring up of the euro area crisis last November, there has been a persistently wider spread between the two.

Given all these warning signs, one wonders what Hollande thinks – does he really believe he can suspend economic laws? He often wears a slightly astonished look, as though he can't quite believe he has come into a position that allows him to try what has never worked all over again, so maybe he really does believe it. As an aside, Hollande has also slapped new taxes on foreign property owners in France, which will predictably put pressure on the property market.
We recently caught a debate on Austrian TV between representatives of the political parties that voted for ratification of the ESM and those that voted against it. Here is a paraphrase of what the representative of the Greens (a special form of Reds) had to say:
“What we are dealing with is a special situation, an attack of speculators on government debt; this is what the ESM is needed for: to combat out-of-control speculators.“ It didn't even occur to the lady in question that there might be a good reason why investors and speculators are selling peripheral European government debt. Apparently these speculators are held to be evil gnomes 'attacking' government debt markets out of the blue just because they feel like it. The notion that the governments in question simply may have been spending too much and amassed too big a debt never even entered her mind. Not to mention the idea that a common currency used by 17 countries with fractionally reserved banking systems able to create fiduciary media domestically without limit could lead to economic and financial troubles on a grand scale. No, it is 'speculators' that need to be reined in – with the help of a tax payer financed bailout fund, no less!

The always slightly astonished looking Francois Hollande.
(Photo credit:

It is generally the case that the cause for the euro area's plight has been misdiagnosed, or rather not been diagnosed at all. It is apparently not considered polite to criticize the practice of fractional reserve banking. The system just 'is', and all discussion of it is held to be beyond the pale.
And yet, if not for the fact that banks can create fiduciary media in nigh unlimited quantities from thin air (the ECB's reserve requirement for demand deposits during the boom was a paltry 2%, and has lately been lowered to an even more laughable 1%), there could never have been a housing bubble in Spain and Ireland or a bubble in government spending in Greece.
The latter is the decisive point: the system is what ultimately allows governments to spend more than they take in. However, they forgot a decisive problem posed by the 'denationalization' of the euro currency, which is issued by a supranational central bank that is not allowed to monetize government debt directly. The drawbacks for spendthrift governments only came to the fore with the arrival of the bust, but by now they are certainly in plain view.
Given this fact, it is perhaps we that should adopt a permanently astonished facial expression: how can it be that the root causes of the problem are never even mentioned?

Addendum 1: Awesome Spending Cuts In Italy

Meanwhile, Italy's government – the bond market of which is in considerably bigger trouble, with CDS spreads recently indicating a cumulative five year default probability of just over 30% – has decided to generously wield the ax on government spending in order to cut down the budget deficit.
Hold on to your hats: Italy is proposing to cut €4.5 billion in spending for the remainder of 2012! That is really going to put an impressive dent into that €2 trillion debt mountain. The bond markets will no doubt be ecstatic over this latest plan.
However, readers should remember here: the career bureaucrat Mario Monti is also among those who have so far had no plan whatsoever of actually shrinking the size of government. The great bulk of his 'reforms' consisted of tax increases as well, combined with extensive harassment of tax payers who are automatically assumed to be cheats in Italy (to be fair, many of them are, but that is the case in all high tax countries – all of them have flourishing 'shadow economies', mainly because people could otherwise simply no longer afford to pay for a great number of services).
Apparently Monti has now belatedly realized that his attempt to squeeze blood from turnips must be regarded as a failure. Contrary to Hollande's plans, he is forced to cut down the size of the bloated public sector at least a little bit – to the chagrin of unions:

“The decree aims to reduce public spending, without hitting services to citizens," Mr. Monti said at a news conference following a cabinet meeting, which lasted about seven hours. "It allows us to avoid a two percentage points VAT (value-added tax) increase, which should have been enacted in October, and is now delayed until July 2013."
The size of the cuts, which faced strong opposition from unions and regional officials, is slightly larger than the €4.2 billion in cuts the government originally projected for this year. They include cuts of at least 20% of managerial posts in the public sector, while at least 10% of lower-level employees will face layoffs.”

(emphasis added)
Well, it's at least a beginning.

Addendum 2: Finland Contests Seniority Clause

Finland continues to throw spanners in what we might call the 'van Rompuy-Barroso works'. The latest comes in the form of Finland pointing out that there is nothing in the agreements of the recent euro-group summit that leads it to conclude that ESM or EFSF loans to Spanish banks do not enjoy seniority in the chain of credit claims against Spain.

Finland is contesting the wording of an agreement struck last week in Brussels, arguing it doesn’t adequately address the possibility that loans to Spain from Europe’s permanent rescue fund can give taxpayers seniority.
A June 29 statement from the 17 euro-area leaders stripping the European Stability Mechanism of its preferred creditor status in Spain was incomplete, said Martti Salmi, a Finnish Finance Ministry official. The 100 billion-euro ($126 billion) bank bailout could provide seniority to contributor nations if fresh funds are transferred by the ESM, he said.
Last week’s release out of Brussels “gives the impression that the entire bailout is without seniority,” Salmi, a director at the Finance Ministry under Jutta Urpilainen, said in a phone interview yesterday. “This is not the case exactly.”
Euro-area finance ministers may decide on July 9 whether the entire Spanish bailout will come from the EFSF, according to Salmi. Use of the temporary fund means Finland will demand collateral, a privilege the country has already paid for after agreeing to forgo any profits the EFSF may generate, he said. Finland also agreed to make its contribution to the ESM up front as a condition for receiving collateral. The country has yet to make that transfer, according to the Finnish Treasury.
Finland’s requests might start to resonate with electorates in other northern countries, who could feel that assistance to southern countries has already reached its limits, especially if economic conditions deteriorate at home,” Costerg said. Finland’s request for collateral could also raise the cost of the bailout, he said.
Inside the euro area, Finland shares its top credit rating with Germany, Luxembourg and the Netherlands at the three main rating companies. The other countries in the monetary union are Austria, Belgium, Cyprus, Estonia, France, Greece, Ireland, Italy, Malta, Portugal, Slovakia, Slovenia and Spain.
Finland’s government on July 2 reiterated its opposition to secondary market bond purchases using the ESM, citing the rescue fund’s limited resources and what it called the proven “ineffectiveness” of such measures. Such interventions could cost as much as “hundreds of billions of euros,” and be a deal-breaker for Finland, Salmi said.”

(emphasis added)
It is noteworthy that Finland managed to hew to the Maastricht criteria both in terms of its budget deficit and its cumulative public debt in spite of suffering a rather stunning economic contraction of 8.4% in 2009. It should be no surprise that the country's people and government are not impressed with the efforts on display elsewhere.
Political resistance to the bailouts is great and growing within Finland. Why should it risk its own credit rating to help those unwilling or unable, for whatever reason, to help themselves? Why should Finland worry about recalcitrant unions in Italy or irresponsible lending practices in Spain? It is up to the governments concerned to take the necessary steps. Removing the seniority clause – if it is to be believed that it has really been removed, as evidently quite a few details remain to be hashed out – may have temporarily calmed the bond markets (the period of calm is already over, it has lasted for all of three trading days this time), but it will also remove the pressure on governments to enact the deep structural reforms that are necessary, regardless of whether they are or aren't popular. This is no longer a popularity contest after all. It is a fight for survival.

Finland's well-preserved minister of finance, Jutta Urpilainen wants to get collateral from Spain.
(Photo credit: Lehtikva)

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