Sunday, February 26, 2012

Mario Draghi reveals the Grand Plan

Policy in Europe has generally been done in the back rooms, with the theatre, e.g. PIIGS debt re-negotiations, done in the front rooms. Last year, the markets were panicked because they perceived the backroom elites had lost control of the situation and events were spiraling out of control.

Today, it appears that the elites have calmed things down and there had always been a Grand Plan. We got hints of this when Angela Merkel said that there was no silver bullet to the eurozone crisis, but resolution was a "long process".

Now ECB head Mario Draghi, in a WSJ interview, reveals the Grand Plan. Not only does he speak on monetary policy, I found it more important that he touched on fiscal policy and micro-economics, which is an indication that he was speaking about the European Grand Plan.

The Grand Plan involves austerity, but it's not all austerity all the time. Draghi distinguishes between "good austerity" and "bad austerity".
WSJ: Austerity means different things, what’s good and what’s bad austerity?

Draghi: In the European context tax rates are high and government expenditure is focused on current expenditure. A “good” consolidation is one where taxes are lower and the lower government expenditure is on infrastructures and other investments.

WSJ: Bad austerity?

Draghi: The bad consolidation is actually the easier one to get, because one could produce good numbers by raising taxes and cutting capital expenditure, which is much easier to do than cutting current expenditure. That’s the easy way in a sense, but it’s not a good way. It depresses potential growth.
Lower taxes and less government expenditures? That sounds positively...Anglo-Saxon (excuse my French).

Draghi went on to say that the next step, after austerity, is structural reform "because the short-term contraction will be succeeded by long-term sustainable growth only if these reforms are in place". Draghi went on to say [emphasis added]:
WSJ: Which do you think are the most important structural reforms?

Draghi: In Europe first is the product and services markets reform. And the second is the labour market reform which takes different shapes in different countries. In some of them one has to make labour markets more flexible and also fairer than they are today. In these countries there is a dual labour market: highly flexible for the young part of the population where labour contracts are three-month, six-month contracts that may be renewed for years. The same labour market is highly inflexible for the protected part of the population where salaries follow seniority rather than productivity. In a sense labour markets at the present time are unfair in such a setting because they put all the weight of flexibility on the young part of the population.
In other words, union busting and going after all of the entrenched interests of the old with their lifetime jobs and gold-plated pensions at the expense of the young jobless. It sounds positively Thatcherite. Draghi went on to say that the old days of the European social model are gone [emphasis added]:
WSJ: Do you think Europe will become less of the social model that has defined it?

Draghi: The European social model has already gone when we see the youth unemployment rates prevailing in some countries. These reforms are necessary to increase employment, especially youth employment, and therefore expenditure and consumption.

WSJ: Job for life…

Draghi: You know there was a time when (economist) Rudi Dornbusch used to say that the Europeans are so rich they can afford to pay everybody for not working. That’s gone.
Mario Draghi is an important central banker and chooses his words carefully. I can't believe that he would go rogue and speak so frankly about fiscal and other government policy outside the ECB's mandate without the consent, or at least informing, the likes of Merkel and Sarkozy. So you have to believe that he is speaking on behalf of either the Elites or at least Merkozy in detailing this Grand Plan.
Can the Grand Plan work?
Today, I see commentary about how austerity is biting and the people of Greece (followed by Portugal) cannot possibly survive with a policy of all-austerity-all-the-time. They are missing the point. Draghi said that structural reforms must follow because "short-term contraction will be succeeded by long-term sustainable growth only if these reforms are in place."
This sounds like a long and hard road. Can it succeed?
The plan sounds like it was written out of the Maggie Thatcher playbook. It is also somewhat Teutonic in that it is well aware of the link between competitiveness and productivity, as well as the remarkable German technique of achieving a consensus between business, labour and government.
I am cautiously optimistic that the Grand Plan could work, which would lead to a period of European Renaissance. For it to work, however, many things have to go right. First of all, you need all of the actors to fall into line and no one to quit because "enough is enough". So watch the upcoming Greek elections and watch the upcoming French elections for how much support Marine Le Pen gets as important barometers of discontent on the Street. I remain optimistic because we are not at that breaking point because, despite the mass content with the bailout plan, the latest opinion polls of Greeks show that 77% want to stay in the eurozone "at all costs".
As well, you need to have an accommodative Dr. Draghi (and Dr. Bernanke) standing by to inject the patient with additional quantitative easing morphine if necessary while he is still in recovery. That appears to have been accomplished. Note how Draghi did not rule out another round of LTRO despite other quarters of the ECB voiced concerns about the banking system becoming overly dependent on ECB support:
WSJ: Would you be open to doing more, or longer, LTROs if needed?
Draghi: You know how we answer these questions. We never pre-commit.
Also notice how the ECB's LTRO program amounts to de facto quantitative easing and money printing, but there hasn't been a single word of protest from the German hardliners? That's an indication that there is a Grand Plan which the elites are executing.
The jury is out on the Grand Plan but if this all works, Merkel could be lionized as the new Thatcher and Draghi as the new Maestro.
Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.
None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

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