Business

WHEN Europeans fear for their jobs and their savings, when their governments and companies cannot easily borrow money, when banks fail and the single currency trembles, then the European Union is facing not just an economic crisis, but a political crisis, as well. And, so far, Europe’s leaders have not been equal to the threat. Over the past 18 months they have mostly taken refuge in denial and bluster, punctuated by bickering and by heaping blame on financial markets. Despite a recent bout of austerity and the 11th-hour launch of a vast bail-out fund for its most fragile economies, Europe seems a diminished force in the world.

In Asia and America it has become fashionable to look upon these failings with disdain. Europe’s time is past, it is said. Its ageing, inward-looking citizens no longer have the resolve to overcome adversity. And yet an ailing Europe benefits nobody. Even now the European Union is the world’s biggest economy. Were it healthy, the worst of the global economic crisis would be over. Politically, everyone has a stake in the fate of Europe’s Big Idea, that rival nation states can do better by pooling some sovereignty instead of going to war. And socially, all democracies eventually have to grapple with Europe’s Big Problem, that governments and social protection tend to grow until they choke the economies that pay for them.

So rather than sneer at Europe’s impotence, the world should be asking whether Europe can rediscover its vigour—and if so how. This newspaper offers an unfashionably optimistic answer. There is nothing ordained about Europe’s failure. Indeed, if EU leaders show a little courage this crisis offers the best chance at revival since the 1980s.

Jacques the lad

In that decade, when central and eastern Europe were still part of the Soviet block, Europe suffered low growth and high unemployment caused by two oil shocks. “Eurosclerosis”, as it was called, led, under the European Commission presidency of Jacques Delors, a brilliant and irascible French politician, to the single market in 1992 and to a rejuvenation of Europe’s institutions. Those reforms laid the ground for one of the most dynamic periods in EU history. There is a lesson here for leaders today. Unfortunately, they seem to be missing the point.

Inspired by Mr Delors, some in Europe now grappling with the fate of the euro argue that crises always lead to a leap in EU integration. Championed by France, they argue that the chaos that has spread from Greece to southern Europe shows the euro zone needs a core of dirigiste powers to run Europe in a more political and less technocratic way. To limit “unfair” competition, they want things like Europe-wide labour standards and some harmonisation of taxes. They want to oversee transfers of communal cash to the euro’s weakest members.

An interactive guide to the EU's debt, jobs and growth worries

Yet the appetite for this sort of integration is not shared in other countries—not even in Germany which, mindful of its own history, does not trust politicians with monetary policy. Its people were assured that the euro would be run with the same discipline as their beloved Deutschmark and they are sick of paying for all of Europe’s new schemes. Instead Germany wants a harsh system of rules, enshrined by treaty if need be, that would ban countries from spending too much.

If the French idea is unacceptable, the German idea is unworkable. Politics has tended to trump economics right from the start of the euro, when indebted countries like Belgium and Italy were allowed in. You cannot simply decree that every one of 16 countries in the euro zone will always behave responsibly. Someone will break the rules and, as often as not, someone else will have reason to connive with them.

Tidy minds contemplating the contradictions between the euro’s two most important members foresee either integration or collapse. They argue that without a clear political mechanism to cope with wayward countries, the euro is doomed to repeat the sort of crisis it has suffered this year. One day this view may be proved right. But tidy minds underestimate the European art of compromise . And they overlook the determination in Europe to make the euro stick—because to pull it apart would be ruinously costly and threaten the EU’s very existence. For the moment, therefore, the most likely outcome is neither collapse nor a dash towards integration, but for the euro zone to muddle through.

1992 and all that

Muddle avoids problems, it does not solve them. Instead of miring itself in internal mechanics, the EU should embrace the lesson from the other, more radical, half of Mr Delors’s programme—the bit that focused on freeing its economy and setting up the single market. By boosting economic growth the EU could ease its political difficulties and help its citizens. At the moment EU leaders are putting their effort into cutting spending: if only they were to add a dose of 1992-style reform.

The single market remains half-built. Mario Monti, an Italian economist and a former commissioner, has recently set out just how much more is left to do*. The EU is 30% less productive than America in services. Because European services companies operate behind national barriers they innovate less and they tend not to gain the full economies of scale. Whole areas, such as health care, are exempted from EU-wide competition. Likewise some high-tech industries, such as telecoms, have been protected and others, such as e-commerce, barely existed in 1992. A single digital market could be worth 4% of EU GDP by 2020. The EU has a costly, fragmented patent system, so products (like far too many workers) cannot cross borders easily; energy supply has not been properly liberalised; debts are hard to collect across borders. And so it goes on. National to-do lists are just as long. In Spain and Italy privileged workers are protected, discouraging new permanent jobs. German entrepreneurs are immediately taxed on equity they put into a start-up. Europeans retire too early everywhere.

The barrier to reform has always been political, not economic. Jean-Claude Juncker, prime minister of Luxembourg, put it best in 2007: “We all know what to do, but we don’t know how to get re-elected once we have done it.”

But does that excuse still hold? The crisis has shifted the political landscape in Europe. The euro was supposed to spur reform by preventing governments from restoring competitiveness by devaluing their currencies. And it did. Not at first, when Greece, Spain and the others used the euro’s low interest rates as an excuse to party. But now they have woken up hung-over, to find that reform can be put off no longer .

There are signs that Europeans understand this better than their timid leaders. Asked if they were better off in a free-market economy, 73% of Germans and 67% of French said yes, according to a survey released in June by Pew Research Centre**. That compares with 65% and 56% respectively at the height of the boom in 2007 and it rivals America, with 68%, and eclipses Britain, with 64%, where support for free markets has fallen.

The moral case for reform has never been clearer. The European “solidarity” that protects jobs for life in Spain for the lucky few is hard to defend when it means that young people, who could only ever get work on temporary contracts, have been thrown onto the dole. In France it is irksome to see your taxes paying healthy people to retire at 60 when schools and hospitals need the money more. Cash-strapped households in Belgium might rather like the idea that competition can lower their bills. Were he speaking in 2010, a European leader seeking re-election as well as reform might just fancy his chances.

Listen to the people

In the past couple of decades Europe’s privileged “insiders” have blocked change. Mr Delors managed to take them on by building a coalition of the free-market liberals and believers in European integration. Today the crisis has given Europe’s leaders the chance to create their own coalition for reform, focused again on the single market. They should seize it.

ON JULY 15th a 75-tonne cap closed off the Macondo well at the bottom of the Gulf of Mexico. The flow of oil ceased, for the first time in the three months since a blowout in the well doomed the rig which had drilled it, Deepwater Horizon. The cap is not necessarily permanent. It sits there at the government’s pleasure, and the administration is giving BP, the well’s operator, permission to keep it in place only one day at a time. But the chances of BP going on to seal the well permanently by mid-August, with little or no oil seeping out in the meantime, look good.

This may not mark a turning-point in BP’s fortunes: it still faces payouts of tens of billions of dollars, and reports and inquiries that could damage its reputation and finances yet further. But it will make it clearer that the company’s wounds are unlikely to be fatal.

The centrepiece of BP’s plan to stop the leak permanently is a relief well, which is now drilled to 12,000 feet (3.7km) below the sea floor and about four feet from the Macondo well. Some 100 feet below where it is now, the relief well will cut into the outer ring of the Macondo well and then into its central drill pipe. The new well will be used to fill the old one with heavy drilling mud that will press down on the reservoir below, stopping more oil from escaping. Then cement seals will be set to hold everything in place. Before the relief well punctures Macondo, engineers may also—if the government allows them—pump some heavy mud down from the now-capped wellhead. That could make the last bit of the procedure both easier and quicker.

Storm watch

Things could still go wrong. The pressure in the capped-off well could blow a new hole in it, letting oil and gas leak out through the seabed. There is also the risk of a hurricane. So far this summer’s hurricane season has been quieter than predicted; but just one bad storm in the wrong place could disrupt the work on the two wells.

A hurricane could also intensify the ecological damage onshore. As of July 14th, the government estimated that there was oil on 572 miles (920km) of gulf coast—35% of the stretch from the Florida Keys to Brownsville, Texas—with 328 miles of Louisiana’s 397-mile coast affected. This was up from 179 miles for the whole coast three weeks earlier. But most of this oil is close to the shoreline. A storm surge could wash it deep into Louisiana’s wetlands, where it would probably kill the grasses that knit what land there is together, raising the risk of further erosion.

Paying for continued clean-up and restoration onshore means that BP’s direct costs will still be hefty even after the operations at the well are scaled down. There will also be huge claims for damages and, eventually, fines. Citigroup Global Markets reckons that the damages, of perhaps $30 billion (reduced to $23.7 billion after tax), will be the biggest chunk of the total bill.

How severe the fines will be depends on how much oil was actually spilled, and how much blame is attached to BP. The government has yet to say how much oil it thinks has been released; its earlier statements suggest 3m-4m barrels, but the range could be broader. Then there is the question of the fine per barrel, which depends on an assessment of the company’s culpability: it could be up to $4,300, giving a total of around $15 billion, on which there would be no tax relief.

BP intends to use its second-quarter figures, due on July 27th, to provide its own assessment of its liabilities, and to show that it can meet them. It has already announced a $7 billion sale of assets to Apache, an oil and gas company good at rejuvenating fields that are past their peak production. That sale will provide money for the escrow fund from which damages will be paid.

Selling assets makes a lot of sense for a company which now has a break-up value much higher than its market capitalisation. When it releases its results the company is likely to start sketching out its defence against the widespread assumption that it was grossly negligent. A number of separate things had to go wrong for the well to blow out, not all of which were necessarily BP’s fault: the rig was leased from another firm, Transocean, and various contractors played crucial roles.

Nevertheless, other oil companies have criticised the way BP designed and operated the well. One of these critics is Anadarko, which had a 25% stake in the Macondo well; it and the other junior partner, Mitsui Oil Exploration, have not stumped up for what BP sees as their share of the costs to date, and this will doubtless lead to further legal action that will turn on BP’s culpability. The company’s case is hardly helped by the fact that Robert Kaluza, BP’s well manager on board the rig at the time of the disaster, has declined to testify in front of an investigation into it, pleading his fifth-amendment right to avoid self-incrimination.

Which courts the future battles will be played out in depends on a hearing in front of a federal panel that will decide on jurisdiction. BP wants all the cases to be held in a court in Houston; many of its plaintiffs prefer Louisiana, where rage against the company runs high. But dislike for BP should not be mistaken for dislike for oil. A Louisiana court has overturned the federal moratorium on deepwater drilling, and the state is keen to see the industry relaunched. The greater costs that will be incurred by drillers when that happens, because of tighter regulatory and technical standards, will flow in part to Louisiana workers and contractors. And it will not be surprising if a slimmer, chastened BP is among the companies paying them. Stricter regulation may increase the advantages of companies that can deploy massive resources; to its cost and detriment, BP has shown that it fits that bill.

THE hefty financial overhaul that Barack Obama signed into law on July 21st (pictured) left behind one big piece of unfinished business. In 2008 Fannie Mae and Freddie Mac, mortally wounded from losses on loans acquired during the bubble, were placed in “conservatorship”, a halfway house between bankruptcy and outright nationalisation. There they remain, their losses duly covered with new injections of capital by the Treasury—$145 billion so far. Tim Geithner, the treasury secretary, has promised to address the matter of Fannie and Freddie by early next year but so far he has no answers, only questions (literally so: in April he asked the public to comment on seven of them).

The hesitancy is understandable. Millstones though they are, the two firms remain critical to the economy. In the first quarter they and Ginnie Mae (which unlike Fannie and Freddie has always enjoyed the explicit backing of the state) guaranteed 96.5% of all newly originated mortgages, according to Inside Mortgage Finance, a newsletter.

It is almost certain that the companies will no longer be allowed to hold a substantial in-house portfolio of securities. Yet the Treasury must still decide what to do with the $5 trillion in mortgages the companies guarantee. It could continue to pump money into the companies to cover losses on the loans as they mature; it could take explicit responsibility for them, inflating the national debt; or it could sell them to private investors.

The cost is apt to be high, regardless. Most of the losses of Fannie and Freddie result from mortgages originated before 2008. Mortgages originated in 2006 and 2007 account for 24% of Fannie’s business but 67% of its credit losses.

In 2008 both firms began tightening their underwriting criteria and raising the fees they charge to guarantee mortgage-backed securities (MBS). Between 2007 and 2009 the proportion of their loans with a loan-to-value ratio of 70% or less rose from 31% to 49%, while the share with a loan-to-value ratio above 95% fell from 10% to 1%, according to the Federal Housing Finance Agency, their regulator. At Freddie Mac 3.9% of mortgages originated in 2008 were at least 90 days delinquent at the end of March 2010. For mortgages originated in 2009, the equivalent figure was barely 0.1%, although renewed signs of weakness in the housing market may yet cause that figure to worsen. “We’ll be paying for the sins of the past for a long time, even though the current book of business is generating positive economic value,” says one official.

If Fannie and Freddie are making money now that they are pricing their insurance differently, this suggests that the private sector could do their job. (Ginnie Mae would continue to back loans to low-income families.) Michael Lea of San Diego State University notes in a recent paper that most other countries get by with far less government backing of mortgage finance, yet their home-ownership rates are not appreciably lower and none suffered as bad a housing crash (see table).

Most reform proposals to date, however, still envisage a permanent federal backstop. Donald Marron and Phillip Swagel, two economists who served in the administration of George Bush, say the federal government should sell an explicit guarantee at a rate designed to recoup future losses to Fannie, Freddie or a purely private competitor. Wayne Passmore and Diana Hancock, economists at the Federal Reserve, similarly propose a government insurance fund that would sell guarantees for any asset-backed security. The Mortgage Bankers Association, a trade group, proposes that the government charter a new set of purely private mortgage insurers who would then have to buy backup federal insurance.

In America 60% of mortgages are securitised rather than kept on banks’ balance-sheets. That partly reflects Americans’ preference for 30-year fixed-rate mortgages that can be pre-paid without penalty—a difficult sort of asset for banks to hedge. The securitisation rate is more than twice as much as that in Canada, Spain and Britain, the next-highest countries. Defenders of a federal backstop say this leaves the American system uniquely vulnerable during a crisis, when investors will refuse to buy any MBS that lacks a government guarantee. Mr Swagel and Mr Marron argue that investors will, probably correctly, assume that the government will always intervene, so it makes sense to charge for that guarantee explicitly.

Ruling out a private-sector solution may be premature. Guy Cecala of Inside Mortgage Finance says the government could start to revive the private-label MBS market by gradually rolling back expanded limits on the size of loans it will guarantee. Other changes to the mortgage market, such as better underwriting, greater use of covered bonds and more adjustable-rate mortgages, would help reduce the need for a guarantee. That said, the private sector is too weak to do much right now. However unnecessary in the long run, the government’s dominance of the mortgage market will not end soon.