From McSweeney’s:

Yesterday, I put up a post of a man apparently relieving himself into his car’s gas tank. Having nothing better to think about (the eurozone crisis just goes on and on and on . . . ), my fertile (pun intended) mind came up with a great idea. An entrepreneur should start a pipeline company with both collecting and dispersal stations spread across the nation. People availing themselves of the collecting stations would be paid (based on the volume of their contributions) via PayPal accounts.

The best name for this company is obvious: URI-NATION.

Now, that’s recycling!

At the time, I didn’t think the conclusions reached in The Limits to Growth were wrong. The book was published on October 31, 1972.

Its authors were professors and lesser-lights at MIT’s Sloan School of Management.I was among the lowest of the lesser-lights, having been an MBA (actually, an MS) student at Sloan when the research that resulted in this book was being done.

The findings published in the book were arrived at by using a modeling technique called “Systems Dynamics (SD).” SD models problems as a set of feedback loops. It was developed by Jay Forrester, a renowned professor of electrical engineering at MIT. “Feedback” is, of course, a fundamental variable of all electronic devices. Forrester developed a computer program that represented these feedback loops as a set of differential equations and then solved them.

The world really is a set of feedback loops. Want an example? The crisis in the eurozone involves feedback among sovereign debt levels, bank solvency, sovereign credit ratings, bank credit ratings, interest rates, GDP growth rates and so on and so forth. Policy initiatives that directly effect one of these variables effect all of the others.

But the efficacy of Systems Dynamics, like that of any other modeling technique (for instance, econometrics) depends on the accuracy of the assumptions employed: for instance, the future rate of technological change. That’s where The Limits to Growth, with its unduly pessimistic conclusions, made its mistake.

All of this is a prelude to the following article from Business Week.

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Everything You Know About Peak Oil Is Wrong

We’re not running out of resources. Quite the contrary. And in our abundance lies a paradox

At some point in the coming months, the confrontation between the West and Iran over the Islamic republic’s nuclear program may reach a breaking point. Even assuming the two sides manage to avoid full-fledged military conflict, the crisis could still cause significant disruption to the world economy. An embargo against Iranian oil exports, or a move by Iran’s leaders to close the Straits of Hormuz—or both—could send the price of oil soaring and jeopardize the re-election hopes of leaders from Paris to Washington. And as happens with every oil crisis, pundits will insist that the pain we’re feeling is nothing compared to what it will be like when the world finally runs out of black gold.

We’ve been warned before. Four decades ago this year, five scientists from the Massachusetts Institute of Technology published an influential set of predictions regarding the sustainability of human progress. Titled Limits to Growth, their report suggested the world was heading toward economic collapse as it exhausted the natural resources, such as oil and copper, required for economic production. The report forecast that the world would run out of new gold in 2001 and petroleum by 2022, at the latest.

Over the intervening years, the threat of “peak oil” has stayed with us—the date when global petroleum production was to reach its supposed maximum, afterward and evermore to decline as dwindling reserves were tapped out. And the exhaustion of the world’s oil reserves was just the start. A host of other critical natural resources, from phosphorus to uranium, have been declared peaking or already peaked.

Forty years later, however, rereading Limits to Growth invokes a growing sense of irony. Far from being depleted, worldwide reserves of minerals continue to climb. New technologies suggest the dawn of U.S. energy independence. The biggest concern isn’t that the planet is running out of resources—it’s having too many for the planet’s own good.

Start with oil. In 1971, the Limits to Growth team forecast that the world’s supply would run out 10 years from today. And yet according to renowned oil analyst Daniel Yergin, technology advances and new discoveries have allowed oil reserves worldwide to keep growing. For every barrel of oil produced in the world from 2007 to 2009, 1.6 barrels of new reserves were added. The World Energy Council reports that global proven recoverable reserves of natural gas liquids and crude oil amounted to 1.2 trillion barrels in 2010. That’s enough to last another 38 years at current usage. Add in shale oil, and that’s an additional 4.8 trillion barrels, or a century and a half’s worth of supply at present usage rates. Tar sands, including some huge Canadian deposits, add perhaps 6 trillion barrels more.

We’re awash in more than oil. One British study from the 1930s predicted an acute global shortage of copper “within a generation.” Not so much. The U.S. Geological Survey estimates global land-based copper resources to be 3 billion tons or more—the equivalent of 185,000 years at current production. That’s almost double the estimate of resources from 11 years ago, which means the number may have further to climb. And when we do finally run out of land-based supplies, there are still the undersea sources to use up.

The long-term picture for phosphate, vital for fertilizer production, is also reassuring, despite a price spike in 2008: Estimated global phosphate reserves climbed from 11 million tons in 1995 to 65 million tons in 2010—equal to 369 years of current production. The list goes on: Current resource estimates suggest it will take 347 years to run out of helium, 890 for beryllium, centuries for chromium, more than a millennium for lithium and strontium. And for those Americans worried about the price of makeup, resources of talc in the U.S. alone are enough to provide more than 1,000 years of supplies at current rates of domestic production.

If we keep on using more minerals, and we don’t do a better job of recycling them, and plans to mine the moon don’t work out, we’ll surely run out of supplies one day. But for pretty much every vital mineral resource, that day looks to be a long way off, which is great news for the world economy. Limits to Growth suggested the world would be on the verge of complete economic collapse around about now, with industrial output falling to its level of 1900 by the end of this century, as resources vital to sustaining a modern economy dried up. However dire today’s global financial crisis, we are nowhere near such a doomsday scenario.

What’s more, expanding resource reserves are great news for poor countries, home to many of the world’s recent mineral discoveries. A growing number of developing economies are likely to earn money from drilling and mining, following in the recent footsteps of countries such as Ghana (on the cusp of an oil boom) and Mongolia (ramping up its copper exports). Although development experts often invoke the “resource curse”—the idea that oil and mining industries predestine a country to dictatorship and poverty—recent analysis by the World Bank suggests the fear of the curse is overblown. “As one might intuitively expect,” the Bank reports, “greater natural resource wealth is associated with higher GDP per capita.”

Managing this planetary cornucopia will, however, present significant challenges. Were we to continue expanding our resource use at current rates, we may pollute our way to a denuded planet. Mining, drilling, and moving industrial commodities is a messy business—the Gulf of Mexico oil spill is just one example—to say nothing of the impact on climate change. The tar sands fields in Alberta, Canada, alone contain 1.7 trillion barrels of oil. That is equal to roughly a half century’s supply at current global oil use—and it’s an environmentalist’s nightmare to extract. Two tons of tar sands are needed to produce every barrel of oil. Getting the sludge-like stuff to the surface takes pumping steam into the tar beds, which in turn takes burning natural gas to heat the steam water. Tar sands oil, in other words, requires greenhouse gasses to produce and emits even more when it is consumed. That was a major reason why climate change activists lobbied so hard for the White House to shut down the Keystone XL pipeline from Alberta to the Gulf of Mexico.

And yet the world economy is becoming increasingly lightweight. Industries consume fewer mineral resources for each dollar of output. As much as two-thirds of global economic activity consists of outputs that don’t pollute or even weigh anything at all—things such as entertainment, education, finance, and health care. The services sectors’ share of global output climbed from 53 percent in 1970 to 71 percent in 2010, according to World Bank data. In part because of that, the amount of energy the planet needs to generate the same amount of wealth is declining.

That evolution may not be happening fast enough to stave off climate change, but it suggests the possibility that we can keep improving global living standards even while reining in our collective impact on the global environment. If we tax carbon emissions, provide financial incentives to preserve global forests, and better regulate mining and drilling to reduce spills and toxic waste, perhaps the global population can protect the planet without sacrificing the well-being of future generations.

There are still plenty of good reasons to conserve the world’s mineral resources—just as there are very good reasons to avoid another war in the Middle East. But fear that the resources will run out isn’t one of them.

Shades of the 1930s:

“this gap between the supply and demand for governance that fuels popular discontent, and gives impetus to the temptation for states to look in on themselves. It explains the rise both of rightwing populism and the anti-capitalist movements of the left, and risks fuelling a dangerous revival of the politics of identity on both sides of the Atlantic. The response of many governments has been to turn inwards and seek to defy the realities of interdependence by elevating narrow definitions of national interest. Old concepts of mutual interest and solidarity have cracked even in the eurozone, the most closely integrated group of rich nations.”

“The danger is that what started out as a crisis of financial capitalism will give way to a new age of nationalisms – a backlash against globalisation and a return to zero-sum politics.”

The Financial Times is continuing to add to its “Capitalism in Crisis” series. The latest addition is by Philip Stephens.

Leaders Who Generate Diminishing Returns

Three years on, the markets call the shots. Rating agencies humiliate the mighty US government and also strip France of its cherished triple A credit status. The implosion of financial capitalism has become a crisis of political authority in the west. Behind this lies an unequal contest between a globalised economy and politicians struggling to answer the demands of national electorates. “It is not the ratings agencies that dictate the policies of France,” François Baroin, that country’s finance minister, declared after the Standard & Poor’s downgrade. To some it seemed a statement of hope as much as fact.

Confidence in capitalism has fallen. A recent opinion poll conducted by GlobeScan indicated that support for the free enterprise system had fallen to about 60 per cent in the US. Ten years ago it was at 80 per cent. Mitt Romney, frontrunner for the Republican nomination in this year’s presidential contest, once boasted of his success in building Bain Capital, the private equity business. Now, a career at the sharp end of capitalism’s creative destruction may prove a political liability.

Ironically, the poll found that faith in the market was significantly stronger in China. There were higher scores, too, in Brazil and Germany. Capitalism, leaders of most political colours seem to agree, is still the only show in town – but must it be unfettered?

In Europe, the debts of the banks have been piled on to the deficits of governments, turning a financial crisis into one centring on sovereign debt. The storms engulfing the euro threaten the continent’s most ambitious project. Angela Merkel, German chancellor, warns with only slight hyperbole that the euro’s failure would imperil decades of European integration. On the other side of the Atlantic, an initial fragile consensus in Washington on rescuing Wall Street has given way to political gridlock. Barack Obama faces a constant struggle with Republicans in Congress to secure enough money to keep the federal government running.

All the while, the Tea Party, the Occupy movement and, in parts of Europe, rightwing populists shout from the sidelines. Greece and Italy have lost elected politicians to technocrats. Elsewhere, presidents and prime ministers more closely resemble victims than masters.

In 2009, things looked as if they would be otherwise. Surveying the nationalisation of a slew of US financial institutions and Washington’s takeover of the automotive industry, a senior Chinese official remarked laconically that he detected “socialism with American characteristics”. In Britain, the crash obliged the government to take controlling stakes in two of the biggest banks and to prop up several smaller ones. What had seemed be a life-threatening event has become a chronic illness – not so much a crisis of capitalism but of the capacity of politicians to manage it.

The banks’ losses have been nationalised. Billions of dollars of toxic assets that once sat on the books of financial institutions have piled further pressure on public deficits already swollen by recession.

Governments badly need growth. The US economy shows signs of life, but its recovery has been anaemic. Mr Obama’s hopes of a second presidential term rest critically on a sustained fall in unemployment. In Europe, growth has all but disappeared. The eurozone’s peripheral economies – Greece, Spain, Portugal and Ireland – are on life support and the continent’s banking groups are kept afloat on a sea of liquidity provided by the European Central Bank.

The pervasive sense of political powerlessness is a western rather than a global phenomenon. China, India, Brazil and the rising rest are not immune from the troubles of the rich nations but their economies have continued to grow. For most Asians, today still feels better than yesterday and tomorrow looks better still. American and European politicians have discovered that capitalism no longer belongs to the west. Instead, the troubles faced by the advanced economies have crystallised the wrenching shift in the balance of global economic power. The Chinese, Indians, Turks and Brazilians now have a say in setting the terms of exchange.

. . .

Politicians of the left and centre-left saw opportunity in the crash. The Washington consensus, the organising idea behind the global advance of laisser-faire financial capitalism, had been discredited. The demise of market liberalism, the socialists and social democrats assumed, would rehabilitate the role of government as the pivotal actor in economic management. Popular fury with the bankers would translate into renewed faith in the efficacy of the state. As things have turned out, the centre-right has all but swept the electoral board.

Policy Network, the progressive think-tank, has an explanation. The mistake of the centre-left was to misread the anger at the excesses of the market as a return of public confidence in the state. The organisation’s opinion surveys show that the crisis has come to be seen in the minds of voters as one of public borrowing and debt as well as of bankers’ greed. Voters do not think the answer to spiralling deficits is more government borrowing. “It is the question of the state – its size, its role, its efficiency – that has become the central issue, not the inherent instability and free-market ideology,” Policy Network observes. Put another way, if capitalism needs fixing, Europeans have decided to leave the task to the politicians who best understand the marketplace.

The Occupy movement that has sprung up across American and European cities has drawn sympathy from beyond the protesters’ natural constituency. But its many threads – some anti-capitalist, some anti-globalisation and many social democratic – have fallen short of a coherent prospectus. On the populist right the themes are sometimes complementary, as in opposition to immigration, but as often as not contradictory. The Tea Party has harnessed Americans’ scepticism about the role and motives of the federal government: Washington is the big danger. In France, the Netherlands, Finland, Hungary and beyond, parties of the far right have targeted global capitalism as the enemy – with the International Monetary Fund and the European Union at times thrown in as co-conspirators.

Waning public confidence is in part simply a reflection of the brutal economic facts. The financial crash inflicted huge losses on the innocent. Unemployment has risen sharply and living standards have stagnated or fallen. Yet even as they have been swept along in treacherous currents, politicians have not helped themselves. The west is not blessed by decisive leadership. Mr Obama lacks the temperament of a Franklin Roosevelt. Ms Merkel’s almost pathological caution has significantly raised the cost of rescuing the euro – if such a rescue remains possible. Nicolas Sarkozy, the French president, has energy and rhetorical ambition but lacks clarity and concentration.

Missing, too, has been a convincing prospectus. The regulation of financial institutions has been tightened. The US has its Dodd-Frank Act and Volcker rule; Britain has its Vickers commission on banking. Germany and France are plotting a financial services tax. Mr Obama promises less Wall Street and more Main Street, Britain’s David Cameron less financial engineering and more of the real sort. The talk of “responsible” capitalism, of rebalancing economies and constraining the rewards of the super-rich, falls short of anything resembling a grand plan. The ambition is to make do and mend.

. . .

Behind all this, however, lies the structural problem – the mismatch between global economics and local politics. States have been shedding power to globalisation. The big lesson has been about the extent to which globalised capitalism has outstripped the capacity of national governments to manage it.

Governments have ceded power to mobile capital, to cross-border supply chains, to instant global communications and to rapid shifts in comparative advantage. Citizens expect their politicians to protect them against the insecurities of the age – whether economic or physical. Yet governments no longer have the tools to provide such a shield. “Inequality is being driven by globalisation,” one senior minister in Mr Cameron’s government says of the wage stagnation faced by the middle classes. “And there is not a lot we can do about it.”

The same might be said of the rise in structural unemployment in most rich economies as comparative advantage has moved rapidly eastwards.

It is this gap between the supply and demand for governance that fuels popular discontent, and gives impetus to the temptation for states to look in on themselves. It explains the rise both of rightwing populism and the anti-capitalist movements of the left, and risks fuelling a dangerous revival of the politics of identity on both sides of the Atlantic. The response of many governments has been to turn inwards and seek to defy the realities of interdependence by elevating narrow definitions of national interest. Old concepts of mutual interest and solidarity have cracked even in the eurozone, the most closely integrated group of rich nations.

Ms Merkel says German voters cannot be held responsible for the feckless behaviour of their spendthrift European cousins. Politicians on the continent’s troubled periphery rail against German selfishness. The effect has been to recast the euro crisis as a zero-sum game. What Greece, Portugal, Spain and Italy stand to gain, creditor nations such as Germany, the Netherlands and Finland must lose.

The signal this sends to rising states is equally counterproductive. The sense of collective interest visible at the post-crash meetings of the G20 has dissipated. If states so politically integrated as those in the eurozone are so reluctant to act in concert, why should China, India or Brazil invest their faith in co-operative global governance? It is a question to which western leaders have yet to find an answer.

Charles Kupchan, a professor of international relations at Georgetown University, says the political breakdown – political stasis in the US, a fracturing of solidarity in Europe and a merry-go-round of prime ministers in Japan – adds up to a crisis of governability. The diffusion of power in the international economic system has diluted the efficacy of traditional policy tools. There are answers to the malaise, he says, including more government activism in the provision of infrastructure and training, and drives to improve competitiveness and weaken the special-interest groups that have captured some of capitalism’s commanding heights.

These, though, are not quick fixes. The danger is that what started out as a crisis of financial capitalism will give way to a new age of nationalisms – a backlash against globalisation and a return to zero-sum politics. The better route would be an effort to extend and refurbish the multilateral order to match economic integration with great global governance. But, for the moment, we are as far from that as from a serious attempt to remake the rules of capitalism.

Across the continent, European leaders warned that 2012 was likely to be tougher than 2011.

Germany:

Angela Merkel told German voters “next year will no doubt be more difficult than 2011.” In her televised address, she said Europe was experiencing its “harshest test in decades” but would ultimately be made stronger by the crisis.

France:

In a sombre address on national television Nicolas Sarkozy said “This extraordinary crisis, without doubt the gravest since the second world war, is not over … you are ending the year more anxious for yourselves and your children.”

Italy:

Prime Minister Mario Monti said in his end-of-year address last week that Italy had hauled itself back from the “edge of the precipice” but he said more needed to be done to reform labor markets and the service sector to restore competitiveness to the stalling economy. President Giorgio Napolitano urged Italians to make sacrifices to rescue the country’s public finances. “Sacrifices are necessary to ensure the future of young people, it’s our objective and a commitment we cannot avoid. No one, no social group, can today avoid the commitment to contribute to the clean-up of public finances in order to prevent the financial collapse of Italy.”

Focus on the European Central Bank

Well, so much for my forecasting how equity markets would initially respond to stronger than expected demand from eurozone banks for funds from the ECB’s emergency loan program (“longer-term refinancing operations,” or LTROs).

The sentiment reversal may be attributable to the fact that only about €190 billion was fresh liquidity; the remainder comprised funds that were switched from shorter term ECB lending programs.

At a time when the ECB is being heavily and widely criticized for not doing enough — for refusing to act as the lender of last resort for the eurozone — a new and diametrically-opposed concern is beginning to surface. That concern is, as Gavyn Davis puts it, is the explosion in the ECB’s balance sheet. Every time that the ECB lends euros to a bank, it does so in exchange for collateral — “of an increasingly dubious nature,” according to Davis — pledged to the ECB by the bank. These transactions show up in the ECB’s balance sheet, which, as shown in the following chart, has balloned this year.

Says Davis,

The increase from August [2011] to February [2012] will be about €700-800 billion, which is an extraordinary amount for a central bank which is supposed not to believe in QE [Quantitative Easing]. There is another three year liquidity injection due to take place in February, and this may well be even larger than today’s action.

The bulk of the borrowers under these facilities will presumably come from the peripheral economies, and the collateral offered will include single A asset-backed securities and also bank loan portfolios for the first time. Although this collateral will of course have been subject to haircuts before being accepted by the ECB, there can be no doubt that the ECB’s potential exposure to defaults in the peripheral economies will once again have ratcheted higher.

The first sentence in the next paragraph is of special interest in that ECB President Draghi (as did his predecessor) has repeatedly stated that serving as a lender of last resort isn’t within the EBC’s remit. If you find yourself confused, all I can say is: join the club.

The ECB’s justification for this action is that it is, and should be, the lender of last resort to the eurozone banking system. That seem fair enough. In the absence of today’s action, there would have been risks of bank failures in 2012 as banks tried to raise the money needed to redeem €600 billion of their own debt, which reaches maturity during the year. With their access to long term funding largely closed, banks would have been forced to reduce their balance sheets in order to meet these obligations, and this deleveraging would have involved forced sales of sovereign bond holdings and reductions in bank lending. Either way, the eurozone’s crisis would have deteriorated further.

Deleveraging would also have caused a shrinkage in broad money (M3) which the ECB is desperate to prevent or mitigate. What will now happen instead is that the monetary base will expand rapidly as central bank funding for the banking sector replaces private funding, and this is likely to prevent the large drop in M3 which would otherwise have occurred.

As I’ve argued on more than one occasion, money supply growth isn’t inflationary if the velocity of money (the rate at which economic transactions take place) isn’t rising.

Questions will be asked, especially in Germany, about whether this liquidity injection will be inflationary. It is probably better described as anti-deflationary. The money multiplier in the eurozone economy (ie M3 divided by the monetary base) is likely to drop, so M3 will stay subdued. Inflation risks will not crystallise until the rise in base money translates into much more buoyancy in bank lending and broad money growth. That may or may not ever happen.

Davis closes with the following:

. . . the ECB is certainly preventing banks from selling sovereign debt that they otherwise would have sold, and it is doing this by expanding its own balance sheet. The alternative to ECB action would have been to increase the size of the EFSF/ESM at a direct cost to government credit ratings. The ECB is also keeping alive banks which would otherwise have failed, and that would have involved new injections of capital from sovereign governments.

The truth is that, in the present state of the eurozone debt crisis, sovereigns and governments are now inextricably interlinked. It is hard to save one without being accused of saving the other. The ECB is not eager to admit it, but it is trying to save both.

If you’re interested in further pursuing the leveraging-up of the ECB’s balance sheet, I recommend reading a briefing note recently published by the UK-based Open Europe think tank. Among the key points in “The battle for the heart and soul of the ECB” are the following:

The ECB has taken on large amounts of low quality collateral in return for providing loans to banks, and has seen a massive surge in the number of asset-backed securities it has taken on to its balance-sheet. Though not all of these assets are bad or ‘toxic’, they are extremely difficult to value. At the same time, the number of banks which are becoming reliant on the ECB is alarming and hopes that the functioning of the European financial markets will ever return to normal are diminishing – creating a long-term threat to Europe’s economy.

Through its government bond buying and liquidity provision to banks, the ECB’s exposure to the PIIGS has now reached €705bn, up from €444bn in early summer. This is an increase of over 50% in only six months and shows how, contrary to popular belief, the ECB is already intervening quite heavily in the markets. It also highlights how the eurozone crisis continues to transfer risks away from private creditors to taxpayer backed institutions. It remains unclear how the ECB would cover losses in the event of asovereign default.

Moving forward, the ECB could offer a liquidity boost to Europe’s economy but little more. The term ‘lender of last resort’ is often misused or misunderstood – the ECB cannot fully backstop sovereign states or return them to solvency. At best it could ease the pressure on illiquid states, but even this depends on the legal constraints on the ECB’s defined role and being seen to give in to political demands that would hurt the ECB’s credibility and independence.

“Following the EU Summit on 9-10 December, Fitch has concluded that a ‘comprehensive solution’ to the eurozone crisis is technically and politically beyond reach.”

Fitch Affirms France at ‘AAA’; Outlook Revised to Negative

Fitch Ratings has today affirmed France’s Long-term foreign and local currency Issuer Default Ratings (IDRs) as well as its senior debt at ‘AAA’. Fitch has also simultaneously affirmed France’s Country Ceiling at ‘AAA’ and the Short-term foreign currency rating at ‘F1+’. The rating Outlook on the Long-term rating is revised to Negative from Stable.

The affirmation of France’s ‘AAA’ status is underpinned by its wealthy and diversified economy, effective political, civil and social institutions and its financing flexibility reflecting its status as a large benchmark euro area sovereign issuer. In addition, the French government has adopted several measures to strengthen the creditability of its fiscal consolidation effort. Nonetheless, government debt to GDP is currently projected by Fitch under its baseline scenario to peak in 2014 at around 92%, higher than any other ‘AAA’-rated sovereign with the exception of the UK and US and significantly higher than other ‘AAA’-rated Euro Area peers.

France’s sovereign credit profile benefits from a broad and stable tax base – the volatility of the revenue to GDP ratio is half the ‘AAA’ median – and the interest service burden is moderate and broadly comparable with other ‘AAA’s. Under Fitch’s baseline scenario that does not incorporate the realisation of substantial fiscal liabilities arising from the Eurozone crisis or other adverse shocks, even such an elevated level of government indebtedness is consistent with France retaining its ‘AAA’ status assuming that government debt is firmly placed on a downward path from 2013-14. The Negative Outlook on the French rating reflects Fitch’s view that the likelihood of the realisation of contingent liabilities, although still not our base-case assumption, has materially increased, as has the risk of a much worse than expected economic and consequently fiscal outturn.

Similar to other highly rated peers, France faces medium and long-term challenges to improve the functioning of the labour market and enhance international competitiveness. Fitch recognises that the authorities have adopted measures to address these weaknesses, though a more radical structural reform agenda would underpin greater confidence in the underlying potential growth rate of the French economy. However, corporate and especially household indebtedness is moderate compared to some ‘AAA’ peers, notably the UK and US, while foreign indebtedness remains modest, albeit rising.

The Negative Outlook is prompted by the heightened risk of contingent liabilities to the French state arising from the worsening economic and financial situation across the Eurozone, as reflected in the Rating Watch Negative placed on the sovereign ratings of several Euro Area Member States (EAMS) on 16 December 2011. As Fitch commented in its report on 23 November, ‘French Public Finances’, the fiscal space to absorb further adverse shocks without undermining its ‘AAA’ status has largely been exhausted.

The intensification of the Eurozone crisis since July constitutes a significant negative shock to the region and to France’s economy and the stability of its financial sector. Since May, when Fitch last affirmed France’s ‘AAA’ status, its forecast for economic growth in 2012 has been cut from 2.1% to 0.7% with around one-in-four chance of outright contraction. Despite the additional fiscal measures announced in August and November equivalent to around 1% of GDP, further measures are likely to be required in order to cut the deficit to 3% of GDP by 2013 and stabilise government debt below 90% of GDP in light of the worsening economic and financial outlook.

In Fitch’s opinion, the commitments made by leaders at the EU Summit on 9-10 December and by the ECB were not sufficient to put in place a fully credible financial firewall to prevent a self-fulfilling liquidity and even solvency crisis for some non-AAA euro area sovereigns. In the absence of a ‘comprehensive solution’, the Eurozone crisis will persist and likely be punctuated by episodes of severe financial market volatility.

Relative to other ‘AAA’ Euro Area Member States, France is in Fitch’s judgement the most exposed to a further intensification of the crisis. It has a larger structural budget deficit and higher government debt burden relative to Euro Area ‘AAA’ peers. Moreover, relative to non-Euro Area ‘AAA’ peers, notably the US (‘AAA’/Negative Outlook) and the UK (‘AAA’/Stable Outlook), the risk from contingent liabilities from an intensification of the Eurozone crisis is greater in light of its commitments to the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM), as well as indirectly from French banks that are less strong than previously assessed as reflected in recent negative rating actions by Fitch.

The Negative Outlook indicates a slightly greater than 50% chance of a downgrade over a two-year horizon. The triggers that would likely prompt a rating downgrade are as follows:

- Increased likelihood that contingent liabilities from an intensification of the Eurozone crisis will be crystallised onto the French state balance sheet.

- Material slippage from the fiscal targets that the government has set itself, notably the aim of stabilising the government debt to GDP ratio from 2013 and placing it on a firm downward path towards levels that would increase the ‘fiscal space’ necessary to absorb adverse shocks.

- Weaker than expected economic performance that prompts a re-assessment of France’s medium to long-term growth potential.

Conversely, economic and fiscal performance in line with Fitch’s baseline expectations, as set out in the Special Report, French Public Finances (23 November 2011), along with the resolution of the Eurozone crisis would likely result in the stabilisation of the rating Outlook.

In the absence of a material adverse shock, most likely associated with dramatic worsening of the Eurozone crisis, Fitch would not expect to resolve the Negative Outlook until 2013.

Fitch Places Belgium, Spain, Slovenia, Italy, Ireland and Cyprus on Rating Watch Negative

Fitch Ratings has placed the ratings of all investment grade rated eurozone sovereigns and their debt with Negative Outlook onto Rating Watch Negative (RWN). The euro area country ceiling of ‘AAA’ is unaffected. The rating actions are as follows:

- Belgium ‘AA+’/'RWN from ‘AA+’/Negative Outlook (‘F1+’ Unaffected)
- Spain ‘AA-’/'F1+’/RWN from ‘AA-’/'F1+’/Negative Outlook
- Slovenia ‘AA-’/'F1+’/RWN from ‘AA-’/'F1+’/Negative Outlook
- Italy ‘A+’/'F1′/RWN from ‘A+’/'F1′/Negative Outlook
- Ireland ‘BBB+’/'F2′/RWN from ‘BBB+’/'F2′/Negative Outlook
- Cyprus ‘BBB’/'F3′/RWN from ‘BBB’/'F3′/Negative Outlook

The RWN indicates that the above ratings are under active review and are subject to a heightened probability of downgrade in the near-term. Fitch expects to complete the review by the end of January 2012. If the review concludes that a downgrade is warranted, it is likely be limited to one or two notches.

Following the EU Summit on 9-10 December, Fitch has concluded that a ‘comprehensive solution’ to the eurozone crisis is technically and politically beyond reach. Despite positive commitments by EU leaders at the Summit, notably the decision to accelerate the creation of the European Stability Mechanism (ESM) and to place less emphasis on private sector involvement (PSI), the concerns held by Fitch prior to the Summit remain pressing and have not been materially eased by the Summit outcome (also see, ‘Summit Does Little To Ease Pressure on eurozone Sovereign Debt,’ 12 December). Of particular concern is the absence of a credible financial backstop. In Fitch’s opinion this requires more active and explicit commitment from the ECB to mitigate the risk of self-fulfilling liquidity crises for potentially illiquid but solvent Euro Area Member States (EAMS).

Fitch recognises that the policy authorities in all of the countries with sovereign ratings subject to review have embarked upon significant fiscal consolidation and structural reform and these efforts will be taken into account in the review. However, the systemic nature of the eurozone crisis is having a profoundly adverse effect on economic and financial stability across the region and for some EAMS poses near-term risks that are beginning to dominate the sovereign-specific risk fundamentals. Today’s announcement is focused on those sovereigns that are potentially vulnerable to the worsening external economic and financial environment as indicated by previous negative rating actions and rating Outlooks.

The RWN is prompted by the following risk factors:

- In the absence of greater clarity on the ultimate structure of a fundamentally reformed Economic and Monetary Union and the recognition by political leaders of the potential for an EAMS to leave the eurozone, Fitch will review its assessment of the balance of risks associated with eurozone membership, especially for sovereigns potentially subject to funding stresses.

- While acknowledging the extraordinary measures the ECB has adopted to provide liquidity to the European banking sector, its continued reluctance to countenance a similar degree of support to its sovereign shareholders undermines the efforts by EAMS to put in place a credible financial ‘firewall’ against contagion and self-fulfilling liquidity and even solvency crises.

- The intensification of the eurozone crisis since July constitutes a significant negative shock to the region’s economy and the stability of its financial sector with potentially adverse consequences for sovereign credit profiles across the region, most immediately for those placed on RWN today.

- In the absence of a ‘comprehensive solution’, the crisis will persist and likely be punctuated by episodes of severe financial market volatility that is a particular source of risk to the sovereign governments of those countries with levels of public debt, contingent liabilities and fiscal and financial sector financing needs that are high relative to rating peers.

In light of these heightened risks, Fitch will re-consider the assumptions and analysis that underpin its current sovereign ratings of Belgium, Slovenia, Spain, Italy, Ireland and Cyprus to ensure that the above risk factors are appropriately reflected in its sovereign ratings in accordance with its sovereign rating methodology.

The focus on investment grade rated sovereign governments with Negative Outlooks reflects previous research and analysis that indicates specific weaknesses that render them especially vulnerable to the intensification of the eurozone crisis. However, the outcome of the review will also incorporate Fitch’s current assessment of the strength of their underlying economic and credit fundamentals as reflected in their current sovereign ratings as well as recent policy measures adopted at the national level.

I received this from my long-time friend Rick:

It is a slow day in a damp little Irish town. The rain is beating down and the streets are deserted.

Times are tough, everybody is in debt, and everybody lives on credit. On this particular day a rich German tourist is driving through the town, stops at the local hotel and lays a €100 note on the desk, telling the hotel owner he wants to inspect the rooms upstairs in order to pick one to spend the night. The owner gives him some keys and, as soon as the visitor has walked upstairs, the hotelier grabs the €100 note and runs next door to pay his debt to the butcher. The butcher takes the €100 note and runs down the street to repay his debt to the pig farmer. The pig farmer takes the €100 note and heads off to pay his bill at the supplier of feed and fuel. The guy at the Farmers’ Co-op takes the €100 note and runs to pay his drinks bill at the pub. The publican slips the money along to the local prostitute drinking at the bar, who has also been facing hard times and has had to offer him “services” on credit. The hooker then rushes to the hotel and pays off her room bill to the hotel owner with the €100 note. The hotel proprietor then places the €100 note back on the counter so the rich traveler will not suspect anything. At that moment the traveler comes down the stairs, picks up the €100 note, states that the rooms are not satisfactory, pockets the money, and leaves town. No one produced anything. No one earned anything. However, the whole town is now out of debt and looking to the future with a lot more optimism.

Note that the necessary and sufficient conditions for the bailout to work are that each person involved in the bailout program (1) has debts of at least €100, (2) knows somebody else who also has debts of at least  €100, and (3) gives the entire €100 to that person.

If  Person A in this debtors’ daisy chain owes less than €100 to Person B and Person C has debt of  €100 or more, Person B, who will receive less than €100 from Person A, will have to dig into his own pocket in order to extinguish Person C’s debt.

The conclusion to be drawn from this not-completely fanciful story is that an optimally-sized bailout program must satisfy the specified necessary and sufficient conditions. This means that the size of the payments to individuals must equal the debt level of the least indebted person in the group of people who are the intended beneficiaries of the program.