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Excuses are, of course, already being prepared for this lamentable state of affairs, and in particular the argument is being run that in fact the responsibility here does not lie with Spain’s central government (which was entirely composed of choirboys and girls), but with a lamentable set of constitutional arrangements which give far too much spending power and control to the country’s regional governments. To some extent this is true, but as I say, it is important not to take everything here at face value, since as ever, all is not what it is made out to be.

This advice could, as it happens, have proved useful to New York Times reporter Suzanne Daly who vertently or inadvertently seems to have been taken for a complete ride with the article she wrote for the newspaper last Friday. The focus of the article was purportedly on regional extravagance in Spain, but in the event she seems to have allowed herself to be used to float a political agenda which primarily seeks to take the attention away from the country’s central government, and the responsibility it has for the current lamentable state of affairs. Naturally examples of regional extravagance certainly abound (hell, the entire country was living beyond its means), but I started to smell a rat when I saw the example she chose to highlight in her article – the prison at Puig de Les Bases, Figueres (which just happens to be located only a few kilometres from where I live).

What worried me is that the prison you can see in the photo above is NOT an example of something that isn’t needed, like a phantom airport, or a golf course where no one will ever play golf. The problem with Puig de Les Bases is not that there aren’t prisoners waiting to be moved there from the two outdated prisons which are scheduled to close (there are, 300 of them, to which can be added an additional 450 once the new one is open). No, the problem here is that there isn’t enough money to run the place after it opens. This situation is not untypical, since many town halls and regional governments, not to mention the central government itself with its new high speed train network that the country can ill afford, find that they invested money on projects using the extraordinary income they were receiving during the years of “excess” but that now they don’t have the current revenue to keep the facilities created operating.

In fact Suzanne Daly does notice this, but she seems to get so carried away with the force of her own rhetoric that she doesn’t catch the significance of the point.

“Evidence of the regional profligacy dots the countryside. On the top of a hill here in the birthplace of Salvador Dalí, in northeastern Spain sits a giant, empty penitentiary. But even without a single prisoner in residence, the prison is costing Spain’s heavily indebted regional government of Catalonia $1.3 million a month, largely in interest payments. If prisoners were actually moved in, it would cost an additional $2.6 million a month. So it sits empty, an object of ridicule around here, often referred to as the “spa.” ”

So the question is, is this an example of regional profligacy, or an example of cuts which are biting, and a country which is coming to terms with its new reality?

The issue, however, goes deeper. The offending prison is in Catalonia, and Catalonia is a region which has long been seriously underfunded by the central government – indeed as was suggested by the regional minister of economics, Andreu Mas Colell, it looks suspiciously like the central government were not paying funds owing to some key regional governments to make the regional deficit look worse, and the central deficit look better.

Mas Colell who is a former Harvard professor, and distinguished micro-economist in his own right, recently told the central government that it should be ashamed of itself for withholding money which legally belonged to someone else (in this case 759 million euros for investments which have already been completed) and basically acting in complete bad faith.

“Els hauria de caure la cara de vergonya”, “és una mala jugada poc honorable i que no oblidarem”, “estan fugint i fent servir excuses de mal pagador”, “són molt poc exemplars”, “no poden desentendre’s amb arguments pobres”, “els avergonyirem”. Són algunes de els expressions que ha utilitzat el conseller d’Economia per referir-se a l’impagament dels 759 milions per part de l’Estat…… Amb tot, el conseller veu una clara intencionalitat en el no pagament d’aquests diners. “L’Estat vol que se’ns carreguin a nosaltres els quatre punts de dèficit que suposen aquests 759 milions i no a ells. I no paga perquè no vol pagar i no vol augmentar el seu dèficit”,

“They should be ashamed of themselves… its an injustice without honour, and we won’t forget… they are running away from their responsibilities using the typical excuses of someone who doesn’t pay their debts… this is hardly setting a good example… they can’t ignore the situation isung pathetic arguments… we will make them feel ashamed”. These are some of the arguments used by the Catalan economy minsiter with reference to the non payment by the Spanish government of the 759 million euros … The minister did not mince his words when it came to the reason behind the non payment. “The central government want to put on our account the 0.4% percent of deficit which these 759 million euros will involve for us, and they don’t want to add them to their deficit. They aren’t paying simply becuase they don’t want to pay, and they don’t want to increase their deficit.”

Naturally, the Catalan government is taking the central government to court over the issue, but given the efficacy with which justice is executed in Spain, I don’t think I’d be waiting for the result before finding solutions to the problem all this represents.

The central point here is picked up on by a group called Collectiu Emma, (an association of activists which spends it time correcting factual inaccuracies which appear about Catalonia in the international press, inaccuracies which in no small part have their origin in a constant public relations campaign conducted from Madrid). As they say:

“One key point that is overlooked in your otherwise informative article on Spain’s economic difficulties (As Spain Acts to Cut Deficit, Regional Debts Add to Woe, December 30, 2011) is that Spain is not a federal State. Under the country’s fiscal arrangement taxes are collected by the central government, which will keep part of the proceeds for itself and distribute the rest among the regions to pay for the services that have been devolved. There is no correspondence between what the regions get to spend and the wealth they have generated.”

“For the last year Catalonia, one of the most productive and most heavily taxed communities, has been undergoing painful cuts in services. And yet, the share of tax money that it contributes to the State and never comes back is estimated today at a staggering 8-9 per cent of its annual GDP. If Catalonia could use even part of those funds to finance essential services for its own population, it would have no deficit and no debt, and could even afford one or two extravagant schemes like those that other regions -and the central government itself- can enjoy as long as they are paid for with somebody else’s money. Catalans would not mind a serious revision of the regional setup, but only if it envisages fiscal responsibility on the recipients’ part, better control over their own money by those who have earned it and more transparent procedures by the central government”.

Now one of the points Collectiu Emma didn’t make, but could have, is that Catalonia is one of the few regional governments (and maybe the only one) which has responsibility for administering the prison service. Catalonia also received so little money from central government in 2011 that it effectively ran out of cash in December (not because it is “extravagant” but because it is seriously underfunded) to such an extent that it was not able to pay all public servant salaries for December before the end of the year. So in fact one of the reasons the prison is lying idle is that the central government is not forwarding money it has a legal responsibility to transfer, and the reason it is doing this is to massage its own deficit, and encourage people like Susanne Daly to write the article she wrote.

It gets worse, since some of the “misinformation” about the situation in Catalonia has, in my opinion, a deliberate political intent – to recentralise Spain. This is certainly the objective of tax minister Cristobal Montoro, since many in the Partido Popular are already very fed up with the fact we insist on using our own language, and doing things our own way (like banning bull fighting).

“And while Spain’s overall fiscal status is nowhere near as dire as Italy’s, it has another problem all its own, as the new budget minister, Cristóbal Montoro, made clear Friday: serious budget shortfalls in its 17 autonomous regions, which have spent recklessly in the past decade”.

It is also striking how the article also draws attention to spending issues in the community of Andalusia (which is the only community the socialist PSOE really controls now, and which the PP hope to win in elections in the spring) while there is no real mention of communities like Valencia, or Galicia, which are controlled by the PP and where there are plenty of examples which could be mentioned, like the phantom airport in Castellon, built under the eager eyes of former Valencian President Francisco Camps, who had to resign and is now facing corruption charges in a trial which is currently attracting a lot of media attention.

Now I am sure, as the Collectiu Emma people point out, there are many examples here in Catalonia of projects which were not needed (the Alguaire airport in Lleida would be one), but the key difference here is that Catalans overspent using their own money, while many regional governments (some of them ruled by the PP) did so using Catalan money. So it is curious, to say the least, that the author decided to kick the article off with a big picture (see above) of a prison in Catalonia to serve as the stylised example to epitomise the problem.

But there is another issue being raised here, since it is not clear whether all the attention which is being focused on the Figueres prison is not – in some warped way – a by-product of protests by prison staff unions against the all the reecent spending cutbacks. Searching around for background information, I discovered a most interesting article in El Pais (sympthetic to the Spanish socialist party PSOE) entitled “locos por ir a la carcel” (desparately seeking to go to prison). The gist of this article concerns the plight of a number of unemployed people who have passed the exams needed to have places in the prison service, but who can’t be offered work since the prison is not open.

What the El Pais article offers us is the view of a heartless Catalan government making swingeing cutbacks on important social projects. Far from putting the blame on the outgoing socialist lead catalan government who built the prison in the first place, the article blames the new justice department head, Pilar Fernández Bozal, who hasn’t opened because she hasn’t been able to obtain the funding needed. The impression I get is that in this game it is hard to win.

At the end of the day the lesson I would advise Suzanne Daly (or Angela Merkel if it comes to it)  to learn from this whole affair is that nothing in Spain is exactly as it appears to be, and that few of the arguments politicians and so called “experts” advance are entirely innocent. Mostl “information” circulating in Spain is highly politicised. Really “independent” analysts are virtually unknown.

Government and opposition in Spain operate like a revolving door. Crickey, I even saw outgoing Minister in the Zapatero government Alfredo Rubalcaba on TV yesterday, openly criticising Mariano Rajoy’s government for all the cutbacks that have just been announced and for having no policy up to the task of dragging Spain out of its crisis, without even blushing or mentioning that the cuts in question were so big because his government overspent – or tolerated overspending – or that the policies the new government are following were basically identical with those which guided his own government.

Far from suggesting that the prison project was an extravagant excess, El Pais implies it is badly needed (since space in the Catalan prison system is extremely scarce), and my feeling is that with crime on the rise after 4 years of continuous crisis, El Pais is probably more right about this than the New York Times author is. Lesson to be learnt: simplistic answers to complex situations are rarely satisfactory. And if you want to come to Figueres and look for a spending white elephant, well, you need go no further than the high speed railway line linking the town with Barcelona. The track has been up and ready for around a couple of years now (see the bridge to nowhere in the photo above), but there is no sign of any train, since there is not sufficient money available to finish the job. But then this particular piece of short term redundancy was planned and executed by the central government on a live-now-pay-later basis, but that wouldn’t fit the story we are being sold, now would it?

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All in all, it would be hard to say that the Euro has worked well for the Italians. Maybe it was a great opportunity that the country was unable to take advantage of, but in any event all they are going to see from here on in is the downside part of it. The inability to adjust the value of a domestic currency they don’t have to compensate for all that wantonly lost competitiveness means they are going to have to do things the hard way, subjecting themselves to a collective ingestion of codliver oil the like of which the country has not seen since the harsh days of the1920s.

Sinking Below Ground

The extent of the problem the country now has can be easily seen in the chart below, which shows annualised growth over a decade (as a moving average). What is absolutely shocking is that in the ten years  up to 2010 Italy had an average annual growth rate of just 0.28%. Assuming growth of about 0.5% in 2011 (which may now be generous), in the decade to 2011 this will drop to 0.15%, and if we pencil in a contraction of 1% in 2012 (perfectly realistic, in fact it will probably be worse) then the number turns negative. That is to say, on average the Italian economy will have shrunk every year for a decade.

Some may say that this result is in part a by-product of the global crisis, and they would be partly right. But look at the trend over the last three decades, far from seeing some stylised version of steady state growth hovering around a constant mean, the rate of expansion in Italian output has been heading relentlessly downwards, so logically it was always bound to cross the zero line at some point. That point now seems to be about to arrive in 2012, a year which may mark a before and after in modern Italian history.

Naturally, the reason why Italian growth has fallen so far is the big point at issue here. One of the reasons is obviously a competitiveness loss resulting from higher than Eurozone average inflation sustained over a long period, but another component is possibly the impact of population ageing, which has hit Italy more than any other European country except for Germany, and it is with Germany, of course, that Italy has the largest competitiveness loss. Demographically speaking Italy is Germany minus all that export competitiveness.

Looked at from another angle, like many other countries Italy probably grew rather over trend in the years between 2004  and 2007, and then dropped back sharply in 2008. But the Italian economy fell further than most of its peers, and subsequently really failed to recover. This is the clearest demonstration of the competitiveness problem, and it won’t be easy to address.

It’s The Competitiveness Silly!

As is well known Italy is weighted down by a massive burden of public debt (120% of GDP). Even before the recent surge in Italian bond yields servicing this debt consumed an onerous volume of government income. But this debt alone does not explain why Italy has such a poor track record. Japan, for example, has a debt burden of over 200% of GDP and still manages to eke out a better growth trajectory. The two countries are similar in that domestic demand is permanently weak (they both have elderly populations, with a median age of around 45) yet difference between the two countries is obvious, since Japan (like Germany) has a large and dynamic export sector which generates a trade and current account surplus, and this buoys investment and GDP growth. Italy, on the other hand, has a trade and current account deficit, and both of these have been worsening since the end of the last recession.

Naturally a negative trade balance weakens the GDP reading, given the impact of the net trade effect, but curiously the recent GDP slowdown has been associated with a drop in government spending (which is what previously had been sustaining Italian GDP in positive territory), a fall in domestic consumption, and a consequent fall in imports (which is why the trade balance has been improving somewhat of late). Indeed, the reduction in imports meant that the net trade effect was one of the few positive points in the latest GDP reading - even while the economy contracted by 0.2% net trade added 0.8 percentage points to what would otherwise have been a devastatingly bad number. So there is no need to call in inspector Clusot to find out what happened, it was clearly the sharp cut in government consumption that finally killed off the fragile Italian recovery, although naturally, given that government debt was – and has been for some years – on an unsustainable path, the spending tap had to be shut off at some point. What Italy now needs – like so many of the countries on the EU periphery –  is a sharp improvement in international competitiveness and a significant surge in investment into the export sector. The two of these naturally go together, since few will invest in activities which are unlikely to be competitive and profitable.

Italy does have a stronger export sector than some of its Southern European counterparts, and exports did surge as the global economy started to recover (see chart above), but they never managed to reach their pre crisis level, and now, at least according to the latest PMI surveys, they are weakening once more as the European and global economy slows.

Italy was far from having a consumer boom during the good years of the first decade of this century. In fact household consumption grew by less than 5% between 2000 and 2008, and in any event the pace was much slower than in the 1990s (see the shift in steepness of the slope in the chart below).

Retail sales have been falling since 2007.

And construction spending has been one steady slide down.

And yet, despite all the pressure on Italian banks there is (as of October) no sign yet of a sharp credit crunch affecting either firms or households, since private sector credit is still growing at an annual rate of around 4%, a stark difference from the picture in Greece, Spain, Ireland and Portugal where private sector credit is steadily contracting.

No Boom, No Bust

So to be clear, Italy did not have any sort of housing or credit driven boom during the first decade of the century, Italian households and companies are not massively in debt when compared with their Euro Area peers, and credit is not in especially short supply. Ageing population dynamics lead domestic consumption to be weak in Italy (following a pattern which is strikingly similar to that seen in Japan and Germany), yet Italy’s export sector has been allowed to drift as competitiveness has been lost. Really the most telling chart I have is this one, which shows how as the current account surplus has widened (ie as competitiveness has been lost) long term growth has steadily declined.

With neither exports nor private consumption able to pull the economy the state has been under constant pressure to offer support via deficit spending, leading to the accumulation of an unsustainable quantity of government debt. This deficit spending is about to come to an end (permanently according to the latest EU agreement), and under these circumstances the economy is likely to remain in or near contraction for as long as it takes to recover competitiveness. The question is, how long is that going to be, and what will happen to the debt dynamics in the meantime.

To take the second question first, one of the reasons that many are confident Italy will make it on through with the debt challenge is the country’s recent record in controlling the deficit. According to OECD data, while Italy ran a cyclically adjusted primary deficit every year between 1970 and 1991, it ran a cyclically adjusted primary surplus every year since 1992. That is to say, before allowing for interest payments Italy has not been running a deficit for many years now, and it is simply the burden of servicing the accumulated debt which is causing the country to spend more than it receives in revenue. As many of those who are in the “optimistic” camp on the question of the country’s ultimate solvency eagerly point out, Italy’s cyclically adjusted primary balance as a proportion of GDP has remained in a better shape than those of the largest developed countries as well as those of European peripheral and core countries since the onset of the crisis. It is only the legacy of the past which acts like a dead weight pulling the country down, but what a legacy this is, and especially as yields on Italian debt have steadily risen.

Poised On A Knife-edge

But given everything it is clear that Italian debt, and with it the future of the Euro, now sits poised on a knife edge, as is illustrated in the chart below (which comes from Barclay’s Capital). If you take a neutral scenario where Italy has a balanced budget and a sum total of zero nominal GDP growth (ie growth+inflation = 0) debt stays put at 120% of GDP out to infinity.

But then imagine the average finance cost of Italian debt rises, and stays high. In this case  the only way to compensate  is by running a larger primary surplus (ie more spending cuts, or revenue increases to compensate for the extra interest cost). The net effect of this would either be to generate deflation or a more sustained economic contraction, in which case debt to GDP would start to rise indefinitely. Think of it like this, either prices fall by one percent and GDP (via exports) rises by 0.5% (for example), in which case nominal GDP falls 0.5% a year (the Japan type case), or prices rise by 0.5%, exports lose more competitiveness, and so growth falls by 1%. I mean, this example is only illustrative, but it is meant to give some sort of feel for what “knife edge dynamics” really mean.

In fact, before the recent surge in the spread, average interest costs on Italian debt had been falling in recent years, but now they are evidently rising again. It is very important here to remember that  yields in bond auctions only affect new emissions of debt (and changes in the secondary market only really affect banks, and sovereigns through possible needs to recapitalise banks). So it is a question of years before the higher levels “lock in” – the average maturity on Italian debt, for example, is around 7.2 years, and indeed since governments finance at fixed and not floating rates (not at a certain % above 3 month Euribor, for example), debt costs are at much at risk from increases in ECB base rates as they are from the actual spread with German bonds. Any substantial increase in interest costs naturally makes selling debt more expensive. Fortunately for peripheral sovereigns, the likelihood of ECB rate rises in the foreseeable future is near to null.

No Way Back Home

But again, let’s do another thought experiment. Imagine I am right, and  Italian debt is on a knife edge path, and suppose the average interest rate on the whole debt creeps up by 1 percentage point. With debt at 120% of GDP, then the primary surplus to cover the added interest costs and maintain a balanced budget would be 1.2% of GDP. But suppose, for the sake of argument, that increasing the primary surplus by 1.2% pushes Italian debt to gdp up to 125% (via a combination of either deflation or economic contraction), then the next year the primary surplus would need to be up by an additional 0.05%, helping force debt to GDP up even further and so on and so forth. This is why people call this the debt snowball. The point is, whichever way you turn, you seem to find the exit door locked.

Coming back to the details of the present situation, the Italian government has committed itself to a consolidation program worth €74bn over the next two years amounting to roughly 3.7% of GDP. This is designed to bring the budget into balance (or the deficit to zero) by the end of 2013. On quite conservative assumptions, just to tread water, and maintain the debt level where it will be in 2013 (which will be more than 120% of GDP due to the recession), Italy will need a primary surplus of 2.3% of GDP.

But then we need to think about the recently undertaken commitment to reduce the debt (the last EU summit). The exact numbers have yet to be agreed for the new pact, but it looks like a cyclical maximum of 0.5%, and (even more importantly) a commitment to reduce outstanding debt over 60% of GDP by 5% a year. This, in Italy’s case will mean the country is going to need (from 2014 onwards) a primary balance of something like 5.5% of GDP (depending on the evolution of interest costs) over the rest of this decade. Which means the Italian economy is going to face an even more restrictive fiscal environment.

Now, those who argue the Italian crisis will have a happy outcome point to history, and argue that Italy was able to achieve a primary surplus of around 5% on average during the years 1995-1998, so why shouldn’t the country be able to do this again? The main counter argument would be that that was then, and this is now. That is to say, these were the years of Italian “coupling” with monetary union, sizable privatisation programmes, falling (not rising) interest rates, and basically Italian trend growth had not fallen as far as it has now.

Moreover, the external environment in Europe will not exactly be conducive to boosting exports. Even core Euro Area countries are commited  to undertaking additional fiscal consolidation beyond what is currently envisaged in order to comply with the new debt rule. Taking 2014 as the starting point, debt to GDP for the Euro Area as whole might be something like 90%. Hence the 1/20th rule would imply that on aggregate the Euro Area will need to reduce its debt ratio by around 1.5 percentage points per year. If this agreement is complied with the adjustment will almost certainly imply a net fiscal drag on growth in the years following 2013. Of course, if it is not complied with then it will almost certainly be “bye bye Euro” (assuming the common currency still exists that far up the road).

It’s All About Structural Reforms, Or Is It?

So basically, what the whole argument about whether or not Italy can make a final burst and reach the finishing line is all about structural reforms, and whether the country can get enough growth (quickly enough) to turn the “knife edge trap” around. Personally I am extremely doubtful that it can, which is why I placed so much emphasis on the growth performance in the first section. The turnaround needed here is massive. It is a 30 year decline we are talking about, and I doubt short of outright default and substantial devaluation we have historical examples of anyone doing this. The adjustment made in Germany between 1999 and 2005 was much smaller in comparison.

One of the proposals is to introduce labour market reforms to increase participation rates, but in fact the Italian labour force grew substantially between 2004 and 2008 (due to large scale immigration), with employment being up by over a million (or around 5%, see chart above), yet the increase in output was ridiculously small. On the other hand we know the Italian working age population is contracting (and the average age rising), while the elderly dependent population is increasing rapidly. Conventional economic models tend to be silent on this issue, but common sense should tell us that this is going to take its toll on growth – a factor the “structural reform answers all our problems people” don’t seem to have given enough thought to.

The Monti government needed  just five weeks in office to push through an additional 30 billion-euro emergency budget package, but how long will he need to get GDP growth back up above 1% annually? And how much time does he have? Investors initially cut him some slack, but judging by the reaction to the final approval of the package by the Senate - the yield on Italy’s 10- year benchmark bond was pushed up by 12 basis points to 6.91%, dangerously close to the key 7% level (although still somewhat below the Euro era record hit on November 9, just before Monti took charge). 7% is  widely considered to be critical if sustained for any great length of time, partly due to the cost of debt servicing but also because of the level of dependence of Italian banks on the ECB that it would produce.

Till The Dowgrades Fall

So the “Full Monti” effect now seems to have  been priced in, while investors nervously wait to see what the real plan for Spain and Italy actually is.

The first quarter of 2012 looks to be critical for Italian debt, with about one third of the total Euro Area debt maturing being Italian. Indeed the battle starts this week with the Treasury having to sell an assortment of T-bills and 2 year and 10 year bonds. In addition the Italian government is now increasingly guaranteeing bonds issued by Italian banks to be used as collateral at the ECB  – with about 40 billion euros being issued last week according to some estimates. So effectively Italy is now more or less guaranteeing the banking system with the likely outcome that ratings agencies will be even harder on the sovereign rating.

Not that the outlook was exactly bright on that front anyway. Understandably, Italy was among the 15 Euro Area countries Standard & Poor’s placed on review for a possible downgrade on December 5. This follows an earlier downgrade to a single A by the agency in September. In addition, Spain and Italy were both warned by Fitch (which cut Italy’s rating to A+ in October) on December 15 to brace for a further debt downgrade after concluding that a “comprehensive solution to the eurozone crisis is both technically and politically beyond reach”. And to complete the set, Moody’s, which cut the country to A2 on October 4, maintained a negative outlook, signifying that a further dowgrade in the coming months was highly probable  The bottom line is that Italy is both too big to fail and too big to be bailed out, which is why it is still hanging dangerously in limbo-land. Since, as I argue in this article, some sort of restructuring or other is well nigh inevitable in the Italian case, the sooner Europe’s leaders work up a credible plan on how to achieve this, the better. Otherwise it will not only be Italy’s citizens who are subjected to the Full Monti, Europe’s leaders may also find themselves with their credibility stripped naked.

This post first appeared on my Roubini Global Economonitor Blog “Don’t Shoot The Messenger“.

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Lessons From Japan?

No idle question this, since it harks back to the time when a good deal of attention was focused on the Bank of Japan, and how much responsibility policymakers there had for the deflation trap into which the country’s economy eventually fell. Now according to a very influential paper published by the Board of Governors of the US Federal Reserve System back in 2002 (Preventing Deflation: Lessons from Japan’s Experience in the 1990s, by Alan Ahearne and colleagues) the most important concern raised by Japanese policy during the country’s first “lost decade” was not that policymakers did not predict the oncoming deflationary slump –that in itself was not especially surprising, after all, neither did the majority of analysts and  forecasters – but that they did not take out sufficient insurance against downside risks through a continuous precautionary loosening of monetary policy. Simulations carried out at the time using the FRB/Global model lead the authors to the conclusion  that, had the BOJ lowered short-term interest rates by a further 200 basis points at any point between 1991 and early-1995, at least the first bout of deflation could have been avoided.  (On the other hand the model indicated that loosening after the second quarter of 1995 would have been too late to avoid deflation, as by that time inflation had already fallen below zero.)

Well, that was 2002, and who else apart from myself and a few other policy wonks with good memories now remembers the once renowned Ahearne et al paper? The Japan lesson was “learnt”, and then conveniently forgotten it seems. Now, of course, the Euro Area is not actually caught in Japan style deflation, but this isn’t over yet, and we don’t know how the story is going to end. What we do know is that the region is once more falling back into recession, while the economy has been submitted to a triphasic cocktail of fiscal austerity, monetary tightening and regulatory pressure for bank recapitalisation. And, of course, with a massive public and private overhang, a credit crunch that is tightening by the day and a backdrop of rapidly ageing populations the deficiency in domestic demand the region is suffering from looks even more visible to the naked eye than that famous hole which appeared in the side of the Titanic must have been after its unfortunate contact with the iceberg. Which is only another way of saying that the deflation risk is a real and ever present one, and a bit of downside insurance would have been a good thing. Prescient even.

Using The Ejector Seat Without A Parachute

Just to ask the question whether policymakers got their ”mix” right here seems like some kind of sick joke in bad taste. Virtually no insurance was taken out against possible downside risks to the price level (inflation was consistently seen as being a much more pressing problem), even if (going by the PMI output prices, see chart below) price pressures seem to have been on a downward path since early 2011. In any event, what inflation there was in the Eurozone was mainly the by-product of imported commodity prices or the knock-on impact of VAT increases, and in no case could it be seen as the result of domestic demand “overheating” which is really what monetary policy is equipped to deal with.
 

So the much discussed ECB “exit strategy” seems to have been applied far too early and far too systematically. In both the case of extraordinary liquidity measures, and in the case of interest rate policy, Mario Draghi has had to put the motor into reverse gear, and emphatically so. Not that this outcome was that hard to see at the time, as I expained in a post on the CNBC blog back in March (Chronicle of a Policy Error Foretold).

Crunch, Crunch, Something Funny Is Going On Here!

The parallel with Japan in fact extends beyond simple interest rate policy. Issues associated with the capitalisation of the banking system also have a certain parallel, as can be seen in the chart below (which comes from a Richard Koo presentation). Fiscal and monetary measures taken following the outbreak of the crisis worked initially, but since the core of the problem was not addressed keeping all the zombie loans going soon gave the banks funding problems which lead to a second credit crunch.

The interesting point here is that this process seems to be now being repeated in the Eurozone, as a second credit crunch firmly starts to set in. If you look at the chart below (which comes from a report by Unicredit), then you will see that the credit standards applied by banks (as extrapolated from the ECB monthly survey) have been tightening for some months now (and are obviously continuing to do so, hence the recent batch of liquidity measures. As Marco Valli (who wrote the Unicredit report) also points out, these lending conditions move in tandem with the PMIs (red line) which means that as they banks steadily close the lending spiggot activity in the real economy slows correspondingly.

Spread Them Wide

So obviously the ECB has been doing quite a bit wrong since the time of those wonderful “how we saved the world from disaster” speeches, leading to an evident waning of confidence in the institution. How much waning? Well that is currently the source of some debate. One line of reasoning, perhaps best personified by nobel economist Paul Krugman, has been arguing that the key turning point in the whole Euro debt crisis came last March, with the ECB decision to raise interest rates. His evidence, echoing that offered by Rebecca Wilder, comes from an examination of  the divergence between the Finish and Swedish 10 year bond yields, which started to drift apart around April.

As Krugman says: “What happened then? Ah, yes — the ECB started raising rates. And…..that’s precisely when euro bond spreads began their upward march, culminating in the current crisis”.

This idea that it has been ECB policy rate decisions which lie to some extent behind the growing financial turmoil which surrounds the Euro is really quite widepread. FT Alphaville’s Izabella Kaminska, for example,  runs a similar argument vis-avis French spread problems and the ECB’s second rate hike in July. As she says ”it’s clear that something influential happened in July. Something which not only destabilised the balancing system but tipped France, in particular, into the red. Could it have been the ECB’s July 7 rate hike to 1.5 per cent?”

Dutch Disease

While I fully agree with both authors that the application of the ECB crisis exit strategy has done a lot to undermine confidence in the idea that policymakers at the bank were really on top of the problems, I am not that convinced that it has been this stratgey in particular which has fuelled the ongoing crisis (heaven forbid, there are really no shortage of candidates here). One of the reasons I am not convinced by the Krugman case is that the Finnish spread itself has been detaching from other core Euro Area spreads, and this is a little difficult to explain simply by referring to ECB policy decisions.

If we look at the chart below, which was prepared by Marcel Bross at Commerzbank, we can see that the Finnish 10 year spread with the Dutch 10 year bond has been widening since early summer. (The black line shows the spread between the Finnish 10 year bond yield (RFGB) and the Dutch one (DSL) – the yellow lines shows the 5 year spread, which has performed rather differently).

Whatever Happened To My Current Account Surplus?

Now rather than the Swedish yield (Sweden remember is not in the Euro, and thus benefits from safe haven status, in that people can buy Swedish government bonds as a hedge against Euro Area break up), what is more interesting is to examine why Finnish yields might have been rising in relation to Dutch (and, of course, German ones). Does anyone have an explanation for this? I think I might have one. The principal exhibit is this.

The point is that Finland has steadily moved from having a goods trade surplus to having a deficit, and the situation has been deteriorating continuously since the start of the global crisis. Even the much renowned current account surplus has been steadily disappearing in recent years.

What Goes Down Doesn’t Necessarily Come Back Up Again

The interesting point is that while exports fell sharply (as they did in say Germany) during the recession, they didn’t recover again afterwards.

In part this could be a question of the product mix they were relying on (and difficulaties in the land of Nokia), but having said that we couldn’t be facing another one of those good old Euro periphery competitiveness issues, could we?

Strange how as the Finnish real effective exchange rate has drifted away from the German one, and now the Finnish 10 year bond yield is doing the very same thing. I wonder if there is a connection?

In fact Finland up to the onset of the crisis had a pretty competitive export driven economy. Then came the great recession, and peak to trough Finnish GDP was down by almost 10%. However, even after the onset of the recovery Finnish  GDP was still nearly 3% below the pre-crisis high at the end of Q3 2011, and now, evidently, as recession starts to fall over Europe output is falling back again.

Growth in Finland resumed in Q1 2010, but the economy has already started to show signs of slowing again, with annual growth falling from 5.4% in Q4 2010 to 2.7% in Q3 2011.

We Couldn’t Have Another One Of Those Credit Driven Housing And Consumer Booms On Our Hands, Could We?

Another part of the picture is the way in which – in contrast to exports – household consumption recovered quite strongly in Finland. Not only did consumption recover, but at the end of Q2 it was 1.5% above the pre crisis high.

So the question is why did this happen? In some ways Finland could be thought of as the good student, steadily correcting one of those horrid imbalances which so worry everyone. But how did it do this? Well ECB interest rates and a house price boom certainly form part of the picture. The low interest rate environment generated in the wake of the global financial crisis has meant that those developed economies which did not experience a major housing boom-bust during the first decade of this century and still have housing market momentum have been running an elevated risk of experiencing one.

In particular the situation in three Scandinavian countries – Norway, Sweden and Finland – has attracted a lot of attention. In each case there was a minor house price correction around the time of Lehman Brothers, following which prices continued on their earlier upward path. And the comparison between the way industrial output failed to recover, while construction output really took off is another warning signal.

Finnish house prices have effectively been rising in real terms since the slump of the early 1990s. They fell back slightly during the crisis, but supported by ultra low interest rates from the ECB – some 95% of Finnish mortgage loans are variable – they soon resumed their upward path. In fact Finland is one of the few examples of a Eurozone country where the monetary stimulus may have actually worked. Let’s just hope they won’t live to regret it.

Anyway, one day or another some sort of correction was inevitable, as even the most reluctant of students among us must surely now have learnt that property prices do not continue to rise forever. To my eyes it seems that that fated day may finally have arrived in Finland in June this year.

Confidence data certainly reinforce this impression.

Don’t Worry, Be Happy!

But why worry, since as I said above, surely this is all part of that very much needed Euro Area rebalancing process? Finland has been running a property boom, but the population is not heavily indebted. Private sector debt is not especially high by some Southern European standards, and government debt is still low (and indeed under 60% of GDP), while the fiscal deficit has not breached the EU 3% limit.

So things are not too bad, unless…. unless you take seriously my ageing populations, export dependency hypothesis, in which case the recent loss of competitiveness is about to pose serious problems. The country is now the fifth oldest on the planet – after Japan, Germany, Italy and Austria – with a median age of 42.5.

This level of ageing is normally associated with low or volatile growth (think Germany and Japan), heavy export dependence, or both. The country has an ageing and declining workforce, and this, as the EU Commission noted in its most recent country forecast looks set to further take its toll on competitiveness and growth.

“The Finnish labour market is confronted with a notable demographic shock. Due to the retirement of a large baby-boom generation, the working-age population is projected to decline by over 5% of the current labour force by the end of the decade…(hence)…. taking account of the weakening of the growth potential of the Finnish economy due to its declining working-age population, the recovery will be more subdued than in previous recovery cycles….”

Conclusion: the country’s debt dynamics are far from unsustainable at this point, but given the weakening in the country’s export performance and the steady unwinding of the housing boom we can now anticipate I would expect growth to be weaker than either the EU or the IMF are currently anticipating, and pressure on the country to increase fiscal spending to maintain expectations to rise, with the implication that pressure on the Finnish spread over 10 year German bunds will continue, as the country risks drifting off from being part of the core towards the growing periphery, at least in the eyes of investors. So finally, coming back to the ECB and movements in the policy rate, it could well be the case that perceptions about rising future interest rates played their part in encouraging individuals not to leverage their balance sheets further thus weakening the housing boom, but my feeling is that in  the Finnish case the catalyst for the coming property implosion may not have been the recent 50 bps interest rate rises from the ECB, but rather the ongoing impact of the sovereign debt crisis on confidence, subsequently reinforced by the inbound shock from the recessionary wave now steadily sweeping Europe.

This post first appeared on my Roubini Global Economonitor Blog “Don’t Shoot The Messenger“.

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Possibly this is so, but given the difficulties presented by having to take this agreement forward outside the formal structure of the EU, it is hard to not reach the conclusion that both Angela Merkel and Nicolas Sarkozy have been guilty if not of a similar blunder, then at least a major error of judgement. On the other hand the issues involved in the proposed new arrangements are highly complex and in some senses ground breaking, so it is indeed suprprising that so many (and so diverse) countries were able to reach such rapid agreement on the need for and the broad outlines of a new agreement.  While Angela Merkel was probably worried before the meeting that too few countries would sign up (there was talk of only a hard core of countries proceeding), now she is surely concerned by the fact that so many have. In many ways the biggest weakness of her debt brake proposal is that it has become “too successful” to be fully credible.

A Continent Which Has Isolated Itself  From The British Isles?

That British “separatism” has again raised its ugly head should not be surprising, since this issue has a long history  (as I was only too clearly reminded yesterday when the local TV news here in Catalonia ran footage of General de Gaulle warning that allowing the UK to enter the common market would be a major strategic mistake and a significant setback for the European construction process), but the water in which all this discourse flows is now so mirky that it is hard to separate what is really relevant to the point at issue, and what isn’t.

In fact France, Germany and the UK  should have reached agreement before the summit even started, and the agreement should have been restricted to measures which were considered necessary to resolving the Euro debt crisis, including the rules and institutions which are lacking.  Maybe it is a pity that these three countries have to have such a decisive role in European decision making, but for better or worse that is the way it is.

Now the UK has exercised its veto, and we have a legal mess. According to Peter Spiegel writing in the Financial Times,  Britain’s rejection of treaty changes means that the other 26 EU members will now have to jerry-rig an intergovernmental system without the automatic right to use the EU’s institutions, leaving decisions taken vulnerable to continuing legal challenge. As a result financial market participants will have one more reason to doubt the new fiscal pact’s viability and credibility.

“The arcane issue of whether a group of countries acting outside the EU’s treaties can use the European Commission, with its surveillance and enforcement powers, and the European Court of Justice, has been pushed to the forefront of the eurozone debt crisis. Britain, which refused to sign up to a treaty, but does not wish to see itself sidelined altogether, insists that its 26 EU partners must do without the European institutions”.

If the European Union’s institutional maze was already proving hard for investors and external policy makers to follow, this latest twist in events will hardly make it easier for them.

This is an outcome that should have been avoided at all costs, and indeed I think the most intelligent thing the three of them could do now would be to meet again and find a solution to the real problem at hand before the euro finally blows itself apart, with highly undesireable consequences for all of us.

People say that the EU was created to ensure there were no more wars in Europe but personally I think a West European centred WWIII was never a very likely eventuality. In any event the EU could have been set up with a much more limited objective, namely to end periodic outbreaks of tribalism and jingoisim. This is the real European curse, and this is what we are now facing in one country after another, as – with the local national press in the vanguard – each blames the other for causing the crisis, or for not reaching the much needed agreement to end it. The sad reality is that Europe’s leaders fiddle even as Rome is about to burn.

Save The Euro!

The nub of the question is the Euro, and setting up some form of workable common governance for those countries who belong to the monetary union. In this sense an agreement between the 17 countries who share the common currency would have made perfect sense, and in is not clear to me at least why the UK (or countries like Bulgaria and Romania for that matter) would need to be party to this kind of agreement. But, it seems, representatives of the EU Commission and the German and French governments have been so concerned to identifty saving the Euro with the idea of saving Europe that this important point of detail seems to have gotten buried well down in the pile of paperwork.

Countries like the UK, Sweden and Denmark do not use the Euro since they decided not to do so. Countries like Latvia and Lithuania do not use it since they were not allowed to, and the EU even refused a 2008 request from the IMF to allow Latvia to devalue and enter the currency area at a moment when that country was indeed in a situation of most urgent need.

What the latest tiff underlines more than anything else is the way we are lacking a coherent and consistent account of what the relationship between the EU and the Euro is, and this is not something which has only been discovered yesterday. Maybe the seeds of what happened last Friday are the result of having the Euro regulations form part of the EU Treaty itself, rather than being an agreement between a more limited group of countries in the manner that is now being proposed. Again, if the Euro was to form one of the indispensible parts of the EU Treaty, in many ways it didn’t make sense to allow the East European members to join until the had fulfilled the Maastricht criteria for Euro membership.

Viewed in this light, last Friday’s events were always a problem which was waiting to happen.

It may well be that the Euro was created as a stepping stone towards a form of political union that not all member countries wanted, but now we are apparently seeing a sort of fait accompli shotgun wedding, since without such an enhanced union, not only may the currency itslef fall apart, but entire global financial system, and everything we know and love seems likely to be carried away with it. I’m not sure whether or not this constitutes moral hazard, but it sure as hell constitutes a pretty potent form of moral blackmail.

Fiscal Pact or Fiscal Union?

Then again, what Europe’s leaders were talking about last Friday was  not just any old kind of political union. Despite all the talk about creating the groundwork for fiscal union (it will be remembered that one of the commonly cited differences between the dollar and the euro as common currencies is that all states in the American Union are backed by the US Treasury, while the world still waits to learn who – or what - is backing the individual states in the European one).  What we we are being offered is not a common treasury of the kind which would convince markets that there was something solid standing behind the currency, but rather what Wolfgang Munchau recently referred to as “another one of those Silly growth and Stability Pacts”.

 ”Contrary to what is being reported, Ms Merkel is not proposing a fiscal union. She is proposing an austerity club, a stability pact on steroids. The goal is to enforce life-long austerity, with balanced budget rules enshrined in every national constitution. She also proposes automatic sanctions with a judicially administered regime of compliance”.

Doing The Berlin Brake Dance

What Wolfgang is getting at here is that the core of the proposed EU agreement is the introduction of the so called “balanced budget amendment” as a binding principle across all the eventual signitaries. Naturally Germany already has this amendment in place. According to Wikipedia: “In 2009 Germany’s constitution was amended to introduce the Schuldenbremse (“debt brake”), a balanced budget provision. This will apply to both the federal government and the Länder (states). From 2016 onwards the federal government will be forbidden to run a deficit of more than 0.35% of GDP. From 2020, the states will not be permitted to run any deficit at all. The Basic Law permits an exception to be made for emergencies such as a natural disaster or severe economic crisis”.

This is the role model for the kind of constitutional amendment other states will now be expected to introduce - as the Economist wryly notes perhaps Schuldenbremse will one day form part of the French and Italian languages in the same way “kindergarten” has become part of the English one.

The 0.35% deficit permitted is in fact a form of what is termed “structural deficit”, that is to say there is a formula according to which it can be averaged out over the economic cycle, although even after allowing for this the deficit number is not going to be that high, and  in any event at no point should the deficit exceed 3% of GDP.

More important even than this deficit restriction, however, is the so called debt brake principle, which implies countries must steadily reduce their debt to 60% of GDP over a specified time period. If, as may be anticipated, growth and inflation in the Euro Area is going to be  low, then effectively countries will not be running deficits at all, but rather surpluses, depending on how much over 60% they will be when the present crisis comes to an end, and what the time scale for reduction eventually is. As far as I can see the current proposal for the new pact coming from the finance ministers (Ecofin) is that from 2013 countries reduce the part of the debt which is over 60% of GDP by 1/20 per annum.

At the end of the day one thing is clear, and this has not been emphasised enough in the press reporting of the summit, this is the end of Keynesian demand management as a policy tool as it has been practised in Europe since the end of WWII. That is to say, while it is be one thing to argue that simply creating more debt through fiscal policy may not be the most appropriate way to solve a crisis which has been caused by excessive indebtedness, it is going a bridge further to suggest that counter cyclical fiscal policy should not be practised. Germany’s leaders have, it seems, crossed that bridge. Naturally not all German economists agree. As the Economist reports Peter Bofinger, one of five economic “wise men” who advise the German government, is one of them. On a normal Keynesian view, the balanced budget ammendment could choke-off economic recoveries – some would argue Germany’s commitment to this principle at this point is an example of this issue. Having a structural component in the target target allows deficits to rise slightly when output falls below trend with the additional deficit being offset by surpluses during upswings. But, as Bofinger argues, this “assumes textbook-like economic cycles,” and garden variety recession. In the real world cycles and crises vary. An externally induced recession followed by a weak recovery can excessively reduce potential growth, while the balanced budget restriction would restrict the deficit spending needed to stimulate demand.

Given the magnitude of these issues, it is surprising how little debate the proposal is generating, and of course it is hard not to be struck by how quickly people who obviously would not have understood what was really involved were to arrive in Brussels and offer to sign on the ditted line without too much attention to the small print. The exact detailing of the amendment varies – in Spain for example the limit is 0.4% of GDP for the deficit, and the limit is operationalised in 2020. In addition the Spanish wording is also interestingly different from the German version, since it stipulates that the limit can only be exceeded in the event of “natural disaster, economic recession or other extraordinary circumstances”. This substitutes the wording “economic recession” for the German “severe economic crisis” variant, which really rather than concealing any sinister intention suggests to me more than anything that the Spanish parliament didn’t understand what they were voting for, since the idea is (as I say) for structural deficit over the cycle, and “cycle” obviously includes recession, so a mere recession cannot be an exception, though what counts as “severe” in the German case doubtless awaits interpreting in the courts.

Here Comes My Nineteenth Nervous Brake-down

Once more the Economist gets the basic point:

“Germany has yet to put its debt brake to the test. The federal government made things easier for itself by a generous calculation of last year’s structural deficit, which is to be cut in equal annual steps to reach the 2016 target. Flush with cash, thanks to a strong economy, it has found room for giveaways to voters without falling foul of the brake. Civil servants will get a bigger Christmas bonus next year, for example. For the Länder, the 2020 deadline seems a long way off: 13 of them budgeted for increases in structural deficits this year, laments a study by RWI Essen, a research institute. A “stability council”, composed of federal and state ministers, has little power to sanction prodigals. Apparently, it is as toothless as the enforcers of European financial discipline”.

There is an imbalance in voting intentions between countries. Angela Merkel is marking out a very long term agenda:”This is a breakthrough to a union of stability,” Reuters cite her as saying. “We will use the crisis as a chance for a new beginning.” It is hard to see why countries like Romania and Bulgaria with a very poor institutional record are in such a hurry to sign up to this without a lot more reflection. The use of the word “stability” is very important. Merkel is prioritising sustainability and stability in the longer run over short term growth. This is very consistent with a whole German view of things and completely in harmony with the ecological strain of thought in the modern German world view. I have a lot of respect for this (even where I disagree), and especially for the fact that someone in Europe is trying to think in the longer term. But I cannot help feeling many of the people and countries voting for the new agreement were only thinking about their financing needs in the short term, and were not fully cognisant of the fact that they were voting for a new beginining, a new type of Europe, where living standards may be lower, but the debt dynamics will be more stable. Personally I can only make sense of this in terms of Europe’s current demographics, and the challenge that is represented by maintaining health and pension systems in the face of low growth and ageing and declining workforces.

Each Unhappy Family Is Unhappy In Its Own Way

Hence perhaps the most worrying thing about last weeks agreement to agree was that each and every one of the 26 countries concerned has stated that “I will stop beating my wife, I promise I will, and soon”, but understands what this means in their own special way. Despite the fact that Germany has been quite clear, for example, the much respected Mario Monti is sure that Euro Bonds are almost within reach.

“Italian Prime Minister Mario Monti said Germany and other countries will eventually be convinced that commonly issued euro zone bonds are a useful way of tackling the region’s debt crisis. “I believe we have enough arguments to convince the Germans,” Monti told Euronews in a television interview”. He also is still pushing to have the funding capacity of the EFSF increased, again as if the German parliament had not voted to put a ceiling on the level of its exposure. “Monti said he regretted that European leaders had not agreed to increase the European bailout fund (EFSF) by more than 500 billion euros ($668.25 billion) at last week’s meeting in Brussels. A more substantial firewall would have been a better guarantee against market tensions, he said, adding this had been blocked by several European countries that “have a very limited view of what is the common interest”.

The worrying thing is not only that Mario Monti believes this but, more importantly, that this is probably what he is telling the Italian electorate, leaving them with a very limited understanding of the kind of sacrifices they are actually going to be ask to accept. Last week’s round of 2012 austerity measures will be as nothing when compared with those that would really be required to get Italian debt back down to 60% of GDP.

Thus many of those who were eagerly struggling to be first to sign on the dotted line last Friday didn’t get the gist of the point of what they were signing up to, and the agreement will only really be adding to credibility once it is tried and tested. In the meantime everyone is simply following the lead given by Mario Monti, and assuming that what is actually going on isn’t the death of Keynes, but the birth of German funded Eurobonds.

Land Ahoy!

But, having said all this, let’s go back to where we started, to the isolation of the UK within the European Union. Could it be, as Philip Stevens suggests in an opinion piece in the Financial Times, that the UK is on its way out of the EU? As he says, it all depends on which end of the telescope you look down. Viewed from one one end, Mr Cameron’s veto was the moment Britain signalled the beginning of a long goodbye to Europe; looked at through the other it was Europe bidding its farewell to Britain. But are we sure, even Stephens has his doubts:

“It is important to insert a caveat here. The presumption of everyone in the room in Brussels was that the eurozone countries will indeed succeed in saving the single currency and build alongside it a more integrated political union. That enterprise could yet fail. Some will say after the limited progress made at the summit on rescue plan, the odds have now stacked against the euro. If it were to fall apart, so too would all other ambitions among the 17 eurogroup members”.

So advertently or inadvertently David Cameron now has a Euro put. If the Euro survives his fate is sealed, in the most negative of senses, yet if it fails, then not only will he have been proved right, he may also find himself having to assume the mantle of leadership (backbench eurosceptics and all) and instill in a European Union in complete disorder the kind of Dunkirk Spirit for which the islands from which he hails have made themselves famous. And while we are on the question of survival, perhaps it would be to the point to close with John Authers assesment of the state of play in the argument.

Amid all the heated speculation about the European Union summit’s impact on Europe’s economic future and Britain’s role in it, traders are asking a more mundane question: “Has it done enough to get us through to Christmas?” Their answer: probably not. The muted market moves on Friday may be misleading. The euro rose against the dollar – but this may have been driven by banks repatriating assets. European bank shares, while above their lows, trade at half their book value, implying grave fears that some of their assets will be written down. The yield on Italy’s 10-year government bond fell 30 basis points during the day to 6.32 per cent – but this is still higher than at any point in the eurozone’s history until a month ago. The risk remains that the market will test Mr Draghi’s resolve by attacking a peripheral country’s debt in the two weeks before Christmas – particularly if a rating agency provides an excuse.

Amen to that!

This post first appeared on my Roubini Global Economonitor Blog “Don’t Shoot The Messenger“.

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From Time magazine,

The region’s budget comes almost exclusively from Russian aid, which has added up to about a billion dollars since 2008 … Besides, the region has only 28,000 registered voters, most of whom hold Russian passports … The region’s President, Eduard Kokoity, openly stated in 2008 that South Ossetia should eventually become a part of Russian territory. So it seemed obvious that when Kokoity’s term in office ran out this year, Russia’s favored candidate would easily succeed him.

Except no. First, in June 2011, armed Kokoity supporters burst into the de facto parliament and demanded laws be changed to allow him to serve a third term as president. Parliament refused to budge. Then a faction attempted to get one Dzhambolat Tedeyev onto the ballot. He, however, lives in Moscow and fell afoul of residency requirements. His armed supporters, too, tried to storm a government body to force it to change its views. It demurred.

Time picks up the thread:

Russia’s leading daily Kommersant. Its sources in the Russian government claimed that officials from the Kremlin, the Defense Ministry and two Russian spy agencies, among others, had been interviewing would-be Presidents of South Ossetia. Finally, at the end of August, they settled on the region’s Minister of Emergency Situations, Anatoly Bibilov, who had studied to be a paratrooper in Russia when he was young. His platform was simple. If he was elected, he would make South Ossetia an official Russian territory, no longer a quasi-independent state.

It turns out that the 28,000 had other ideas. The first round of voting on November 13 did not produce a clear winner, with Bibilov practically tied with Alla Dzhioyeva a former Minister of Education in the de facto government, whom the AP report describes as an “anti-corruption crusader.” On November 27, initial results from the runoff election showed her with a 16% lead over Bibilov.

After those results became public, Bibilov accused Dzhioyeva’s supporters of bribery and intimidation. He appealed to the region’s Supreme Court to annul the election. Which the Court did on November 29. For good measure, it ruled that the results of the November 27 elections should not be made public, and that Dzhioyeva should be prohibited from running in a new election. The Court declined to say which parts of the election law served as the basis for its ruling.

The situation remains volatile. Crowds have gathered in front of the parliament building in the separatist region’s capital of Tskhinvali. As Radio Free Europe’s Liz Fuller writes, “Kokoity, who affirmed the day after the first round that it was unthinkable that a woman should be elected to head a Caucasus republic, appears ready to resort to violence against Dzhioyeva’s supporters.”

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