Category Archive for: International Finance [Return to Main]

Wednesday, July 25, 2012

Feldstein: A Rapid Fall in the Euro can Save Spain

Martin Feldstein calls for a fall in the value of the euro:

A rapid fall in the euro can save Spain, by Martin Feldstein, Commentary, FT: The possible breakup of the eurozone is now openly discussed... The declining value of the euro holds the key to the eurozone’s survival. ...
A lower value of the euro would reduce the prices of eurozone exports and raise the cost of imports, reducing or eliminating the current account deficits of the peripheral European countries... The weaker euro would also boost Germany’s net exports, raise German wages and prices and reduce the trade imbalance within the eurozone.
The increase in peripheral country net exports would also raise their gross domestic product and so reverse their recessions that were caused by higher taxes and cuts in government spending. That would make it politically easier to achieve the needed fiscal consolidations. And shifting from recession to growth would raise business incomes and employment, reducing the volume of bad loans and mortgage defaults now hurting the banks. ...
The continuing decline of the euro reflects the market’s perception that the euro must fall or the eurozone will collapse. ... The decline of the euro can therefore occur without specific action by the European Central Bank. But a further shift by the ECB toward a looser monetary policy would speed the euro’s decline. ...
I believe now, as I did 20 years ago, that imposing a single currency on a heterogeneous group of countries is a mistake. ... But while the creation of the eurozone was an economic mistake, allowing it to dissolve now would be very costly to governments, investors and citizens. ... A new start for the euro is still well worth trying.


Tuesday, July 24, 2012

Fed Watch: Is There Even a Panic Button in Europe?

One more from Tim Duy:

Is There Even a Panic Button in Europe?, by Tim Duy: I didn't think it was possible, but my confidence in the ability of European policymakers to pull the Continent out of crisis continues to fall. This is saying a lot because I had virtually no confidence to begin with.

Consider where we are at today. Greece once again is making the headlines, as it is increasingly evident that they have made virtually no progress on the last bailout package, and will therefore need another. This should have come as no surprise; it was increasingly politically impossible to engage in additional austerity with the Greek economy plummeting into the abyss. But bailout fatigue will finally hit this time, as there appears to be no more appetite to limp Greece along. Evan Ambrose-Pritchard argues that Germany is leading the drive to finally force Greece out of the Eurozone. Ambrose rightly places at least some, if not the lion's share, of the blame for this outcome at the feet of the Troika:

This was entirely predictable – and was predicted by many critics – since Greece faced an IMF-style austerity package without the usual IMF cure of devaluation. The Troika's ideology of "expansionary fiscal contraction" – which the IMF has to its credit since abjured, but the fanatics in charge still swear by – is breaking a whole society on the wheel.

The Greeks were never given a bailout plan that had any hope of success. And they deserved such a bailout, given the rest of Europe's culpability in this crisis for letting Greece into the Euro in the first place.

Whether or not Greece can be forced from the Euro with little impact elsewhere remains to be seen. I doubt we will need to wait much longer to learn the outcome of Grexit. But the devastating train that is the debt crisis keeps rolling right along, currently crashing through Spain's economy.

And make no mistake, European policymakers have learned nothing from the Greek experience. One gets the sense that policymakers think the prescription was correct, but that the patient was simply unwilling to take the medicine. Where Greece failed, Spain will succeed, or at least so it is hoped. Indeed, today Spanish Finance Minister Luis de Guindos met with his German counterpart, and the FT reports:

Germany on Tuesday threw its considerable weight behind the reform and austerity programme of the Spanish government, in the face of a continuing surge in the cost of borrowing for Madrid, and strong protests against its spending cuts.

Spain is doing the right thing, apparently. It's just the markets that have it all wrong:

A joint statement by Wolfgang Schäuble, German finance minister, and Luis de Guindos, Spanish economy minister, condemned the high interest rates demanded for the sale of Spanish bonds as failing to reflect “the fundamentals of the Spanish economy, its growth potential and the sustainability of its public debt”.

The truth is exactly the opposite - market participants have looked at Spain's fiscal and economic situation, including the issue of provincial bailouts, and concluded that another sovereign bailout is coming, complete with private sector involvement. The "voluntary" kind of involvement, of course. And in return for this bailout, Spain will be pushed further down the same path of never ending recession as Greece. Because if once you don't succeed, try, try again. European policymakers will pursue the same path because they know of no other:

But after talks in Berlin last night on the eurozone crisis, the two gave no hint of any new initiatives to try to calm the markets, or prevent contagion from Spain affecting any other members of the eurozone, such as Italy.

This comes as Spanish 10 year yields hit 7.62% and the Italian equivalent lurches up to 6.60%. And unbelievably, the ECB is apparently out of the game, no longer willing to buy sovereign debt either to avoid being a victim of "public sector bailout" or because they believe that restrictions against monetizing the debt of member states trump imminent financial collapse. Meanwhile, the crisis is increasingly bleeding through to the supposedly immune German economy, with the Markit PMI continuing to fall. The deeper Europe slides into recession, the harder it will be to find solutions.

And it is already almost near impossible to find solutions, a fact proved by the seemingly pointless European summits that always seem to come too late and offer too little.

Yet despite what is obviously clear and present danger to the Eurozone project, and, more importantly than the project, but to the economy on which millions depend for their livelihood, there doesn't seem to be any panic in official circles. No sense that policies need to be fundamentally reassessed. No sense that time is of the essence. No one is even bothering to leak unsubstantiated and false rumors of some "Grand Plan" in the works.

In my view, the lack of panic is downright scary. Is Europe completely devoid of new ideas? Or is everyone simply on vacation?

Bottom Line: Still a Euroskeptic, and an increasingly pessimistic one at that. I really, really want to believe that Europe will quickly coalesce around a solution to the crisis, and I hope to see a move in that direction soon. At a minimum, the ECB should throw in the towel and backstop sovereign debt. But all I see are the same failed policies again and again. Worse, no one is running for the panic button. Maybe there isn't a panic button; I guess it was another piece of the necessary institutional framework forgotten during the creation of the Euro.

Monday, July 02, 2012

Paul Krugman: Europe’s Great Illusion

Can Europe save itself?:

Europe’s Great Illusion, by Paul Krugman, Commentary, NY Times: Over the past few months I’ve read a number of optimistic assessments of the prospects for Europe. Oddly, however, none of these assessments argue that Europe’s German-dictated formula of redemption through suffering has any chance of working. Instead, the case for optimism is that ... a breakup of the euro ... would be a disaster for everyone, including the Germans, and that in the end this prospect will induce European leaders to do whatever it takes to save the situation.

I hope this argument is right. But every time I read an article along these lines, I find myself thinking ... disaster, no matter how obvious, is no guarantee that nations will do what it takes... And this is especially true when pride and prejudice make leaders unwilling to see what should be obvious.

Which brings me back to Europe’s still extremely dire economic situation. ... European leaders committed themselves to ... the notion that fiscal austerity and “internal devaluation” (basically, wage cuts) would solve the problems... Meanwhile the euro’s crisis has metastasized... Yet the policy prescriptions coming out of Berlin and Frankfurt have hardly changed at all.
But wait, you say — didn’t last week’s summit meeting produce some movement? Yes... Germany gave a little ground... But these concessions remain tiny compared with the scale of the problems.
What would it really take to save Europe’s single currency? The answer, almost surely, would ... involve both large purchases of government bonds by the central bank, and a declared willingness by that central bank to accept a somewhat higher rate of inflation. Even with these policies, much of Europe would face the prospect of years of very high unemployment. But at least there would be a visible route to recovery.
Yet it’s really, really hard to see how such a policy shift could come about.
Part of the problem is ... that German politicians have spent the past two years telling voters something that isn’t true —... that the crisis is all the fault of irresponsible governments in Southern Europe... — ... now the false narrative stands in the way of any workable solution.
Yet ... even elite European opinion has yet to face up to reality. ... So will Europe save itself? The stakes are very high, and Europe’s leaders are, by and large, neither evil nor stupid. But the same could be said ... about Europe’s leaders in 1914. We can only hope that this time is different.

Monday, June 11, 2012

Fed Watch: A Bigger Bailout Awaits

Tim Duy:

A Bigger Bailout Awaits, by Tim Duy: The half-life of European bailouts is getting shorter and shorter, which should come as no surprise in these kinds of repeated games. The announced Spanish bank bailout triggered some early euphoria in financial markets which at the moment is quickly fading. Why? I suspect that market participants fear the bank bailout is simply a precursor to a much bigger bailout of Spanish government debt, a bailout that will involve some sizable private sector involvement.

One of the most telling stories is this from the FT:

Spain’s Treasury on Monday vowed to continue as normal with sovereign bond auctions, arguing that the eurozone’s weekend agreement on a €100bn bailout for Spanish banks would underpin the country’s debt market.

Spain desperately needs to be able to finance at lower bond yields - the fiscal situation simply is not sustainable at interest rates currently north of 6%. They can't close deficits fast enough at those yields. Moreover, the ECB for all intents and purposes is out of the game. Not only do they feel honor bound to avoid anything that looks like the direct financing of national deficits, but they have likely run out of patience. Recall ECB President Mario Draghi's comments in May:

In a damning indictment of Spain’s handling of the problems at Bankia, its third largest lender, ECB president Mario Draghi said national supervisors had repeatedly underestimated the amount a rescue would cost. He also cited the rescue of Dexia, the Franco-Belgian lender, as an example.

“There is a first assessment, then a second, a third, a fourth,” Mr Draghi said. “This is the worst possible way of doing things. Everyone ends up doing the right thing, but at the highest cost.”

One also wonders what kind of fiscal deterioration is being hidden from the general public. Or other EU officials for that matter.

Apparently, the hope was that by channeling the bailout funds to Spain's Fund for Orderly Reconstruction, it would appear as if Spain itself is not paying for the bailout. The lack of a "program" with IMF involvement was added to further create the illusion that this was not a sovereign bailout, and was instead some type of EuroTARP. Thus, a potential liability would be avoided and Spanish bond yields would fall accordingly. In essence, the bank bailout was a last-ditch gamble on the part of the Spanish government to avoid a general government bailout. (For further reading, FT Alphaville has a nice series of posts trying to understand the details of the bailout. See here, here, and here).

The trouble is that market participants started to poke holes in this ruse, realizing that the bailout is just sovereign debt by another name, and debt that most likely would be senior to existing bondholders. There was some initial confusion over this point, although it seems that Germany wants the funds to coming from the soon-to-be-launched ESM, in which case the debt will be senior. It really doesn't matter, though. FT Alphaville hits the nail on the head:

But we’ll close by noting even ‘pari passu’ EFSF debt (or ESM debt which might subsequently absorb EFSF pari passu status) has shown signs of de facto seniority in Greece. EFSF loans to Greece were rescheduled before bondholders, but when it came to the PSI, the EFSF did not take write-downs in common with bondholders.

I think that no matter how many smoke and mirrors the Europeans try to put into the place, they can't cover up the fact that the Spanish government owns this bailout. Market participants came to this conclusion as well and sent Spanish yield higher:


Which means that as of roughly 9am on the West Coast, Spain's gamble has failed. And that pushes Spain once step closer to a real bailout of sovereign debt, and the mess - private sector involvement, Troika monitoring, etc - that comes with it.

Thursday, May 31, 2012

Fed Watch: Push Comes to Shove

Another one from Tim Duy:

Push Comes to Shove, by Tim Duy: The Spanish banking crisis is forcing another showdown in Europe with the German-led Northern contingent increasingly under siege not just from the South but now from just about everyone else. Spain is under pressure to finance a bank recapitalization, but worries that that path will push them straight into a Troika bailout program. And we all know just how well that has worked for Greece and Ireland and Portugal. And Spain holds real leverage. No one is under the delusion (well, almost no one) that Spain can exit the Euro without significant economic damage throughout Europe. Hence we are seeing increasing pressure on Germany to step-up the timetable to real fiscal integration, starting with a Euro-wide banking rescue using ESM funds. From Bloomberg:

German Chancellor Angela Merkel was besieged by critics for letting the euro crisis smolder, with the leaders of Italy and the European Central Bank demanding bolder steps to stabilize the 17-nation economy.

Italian Prime Minister Mario Monti and ECB President Mario Draghi pushed Germany to give up its opposition to direct euro- area aid for struggling banks. Monti further antagonized Germany by urging a roadmap to common borrowing.

The idea is to let banks tap the funds directly without going through their respective national governments - thus avoiding another Troika bailout disaster. Germany, of course, continues to resist, as this would force them to give up one of their tools to enforce austerity throughout Europe. Perhaps, however, German Chancellor Angela Merkel is starting to break under the pressure:

Merkel put some nuance into the German position today. While promising “no taboos” in attacking the crisis, she floated a timeline of “five to 10 years” for fixing flaws in a currency shared by countries with divergent wealth and attitudes toward taxing and spending.

Of course, Europe doesn't have a 5 to 10 year horizon. I am thinking they have something closer to a 5 to 10 week horizon to get their act together. Something big is going to happen in Europe this summer, and I think the odds of a tail-end outcome are increasing, at both ends of the tail. Either Europe pulls together sooner than the German timeline, or finally blows apart. The middle-ground, muddle-through option looks less attractive each day.

Fed Watch: Cash Exiting China

Tim Duy:

Cash Exiting China, by Tim Duy: Something that I have thinking about for a few weeks - and was reminded of reading Ryan Avent this morning - is the series of pieces at FT alphaville regarding the outflow of cash from China. See here and here and here. The thinking had been that the renminbi was a one-way bet as China moved forward with capital account liberalization as investors rushed to be part of the Chinese story. The growing exodus of cash, however, is calling that story into question.

Moreover, I am interested in how much of the outflow is attributable to a generalized rush to safety as a result of the European crisis versus how much is attributable to capital flight due to a a deteriorating economic environment inside China itself. I am reminded of this story from the Wall Street Journal earlier this year:

With a fortune of at least $1.6 million, Mr. Shi is part of the wealthy elite that benefited most from the Communist Party's brand of capitalism. He is riding the crest of arguably the biggest economic expansion in history.

And yet, while the party touts the economic success of the "Chinese model," many of its poster children are heading for the exits. They are in search of things money can't buy in China: Cleaner air, safer food, better education for their children. Some also express concern about government corruption and the safety of their assets.

Domestic money in China will be the first to head for the exit - insiders will always know more than outsiders about the underlying economic conditions. So the exodus of cash could indicate that the Chinese story is coming to a close - and that will have significant consequences for the global economy. It is another signal that emerging markets will not be supporting global demand anytime soon. I think the team at alphaville is right - this story is slipping under the radar while we all have our eyes focused on the farce in Europe. But it could be the real game changer in the global economy.

Thursday, May 24, 2012

Fed Watch: Total Failure

Tim Duy:

Total Failure, by Tim Duy: With the crisis once again nipping at their heels, European policymakers accomplished exactly what was expected of them. Absolutely nothing. From the FT:

European leaders put off any decisions on shoring up the region’s banks at a late-night summit on Wednesday despite rising concerns that instability in Greece was undermining confidence in the eurozone’s financial sector.

Instead, the heads of the EU’s main institutions were given the task of drawing up proposals for closer fiscal co-ordination in time for another summit next month, including plans that could include a path towards a Europe-wide deposit guarantee scheme and, in the longer term, commonly-backed eurozone bonds.

The trouble is that Europe doesn't have a month to wait for another summit. I am not confident they even have a week. But not to fear - the ECB is expected to step into the breech once again. At least that is the hope. But notice the irony. Germany doesn't want Eurobonds because of the moral hazard risk. They don't want to get stuck paying for Southern Europe's profligacy. At the same time, the ECB does want to act as lender of last resort for fear that will only encourage policymakers to put off hard decisions on fiscal union. Moral hazard to the right, moral hard to the left. The only path left is gridlock - and failure.

In the meantime, the Wall Street Journal reports on accelerating plans for a Greek exit.

European officials are stepping up contingency planning for a possible Greek exit from the euro zone, even as Europe's leaders struggled to overcome differences on how to resolve the currency bloc's crisis at a summit meeting here.

And, for good measure, St. Louis Federal Reserve President James Bullard let's us know that he sleeps easy at night. Via Reuters:

"I'm one that thinks that Greece could exit, and it could be handled in an appropriate way without causing too much damage, either in Europe or in the U.S.," St. Louis Federal Reserve Bank President James Bullard told Reuters.

I wish I could be so confident.

Wednesday, May 23, 2012

Fed Watch: Cutting Off Your Nose...

Tim Duy:

Cutting Off Your Nose...: spite your face. This should be the new, official slogan of German policymakers. It is pretty clear that financial conditions in Europe are unravelling, now putting the Euro into free-fall. European policymakers simply became far too complacent over the winter, thinking that the ECB's two LTROs had fixed the problem. And, in a sense they did - for the moment. But as it became increasingly evident that the ECB was back out of the game, everything went sour. The economic realities came back into play. Moreover, there has been precious little action taken to resolve those problems - essentially, the lack of an federal fiscal institutional structure - that would make a common currency workable.

Moreover, Germany continues to block movement in that direction. From the FT:

Germany refused to share the debt burden of stressed eurozone peers on Tuesday, ignoring two of the most influential international economic bodies which offered support for proposals championed by Paris, Rome and Brussels ahead of a summit.

Angela Merkel, Germany’s chancellor, has argued that any co-mingling of eurozone debt would remove incentives for southern economies to adopt structural reforms. The calls from the International Monetary Fund and the Organisation for Economic Co-operation and Development came on the eve of Wednesday’s EU summit.

Merkel sees a large stick as the only way to end the crisis. She is unwilling to recognize that she needs to match that stick with a large carrot. At the end of the day, rather than concede on the necessity of internal fiscal transfers to make this work, she would rather doom the entire project to failure.

And speaking of the path to failure, notice another warning sign. Germany is now selling zero coupon bonds. Again from the FT:

Germany sold €4.5bn of two-year government bonds at a record low yield of 0.07 per cent, underscoring the strong demand for safer assets amid fears that Greece could be forced out of the eurozone.

The German Bundesbank said the two-year “Schatz”, which was sold with a zero-coupon for the first time, received bids for €7.7bn, compared to a maximum sales target of €5bn.

Germany is rushing headlong on the Japanese (and arguably) US path, dragging the rest of Europe along for the ride. Of course, German policymakers see it exactly the other way, and worry about the moral hazard implications of changing course. But Europe is beyond moral hazard, which at this point is just something to talk about over a few pints at the pub. Germany needs put moral hazard concerns in the back seat and find a cooperative path, and needs to find it soon.

Tuesday, May 22, 2012

Fed Watch: Calm Before the Storm?

Tim Duy:

Calm Before the Storm?, by Tim Duy: A relatively calm start to the week. Can it last? Almost certainly not. It will get worse before it gets better.

A few themes popped since last Friday that are worth considering. First is that some calmer voices have come to the forefront, arguing that a Greek exit is not really all that likely. See Brad Plummer at Ezra Klein's blog or Kate MacKenzie at FT Alphaville. The general point: Breaking up is hard to do. No argument here - a Greek exit would be ugly for Greece, and the rest of Europe as well. And, by all accounts, the Greek people don't want that outcome. The problem, however, is that the alternative, unending austerity to induce a substantial internal devaluation, is not really a solution either.

Indeed, it seems to me that on the current path, the cost of austerity will soon outweigh the cost of exit. And we are running out of time to change that trajectory. As I noted in my last post, it looks like the Greece fiscal situation is quickly deteriorating. And it looks like a collapsing tourism industry will only worsen the economy, thereby putting additional pressure on deficit to GDP targets. From FT Alphaville:

Greece received a boost last year as the unrest in the Middle East made countries such as Egypt unattractive destinations. But it looks like German tourists won’t be propping up the Greek economy so much this summer...

...When you think of the tax revenue that might be lost from this drop in activity, it’s possibly another sign that the bailout programme may be so far off course since the elections that it could have to be renegotiated anyway.

The last bailout is quickly being overtaken taken overtaken by events. What will be the demands of any new bailout? If history is any guide, more austerity - and with it a higher probability of exit.

This seems to be exactly the story that Syriza party leader Alexis Tsipras is trying to sell in Germany. To be sure, this is politically motivated, as he seeks to convince Greeks that voting for his party does not ensure an exit. Indeed, he is pushing the opposite story - that only by tearing up the bailout agreement can Greece stay in the Euro. From Bloomberg:

“Until when should German taxpayers pay into a bottomless pit?” Tsipras said to reporters in Berlin today after he held talks with leaders of Germany’s anti-capitalist Left Party. “It apparently flows to the Greek economy, but in reality only the banks and bankers are being financed.”...

...For Greeks, voting for Syriza “doesn’t mean that we’ll be kicked out of the euro,” he said. “It will mean a great opportunity for us to save the euro.”

A victory for Syriza would mean stability for Greece, whereas insisting on a continuation of the “catastrophic” austerity measures means a return to the drachma, Tsipras said.

I think he is right - except that to the Germans, tearing up the bailout is the same thing as exiting the Euro. Both sides have their hands on the buttons that ensure mutually assured financial destruction, and each austerity package forces Greece closer to pushing that button.

Another theme is one I find particularly intriguing - the idea that Greece will establish an internal currency that trades side-by-side with the Euro. FT Alphaville explains a version of this plan by Deutsche Bank’s Thomas Mayer. The basic idea is that the government will need to turn to issuing some kind of IUO's in the weeks ahead due to its deteriorating fiscal situation. The new currency would trade internally and need to be exchanged for Euros to pay for imports. The exchange rate would not be one to one, of course, and internal prices would be devalued against the Euro. To prevent the banking system from collapsing, it would need to be pulled into European supervision that guarantees Euro denominated accounts - thereby alleviating the fear of depositors that their Euro accounts would be replaced with a New Drachma, thus preventing a massive bank run. This is only a half exit, and the goal would be to stabilize the budget to the point where the government could cease printing the New Drachmas and eventually return to the Euro.

I am not confident this would work - and particularly not confident that the Greek government could wisely use its new-found power of the printing press. But it is a possible third way out, and this is a situation that desperately needs a third way.

Finally, Eurobonds are back on the table. Sort of. From the Wall Street Journal:

But next month's elections in Greece could dramatically change the euro zone's political calculus, analysts say. A victory by parties opposed to the bailout negotiated with the euro zone and the International Monetary Fund would sharply raise the risk of Greece leaving the currency area, and possibly prompt policy makers to adopt more far-reaching measures to contain the turmoil arising from such a threat.

These bolder policies include the creation of "euro bonds," or debt jointly guaranteed by the euro zone that would allow weaker countries such as Spain to borrow at interest rates partly subsidized by Germany. Berlin remains staunchly opposed, though new French President François Hollande is expected to raise the topic during informal discussions at the summit.

Edward Harrison argues that Germany is not entirely opposed to the idea and see a path - an austerity-laden path - to Eurobonds. (Other views on the role of Eurobonds can be found at the NYT's Room for Debate). The challenge, however, is that Europe doesn't have time to wait. Nor does it have time to wait for the other institutional plumbing, such a mechanism for Eurozone bank recapitalization under a full banking union.

Lacking a path to a real fiscal and economic union, the outcome of tomorrow's EU meeting is likely to disappoint. Back to the Wall Street Journal:

Without agreement on these major steps, the leaders will in the meantime back three relatively minor policy initiatives. The first is a proposal to increase the capital of the European Investment Bank, the bloc's long-term lending arm, by €10 billion. The second proposal would ease requirements for troubled governments to use funds due to them from the EU budget.

The third is a plan to borrow money against the EU budget that would be dedicated to infrastructure-investment projects. The plan would create a pilot project using €230 million in EU budget money that could leverage funds of up to €4.6 billion. After two years, the program will be reviewed and possibly increased.

Analysts say none of these ideas is enough to have a significant, near-term macroeconomic effect in the bloc's troubled economies.

"These ideas don't materially improve trend growth prospects in the euro zone," said Mujtaba Rahman, an analyst at the Eurasia Group, a political risk consulting firm. "It's a lot of rhetoric and not a lot substance."

Enough to look like policymakers are doing something, but a far cry from the steps needed to bring the crisis under control. In other words, more of the same.

Friday, May 18, 2012

Paul Krugman: Apocalypse Fairly Soon

Can the euro be saved?:

Apocalypse Fairly Soon, by Paul Krugman, Commentary, NY Times: Suddenly, it has become easy to see how the euro — that grand, flawed experiment in monetary union without political union — could come apart at the seams ... with stunning speed, in a matter of months... And the costs — both economic and, arguably even more important, political — could be huge. ...
Greece is, for the moment, the focal point. Voters who are understandably angry at policies that have produced 22 percent unemployment — more than 50 percent among the young — turned on the parties enforcing those policies. And ... the result ... has been rising power for extremists. ... Greece won’t, can’t pursue the policies that Germany and the European Central Bank are demanding.
So now what? Right now, Greece is experiencing ... a somewhat slow-motion bank run, as more and more depositors pull out their cash in anticipation of a possible Greek exit from the euro. Europe’s central bank is, in effect, financing this bank run by lending Greece the necessary euros; if and (probably) when the central bank decides it can lend no more, Greece will be forced to abandon the euro and issue its own currency again.
This demonstration that the euro is, in fact, reversible would lead, in turn, to runs on Spanish and Italian banks. Once again the European Central Bank would have to choose whether to provide open-ended financing; if it were to say no, the euro as a whole would blow up.
Yet financing isn’t enough. Italy and, in particular, Spain must be offered hope —... some reasonable prospect of emerging from austerity and depression. Realistically, the only way to provide such an environment would be for the central bank to ... accept and indeed encourage several years of 3 percent or 4 percent inflation...
Both the central bankers and the Germans hate this idea, but it’s the only plausible way the euro might be saved. ... So will Europe finally rise to the occasion? Let’s hope so... For the biggest costs of European policy failure would probably be political.
Think of it this way: Failure of the euro would amount to a huge defeat for the broader European project, the attempt to bring peace, prosperity and democracy to a continent with a terrible history. It would also have much the same effect that the failure of austerity is having in Greece, discrediting the political mainstream and empowering extremists.
All of us, then, have a big stake in European success... The whole world is waiting to see whether they’re up to the task.

Fed Watch: Closer to Colliding

Tim Duy:

Closer to Colliding, by Tim Duy: Each passing day brings the runaways trains closer to collision.  

The European strategy to scare the Greek people into voting for pro-austerity parties was always risky. My tendency is to think it will drive voters in the other direction, this is especially the case if voters come to believe they hold the real leverage. And that is exactly the strategy that is emerging. From the Wall Street Journal:

The head of Greece's radical left party says there is little chance Europe will cut off funding to the country and if it does, Greece will repudiate its debts, throwing down a gauntlet that could increase tensions between Greece's recalcitrant politicians and frustrated European creditors...

..."Our first choice is to convince our European partners that, in their own interest, financing must not be stopped," Mr. Tsipras said in an interview with The Wall Street Journal. "If we can't convince them—because we don't have the intention to take unilateral action—but if they proceed with unilateral action on their side, in other words they cut off our funding, then we will be forced to stop paying our creditors, to go to a suspension in payments to our creditors."

Europe and the Greece are locked in a battle of mutually assured financial destruction. Nor can European leaders afford to take Tsipras' threats lightly:

According to recent opinion polls, Mr. Tsipras' party is poised to win the most votes in repeat elections next month, bettering its surprise second-place finish in an inconclusive May 6 vote that left no party or coalition with enough seats in Parliament to form a government. With Mr. Tsipras poised to win pole position in the coming vote, it raises the risk that Greece will soon face a showdown with its European creditors over the contentious austerity program that Athens must implement in order to receive fresh aid.

If Europe caves and gives in to Greek demands, however, a new set of challenges to the austerity agenda will arise. How long would it be before the people of Spain or Italy or Portugal or Ireland realize that they too have much more leverage than they ever imagined. Can the Troika cave to Greece while remaining credible with other troubled economies?  I doubt it - which I think increases the risk that the core of Europe will believe it necessary to create a moral hazard example out of Greece.  

Of course, this worked so well with Lehman Brothers. We will just foget about that little detail for the moment.

Thursday, May 17, 2012

Fed Watch: Europe Overnight

Tim Duy:

Europe Overnight, by Tim Duy: European policymakers are trying to sway the vote in Greece. From the Financial Times:

Senior European leaders are attempting to turn Greece’s repeat national election next month into a referendum on the country’s membership of the euro, a high-stakes political gamble that officials believe can win back voters disillusioned by the tough bailout conditions but eager to stay in the single currency.

José Manuel Barroso, president of the European Commission, made the choice clear on Wednesday, telling Greek voters the €174bn rescue programme would not be changed and that remaining in the eurozone was now in their hands...

...“The next election is going to be a sort of referendum election,” said one eurozone finance minister. “We are going to convey very clearly to the Greek people that if there is no stable government to implement the conditions of the programme then we are going to have difficulties and are going to have to adopt plan B.”

I thought the last election was supposed to be a referendum on Greece's commitment to the Euro. European policymakers fail to understand that they have provided the Greek people no way out - they are damned if they do, damned if they don't. Even if the Greeks overwhelming want to remain in the Euro, the austerity program guarantees ongoing recession, and the Greek people are being asked to commit to a program that is effectively already overtaken by events. The deteriorating fiscal situation seems to guarantee a new program will be necessary in the months if not weeks ahead. Would the rest of Europe agree to another bailout, regardless of whatever new conditions were required to get another deal done? If the rest of Europe really wants Greece to stay in the Euro, I think it can only work with a program of bilateral transfers to Greece in exchange for radical, rapid restructuring of the economy. Carrot, meet stick.

The rest of Europe might not think this is fair, but let's be honest - ultimately, it wasn't fair to bring Greece into the Euro in the first place.

On the issue of internal fiscal transfers, British Prime Minister David Cameron is joining the chorus of policymakers calling on Continental leaders to understand the extent of their problem:

“Either Europe has a committed, stable, successful eurozone with an effective firewall, well-capitalised and regulated banks, a system of fiscal burden sharing and supportive monetary policy across the eurozone or we are in uncharted territory which carries huge risks for everyone.”

That pretty much summarizes the situation. The institutional structure, the fiscal plumbing, simply isn't present in the Eurozone to adequately adjust for asymmetric shocks. End of story. Either get that structure in place or accept that the project is a failure. Can Europe make such a transition fast enough? Yes - with German leadership to offer a mix bilateral transfers, Eurobonds, and ECB commitment to stand as lender of last resort to all the region as a whole. Economically possible and politically possible, however, are two different things.

Finally, the ECB has reverted to its usual helpful self. From Bloomberg:

The European Central Bank is conducting a comprehensive review of all its policy tools and has no immediate plans to increase stimulus even as market tensions mount, two euro-area officials said.

The review, mandated by the central bank’s six-member Executive Board, intends to assess the effectiveness of its measures, including the bond-buying program and long-term refinancing operations, and is scheduled to be completed in June or July, said the officials, who spoke on condition of anonymity because the deliberations are private. A third official said the ECB may not consider taking any further policy action until July, and that the bank sees current market tensions as a way of focusing politicians’ minds on reform efforts.

Way to stay ahead of the central banking curve! Maybe if ECB members just close their eyes, tap their heels together, and softly whisper "there's no place like home," the crisis will come to a sudden end.

Hey, it works in the movies.

Wednesday, May 16, 2012

James Galbraith on the Euro Crisis

Here's the third part (German version) of an interview of Jamie Galbraith conducted a few weeks ago by Roger Strassburg and Jens Berger of the German blog NachDenkSeiten (first part, second part). This is on the Euro crisis:

NDS: You've pretty much followed what's been happening in Europe in the past years, haven't you?
Galbraith: I have been.
NDS: You've seen what's been going on in Germany? I've sent you some stuff that may or may not have enhanced what you know.
Galbraith: Thanks to you I have some familiarity.
NDS: I think if you look at the euro crisis, the financial crisis, and the reaction from German policy-- because Germany's power – became the European answer to the Euro crisis. Do you think that if we look at inequality, is inequality rising due to reactions like the austerity policy, like the constitutional debt brake, which now comes in future and … the Stability Pact...
Galbraith: Well, what you're seeing already is divergence across Europe, and that's the basic mechanism of rising inequality – and again, what played out in the United States in the form of credit booms to sectors, and in some cases in housing to various parts of the country – that boom followed by a bust played out in Europe as credit booms to countries, so you see the rise and the fall of Ireland and Spain and so forth, and it's that divergence which is truly the major, the largest single stress in the euro zone right now. Obviously what you describe going on inside Germany is also important, but the German national community is still bound together with a great many stabilizing institutions that still exist, although they are – as in the United States...
NDS: ...very much weakened...
Galbraith: …they're weakened, but they are still strong compared to what happens across national lines. So you expect things to fracture along the weakest links, and that's clearly the national boundaries in Europe. What will happen as a result of that is that you'll have a re-management of populations. It's clear that anybody with a professional qualification and the ability to do so will exit Greece to large expatriate communities already in the United States and in Australia. People will go – and Europe has a long history of people emigrating from Portugal and Spain – and if pressed, they will do that again. So you're going to see that the failure to stabilize national economies in Europe is simply going to lead, in the long run, to the redistribution of its populations.
NDS: I know you did compare inequality in Europe with the United States in your book. Do you think it's really legitimate to compare Europe, though, to the United States? In general you don't move from one country to another very often, because learning a language, of course, you're not going to learn a language and then move somewhere else two years later.
Galbraith: But I assure you, people do in fact, and they will. But it doesn't matter – in any event, for a valid measure of inequality, it is not necessary that people physically move. The important thing is that Europe is a unified economic whole from the standpoint of, let's say, an enterprise making investment decisions or an investor making portfolio decisions. The absence of barriers to capital mobility is just as decisive in creating a unified entity as fluidity of labor movement. But the other thing is one should not exaggerate the extent to which people inside the United States move permanently from one part of the country to another – it's very common for professionals, but a very large part of the population lives where it started from.
NDS: I don't know if you'd just call it a strategy, or if it's just more of an ideology of competitiveness between countries – Germany even goes so far as to want to have competition between the states for investment.
Galbraith: One consequence of European integration, which was clearly foreseen from the beginning and is characteristic of all industrial systems as they move to larger scale is that activity concentrates in the most competitive spot, and it's not just industrial, it's also agricultural. You've actually had concentration of certain agricultural activities in north Europe, which would hardly be thought to be ideal for that, but it happens. And it was foreseen that this would require compensating investments in the European periphery, but those investments haven't been close to being of an adequate scale. The same exact thing was true in the United States. You had, as the country developed on a continental level, industrial activity concentrated the North, Northeast and the Midwest. What ultimately happened to offset that was the New Deal. And the New Deal distributed economic activity – massive infrastructure projects in the South. We had, of course, the advantage of having a single country from the standpoint of distributing military expenditures, which is very important in the State of Texas, very important in other parts of the South. And we had a continental-level Social Security system that was established, which basically means that your base retirement is done at the national standard, not the local standard. So if you have a working life in Alabama, you're still getting at least the federal minimum Social Security payment. This has an enormous equalizing effect. People talk about the ways in which the United States is a very unequal country, but over the last 80 years, it has become radically less unequal geographically than it was before. It was a huge difference between the North and the South, which is no longer the case. Even forty years ago, when I was a kid, nobody, let's say, very few academics would consider making a move from New England to Texas. Because it was a oneway trip, you took a big cut in pay and you would never be able to come back. Now it's routine. The whole place has become substantially integrated, at least to a certain level. Now there are lots of inequalities and growing inequalities at the local level in the U.S., which is what people observe, but at the national level, it's much, much less than it used to be.
NDS: So do you think that a modern version of the Roosevelt New Deal would be the right answer for the euro crisis?

Continue reading "James Galbraith on the Euro Crisis" »

Wednesday, May 09, 2012

Fed Watch: Hopeful Signs From Europe?

One more from Tim Duy:

Hopeful Signs From Europe?, by Tim Duy: While I suspect this is a case of too little, too late, it is increasingly evident that European policymakers on some level realize the errors of their ways. From the Wall Street Journal:

Euro-zone governments are expected to give Spain more leeway to meet its budget-deficit target next year, according to officials involved in the discussions, in a sign they intend to shift away from rigid enforcement of the currency bloc's budget rules.

Austerity will still be the guiding principle of European fiscal policies. But the likely Spanish move suggests the rules will be adjusted in some cases to account for the fact that when economies go into recession, their budget deficits usually rise.

Officials said the flexibility is unlikely to stop with Spain's politically sensitive deficit target. Among other countries that may take advantage of the rules in the future is France, which would have to pass large cuts to achieve its current deficit target for next year—a task likely to clash with the pledges of Socialist President-elect François Hollande to spur economic growth.

It is not clear that this shift gives struggling nations enough room, but it is a step in the right direction that policymakers now recognize that austerity programs have been self-defeating. Likewise, perhaps even the Bundesbank is coming around to the realities of European adjustment. From the FT:

The Bundesbank, the most hawkish of central banks, has signalled it would accept higher inflation in Germany as part of an economic rebalancing in the eurozone that would boost the international competitiveness of countries worst-hit by the region’s debt crisis.

A future German inflation rate above the eurozone average could be part of a natural adjustment process as crisis-hit countries pulled themselves out of recession, the Bundesbank argued in evidence to German parliamentarians submitted on Wednesday.

That said, I wouldn't get too eager that the Bundesbank is eager to rush into more easing:

“In this scenario, Germany could in the future have an inflation rate somewhat above the average within the European monetary union, although monetary policy will have to ensure that inflation overall in the Emu is consistent with the goal of price stability and that inflation expectations remain firmly anchored,” the bank said.

They are not talking about easing overall policy, just acknowledging that even in the context of a maintained inflation target, Germany will experience inflation in excess of that target.

All in all, though, positive developments, at least at the margin. My concern is that all the recent talk about "growth compacts" and such will yield more headlines than positive outcomes, and as a consequence policymakers will begin to believe that the original path of austerity was in fact the only path to follow.

Tuesday, May 08, 2012

Fed Watch: Greece, Again

Tim Duy:

Greece, Again, by Tim Duy: It is shaping up to be another long, hot summer, and not just because of global warning. As has been widely noted, the austerity backlash in Europe began in earnest this past weekend. And Greece is once again the epicenter, at least for now. The Greek political system appears rudderless, which is calling into question the nation's resolve to complete the conditions of the last bailout package. Moreover, there are open calls for Greece to renege on the deal:

Greece’s Syriza party leader Alexis Tsipras, charged with forming a government, told his pro-bailout counterparts they must renounce support for the European Union- led rescue if there is to be any chance of forging a coalition.

Tsipras said he expected Antonis Samaras of New Democracy and Evangelos Venizelos, the former finance minister who leads the Pasok party, to send a letter to the EU revoking their pledges to implement austerity measures by the time he meets with them tomorrow to discuss forming a coalition. Samaras said he would not do so, and would support a minority government if necessary.

The Troika can't be particularly optimistic about Greek resolve whatever government finally holds together. Also note that in the coming days, Greece is faced with some real debt management decisions. From Bloomberg:

The government taking office after this weekend’s election has 30 days to decide whether to make today’s interest payment on 20 billion yen ($250 million) of 4.5 percent notes maturing in 2016, or default. Then, by May 15, officials must decide if they’re going to repay the 436 million euros ($555 million) due on a floating-rate note issued a decade ago.

These are among about 7 billion euros of bonds whose holders took advantage of being governed by foreign rather than Greek law to sidestep losses suffered under the private-sector involvement rescheduling, or PSI. Paying the holdouts in full would arouse the ire of Greek taxpayers, as well as investors who cooperated with PSI. A failure to pay would signal Europe’s debt crisis is worsening.

A lot of moving pieces here, but any way you organize the pieces, the odds of a Greek exit from the Eurozone are heading up with each passing day, and market participants are increasingly leaning in that direction. From Bloomberg:

“This summer I think is very likely,” Taylor, founder and chief executive officer of FX Concepts in New York, said today in an interview on Bloomberg Television’s “Inside Track” with Erik Schatzker and Sara Eisen. “The Europeans aren’t going to give them the money, the International Monetary Fund’s not going to give them an OK. They will be out of money in June.”

June is coming up fast. And, for the moment, the rest of Europe is drawing a line in the sand. As expected, the Germans are at the forefront. From Reuters:

The European Central Bank will not renegotiate Greece's bailout package and there are no alternatives to sticking with it if Greece wants to stay in the euro zone, ECB Executive Board member Joerg Asmussen was quoted as saying on Tuesday.

"Greece needs to be aware that there are no alternatives to the agreed bailout program, if it wants to stay in the euro zone," Asmussen told German financial daily Handelsblatt.

See also Athens News. Of course, the sustainability of the last bailout might have been a moot point anyway, given that the Greek economy will likely deteriorate more than expected anyway. From Athens news:

The economy will contract by a steeper-than-expected 5 percent this year, the central bank chief said in a speech to the bank's shareholders on Tuesday.
Last month, the bank in March had forecast a 4.5 percent contraction in the economy this year.

I don't know if this includes expectations of a decline of the Greek tourism industry. From ekathimerini:

Online tourism bookings from abroad are pointing to a 12.5 percent decline for this year, according to the Airfasttickets travel agency.

Nikos Koklonis, head of the company that owns the agency, says that the biggest drop in bookings for Greek destinations this year is from the German market, which last year accounted for 15 percent of all bookings. Its share has now shrunk to just 3 percent.

In my opinion, what makes a Greek exit more likely is the apparently growing belief that the external costs will be minimal. Back to Bloomberg:

“I think that people are feeling the implications of a Greek exit aren’t so bad,” Taylor said. If Greece leaves the euro, Europeans will “turn around and huddle together and say, ‘how do I help Portugal and Spain?’”

And Athens News:

Voters' rejection of pro-bailout political parties in Sunday's election has raised the chances of Greece leaving the euro, but this unprecedented step is seen as manageable rather than catastrophic for the currency bloc.
Some banks have raised estimates of the likelihood of Greece quitting the euro. But after a year of investors shedding bonds issued by highly indebted euro zone countries and big injections of central bank cash, they said the damage could be contained.
And from CNNMoney:

The results of the latest elections in Greece may make it more likely that the country will eventually leave the eurozone. But such an exit would probably be more orderly than Greece's default, experts said....

..."[Greece] is not going to get pushed, but they might walk out," Citi chief economist Willem Buiter said at last week's Milken Institute Global Conference...

...Economist Nouriel Roubini thinks Portugal and Ireland may also find themselves restructuring their debt and could even wind up following Greece out the door, but none of that should prove disruptive to world markets.

"If a small country -- like Greece or Portugal -- exit, you can have an orderly divorce, but if that restructuring and/or exit hits Italy or Spain, effectively you could get a breakup of the eurozone," Roubini said. But he added that's an unlikely scenario....

The proximate cause for such optimism, I believe, is that the much feared Greek debt default failed to trigger a financial collapse. Apparently, European policymakers kicked that can far enough down the road that financial market participants had time to adjust to that ultimate outcome. That, in addition to the two LTRO's and more firepower in other emergency funding facilities have perhaps created a sense of complacency about a Greek exist from the Eurozone. And that complacency suggests that there will be no third bailout for Greece, especially if that means reserving resources for other ailing Euro members. No bailout renegotiations will likely tip the balance such that staying in the Eurozone will be more costly than exit.

Whether or not Europe should become so sanguine about a Greek exit is another question entirely. But perhaps at this point such concerns are irrelevant anyway. Unless economic conditions dramatically shift in a positive fashion in Greece, it is increasingly difficult to see how this ends with anything but a Greek exit from the Eurozone.

Monday, May 07, 2012

Stiglitz: After Austerity

Joe Stiglitz on Europe:

After Austerity, by Joseph Stiglitz, Commentary, Project Syndicate: This year’s annual meeting of the International Monetary Fund made clear that Europe and the international community remain rudderless when it comes to economic policy. Financial leaders, from finance ministers to leaders of private financial institutions, reiterated the current mantra: the crisis countries have to ... bring down their national debts, undertake structural reforms, and promote growth. Confidence, it was repeatedly said, needs to be restored.
It is a little precious to hear such pontifications from those who, at the helm of central banks, finance ministries, and private banks,... created the ongoing mess. Worse, seldom is it explained how to square the circle. How can confidence be restored ... when austerity will almost surely mean a further decrease in aggregate demand, sending output and employment even lower? ...
There are alternative strategies. Some countries, like Germany, have room for fiscal maneuver. Using it for investment would enhance long-term growth, with positive spillovers to the rest of Europe. ...
Europe as a whole is not in bad fiscal shape... If Europe – particularly the European Central Bank – were to borrow, and re-lend the proceeds, the costs of servicing Europe’s debt would fall, creating room for the kinds of expenditure that would promote growth and employment.
There are already institutions within Europe, such as the European Investment Bank, that could help finance needed investments in the cash-starved economies. ...
The consequences of Europe’s rush to austerity will be long-lasting and possibly severe. If the euro survives, it will come at the price of high unemployment and enormous suffering, especially in the crisis countries. And the crisis itself almost surely will spread. ...
The pain that Europe, especially its poor and young, is suffering is unnecessary. Fortunately, there is an alternative. But delay in grasping it will be very costly, and Europe is running out of time.

Wednesday, May 02, 2012

"Why a More Flexible Renminbi Still Matters"

A quick one while waiting for Bill Clinton to take the stage at the conference I'm attending. This is Ken Rogoff:

Why a More Flexible Renminbi Still Matters, by Kenneth Rogoff, Commentary, Project Syndicate: One of the most notable macroeconomic developments in recent years has been the sharp drop in China’s current-account surplus. The International Monetary Fund is now forecasting a 2012 surplus of just 2.3% of GDP, down from a pre-crisis peak of 10.1% of GDP in 2007, owing largely to a decline in China’s trade surplus – that is, the excess of the value of Chinese exports over that of its imports.
The drop has been a surprise to the many pundits and policy analysts who view China’s sustained massive trade surpluses as prima facie evidence that government intervention has been keeping the renminbi far below its unfettered “equilibrium” value. Does the dramatic fall in China’s surplus call that conventional wisdom into question? Should the United States, the IMF, and other players stop pressing China to move to a more flexible currency regime?
The short answer is “no.” China’s economy is still plagued by massive imbalances, and moving to a more flexible exchange-rate regime would serve as a safety valve and shock absorber. ...[continue reading]...

Sunday, April 15, 2012

"The ECB’s Lethal Inhibition"

Barry Eichengreen:

The ECB’s Lethal Inhibition, by Barry Eichengreen, Commentary, Project Syndicate: Last December, with Europe’s financial system on the brink of disaster, the European Central Bank stunned the markets with an unprecedented intervention... The ECB’s surprise liquidity operation put the continent’s crisis on hold. But now, just fourth months later, matters are again coming to a head. The big southern European countries, Spain and Italy, battered by austerity, are spiraling into recession. ... So, will it be once more into the breach for the ECB?
The hurdles to further monetary-policy action are high, but they are largely self-imposed. At its most recent policy meeting, the ECB left its policy rate unchanged, citing inflation half a percentage point above the official 2% target. ...
A second argument against further monetary-policy action is that it should be considered only as a reward for budgetary austerity and structural reform, areas in which politicians continue to underperform. ...
With governments hesitating to do their part, the ECB is reluctant to support them. In its view, rewarding them with monetary stimulus ... only relieves the pressure on national officials to do what is necessary.
If this is the ECB’s thinking, then it is playing a dangerous game. Without spending and growth, there can be no solution to Europe’s problems. Absent private spending, budget cuts will only depress tax revenues, requiring additional budget cuts, without end. There will be no economic growth at the end of the tunnel, and political support for structural reforms will continue to dissipate.
The ECB is preoccupied by moral-hazard risk... But it should also worry about meltdown risk... The ECB will object, not without reason, that ... a ... cut in policy rates or “quantitative easing” by another name will do nothing to enhance the troubled southern European economies’ competitiveness.
True enough. But, without economic growth, the political will to take hard measures at the national level is unlikely to be forthcoming. ...

Monday, February 27, 2012

Paul Krugman: What Ails Europe?

Paul Krugman writing from Lisbon:

What Ails Europe?, by Paul Krugman, Commentary, NY Times: Things are terrible here, as unemployment soars past 13 percent. Things are even worse in Greece, Ireland, and arguably in Spain, and Europe as a whole appears to be sliding back into recession.
Why has Europe become the sick man of the world economy? ... Read ... about Europe ... and you’ll probably encounter one of two stories, which I think of as the Republican narrative and the German narrative. Neither story fits the facts.
The Republican story — it’s one of the central themes of Mitt Romney’s campaign — is that Europe is in trouble because it has done too much to help the poor and unlucky, that we’re watching the death throes of the welfare state. ...
Did I mention that Sweden, which still has a very generous welfare state, is currently a star performer...? But let’s do this systematically. Look at the 15 European nations currently using the euro..., and rank them by the percentage of G.D.P. they spent on social programs before the crisis. Do the troubled Gipsi nations (Greece, Ireland, Portugal, Spain, Italy) stand out for having unusually large welfare states? No,... only Italy was in the top five, and even so its welfare state was smaller than Germany’s.
So excessively large welfare states didn’t cause the troubles.
Next up, the German story, which is that it’s all about fiscal irresponsibility. This story seems to fit Greece, but nobody else. ...
So what does ail Europe? The truth is that the story is mostly monetary. By introducing a single currency without the institutions needed to make that currency work, Europe effectively reinvented the defects of the gold standard — defects that played a major role in causing and perpetuating the Great Depression. ...
If the peripheral nations still had their own currencies, they could and would use devaluation to quickly restore competitiveness. But they don’t, which means that they are in for a long period of mass unemployment and slow, grinding deflation. Their debt crises are mainly a byproduct of this sad prospect, because depressed economies lead to budget deficits and deflation magnifies the burden of debt.
Now, understanding the nature of Europe’s troubles ... makes a huge difference, because false stories about Europe are being used to push policies that would be cruel, destructive, or both. The next time you hear people invoking the European example to demand that we destroy our social safety net or slash spending in the face of a deeply depressed economy, here’s what you need to know: they have no idea what they’re talking about.

Tuesday, February 21, 2012

"This Really Isn’t Credible"

Teaching day, so a quick one on Greece -- the reviews are in:

Greece, by Paul Krugman:

We must do something. This is something. Therefore we must do it.

Yes, Minister.

What can I say? As Felix Salmon says, this really isn’t credible. The problem with all previous rounds here has been that austerity policies depress the economy to such an extent that it wipes out most of the topline fiscal gains: revenue fall, so does GDP, so the projected debt/GDP ratio gets, if anything, worse.

Now we have another round of austerity — which is assumed not to do too much damage to growth. The triumph of hope over experience.

OK, nobody here is an idiot (although see my next post). What’s happening is that nobody is prepared to take the plunge into either of the paths that might eventually lead out of this: sustained aid (not loans) to Greece, or departure from the euro, leading eventually to higher competitiveness and faster growth. Both options would be politically catastrophic, which means that they can’t be taken until there is literally no alternative.

So Greece will be strung along some more.

Thursday, February 09, 2012

"Bretton Woods: Not the Gold Standard"

Eric Rauchway tries to clear up some misconceptions about the gold standard:

Bretton Woods: not the gold standard, by Eric Rauchway, Edge of the American West: In a WSJ op-ed called “Forty Years of Paper Money,” Detlev Schlichter, a supporter of the gold standard, begins thus:

Forty years ago today, U.S. President Richard Nixon closed the gold window and ushered in, for the first time in human history, a global system of unconstrained paper money under full control of the state.

Now, with that title, that lede, and Schlichter’s very stern opinions about paper money, you’d think that the paper money era began right then, forty years ago. But as Schlichter himself says in his very next sentence,

It is not that prior to August 15, 1971, there was a gold standard. Far from it. Most countries had severed any direct link between their currencies and gold many years earlier.

Right..., the monetary thing that was not, per Schlichter, a gold standard – the monetary thing that happened to go along with decades of global growth and prosperity, the monetary thing that goes wholly unmentioned in the op-ed, was the Bretton Woods system.

The whole point of Bretton Woods was to get away from the gold standard. Indeed, that was practically the whole point of the Roosevelt administration’s monetary policy. Which is unsurprising, because adherence to the gold standard exacerbated the Great Depression, as Federal Reserve officials viewed keeping gold in vaults a more important goal than adding jobs to the economy. ...

The best monetary arrangement, some of Roosevelt’s Treasury officials figured in 1934, was to fix exchange rates – that would give you one advantage of gold, which is to say that international contracts would always be predictable, so trade would be easy – but you would also reserve the right to move rates in case of need. Best of both worlds... Hence Bretton Woods and the adjustable peg – currencies convertible to one another at fixed, but (at need) adjustable, rates.

The dollar was off gold for domestic purposes – there were no circulating gold coins after 19331 nor was paper money redeemable in gold – but the dollar remained convertible at $35/oz for international claims. The IMF existed to stabilize exchange rates among member currencies.

Wait, you say, isn’t that a gold standard? No, in thunder, wrote Bretton Woods’s architects – read what Harry Dexter White said: under a gold standard you’re interested only in price stability – “the sole purpose of the Fund might be misunderstood to be stability of exchange rates.” That’s actually not how Bretton Woods worked. Take a look at the IMF charter – stability of prices is subordinate to “high levels of employment and real income” – stability of currency was “a means of achieving the objectives” of jobs and high wages.

The Roosevelt administration had to fight like tigers for the IMF against bankers who hated it for just this reason – the bankers wanted debts paid off first, without inflation, and they didn’t care much about jobs or wages. They wanted “the hard, patient labor of reestablishing the economic soundness of participating countries, balancing of budgets … checking inflationary influences” – what we now call “austerity”.

FDR’s Treasury said no, we need jobs, to make sure the Depression doesn’t come back, see; then we will worry about balanced budgets and stability.

It was those guys – the Roosevelt Treasury – who won, and their system – and not the gold standard – that prevailed until Tricky Dick’s time.

So why does Schlichter portray a choice between the current policy and the gold standard, when he knows there was an intermediate and evidently effective system? In fairness, op-eds are very difficult to do in any responsible way, and maybe he talks about Bretton Woods in his book. But he didn’t on Start the Week, either.

1I keep meaning to tell this story, and I will.

Monday, February 06, 2012

Stiglitz: Capturing the ECB

A quick post between appointments -- Joe Stiglitz is unhappy with the ECB. He says, "The ECB’s behavior should not be surprising: as we have seen elsewhere, institutions that are not democratically accountable tend to be captured by special interests":

Capturing the ECB, by Joseph Stiglitz, Commentary, Project Syndicate: Nothing illustrates better the political crosscurrents, special interests, and shortsighted economics now at play in Europe than the debate over the restructuring of Greece’s sovereign debt. Germany insists on a deep restructuring – at least a 50% “haircut” for bondholders – whereas the European Central Bank insists that any debt restructuring must be voluntary.
In the old days – think of the 1980’s Latin American debt crisis – one could get creditors, mostly large banks, in a small room, and hammer out a deal, aided by some cajoling, or even arm-twisting, by governments and regulators eager for things to go smoothly. But, with the advent of debt securitization, creditors have become far more numerous, and include hedge funds and other investors over whom regulators and governments have little sway.
Moreover, “innovation” in financial markets has made it possible for securities owners to be insured, meaning that they have a seat at the table, but no “skin in the game.” They do have interests: they want to collect on their insurance, and that means that the restructuring must be a “credit event” – tantamount to a default. The ECB’s insistence on “voluntary” restructuring – that is, avoidance of a credit event – has placed the two sides at loggerheads. The irony is that the regulators have allowed the creation of this dysfunctional system. 
The ECB’s stance is peculiar. ... There are three explanations for the ECB’s position, none of which speaks well for the institution and its regulatory and supervisory conduct. ...[continue reading]...

Fed Watch: Another Experiment?

Tim Duy:

Another Experiment?, by Tim Duy: In the fall of 2008, US authorities conducted a financial market experiment. They allowed a large and heavily interconnected firm, Lehman Brothers, to file for bankruptcy, apparently under the belief that the consequences should be limited as everyone knew this was coming. I think that, in retrospect, US policymakers wished they had pursued an alternative path. The experiment was not exactly successful.

Now it seems that European policymakers are willing to risk yet another such experiment. To be sure, they could still pull the rabbit out of the hat, but it is starting to look like the Troika and Greece have was they call in divorce court "irreconcilable differences." Via the Financial Times:

Lucas Papademos, the Greek premier, failed to make party leaders accept harsh terms in return for a second €130bn bail-out, pushing Athens closer to a disorderly default as early as next month...

...After five hours of discussions, the three leaders of Greece's national unity government had not accepted demands by international lenders for immediate deep spending cuts and labour market reforms as part of a new medium-term package.

The Troika does not look ready to back down either:

The talks with the three leaders of a national unity government came after the government failed to persuade the so-called “troika”– representatives of the European Commission, European Central Bank and International Monetary Fund – to ease conditions for the rescue deal.

Patience with Greek politicians has evaporated among its creditors. During a conference call on Saturday, eurozone finance ministers bluntly told Athens to deliver on its promises and agree to reforms or face default next month.

Apparently, the Troika is playing serious hardball:

Eurozone officials are deliberately refusing to allow Greece to sign off on a €200bn bond restructuring plan because the threat of default is the leverage they have to convince recalcitrant Greek ministers to implement necessary cuts.

Now, perhaps Greece's leaders are just putting up a fight to look good to their voters and thus this will all blow over tomorrow morning with another last minute deal cobbled together that no one really believes will work. Indeed, everyone already knows the numbers are too small:

A further complication is the uncertainty over supplementing the €130bn bail-out to take account of the deteriorating economic position in Greece.

Some officials believe around another €15bn is needed – funds that Germany and other countries have said they are unwilling to provide.

It doesn't really make sense for Greece to accept a deal they know is doomed to failure from the start. Especially as the terms of the deal - including a steep wage cut to improve competiveness - is virtually guaranteed to plunge the Greek economy deeper into recession.

Fundamentally, the problem is as it always was - any decent adjustment program has the stick and the carrot. The carrot usually comes partly in the form of a currency devaluation that accelerates the process of adjustment by providing stimulus via the external accounts. This short-run stimulus allows for structural changes to take root. The approach to Greece has always been just the stick - more austerity and structural change, no carrot.

And I have to admit that I find the enforced wage-cutting a draconian solution. Will this policy eventually be applied to Spain and Portugal and Ireland? Is this the future of Eurozone economic policy? There are two ways to reduce competitive imbalances. Inflate German wages up, or deflate everyone else down. I think the former would prove to be a lot more fun than the latter.

Truth be told, I honestly believe that Greece is beyond saving without a significant transfer, not loan, that buys real time for the Greek economy to adjust. That is the only way to compensate for the lack of currency adjustment and is the conclusion I wish the Troika would ultimately reach. But, I am also starting to think that the ECB has made the Troika overconfident. When the ECB finally decided that yes, serving as lender of last resort, at least to the financial system, is actually the job of a central bank, they dramatically eased financial market stress throughout Europe. That stress, however, was Greece's leverage. Absent that stress, the Troika appears to believe Greece is backed into a corner with no other way out but to submit to Troika demands.

This is a dangerous game. Sometimes the person backed into a corner makes a sucide run at their attackers. And maybe Greece has nothing else to lose at this point. To be sure, they will suffer a devastating blow if they exit the Euro, but at least it will be the process of self-determination, rather than the devastating blow of Troika imposed austerity.

And, while I am thinking about it, what exactly is the policy precedent the Troika is trying to set? That it is acceptable to force European citizens - a whole people - into poverty? When does this become a human rights issue?

In any event, I don't think financial market participants are really prepared for Greece to make a suicide run. Why should they be? This whole episode is like The Boy Who Cried Wolf. Everytime we come to the brink, and prognosticators call for the apocalypse, someone backs down. Why should this time be any different? Honestly, it is tough to argue with that logic. Expectations of imminent financial crisis have simply gone unmet, leaving markets relatively unphased by the most recent events in Greece. Perhaps the ECB haas done enough to let Greece slide out of the Euro without much noise.

It would be an interesting experiment to see unfold. I am curious to see if the ECB has indeed done enough. Not curious enough, however, to want to take such a risk. The Boy Who Cried Wolf ultimately had a poor ending.

Friday, February 03, 2012

Fed Watch: How This Gets Even Uglier

Tim Duy:

How This Gets Even Uglier, by Tim Duy: At this risk of beating a dead horse, I reiterate that I don't see how the European situation comes to a happy conclusion. Conditions in Greece appear to be deteriorating rapidly. Via Athens News, retail sales are in freefall:

Retail sales by volume fell 8.9 percent year-on-year in November after a 10.8 percent drop in October, statistics service data showed on Tuesday.

Households, burdened by austerity measures to plug deficits and rising unemployment, have cut back on spending.
Consumer confidence has also been hurt by a climb in the jobless rate to 17.7 percent in the third quarter.

Officially, hope springs eternal:

"Increasing unemployment and austerity are likely to continue weighing on disposable incomes and consumer demand in the first months of 2012. However, a positive conclusion of the PSI deal and the approval of the second bailout package could provide a kind of positive shock to business and consumer sentiment," he added.

Right, good luck with that, as the next agreement is only about tightening the screws even more. How exactly will consumer confidence get a boost given an acceleration in wage cuts, a late holiday gift from the Troika. An interview with the IMF's Poul Thomsen, via Kathimerini:

Are you advocating wage cuts?

Let me begin by saying what I think we all agree on. Greece still has a large competitiveness gap. Closing this gap will require actions on many fronts, not only wages, but it is clear that wages for the economy as a whole are too large compared to Greece’s productivity. One could hope to magically raise productivity to levels that will justify the current wage level. We are trying, but there is a limit to this. Thus, part of the adjustment must come by more closely aligning productivity in individual enterprises with wages. Reforms to the wage setting mechanism, to the system for collective agreements could help in this regard. I think that most of us agree on what I have said so far. Where we need to be more convinced, is that such reforms can deliver results in the foreseeable future. If not, we believe that the government should consider more direct interventions for a temporary period, until reforms become effective. These could include limitations on the minimum wage and possibly the 13th and 14th salaries. We are still discussing this. It is too early to say. We need to better understand what kind of reforms the government has in mind.

Under conditions of never-ending austerity with no exchange rate release valve, what exactly is the half-life on any new plan to reduce Greece's debt to GDP ratio to 120% by 2020 (itself a questionable goal)? 3 months? 6 months? Back to deteriorating conditions, via Kathimerini:

Archbishop Ieronymos, the head of the Church of Greece, has taken the rare step of writing to Prime Minister Lucas Papademos to express serious concerns about the effectiveness of the government’s fiscal policy and the effect it is having on Greek people.

In his letter, Ieronymos also raises doubts about the role of the European Commission, European Central Bank and International Monetary Fund – or troika – in the country and whether Greece should agree to further austerity measures to receive its next bailout, suggesting that they are “larger doses of a medicine that is proving deadly.”

Ieronymos expresses concern about the impact of the crisis, describing a rise in suicides, homelessness and unemployment and the desperate state that an increasing number of Greeks find themselves. He warned that this was creating a dangerous social situation.

“Greeks’ unprecedented patience is running out, fear is giving way to rage and the danger of a social explosion cannot be ignored any more, neither by those who give orders nor by those who execute their deadly recipes,” he wrote.

Meanwhile, Germany appears to have underestimated the possibility of resurgent nationalism in the periphery. Via Athens News:

Twenty-eight MPs tabled a proposal in parliament on Thursday requesting a debate on the so-called occupation loan paid by the collaborationist government to Germany during the Second World War as well as the issues of reparations for victims of Nazi atrocities and looted treasures...

...The MPs stressed that the now united German state owes Greece, a Second World War victor, roughly 54bn euros before interest, underlining that Greece was the victim of unparalleled cruelty inflicted by the Nazi forces.

The signatories stressed that Greece has been the subject of an obvious injustice because it is the only country to which Germany has not paid reparations.

Reopening the wounds the Euro was meant to close.

Call me a pessimist, but I can't help but conclude that unless Greece gets real relief more quickly, the cost of being in the Euro will outweigh the costs of leaving. At this point, I am starting to wonder what was the bigger mistake - to allow Greece into the Euro in the first place, or to force them to stay?

Tuesday, January 31, 2012

Fed Watch: I Don't See How This Can Continue

Tim Duy:

I Don't See How This Can Continue, by Tim Duy: The European unemployment numbers are out. The story from the Financial Times:

Unemployment in the 17 euro countries climbed to 10.4 per cent in December, with the November rate revised upwards to the same rate, setting a fresh record since the introduction of the single currency in 1999. So-called “peripheral” members such as Spain and Greece recorded the highest rates, of 22.9 per cent and 19.2 per cent respectively.

By contrast, national data from Germany, the eurozone’s bulwark, showed joblessness declined in January to 6.7 per cent, the lowest level since reunification in 1991.

And a picture is worth a thousand words:


Perhaps France and Italy can hang on while relative wage deflation increases competitiveness with Germany, but conditions in the periphery look downright dire. And note that years of austerity have done little to help Greece and Ireland. I don't see the same medicine working in Spain or Portugal either. It is no wonder that Greece is looking for very substantial reductions in its debt, and it seems inevitable that Portugal will come to the same conclusion sooner or later. The great disparity in unemployment rates is another factor that leaves me pessimistic on the ultimate outcome of the Euro experiment. We need real fiscal transfers, and soon. More carrot with stick.
For now, however, market participants are focused on the salutary effects of the ECB's LRTO (not to mention expectations for another round of QE from the Fed). Have these efforts eased conditions enough to allow for a Portuguese restructuring or even Greece's exit from the Euro? Or have market participants and European policymakers been drawn into a dangerous path of complacency? Thinking aloud, do current market conditions embolden German politicians to think they can finally cut Greece loose with little or no consequences to the rest of Europe? Would this indeed be the case? I have trouble believing in the "orderly exit" story, but perhaps the can has been kicked far enough down the road that it can happen.

"Should The U.S. Take A Harder Stance On China's Currency?"

Joe Gagnon says the "best way to discourage currency manipulation is to tax it heavily":

Should The U.S. Take A Harder Stance On China's Currency?, by Joe Gagnon, Planet Money: ...Ben Bernanke recently said that Chinese currency manipulation "is blocking what might be a more normal recovery process." In fact, the problem goes beyond China to include many other emerging economies and even a few advanced economies. ... The evidence suggests that currency manipulators jointly have increased their trade balances by about $1 trillion relative to where they would have been in the absence of manipulation. Europe and the United States have suffered the corresponding decline in trade balances. ...
Based on estimates of the International Monetary Fund, the $1 trillion boost to European and US net exports from the ending of currency manipulation would return these economies to nearly full employment.
The best way to discourage currency manipulation is to tax it heavily. The taxes should apply to all purchases of European and US assets, including bank deposits, by governments that engage in currency manipulation. Unlike trade sanctions, such taxation is allowed under international law, and it also does not cause the economic distortions that trade sanctions cause. As I outlined recently with my colleague Gary Hufbauer, anti-money-laundering procedures now in place can prevent currency manipulators from hiding their investments through third parties.
One consequence of a reduction in currency manipulation would be a sharp drop in the values of the dollar and the euro in terms of the currencies of the manipulators. It is this exchange rate adjustment that would boost US and European exports, thereby generating jobs. ...

Wednesday, December 28, 2011

Feldstein: France Should Quit "Lashing Out at Britain"

Martin Feldstein says The French Don’t Get It:

The French government just doesn’t seem to understand the real implications of the euro, the single currency that France shares with 16 other European Union countries.
French officials have now reacted to the prospect of a credit rating downgrade by lashing out at Britain. The head of the central bank, Christian Noyer, has argued that the rating agencies should begin by downgrading Britain. The finance minister, Francois Baroin, recently declared that, “You’d rather be French than British in economic terms.” And even the French Prime minister, Francois Fillar, noted that Britain had higher debt and larger deficits than France.
French officials apparently don’t recognize the importance of the fact that Britain ... has its own currency, which means that there is no risk that Britain will default on its debt. When interest and principal on British government debt come due, the British government can always create additional pounds to meet those obligations. By contrast,... the French central bank cannot create euros. ... That is why the market treats French bonds as riskier and demands a higher interest rate...
There is a second reason why the British situation is less risky than that of France. Britain can reduce its current-account deficit by causing the British pound to weaken relative to the dollar and the euro, which the French, again, cannot do without their own currency. Indeed, that is precisely what Britain has been doing with its monetary policy: bringing the sterling-euro and sterling-dollar exchange rates down to more competitive levels. ...
France should focus its attention on its domestic fiscal problems and the dire situation of its commercial banks, rather than lashing out at Britain...

Wednesday, December 21, 2011

Sanity Clauses

Olivier Blanchard:

2011 In Review: Four Hard Truths, by Olivier Blanchard: What a difference a year makes …
We started 2011 in recovery mode, admittedly weak and unbalanced, but nevertheless there was hope. ... Yet, as the year draws to a close, the recovery in many advanced economies is at a standstill, with some investors even exploring the implications of a potential breakup of the euro zone, and the real possibility that conditions may be worse than we saw in 2008.
I draw four main lessons from what has happened.
•First, post the 2008-09 crisis, the world economy is pregnant with multiple equilibria—self-fulfilling outcomes of pessimism or optimism, with major macroeconomic implications.
Multiple equilibria are not new. We have known for a long time about self-fulfilling bank runs; this is why deposit insurance was created. Self-fulfilling attacks against pegged exchange rates are the stuff of textbooks. And we learned early on in the crisis that wholesale funding could have the same effects, and that runs could affect banks and non-banks alike. This is what led central banks to provide liquidity to a much larger set of financial institutions.
What has become clearer this year is that liquidity problems, and associated runs, can also affect governments. Like banks, government liabilities are much more liquid than their assets—largely future tax receipts. If investors believe they are solvent, they can borrow at a riskless rate; if investors start having doubts, and require a higher rate, the high rate may well lead to default. The higher the level of debt, the smaller the distance between solvency and default... Without adequate liquidity provision to ensure that interest rates remain reasonable, the danger is there.
•Second, incomplete or partial policy measures can make things worse.
We saw how perceptions often got worse after high-level meetings promised a solution, but delivered only half of one. Or when plans announced with fanfare turned out to be insufficient or unfeasible.
The reason, I believe, is that these meetings and plans revealed the limits of policy, typically because of disagreements across countries. Before the fact, investors could not be certain, but put some probability on the ability of players to deliver. The high-profile attempts made it clear that delivery simply could not be fully achieved, at least not then.  Clearly, the proverb, “Better to have tried and failed, than not to have tried at all,” does not always apply.
•Third, financial investors are schizophrenic about fiscal consolidation and growth.
They react positively to news of fiscal consolidation, but then react negatively later, when consolidation leads to lower growth—which it often does. Some preliminary estimates that the IMF is working on suggest that it does not take large multipliers for the joint effects of fiscal consolidation and the implied lower growth to lead in the end to an increase, not a decrease, in risk spreads on government bonds.  To the extent that governments feel they have to respond to markets, they may be induced to consolidate too fast, even from the narrow point of view of debt sustainability.
I should be clear here. Substantial fiscal consolidation is needed, and debt levels must decrease. But it should be, in the words of Angela Merkel, a marathon rather than a sprint. It will take more than two decades to return to prudent levels of debt. There is a proverb that actually applies here too: “slow and steady wins the race.”
•Fourth, perception molds reality.
Right or wrong, conceptual frames change with events. And once they have changed, there is no going back. For example,... not much happened to change the economic situation in the Euro zone in the second half of the year. But once markets and commentators started to mention the possible breakup of Euro, the perception remained and it also will not easily go away. Many financial investors are busy constructing strategies in case it happens.
Put these four factors together, and you can explain why the year ends much worse than it started.
Is all hope lost? No, but putting the recovery back on track will be harder than it was a year ago. It will take credible but realistic fiscal consolidation plans. It will take liquidity provision to avoid multiple equilibria. It will take plans that are not only announced, but implemented. And it will take much more effective collaboration among all involved.
I am hopeful it will happen. The alternative is just too unattractive.

As Krugman notes here and here -- the former memorable for the line "there is a sanity clause" -- the IMF wasn't as crazy as the ECB and the OECD (and policy elites more generally) on the austerity issue:

...the [IMF] report takes on Alesina-type studies, which have been heavily promoted... The IMF basically finds them all wrong, largely for the reasons I have pointed out in the past: their methodology does a really terrible job at identifying actual changes in fiscal policy. ... And it turns out that identifying the episodes right reverses the results: contractions are contractionary, after all.

However, while sanity may have prevailed on fiscal policy, the lack of comments on monetary policy -- particularly as it relates to the euro and the ECB -- is notable. Blanchard has, in the past, called for higher inflation targets and more aggressive policy, and I doubt it's an accident that this is omitted from his comments. There are vague references to this, e.g. "Without adequate liquidity provision to ensure that interest rates remain reasonable, the danger is there," but nothing specific. I think there's a big lesson to be learned about what can happen if a central bank refuses to act as a lender of last resort, and would have liked to have seen something along these lines included among the bullet points.

Thursday, December 15, 2011

Fed Watch: ECB Still Not the White Knight

Tim Duy:

ECB Still Not the White Knight, by Tim Duy: The Wall Street Journal has the story on today's speech by ECB President Mario Draghi:

The ECB's purchases of government bonds are "neither eternal, nor infinite," Mr. Draghi said in a speech in Berlin, stressing it would take "a lot" more than monetary-policy measures to restore market confidence in the euro zone.

Asked whether the ECB should copy the U.K. and U.S. in printing money to buy government bonds, a policy known as quantitative easing, Mr. Draghi said: "I don't see any evidence that quantitative easing leads to stellar economic performance" in those economies. EU treaties forbid monetary financing of government debt, he added.

This suggests Draghi believes quantitative easing should only be used if it delivers "stellar" economic performance. This is depressing, not to mention severely misguided. The appropriate metric should not be achieving a "stellar" economy, but what would have occurred in the absence of QE. Hopefully, he will recognize this distinction should (when) the situation deteriorate further.

The combination of fiscal consolidation and ECB intransigence promises to keep the European crisis in the headlines for a long, long time.

Fed Watch: Europe Still Heading For Collapse

Tim Duy:

Europe Still Heading For Collapse, by Tim Duy: The half-life of the effectiveness of European summits is growing increasingly shorter. While I have been a long-term Europessimist, market participants are more willing to trade on whatever appears to be positive news, thus markets jump whenever it appears the Europeans are taking action. But eventually the game will wear thin as market participants increasingly realize European "solutions" are never more than half-measures intended to kick the can down the road another few months.

And the last summit was no exception. The reality is quickly sinking in that, relative to the dimensions of the challenge, very little was really accomplished two weeks ago. And very little will be accomplished until European leaders come to the realization that they continue to treat the symptoms of the disease, not the cause of the disease. They need to find a mechanism to address Europe's internal imbalances that does not rely exclusively on deflation as a cure. Alan Blinder provided the background in the Wall Street Journal:

All financial eyes are fixed on the euro. Europe's common currency actually has two gigantic problems. The debt and banking crisis hogs all the attention because of its immediacy, plus the high drama of all those summit meetings. But the other, slower-acting problem—lopsided competitiveness within the euro zone—is far more intractable.

Blinder sees three paths out of the resultant mess:

There are three ways for the other countries to close the gap with Germany—and remember, the gap is large. First, Germany can volunteer for higher inflation than its euro partners by, for example, implementing a large fiscal stimulus or ending its wage restraint. How do you say "ain't gonna happen" in German?

Second, the other countries can engineer German-like productivity miracles through structural reforms while Germany, relatively speaking, stands still. Good luck with that. And even if it somehow happens, the timing is all wrong. Reforms take years to bear fruit while financial markets count time in seconds.

Third, the other countries can experience deflation, meaning a prolonged decline in both wages and prices, which is incredibly difficult and painful—and generally happens only in protracted recessions. Sadly, this may be the most likely way out.

The reality of Blinder's view - that option two will not work and option three is excessively painful - is revealed by the most recent IMF update on Greece. From the report:

Meanwhile, since the fourth review, the economic situation in Greece has taken a turn for the worse, with the economy increasingly adjusting through recession and related wage-price channels, rather than through structural reform-driven increases in productivity.

Really, this is a surprise to IMF economists? Yet apparently, the IMF still believes that structural change is an immediate cure:

We recognize the need to reach a critical mass of reforms and reform synergies to jump-start growth.

I like this - the IMF does not believe in "confidence" fairies; they believe in "synergy" fairies. I keep kicking myself for missing the "synergy" fairy lecture in graduate school. Apparently all the IMF economists made it to that lecture.

Of course, it is not their fault. The IMF attempts to shift some of the blame onto the Greeks:

Structural reforms have not yet delivered expected results, in part due to a disconnect between legislation and implementation.

While likely true, this is something of a red herring. The long-term nature of reforms was no match for the pace of financial market developments, while the willingness of the population to accept externally-driven reforms is understandably lacking given the desire of the external agents to support ongoing recession. Without more direct transfers and debt relief, the IMF, ECB, and EU continue to use more stick than carrort.

Arguably, European policymakers might see the fundamental problem, but also recognize a real solution in years away. Via the Financial Times:

Member states of the eurozone have set themselves on an “irreversible course towards a fiscal union” to underpin their common currency, even if it may take years to reach that goal, Angela Merkel, the German chancellor, told her parliament on Wednesday.

Europe doesn't have years. The vice of austerity packages will eventually crush to hard, and the cost of staying within the Euro will exceed the costs of exit.

Meanwhile, the ECB is at best having mixed results. On one hand, recent actions appear to have stabilized government debt markets in Spain, Belgium, and France. On the other, Italian yields have retraced much of their collapse. Probably more importantly, however, stabilization of the banking crisis remains elusive. From the Financial Times:

But, despite the central bank facilities, the cost of obtaining dollar funding in the private market continues to soar, pointing to a dollar funding squeeze as Europe’s banks head into their all-important year-end reporting period.

The three-month euro-US dollar basis swap dropped to as low as -150 basis points on Wednesday, meaning banks would have to pay an extra 1.5 per cent premium to swap their euros into dollars for a three-month period. The premium has not been persistently below the -140bps region since late 2008, during the depths of the financial crisis.

Not good, not good at all. Also, the hopes that the ECB will provide an unlimited backstop for soveriegn debt now look to be premature at best. Via the Wall Street Journal:

With many in Europe still hoping against hope that the European Central Bank will step in more aggressively to buy bonds and bring down borrowing costs for struggling governments, Jens Weidmann, the president of Germany's Bundesbank and member of the ECB governing council, indicated his opposition to that hadn't softened.

The idea that the ECB should turn on the printing presses to help finance some debt-ridden euro-zone states should be put to rest for good, Mr. Weidmann said. Central bank "independence is lost when monetary policy is tied to the wagon of fiscal policy and then loses control over prices," he said.

Some argue the ECB is just jawboning to drive a hard bargain when it comes to fiscal and structural reforms. I am not so sure - these guys sound pretty serious to me.

And perhaps you thought the Fed would ride to the rescue. Think again. From Bloomberg:

Federal Reserve Chairman Ben S. Bernanke told Republican senators the Fed plans no additional aid to European banks amid the region’s sovereign debt crisis, according to two lawmakers who attended the meeting.

Senator Bob Corker, a Republican from Tennessee, said Bernanke made it “very clear” in closed-door comments today the central bank doesn’t intend to rescue European financial institutions. Lindsey Graham, a South Carolina Republican, said Bernanke told lawmakers that “he doesn’t have the intention or the authority” to bail out countries or banks. Both senators spoke to reporters after leaving the one-hour session at the Capitol in Washington.

Simply put, the Fed is politically limited in what it can do for Europe. I don't see the hopes that the Fed could step in for the ECB being realized. Moreover, US lawmakers will resist efforts to contribute more to the IMF to help Europe, especially if this is the general attitude:

Senator Charles Grassley, speaking after leaving the meeting with Bernanke, said excessive U.S. financial support may enable Europe to avoid enacting necessary measures in fiscal austerity.

“If there’s too much of an effort on the part of the United States to help Europe, it’s going to impede their fiscal changes that must be made,” Grassley, a Republican from Iowa, said to reporters.

The belief in fiscal austerity runs deep. We need to teach those Europeans a lesson even if it means shooting ourselves in the foot. Now, in all honesty, you really can't expect US taxpayers to offer much support to Europe when German taxpayers themselves are resistant. Because I think that fundamentally Blinder is right on the appropriate cure to save the Euro. Germany needs to issue a massive amount of debt to support demand in Europe, even at the cost of higher relative inflation. And, better yet, to support debt writedowns in the periphery. The response from Germany: Nein.

Bottom Line: I still don't see where this ends well. Play the news cycle if you are so inclined, but keep one eye on the key issue. Is Europe working to resolve their fundamental internal imbalances with anything other than deflation? As long as the answer continues to be "no," be afraid. Be very afraid.

Saturday, December 10, 2011

Eichengreen: Disaster Can Wait

Barry Eichengreen cannot endorse the disaster scenario for Europe, at least for 2012. But if the problems persist, 2013 could be a different story:

Disaster Can Wait, by Barry Eichengreen, Commentary, Project Syndicate: Nowadays there is no shortage of pundits, economic or otherwise, warning of impending disaster. ... My view is different: 2012 ... will be a year of muddling through.
Many people think that 2012 will be the make-or-break year for Europe – either a quantum leap in European integration,... or the eurozone’s disintegration, igniting the mother of all financial crises.
In fact, neither scenario is plausible. The collapse of the eurozone would, of course, be an economic and financial calamity. But that is precisely why the European Central Bank will overcome its reluctance and intervene in the Italian and Spanish bond markets, and why the Italian and Spanish governments will, in the end, use that breathing space to complete the reforms that the ECB requires as a quid pro quo. ...
While the eurozone is unlikely to collapse in 2012, there will be no definitive answer to the question of whether the euro will survive, because there will be no quantum leap in European integration. Treaty revisions take time to draft – and more time to ratify. ...
It is a sad state of affairs when a recession qualifies as muddling through. But such is the European condition. ... But muddling through cannot continue forever. Europe needs to draw a line under its crisis and figure out how to grow. The US needs to overcome its political polarization and policy gridlock. And China needs to rebalance its economy – shifting from construction and exports to household consumption as the main engine of growth – while it still has time.
Of course, if none of this happens – or if not enough of it does – 2013 could turn out to be the annus horribilis of the perma-bears’ dreams.

Friday, December 09, 2011

"A Mixed Bag From Europe"

Tim Duy:

A Mixed Bag From Europe, by Tim Duy: I find it somewhat hard to judge the merits of this week's developments in Europe. Some positives, some negatives. On net, though, I remain a Europessimist. In my opinion, the issues of internal rebalancing remain completely ignored, and this will eventually doom the Euro if not addressed.

The European Central Bank moved forward with additional easing specifically intended to alleviate pressures in the banking system. The breakdown in the interbank lending market threatened to create a Lehman-type event sooner than later, and that threat was receded with the ECB's extension of liquidity facilities and cutting in half reserve requirements for commercial banks. The ECB also cut interest rates to 1%, with more cuts expected.

That said, the European financial system remains under pressure with continuing deleveraging and eventually more bank recapitalizations efforts needed. The result will be a worsening of the European recession, an event that is only in its infancy. And, as has been widely reported, ECB President Mario Draghi did not offer unlimited support for Eurozone sovereign debt, which was greeted with disappointment yesterday. I think it is premature to expect such a commitment; they will only play that card as a very last measure.

Overall, somewhat more aggressive than than I expected, and a clear indication that the ECB now realizes the depth of the Eurozone's financial problems. So far, so good. Yes, I would be happier with a clear statement that the ECB is the lender of last resort for European sovereign debt, but I just don't expect to hear this yet anyway.

In contrast, the Eurozone summit predictably failed to meet expectations. The UK bowed out of the agreement, guaranteeing a lack of EU wide commitment. At best you get the 17 Eurozone nations plus a few others to sign up. This opens up the possibility of more EU ruptures in the future. The seal has been broken. Second, as Felix Salmon points out, we have an agreement in principle, but ratification battles lie ahead:

It seems that German chancellor Angela Merkel is insisting on a fully-fledged treaty change — something there simply isn’t time for, and which the electorates of nearly all European countries would dismiss out of hand. Europe, whatever its other faults, is still a democracy, and it’s clear that any deal is going to be hugely unpopular among most of Europe’s population. There’s simply no chance that a new treaty will get the unanimous ratification it needs, and in the mean time the EU’s crisis-management tools are just not up to dealing with the magnitude of the current crisis.

Many opportunities for national politics to blow this agreement apart in the weeks ahead.

As far as Eurozone crisis-management tools are concerned, we are simply still where we have always been - the wealthier nations of the Eurozone - largely Germany - continue to resist putting in the necessary capital to create effective crisis funds. Moreover, the ECB appears to remain unwilling to lend the necessary money to rescue funds. In the absence of internal support, Europe continues to look toward international support. I still think this is ludicrous. How much help should Europe really expect knowing that Germany is not willing to go all-in financially to save the Euro, and now that we know the UK is making a calculated bet that the Euro is already a doomed experiment?

Let's put aside the above concerns for a minute. When all is said and done, I am still amazed that the outcome of this summit is being described as a move toward fiscal union. It is not that - it is commitment to unified fiscal austerity, nothing more. Consider just a strict enforcement of the 3% deficit ceiling in light of actual deficits in the EU. Via NPR:


Just on the surface, it is tough to see any commitment to fiscal austerity as credible. Germany itself exceeded the targets in 7 out of the past 11 years. Talk about the pot calling the kettle black. France missed 6 in the past 11 years. And Italy 8 times. Thus, in addition to the periphery nations, the biggest economies in the Eurozone will all need to increase government saving to meet these targets.
Such saving will be attempted in the context of a recession in which the private sector also will be increasing savings as well. In other words, the public sector will be engaging in massive pro-cyclical fiscal policy as the recession intensifies. You have to imagine the end result is a substantial deflationary environment.
In short, I think Europe is rushing full speed to a Japanese outcome, with slow growth coupled with an appreciating currency. And it is that promise of slow growth and a strong currency will be what eventually tears the Eurozone apart. And this is truly sad given that deficits are not really the problem to begin with.
Why will the Eurozone fail? Because we still see nothing that addresses the internal imbalances between the core (largely Germany), and the periphery. That is the result of failing to commit to a real fiscal union. Such a union would include automatic internal fiscal transfers that are essential to maintaining regional economic stability. For example, economic distress in a US state results in an automatic relative transfer of resources via decreased tax revenue from and increased transfer payments to that state. Lacking such a mechanism, a slow growth, hard money regime will increasingly ratchet up the levels of economic distress in the periphery. And eventually the costs of staying in the Euro will exceed the costs of exit.
If Europe was serious about saving the Euro, they would commit to issuing more safe assets (more sovereign debt), using the ECB backstop to create such assets, and engage in direct fiscal transfers to reduce economic pain in the periphery while encouraging continuing structural and budget reforms in recipient economies. I don't think we are anywhere near such a plan - and are arguably moving in the opposite direction.
Bottom Line: I remain a Europessimist. The ECB is moving aggressively to preventing an imminent financial collapse. That should be seen as good news. But there remain unresolved deeper issues. At the core of those issues is the inability to see Europe as one large, fiscal unified economy rather than a combination of separate, fiscally austere economies. And in that remains the long-term vulnerability of the Euro experiment.

Tuesday, December 06, 2011

"The Eurozone’s Terrible Mistake"

Felix Salmon:

The eurozone’s terrible mistake, by Felix Salmon: The FT is reporting today that the new fiscal rules for the EU “include a commitment not to force private sector bondholders to take losses on any future eurozone bail-outs”. If this principle really does get enshrined into some new treaty, it will be one of the most fiscally insane derelictions of statesmanship the world has seen — but it certainly helps explain the short-term rally that we saw today in Italian government debt.
Right now, the commitment is still vague...
To understand just how stupid this is, all you need to do is go back and read Michael Lewis’s Ireland article. The fateful decision in Ireland was to take the insolvent banks and give them a blanket bailout, with the banks’ creditors all getting 100 cents on the euro. That only served to put a positively evil debt burden onto the Irish people, forcing a massive austerity program and causing untold billions of euros in foregone growth, while bailing out lenders who deserved no such thing.
Are we really going to repeat — on a much larger scale — the very same mistake that Ireland made? ...

On Ireland, see: Despite Praise for Its Austerity, Ireland and Its People Are Being Battered.

Monday, December 05, 2011

"What Can Save the Euro?"

Stiglitz on Europe:

What Can Save the Euro?, by Joseph Stiglitz, Commentary, Project Syndicate: Just when it seemed that things couldn’t get worse, it appears that they have. Even some of the ostensibly “responsible” members of the eurozone are facing higher interest rates. Economists on both sides of the Atlantic are now discussing not just whether the euro will survive, but how to ensure that its demise causes the least turmoil possible.
It is increasingly evident that Europe’s political leaders, for all their commitment to the euro’s survival, do not have a good grasp of what is required to make the single currency work. ...[continue reading]...

Krugman today:

Markets clearly believe that the Europeans have found a formula that will make it possible for the ECB to step in and buy lots of Italian bonds.
I hope they’re right

Will the euro survive? I've always thought that it would, but that is based upon political considerations, not economics, and I can't claim to be an expert on the politics of the eurozone. What do you think?

Friday, December 02, 2011

Paul Krugman: Killing the Euro

"Deficit scolds and inflation obsessives" are leading us "down the path to ruin":

Killing the Euro, by Paul Krugman, Commentary, NY Times: Can the euro be saved? Not long ago we were told that the worst possible outcome was a Greek default. Now a much wider disaster seems all too likely..., even optimists now see Europe as headed for recession, while pessimists warn that the euro may become the epicenter of another global financial crisis.
How did things go so wrong? The answer you hear all the time is that the euro crisis was caused by fiscal irresponsibility. Turn on your TV and you’re very likely to find some pundit declaring that if America doesn’t slash spending we’ll end up like Greece. Greeeeeece!
But the truth is nearly the opposite. Although Europe’s leaders continue to insist that the problem is too much spending in debtor nations, the real problem is too little spending in Europe as a whole. And their efforts to fix matters by demanding ever harsher austerity have played a major role in making the situation worse. ...
Warnings that this would deepen the slump were waved away. “The idea that austerity measures could trigger stagnation is incorrect,” declared Jean-Claude Trichet, then the president of the European Central Bank. Why? Because “confidence-inspiring policies will foster and not hamper economic recovery.”
But the confidence fairy was a no-show. ...
At this point, markets have lost faith in the euro as a whole, driving up interest rates even for countries like Austria and Finland, hardly known for profligacy. And it’s not hard to see why. The combination of austerity-for-all and a central bank morbidly obsessed with inflation makes it essentially impossible for indebted countries to escape from their debt trap and is, therefore, a recipe for widespread debt defaults, bank runs, and general financial collapse.
I hope, for our sake as well as theirs, that the Europeans will change course before it’s too late. But, to be honest, I don’t believe they will. In fact, what’s much more likely is that we will follow them down the path to ruin.
For in America, as in Europe, the economy is being dragged down by troubled debtors — in our case, mainly homeowners. And here, too, we desperately need expansionary fiscal and monetary policies to support the economy as these debtors struggle back to financial health. Yet, as in Europe, public discourse is dominated by deficit scolds and inflation obsessives.
So the next time you hear someone claiming that if we don’t slash spending we’ll turn into Greece, your answer should be that if we do slash spending while the economy is still in a depression, we’ll turn into Europe. In fact, we’re well on our way.

Thursday, December 01, 2011

Is Anything Better Yet?

 Tim Duy:

Is Anything Better Yet?, by Tim Duy: I think the world's central banks just validated my pessimism - the Eurozone financial system is falling apart. Will this be enough to put the pieces back together? Paul Krugman is doubtful:

I am, I have to say, somewhat mystified. Of course the Fed will make dollar liquidity available to other central banks as needed; that was never in question, because Bernanke doesn’t want to be the man who destroyed the world to save a few pennies. And reducing the interest rate on those loans seems to me to make virtually no difference; it was a trivial charge anyway.

Indeed, the only surprise here is that it took this long for somebody to push the panic button. Actually, there was another surprise - the dissent of Richmond Fed President Jeffrey Lacker to the increased swap lines. From Reuters:

"I dissented on the vote because I opposed the temporary swap arrangements to support Federal Reserve lending in foreign currencies," Lacker said in an emailed statement.

"Such lending amounts to fiscal policy, which I believe is the responsibility of the U.S. Treasury. The Federal Reserve has provided and can continue to provide sufficient dollar liquidity through purchases of U.S. Treasury securities," he said.

This is misguided. The Fed is responsible for protecting the US financial sector, and needs to do so, when possible, even if the threat is eminating from overseas. US banks may not be in need of dollar liquidity, but their foreign counterparties might be - and failure to provide it would more rapidly turn a European problem into a US problem.

Equity markets took the bait and ran with it. Perhaps, as Krugman suggests, market participants see this as a precursor for more to come. To be sure, the European Central Bank is almost sure to cut rates further, as well as extend liquidity facilities. But this, as well as eventual quantitative easing, are already anticipated. And if this is the final cure, why did Treasuries hold the line? Yields on the ten-year bond where up only 7bp today - not exactly a signal that investors are vastly increasing their appetite for risk.

That said, I admit to being mystified by the compulsions of equity traders. I reiterate my observation that equity prices held their ground and then some in 2007, even as the Fed was beginning a rate cut cycle that would eventually take them to zero. There is no reason to expect a different story now. In fact, the data flow on this side of the Atlantic is, quite frankly, not bad at all - see Ryan Avent's rundown. I don't really expect equities would be hit hard unless it became evident the US would not decouple from the rest of the globe. And although I am somewhat pessimistic on that point, I also admit the jury is still out.

And how exactly is the rest of the globe? Not good. Not good at all. Eurostat confirmed the unemployment rate in the Eurozone continues to rise and now stands at 10.3% in October, although with vast differences accross countries. Austria is at the bottom with 4.1%, Spain at the top with 22.8%. Notice Germany's unemployment rate continues to drop, from 5.7% to 5.5% in October. No wonder the German public resists more forceful crisis responses. Crisis? What crisis?

If you thought unemployment rates are high now, remember that we are only in the initial stages of this recession. It will get worse.

I call attention again to Portugal (unemployment 12.9% in October, up from 12.3% a year ago). The austerity parade marches forward. From the Washington Post:

Portugal’s Parliament gave its blessing Wednesday to the country’s severest austerity measures in almost 30 years as it scrambles to free itself from a ruinous debt crisis and help relieve pressure on the wider eurozone.

Lawmakers approved the government’s spending plans for next year, including a new round of tax hikes and pay and welfare cuts that will further crunch living standards amid a deepening recession and record unemployment....

...Finance Minister Vitor Gaspar told lawmakers the cuts are needed “to restore the confidence of the Portuguese people, the markets and our international partners.” The budget will help “put (Portugal) back on the path to sustainable development,” he said.

How fast is confidence being restored? While most of Europe was getting relief from today's central bank action in the form of lower interest rates, yields continued to back up in Portugal, rising 42bp on the ten-year to 14.5%, extending last week's rating cut induced rise. Doesn't sound like much confidence to me. What it sounds more like is "private sector involvement."

On a completely difference topic, Eurostat also released obesity statistics. Italy looks to be doing something right.

On the other side of the world, we see that where European manufacturing goes, so too does China's. From Bloomberg:

China’s manufacturing recorded the weakest performance since the global recession eased in 2009, underscoring the case for monetary stimulus as Europe’s crisis weighs on the world’s second-largest economy.

A purchasing managers’ index compiled by the China Federation of Logistics and Purchasing slid to 49 in November, lower than all but two of 18 forecasts in a Bloomberg News survey. Readings below 50 signal a contraction. Separate reports showed slowing retail sales and an industrial slump in Australia, which relies on China as its biggest export customer.

No wonder Chinese policymakers are stepping on the gas.

Bottom Line: Central banks took a step in the right direction. But nothing in Europe is close to be solved by that action. We are still closer to the beginning of this mess than the end.

Wednesday, November 30, 2011

Did the Fed Go Far Enough?

More comments at the NY Times Room for Debate on today's announcement that monetary authorities are taking steps to increase the availability of dollar loans to foreign banks in the hopes of avoiding a Lehman-like crisis. The question we were asked is:

Should the Fed be more aggressive in dealing with Europe’s financial crisis? What are the risks of its involvement?

Here are our responses:

[Additional comments here.]

The Fed's Move to Help Europe

I did a short Q&A for CBS News on the news that central banks around the world are taking steps to make it cheaper for foreign banks to borrow dollars:

Will the Fed's move to help Europe hurt the U.S.?

Tuesday, November 29, 2011

More Europessimism

One more from Tim Duy:

More Europessimism, by Tim Duy: I hate to beat a dead horse, but the situation in Europe is dire, and two issues crossing my desk this afternoon only add to my angst. First, Karl Smith at Modeled Behavior sees that the ECB is losing all control of monetary policy:

Based on entirely different indicators this looks to be the point where the ECB’s control over Eurozone monetary policy began to come unmoored.

At the crux of the problem seems to be the inability to arbitrage away differences in funding costs between institutions and countries because of malfunctioning in the European Repo market.

This malfunctioning appears to be down right mechanical with trades regularly not settling on time, collateral not being delivered, awkward interventions by local regulatory agencies and a host of other deep, deep problems.

Very, very scary - remember that the ECB is the last great hope. But it can't be effective if the European banking system collapses, which looks more likely each day. A signal that the related rush to cash is severe is that the ECB is no longer able to fully sterilize its asset purchases. Stories at the Wall Street Journal and the Financial Times. Recognize the risk that even when the ECB switches to quantitative easing, the resulting cash just sits unused in bank reserves. Sound familiar? Europe has liquidity trap written all over it.

A second point comes from Edward Harrison, who spots a story which claims France and Germany are looking to impose a strict zero (!) percent budget deficit target by 2016. Harrison's take:

Note that an adjustment to balanced budgets throughout the euro zone requires either an exactly equivalent offset in private sector savings down or in the export sector up . So implicitly, Germany and France are calling for a massive private sector dissaving or a large reduction in the external value of the euro area currency. I see this as a pipe dream. It tells you that bad things are definitely going to happen in Euroland.

This is my fear - that Germany and France continue to press ahead with the "austerity first" plan, with the ECB cheering them along. Unequivocally, this is not going to work. It hasn't worked yet, and there is zero reason to believe that it will in the future. All Europe is doing is setting itself up for greater speculative attacks as each new turn toward austerity pushes the deficit targets further out of reach.

We are setting the stage for a massive counter-example to the US reaction to its financial crisis. The US allowed the fiscal deficit to swell while force-feeding capital to the banking sector (not enough, but that is another story). Europe is pushing for massive fiscal austerity and, to prevent additional fiscal borrowing, pretending that the banks can survive via "liability management exercises." If you think the US would have been better off shrinking the deficit while letting the banking system collapse, it is time for you to go long on Europe.

For the rest of us, enjoy the policy-driven market upturns while they last.

Another European "Solution" Coming?

Tim Duy:

Another European "Solution" Coming?, by Tim Duy: Financial market participants continue to digest what is viewed as generally good news coming out of Europe. Importantly, European policymakers appear to be aggressively moving toward what they see as an overarching response to the crisis. Edward Harrison at Credit Writedowns offers a possible three pillar policy path that has emerged in recent days. My summary:

  1. An IMF aid package for Italy and likely Spain, financed by the ECB.
  2. A credible, binding agreement for EU fiscal oversight. In return, the ECB would intervene more aggressively to support sovereign debt.
  3. A path to Eurobonds, assuming point 2 above.

Despite these optimistic signals, there remains room for plenty of disappointment in the days ahead. Notably, Reuters reports that German Chancellor Angela Merkel will not back Eurobonds or additional ECB intervention. This may be just internal posturing, but does speak to the high degree of internal resistance toward greater EU fiscal integration. Moreover, we have seen in the past the internal bickering yields responses that seem bold at first but quickly fail to stabilize the crisis.

And, when assessing the economic impact, what you don't see is as important as what you do see. What I don't see here is:

  1. A path to true fiscal integration, which would imply direct transfers from relatively rich to relatively poor member states.
  2. Similarly, a new path toward internal rebalancing. A commitment to stronger fiscal oversight implies continued pursuit of rebalancing via deflation in troubled economies. Moreover, as Paul Krugman notes, this will be attempted in the context of low inflation, which only exacerbates and extends the pain of adjustment. This path only ensures deeper recession.
  3. A coordinated, continent-wide banking sector recapitalization. Note that Moody's just placed European bank debt under review. Downgrades are almost inevitable at this point.
  4. An open door for stimulative policies to offset the demand contraction currently underway.

These are not small details. My fear is that European leaders think they can avoid these issues by enshrining fiscal austerity which, when combined with ECB intervention, will end the sovereign debt crisis. Confidence fairies will then fly to the rescue and fix the rest of the problems. To be sure, I think getting the sovereign debt crisis under control is critically important, but that alone will not stop the recession from deepening.

For those still expecting a mild European recession, I offer up Bloomberg's chart of the day - shipping rates from China to the US and Europe. The text:

Slumping shipping costs show exports to Europe from China are “falling off a cliff” as the euro- region crisis chokes off consumer spending, according to RS Platou Markets AS, a unit of Norway’s biggest shipbroking group.

The CHART OF THE DAY shows how the cost of hauling goods to Europe from China is falling faster than rates for deliveries to the U.S. The price for shipments to Europe is down 39 percent to $511 per twenty-foot box since Aug. 31, according to figures from Clarkson Securities Ltd., a unit of the world’s largest shipbroker. That’s more than double the 18 percent slide in the cost to the U.S. West Coast, measured in 40-foot units.

Not surprisingly, the appreciation of the renminbi has come to a standstill as Chinese authorities act to support exporters.

Finally, note that Portuguese bond yields are pushing higher in recent days, up 15bp to 13.60% today, above the highs of last July. It looks like market participants expect the next bailout will require some private sector involvement. Unsurprisingly, austerity isn't working. From Market News International:

The deterioration of Europe's debt crisis over the past months is hitting Portugal's banking sector and making it more difficult for the country to execute its fiscal adjustment program, the Bank of Portugal said in its financial stability report published Tuesday.

The central bank noted that in the past six months, the "materialization of risks" to financial stability have intensified "substantially," both internationally and inside Portugal. "This aggravation of economic and financial conditions has resulted in a deterioration of profitability in the Portuguese banking system," it added. "In the short term, this trend towards aggravation of risks is likely to persist."

The bank warned that the situation "is increasing the challenges confronted by the Portuguese economy, as well as by the Portuguese financial system, given that the adjustment of economic imbalances must now be carried out in a much more adverse context, particularly as regards the expected trajectory of external demand."

Bottom Line: European policymakers understand they need faster and bolder action. But the situation has many, many moving pieces. It is increasingly difficult to pull the brakes on this runaway train.

Time for the Fed to Take Over the ECB’s Job?

Dean Baker says the Fed should step in if the ECB refuses to act as a lender of last resort (Antonio Fatas is also frustrated with the ECB's failure to act):

Time for the Fed to Take Over the European Central Bank’s Job, by Dean Baker, Al Jazeera English: The European Central Bank (ECB) has been working hard to convince the world that it is not competent to act as central bank. One of the main responsibilities of a central bank is to act as the lender of last resort in a crisis. The ECB is insisting that it will not fill this role. It ... would sooner see the eurozone collapse than risk inflation exceeding its 2.0 percent target.
It would be bad enough if the ECB’s incompetence just put Europe’s economy at risk. ... However, it is also likely that the financial panic following the collapse of the euro will lead to the same sort of financial freeze-up that we saw following the collapse of Lehman. In this case,... we will be seeing unemployment possibly rising into a 14-15 percent range. This would be a really serious disaster.
Fortunately, the Fed has the tools needed to prevent this sort of meltdown. It can simply take the steps that the ECB has failed to do. First and most importantly it has to guarantee the sovereign debt of eurozone countries. ... This doesn’t mean giving the eurozone countries a blank check. The Fed can adjust the interest rate at which it guarantees debt depending on the extent to which countries reform their fiscal systems. ... The difference between a 2.0 percent interest rate and 7.0 percent interest would be a powerful incentive to eliminate corruption and waste. ...
Of course this sort of intervention will look horrible from the standpoint of the eurozone countries. It will appear as though they cannot be trusted to manage their own central bank and deal with their own economic affairs.
Unfortunately, this is the case. They have entrusted the continent’s most important economic institution to a group of ideological zealots who are infatuated by the sight of low inflation rates...
Perhaps the Europeans will respond... But if they can’t rise to the task, we should not allow the ECB ideologues to wreak havoc on the lives of tens of millions of innocent people in Europe, the developing world, and here in the United States.

While the Fed is solving the world's problems, it might also think about the high rates of unemployment that already exist in the US, and how easing policy at home could help.

Monday, November 28, 2011

Can the US Decouple From the Eurozone?

Tim Duy:

Can the US Decouple From the Eurozone?, by Tim Duy: The OECD cut forecasts for 2012. Via the Wall Street Journal:

The Paris-based think tank cut its forecasts among its 34 members to 1.9% this year and 1.6% in 2012, from 2.3% and 2.8% in May. The OECD said it expects the euro zone's economy to contract by 1% at an annualized rate in the last quarter of this year and by 0.4% in the first three months of 2012.

For 2012, the OECD said the 17-country bloc's economy will only grow by 0.2%.

This is far too optimistic. The European economy is about to fall over a cliff, and last week's Eurostat report on new industrial orders reveals that manufacturing is leading the way. New orders fell by a whopping 6.4%, a move that hearkens back to the darkest days of 2008. Will the US be able to resist the pull of the European downturn? These charts don't offer much optimism:



Not a perfect match, but enough to suggest the idea of substantial decoupling looks like more myth than reality, especially in the face of a severe recession. Could this be why US Treasury yields held steady today even as equities roared forward?  

Bottom Line: Don't take US resilience for granted this time around - Europe is getting ugly, and it is far too late to prevent severe recession. The best policymakers can hope for at this point is too avoid a depression.

Sunday, November 27, 2011

Fed Watch: Europe Scrambles for Solutions

Tim Duy:

Europe Scrambles for Solutions, by Tim Duy: Monday morning is fast approaching, and European leaders are scrambling to come up with something credible to float ahead of the market opening. Recall that we ended last week with the S&P downgrade of Belgium, and policymakers would like to have something on the table in response. Most significant is that policymakers now realize that changing the Lisbon Treaty to enshrine fiscal discipline is a far too lengthy process to serve as an effective counterweight to emerging the soveriegn debt crisis. From Reuters:

Germany's original plan was to try to secure agreement among all 27 EU countries for a limited change to the Lisbon Treaty by the end of 2012, making it possible to impose much tighter budget controls over the 17 euro zone countries -- a way of shoring up the region's defenses against the debt crisis.

But in meetings with EU leaders in recent weeks, it has become clear to both German Chancellor Angela Merkel and French President Nicolas Sarkozy that it may not be possible to get all 27 countries on board, EU sources say.

Even if that were possible, it could take a year or more to finally secure the changes while market attacks on Italy, Spain and now France suggest bold measures are needed within weeks.

As a result, senior French and German civil servants have been exploring other ways of achieving the goal, either via an agreement among just the euro zone countries, or a separate agreement outside the EU treaty that could involve a core of around 8-10 euro zone countries, officials say.

The goal is to provide enough of a framework to allow the ECB to step in and shore up debt markets more decisively:

Germany's Welt am Sonntag newspaper reported on Sunday that Merkel and Sarkozy were working on a new Stability Pact, setting out national debt limits, that could be signed up to by a number of euro zone countries and which would allow the ECB to act more decisively in the crisis.

"If the politicians can agree to a comprehensive step, the ECB will jump in and help," the paper quoted a central banker as saying.

Is the plan for real or just a bargaining ploy?

While EU officials are clear about the determination of France and Germany to push for more rapid euro zone integration, some caution that the idea of doing so with fewer than 17 countries via a sideline agreement may be more about applying pressure on the remainder to act.

By threatening that some countries could be left behind if they don't sign up to deeper integration, it may be impossible for a country to say no, fearing that doing so could leave it even more exposed to market pressures.

The risk here is that market paricipants read the bilateral agreements as they emerge as an invitation to attack those nations not yet signed up to the plan. Those nations would be even more vulnerable as they would explicitly lose any ECB backstop. The other choice for some nations would to be to go down the road of Greece and accept crushing austerity in order to stay in the Eurozone. Damned if you do, damned if you don't.

Note also that although these ideas are bandied about in terms of "greater fiscal integration," I don't think we are seeing much mention of fiscal transfers, just mechanisms to enforce budget discipline. This is certainly a framework for a two-speed Europe.

In other news, someone is floating rumors that the IMF is preparing a massive lending program for Italy. From Bloomberg:

The International Monetary Fund is preparing a 600-billion euro ($794 billion) loan for Italy in case the country’s debt crisis worsens, La Stampa said.

The money would give Italy’s Prime Minister Mario Monti 12 to 18 months to implement his reforms without having to refinance the country’s existing debt, the Italian daily reported, without saying where it got the information. Monti could draw on the money if his planned austerity measures fail to stop speculation on Italian debt, La Stampa said.

Details are unclear. Ed Harrison at Credit Writedowns has a translation of a German version of the story that mentions the possibility of ECB funding of the bailout, with an IMF gaurantee.

Speaking of Italy, the austerity parade marches forward, via Bloomberg:

The Italian government, led by Prime Minister Mario Monti, may introduce additional austerity measures totaling as much as 15 billion euros ($20 billion) on Dec. 5, Il Sole 24 Ore reported.

Monti may levy a tax on first homes, increase value-added tax, and introduce anti-evasion measures on transactions of more than 300 euros to 500 euros, the Italian daily reported, without saying where it got the information. The introduction of a wealth tax is still uncertain, Il Sole said.

Italy needs reform, to be sure. But in the near term, austerity only worsens the European crisis. Troubled European nations need compasionate austerity that rewards progress toward long-term goals with near-term stimulus. But without a fiscal transfer mechanism, their is no way to offer such stimulus.

Finally, I emphasize that austerity and ECB intervention may bring short-term relief to financial markets, and at least one element of the crisis under control, but these efforts do not address the banking crisis that is settling over the Continent. Felix Salmon points us to a must-read IFR report:

European banks are being forced to abandon their efforts to sell off trillions of euros worth of loans, mortgages and real estate after a series of talks with potential investors broke down, leaving many already struggling firms with piles of assets they can barely support.

Lenders have instead turned their attention to reducing the burden of carrying such assets over months and years, with many looking at popular pre-crisis “capital alchemy” arrangements to minimise capital requirements and boost their ability to use the assets to tap central banks for cash.

Deadlocked talks with potential buyers – a mix of private equity firms, hedge funds, foreign banks and insurers – show little sign of making breakthroughs, say bankers taking part in those negotiations, with the stalemate threatening to block the industry’s ability to save itself from collapse through a mass deleveraging.

The article concludes with a key insight:

“Natural deleveraging through not renewing loans is one of the few options remaining to banks to shrink their balance sheets, but the timetable for implementing this kind of strategy can be very protracted,” said Ryan O’Grady, head of fixed income syndicate for EMEA at JP Morgan.

One way or another, Europe will experience a massive credit shock. Presumable, the ECB could help offset this by allowing governments to loosen spending to support demand and fund bank recapitalization. But the path we are on appears to provide ECB help only in return for more austerity. And it is that never-ending pursuit of austerity that leaves me bearish on Europe, regardless of the political news of the day.

Friday, November 25, 2011

Fed Watch: Greece Again

One more from Tim Duy:

Greece Again, by Tim Duy: Just a day after Greece's ND opposition party "committed" in writing to the details of the October summit agreement, Zero Hedge spots a potentially decisive Reuters story:

The country has now started talking to its creditor banks directly, the sources said.

"There are a number of people in the market who are saying why did (the IIF) take upon themselves this responsibility," one of the people said, asking not to be named.

"In part for that reason, Greece has been talking to creditors individually, just to get their own sense of market sentiment," the person said.

The Greeks are demanding that the new bonds' Net Present Value, -- a measure of the current worth of their future cash flows -- be cut to 25 percent, a second person said, a far harsher measure than a number in the high 40s the banks have in mind.

Banks represented by the IIF agreed to write off the notional value of their Greek bondholdings by 50 percent last month, in a deal to reduce Greece's debt ratio to 120 percent of its Gross Domestic Product by 2020.

In all fairness to Greece, the details of the October summit were somewhat fuzzy (as in nonexistent), and so arguably they are not backing out. But the banks were clearly thinking the ultimately haircut not be as great as Greece is demanding. Once again, the complete lack of useful outcomes calls into question why the Europeans even bother to have summits.

But probably more important is the fact that Greece is now taking a direct role in negotiations. Remember that the previous haircuts were "voluntary" and negotiated by Greece's European overlords to prevent triggering a credit event and CDS payouts. And one has to believe that "following the October agreement" implicitly means the Greeks will not upset the apple cart and trigger a credit event unilaterally. But if Greece is at the table forcing lenders to take massive haircuts, it will be virtually impossible to justify that this is not a technical default.

This is shaping up to be the final test of the credibility of the sovereign CDS market - either exposure is hedged or it is not. Interestingly, either outcome is potentially catastrophic, with the end result being either the unknown outcomes of triggering CDS payouts or a complete flight from European sovereign debt. Maybe both.

I really hope somebody at the ECB is sticking around to work this weekend.

Fed Watch: From Bad to Worse

Tim Duy:

From Bad to Worse, by Tim Duy: I awoke to this news, via the Wall Street Journal:

Italian two-year and five-year government-bond yields soared to euro-era highs Friday as investors began giving up on the euro zone's ability to break the political gridlock that is blocking a more decisive response to the currency bloc's debt crisis.

Italian two-year and five-year yields climbed to 7.7% and 7.8%, respectively, and the 10-year yield moved further above the key 7% mark to 7.3%.

This just a day after an apparently not-confidence boosting meeting of the leaders of Germany, France and Italy. Perhaps European policymakers need fewer summits, not more?

Contrary to conventional wisdom, Ralph Atkins at the Financial Times views yesterday's European commitment to back off the ECB as a positive development:

My reaction on hearing that Mr Sarkozy had agreed to keep silent was that it would actually increase the ECB’s room for manoeuvre. Fiercely independent, the Frankfurt-based institution would have hated any suggestion it was reacting to pressure from Paris. Now, any steps it took would clearly be at its own initiative.

I am sympathetic to this line of reasoning. That said, Atkins gets to the next problem:

Of course, this does not mean the ECB will act. Mario Draghi, new ECB president, sees governments as responsible for resolving the crisis and the central bank as having a limited role. He worries about putting ECB credibility at stake.

Yes, if European Central Bank President Mario Draghi has more room to act, he apparently isn't using it. The ECB's forays into the bond markets appear to be increasingly futile. Via the Financial Times, the ECB is in the market again today:

The European Central Bank again bought Italian and Spanish debt on Friday but analysts have complained that its purchases are no longer sufficient to stem a wave of selling. Yields on the 2-5 year range for Italy were 7.67-7.77 per cent in late Friday trading.

Despite the mess in Europe, hope springs eternal on Wall Street. The early news from Bloomberg:

U.S. stocks rose, snapping a six-day drop in the Standard & Poor’s 500 Index, as speculation European leaders will do more to fight the debt crisis overshadowed concern about higher borrowing costs in the region.

I think it is dangerous to attribute too much day-to-day noise to news flow. Still, if this is anywhere near accurate, whoever is left on Wall Street today must still be groggy from Thanksgiving feasting. Zero Hedge attributes the morning rally to hopes the Swiss National Bank will act to support the Euro. In any event, the momentum looks to be fading in the late-morning as reality sets in.

Bottom Line: Europe is quickly moving from bad to worse. To be sure, we should anticipate a rally will follow the eventual ECB capitulation on quantitative easing, but that will only be half the battle. The ECB will only capitulate in return for massive, sustained austerity. It is too late for an easy end to this story.

Fed Watch: Europe Can't Move Fast Enough to Halt Crisis

Tim Duy:

Europe Can't Move Fast Enough to Halt Crisis, by Tim Duy: Today the leaders of Germany, France, and Italy came together, offering a commitment to work toward new fiscal rules in Europe while keeping a leash on the European Central Bank. From the Wall Street Journal:

The leaders of the euro zone's three largest economies pledged Thursday to propose modifications to European Union treaties to further integrate economic policy and crack down on profligate spenders, but they played down suggestions that the European Central Bank have a greater crisis-busting role.

It should be painfully evident at this point that any process toward greater fiscal integration will be a years-long process. Financial markets, however, move at something much closer to the speed of light - as fast as traders can hit the "sell" button. As such, the European political process is grossly incapable of addressing the fiscal crisis. Apparently, however, market participants continue to hold out hope:

Investors were quick to register their disappointment that the leaders hadn't produced some sort of breakthrough to address the bloc's protracted sovereign-debt crisis. European stocks lost ground while the euro fell to its lowest level in seven weeks.

Seriously, who believes a breakthrough is coming? I imagine some thought the disastrous German bund auction would force Chancellor Angela Merkel's hands, but it appears to have only deepened her resolve. Obviously, one interpretation of the auction is that the crisis is spreading to Germany, making its debt more risky. But risky how? The specter of Eurobonds, in my opinion, argues for shying away from Eurobonds as investors need to price German debt at that of the eventual Eurobond, which will almost certainly be greater than current German prices. This would help explain Merkel's objection to Eurobonds:

Germany vehemently opposes creating such commonly backed bonds before a natural alignment of euro-zone economies is achieved through sound economic policies, the introduction of so-called debt brakes to restrict deficits, and creating the ability to severely punish profligate euro-zone members.

Ms. Merkel, addressing the issue during the news conference, said the recent widening of the gap between euro-zone interest rates reflects the strengths of countries such as Germany and the structural weaknesses of those such as Greece and Portugal. The introduction of euro-zone bonds would create artificial convergence of interest rates and not address the root cause of the crisis, she said.

"It would be a completely wrong signal to allow these different interest rates to become ineffective because they are an indication of where more work is needed," said Ms. Merkel. "If we all work responsibly, convergence will take place all on its own. But to impose convergence on everyone would weaken us all."

The message is that you can't identify the bad actors without differential yields, which is possibly reasonable with respect to solvency issues but less so when considering liquidity crisis. Germany is looking for hard and fast rules that would force the periphery debt down to German yields rather than the latter up to the former. Does this suggest that Germany would insist on some sort of convergence criteria as a precondition for the issuance of Eurodebt as well? Something to think about. Calculated Risk directs us to an even more disconcerting Merkel quote via the Telegraph:

Ms Merkel instead used a three-way summit with France and Italy in Strasbourg to insist that new treaty powers to intervene and punish sinner states remained the key focus of Europe's rescue efforts. She said: "The countries who don't keep to the stability pact have to be punished – those who contravene it need to be penalised. We need to make sure this doesn't happen again."

Similarly, Germany needed to be punished via the Versailles Treaty - and look how well that worked. It is tough to advise anything other than to sell Europe as long as Germany insists on this morality play.

If you have any delusions about the difficulties of pushing through new fiscal rules, turn to the story evolving in Ireland. Credit Writedowns points us to Ambrose Evans-Pritchard at the Telegraph:

The Irish government has suddenly complicated the picture by requesting debt relief from as a reward for upholding the integrity of the EU financial system after the Lehman crisis, though there is no explicit linkage between the two issues...

..."We are looking at ways to reduce the debt. We would like to see our European colleagues address this in a positive manner. Wherever there is a reckless borrower, there is also a reckless lender," he said, alluding to German, French, British and Dutch banks.

"We have indicated to Europe's authorities that it will be difficult to get the Irish public to pass a referendum on treaty change," he said.

The EU's new fiscal rules would be legally binding and "justiciable" before the European Court, he said. This raises the likelihood that Ireland's top court would insist on a referendum.

Translation: If you want to move forward on fiscal unity, we need a quid-pro-quo in the form of debt relief. Ultimately, Portugal will want the same. And Greece will eventually ask for more as well. True, the imminent standoff on the next tranche of aid has been alleviated as the ND opposition party offered its written commitment to the October summit deal. Of course, the commitment is predictably soft, with the money quote:

On the evidence of the budget execution so far, we believe that certain policies have to be modified, so as to guarantee the Program’s success. This is more so, since according to the latest European Economic forecasts, Greece in 2012 will be the only European country with 5 consecutive years in recession!

The agreement is crushing the Greek economy, so modifications will be needed. But does anyone believe that only minor modifications will suffice? Anyone? Bueller? Still, given the clock was ticking down on the next aid tranche, policymakers probably believe it best for all parties to back down a little and kick the can down the road for another three months, when we can expect another "voluntary" haircut after the deteriorating economic conditions further erodes the Greek fiscal situation.

While European leaders continue to pretend there exists a timely political solution to the crisis - that the crisis will end the instant sinner states offer up enough political commitment to the ever changing goal of austerity - Germany continues to insist the ECB be kept on a short leash, pushing Italian debt pack above 7%. Via the Telegraph:

“The three of us want to indicate our support to the ECB and its leaders,” Mr Sarkozy said. “The three of us have indicated that we will respect the independence of this essential institution and we agreed that we should refrain making any demand, positive or negative, on it. That is a position that we have elaborated together.”

The statement appeared to contradict comments from senior French politicians earlier today that the country was seeking a greater degree of involvement from the area's central bank in tackling the debt crisis.

Like it or not, the ECB is the one institution that can act quickly. To be sure, arguably it is now too late to act "quickly." Now quick action is needed to just limit the damage as financial conditions accross Europe freeze solid as a block of ice.

This is not shaping up to be a festive holiday season in Europe.

Wednesday, November 23, 2011

Barry Eichengreen: Europe's Never Ending Crisis

Fed Watch: And the Global Economic Saga Continues

Tim Duy:

And the Global Economic Saga Continues, by Tim Duy: The last week has been a non-stop flood of news. And, quite honestly, none of it is encouraging. I imagine the sole exception to that rule is the relatively sanguine nature of the US data. That said, I remain unconvinced that the US can for much longer resist the downward pull of the rest of the globe.

What more can we say about Europe that has not already been said? There has been no forward progress in the past week. To be sure, ECB bond buying has helped keep a lid on Italian bond yields. Yet, while ECB monetary policymakers focus on Italy, Spain and Belgium are slipping away. And France is clearly the next domino to fall. The "accidental" downgrade last week simply reveals that S&P has already prepared the report, clearly anticipating a deterioration in France's budget position as the Eurozone recession deepens. And to make matters worse, Zero Hedge points us to signs the Dexia bank rescue is faltering, and the Belgians realize they need to shift more of that burden of that rescue onto France. Meanwhile, the situation in Eastern Europe is rapidly deteriorating - Yves Smith directs us to the Telegraph for that story. And in Greece, the opposition party still insists they will not sign any pledge to commit to the October deal. Was any deal really reached last month?

Conventional wisdom is that the European Central Bank eventually acts as a lender of last resort to alleviate the sovereign debt crisis. This was clearly not on the mind of ECB President Mario Draghi in his recent speech. I certainly hope something was lost in translation, as the speech has some memorable moments. Notably:

Activity is expected to weaken in most of the advanced economies. This is the result of a weakening of various components of aggregate demand, both domestic and foreign.

Economic activity is weakening because the underlying components of economic demand are weakening. I am not sure this is particularly insightful. Is this the best analysis he can muster from the intellectual firepower of ECB economists? If so, we are in very big trouble. But it continues. The first two of Draghi's three pillars of monetary policy:

Continuity first and foremost refers to our primary objective of maintaining price stability over the medium term.

Consistency means to act in line with our primary objective and with our strategy both in time and over time.

I am having a hard time distinguishing between "continuity" and "consistency" here. The third (second?) pillar is predictable:

Credibility implies that our monetary policy is successful in anchoring inflation expectations over the medium and longer term. This is the major contribution we can make in support of sustainable growth, employment creation and financial stability. And we are making this contribution in full independence.

Gaining credibility is a long and laborious process. Maintaining it is a permanent challenge. But losing credibility can happen quickly – and history shows that regaining it has huge economic and social costs.

Translation: "We can only save the Euro, but only at the cost of German hyperinflation of the 1920's." He then pulls a Ben Bernanke and tosses the ball back to fiscal policymakers"

National economic policies are equally responsible for restoring and maintaining financial stability. Solid public finances and structural reforms – which lay the basis for competitiveness, sustainable growth and job creation – are two of the essential elements.

But in the euro area there is a third essential element for financial stability and that must be rooted in a much more robust economic governance of the union going forward. In the first place now, it implies the urgent implementation of the European Council and Summit decisions. We are more than one and a half years after the summit that launched the EFSF as part of a financial support package amounting to 750 billion euros or one trillion dollars; we are four months after the summit that decided to make the full EFSF guarantee volume available; and we are four weeks after the summit that agreed on leveraging of the resources by a factor of up to four or five and that declared the EFSF would be fully operational and that all its tools will be used in an effective way to ensure financial stability in the euro area. Where is the implementation of these long-standing decisions?

Here I think that Draghi is simply delusional. Does he not realize that plans to expand the ESFS are essentially dead at this point? That France and Germany are not willing or able to contribute more capital? That the plans to leverage the ESFS are floundering as the reality sets in that financial engineering will not work here? That the Chinese scoffed at efforts to get them to buy into such a plan? That the EU political system is capable at moving even a fraction of the speed of financial markets?

I understand the ECB does not want to take on the role of fiscal authority, but what other choice do they have? Little else than to oversee the collapse of the currency they are charged to protect.

Meanwhile, word is the Greek debt haircut deal is in jeopardy. Not a surprise, as not real was really reached at the summit, just a desperate attempt to buy time. Market participants should by now realize the outcome of any European summit is little more than smoke and mirrors.

Speaking of smoke and mirrors, the news from this side of the pond is not exactly encouraging. The Supercommitte hit a brick wall, to no one's surprise but Wall Street's. The stage is set for a nontrivial fiscal tightening in short order - 5 weeks or so. Greg Ip at the Economist puts some numbers on what is at stake, and comes up with contractionary policy on the order of 2.4% of GDP. Note that the Federal Reserve forecast for 2012 is 2.5% to 2.9%, and I bet not much fiscal contraction is built into those numbers. So, make no mistake, the failure of the Supercommittee to come up with a plan for "smart" austerity - austerity focused on the medium and long-runs, with stimulus in the short run, is very meaningful. The conventional wisdom is that Congress will not go home for the holidays without at a minimum extending the payroll tax credit. I will follow that lead, but remain worried that the weight of Washington gridlock argues for more disappointment in the weeks ahead.

Across the Pacific, another storm is brewing - the Chinese economy continues to slow. Via Bloomberg:

China’s manufacturing may contract this month by the most since March 2009 as home sales slide, adding to evidence the world’s second-biggest economy is slowing, a preliminary purchasing managers’ index shows.

The reading of 48 reported by HSBC Holdings Plc and Markit Economics today compares with a final number of 51 last month. A number below 50 indicates a contraction.

Conventional wisdom is that the downside is limited, as at its heart China is a command and control economy. That said, even a minor slowdown is disconcerting, as the US economy does not need another trade shock to add to the trade and, more importantly, financial shock about to flow from Europe.

Bottom Line: The world economy remains in a precarious place as we head into the final month of 2011.

Tuesday, November 22, 2011

"Germany's Finances Not as Sound as Believed"

There may be politics behind this I'm unaware of (or not), but this is an interesting claim from Spiegel:

Germany's Finances Not as Sound as Believed, by Ralf Neukirch and Christian Reiermann, Spiegel: The German government likes to pride itself on its solid finances and claim the country is a safe haven for investors. But Germany's budget management is not nearly as exemplary as it would have people believe, and the national debt is way over the EU's limit. In some respects, Italy's finances are in much better shape.

When it comes to fiscal stability, frugality and responsible economic management, German Chancellor Angela Merkel and Finance Minister Wolfgang Schäuble have only one role model: themselves.

The chancellor praises herself and her team for having "a clear compass for reducing debt," and insists: "Getting our finances in order is good for our country." ...

But it is debatable how much longer Germany can be seen as a refuge of stability and security. In reality, German government finances are not nearly in as good shape as the chancellor and the finance minister would have us believe. ...

Monday, November 21, 2011

Paul Krugman: Boring Cruel Romantics

Real technocrats don't take "refuge in fantasy as things go wrong"

Boring Cruel Romantics, by Paul Krugman, Commentary, NY Times: There’s a word I keep hearing lately: “technocrat.” ... I call foul. I know from technocrats; sometimes I even play one myself. And these people — the people who bullied Europe into adopting a common currency, the people who are bullying both Europe and the United States into austerity — aren’t technocrats. They are, instead, deeply impractical romantics. ...
And to save the world economy we must topple these dangerous romantics from their pedestals.
Let’s start with the creation of the euro. ...Europe’s march toward a common currency was, from the beginning, a dubious project on any objective economic analysis. ...
So why did those “technocrats” push so hard for the euro, disregarding many warnings from economists? Partly it was the dream of European unification, which the Continent’s elite found so alluring... And partly it was a leap of economic faith ... driven by the will to believe ... that everything would work out as long as nations practiced the Victorian virtues of price stability and fiscal prudence.
Sad to say, things did not work out as promised. But rather than adjusting to reality, those supposed technocrats just doubled down — insisting, for example, that Greece could avoid default through savage austerity, when anyone who actually did the math knew better.
Let me single out in particular the European Central Bank (ECB), which is supposed to be the ultimate technocratic institution, and which has been especially notable for taking refuge in fantasy as things go wrong. Last year, for example, the bank affirmed its belief in the confidence fairy ... that hasn’t happened anywhere.
And now, with Europe in crisis — a crisis that can’t be contained unless the ECB steps in to stop the vicious circle of financial collapse —... Mario Draghi, the ECB’s new president, declared that “anchoring inflation expectations” is “the major contribution we can make in support of sustainable growth, employment creation and financial stability.”
This is an utterly fantastic claim to make at a time when expected European inflation is, if anything, too low, and what’s roiling the markets is fear of ... financial collapse. ...
Just to be clear, this is not an anti-European rant, since we have our own pseudo-technocrats warping the policy debate. ...
So am I against technocrats? Not at all. I like technocrats — technocrats are friends of mine. And we need technical expertise to deal with our economic woes.
But our discourse is being badly distorted by ideologues and wishful thinkers — boring, cruel romantics — pretending to be technocrats. And it’s time to puncture their pretensions.