Category Archive for: International Finance [Return to Main]

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:

Euunemp

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:

Europedebt

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:

Fedwatch1

Fedwatch2

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.

Wednesday, November 16, 2011

"Games of Chicken"

Tim Duy:

Games of Chicken, by Tim Duy: The Eurozone is stuck on a path that leads to a very nasty equilibrium. From the Financial Times:

In a day that euro-era records tumbled, Italian yields moved through 7 per cent – a level viewed as unsustainable – for the second time in a week. The Spanish premium to Germany hit 482bp, above the critical 450bp rate at which Irish and Portuguese yields spiralled out of control and forced both countries into international bail-outs. Belgium also saw its bonds’ spread over German debt reach record levels of 314bp.

The proximate cause of the sell-off appears to have been the weak GDP 3Q GDP report:

Europe’s economic expansion failed to accelerate in the third quarter as Germany and France struggle to shore up a region bracing for a recession sparked by an escalating debt crisis.

Gross domestic product increased 0.2 percent from the previous three months, when it rose at the same pace, the European Union’s statistics office in Luxembourg said in a statement today. That matched the median forecast of 39 economists surveyed by Bloomberg News. From a year-earlier, GDP increased 1.4 percent. A separate report showed that German investor confidence fell to a three-year low in November.

One would normally anticipate that as growth decelerated, bond yields would fall in expectation of monetary easing. Not so in Europe, as slower growth fosters fear of sovereign default as deficits widen. As is well known at this juncture, the response of policymakers will be to enact deeper austerity measures, which will in turn slow growth further. Not what one would call a path to a good equilibrium.

For its part, the ECB continues to dabble in bond markets, although to limited effect, failing to hold Italian yields below 7%. Market participants are convinced that the ECB will step up to the plate eventually and act as a real lender of last resort, completely backstopping sovereign debt in the Eurozone. Monetary policymakers, however, are digging in their heels:

The president of Germany’s powerful Bundesbank has firmly rebuffed international demands for decisive intervention in the bond markets by the European Central Bank to combat the eurozone debt crisis, warning that such steps would add to instability by violating European law...“I cannot see how you can ensure the stability of a monetary union by violating its legal provisions,” Mr Weidmann argued. “I don’t see how you can build trust in a system that violates laws.”

Fiddling while Rome burns. Literally. One has to believe expectations of a ECB backstop are warranted, otherwise there is little if any hope for the Euro. That said, given ECB resistance to the idea, I am beginning to believe that we will need a "Lehman" event to force their hand - at which point, of course, it would already be game over for the European financial situation.

In any event, time is running short. From Bloomberg:

The ECB mops up the liquidity created by its purchases of distressed government bonds -- 183 billion euros ($251 billion) so far -- to prevent them from fueling inflation and ensure it can’t be accused of financing profligate governments.

Rabobank economist Elwin de Groot estimates that there is a “natural limit” of 300 billion euros the ECB can sterilize. “If it maintained a pace of 11 billion additional purchases each week, the average amount of purchases in the period August- September, it would hit that natural limit by mid-January,” De Groot said in a note to investors today.

When the ability to sterilize evaporates, the ECB will have to choose between expanding the balance sheet or ceasing to purchase additional Italian and Spanish bonds. In the meantime, the ECB appears to be waiting for troubled European governments to enact just the right amount of austerity to boost confidence and send private investors scrambling for European debt. They seem to be completely ignorant that the debt-deflation dynamic in place only erodes confidence further.

Meanwhile, the Greece situation remains unresolved. From the Athens Times:

Greece's conservative party leader on Monday vowed to reject any toughening of austerity measures in return for a multi-billion euro bailout, signalling the new coalition government may not enjoy the kind of cross-party support demanded by lenders.

New Democracy leader Antonis Samaras said he would not vote for any new austerity measures and added that the policy mix of spending cuts and tax rises agreed with international lenders should be changed in favour of economic growth...

...Crucially, Samaras said he would not sign any letter pledging support for conditions on a 130bn euro bailout as EU Economic and Monetary Affairs Commissioner Olli Rehn has demanded.

Another game of chicken. One of the two must back down, it is thought, else the end result is something no one wants, an immediate Greek default. But here again is an opportunity for another Lehman moment.

And while the the European financial system remains in jeopardy, a heavily trumpeted, supposedly key piece of the firewall, remains mired in technical difficulties, as efforts to leverage up the EFSF look doomed to fail. From Reuters:

Efforts to amplify the power of the euro zone's rescue fund and convince markets the bloc can handle its debt crisis risk being undermined by delays, surging bond yields and limited investor interest, potentially ruining the plan altogether.

See also FT Alphaville on rising EFSF spreads. Not exactly an auspicious beginning.

Side note - Isn't investor participation in the EFSF inherently risky from Europe's point of view? What is to prevent market participants from launching a speculative attack on both the bonds of the EFSF and the bonds of trouble nations? Indeed, it seems like the existence of a investor dependent ESFS would only enhance the power of speculative attacks. What am I missing hear?

Any way you cut it, the end result is recession in Europe. For Wall Street and Washington, the question remains: Will the US decouple, gaining traction while Europe flounders? Or will the US be caught in the downdraft? I remain cautious on the US outlook, despite recent possitive data. If the US suffers from Europe's malaise, I don't think it would be evident before next year, which means I take little solace in the near term data flow.

Bottom Line: The European situation remains tenuous. Indeed, I am not sure any real progress has been made in the last few months - certainly not if the bond markets are any guide. It will continue to get worse before it gets better, and I worry that a Lehman event will be the only thing that draws in the ECB.

Update: Zero Hedge attributes the bond sell-off not to GDP weakness, but to poor auctions.

Tuesday, November 15, 2011

The Optimistic Case for Italy

Antonio Fatás does his best to paint an optimistic picture for Italy:

Italy: not good but we have seen this before, by Antonio Fatás: It is hard to find much optimism by looking at the Italian economy today:... I will do my best to be a contrarian and argue that maybe it is not as bad as it looks. Or maybe it is, but ... there is some hope. ...
Below is the Italian government debt expressed as % of GDP. There are two lines, the gross and net values of government debt. Net debt is a more appropriate measure as it ... is equivalent to what is referred to in the US as "government debt held by the public". ...

...If we focus on net debt the current level of debt is significantly below what it was in 1994. So Italy has seen similar or higher levels of debt before.
We can then argue that those times were different, that Italy had its own currency (although it was heading towards the Euro) and that a combination of high inflation and fast growth allowed them to stabilize that high level of debt.
Certainly it was not growth that saved them. GDP growth in Italy has been low during this period of time..., clearly below the growth in other Euro countries... What about interest rates? Maybe the government of Italy did not face the high interest rates that they face today? Below is a chart of the 10-year interest rate for Italian government bonds.

As it is clear from the chart, financial conditions back in 1994-1995 were extremely difficult for the Italian government with nominal interest rates as high as 12%. Much higher than the current levels of 6-7% that look unsustainable. Of course, what matters is not nominal rates but real rates (what really matters is the difference between interest rates and growth but I do not have that chart ready in my computer). Below is a chart with real rates that confirms that interest rates today remain low compared to the ones faced by Italy in 1994-95.

Here is what I learn... To my surprise, and the surprise of many, Italy has managed to sustain a very high level of debt even when facing high interest rates by generating large enough primary surpluses. And it has done so with a political environment that has been volatile and in some cases driven by very poor choices. Does it mean that they can keep going like this forever? No... But ... it is interesting to see when we look back at history that a similar episode did not automatically lead to default even with poor economic policy choices. And if you want to be even more optimistic, there is some hope that this crisis is not wasted and the future Italian government finds an even better way to manage a very difficult situation.

Friday, November 11, 2011

Paul Krugman: Legends of the Fail

The moral of the story:

Legends of the Fail, by Paul Krugman, Commentary, NY Times: ...Not long ago, European leaders were insisting that Greece could and should stay on the euro while paying its debts in full. Now, with Italy falling off a cliff, it’s hard to see how the euro can survive at all.
But what’s the meaning of the eurodebacle? As always happens when disaster strikes, there’s a rush by ideologues to claim that the disaster vindicates their views. So it’s time to start debunking. ...
I’ve been hearing two claims, both false: that Europe’s woes reflect the failure of welfare states..., and that Europe’s crisis makes the case for immediate fiscal austerity in the United States.
The assertion that Europe’s crisis proves that the welfare state doesn’t work comes from many Republicans. ... The idea, presumably, is that the crisis countries are in trouble because they’re groaning under the burden of high government spending. But .. the nations now in crisis don’t have bigger welfare states than the nations doing well — if anything, the correlation runs the other way. Sweden, with its famously high benefits, is a star performer... Meanwhile, before the crisis ... spending on welfare-state programs ... was lower, as a percentage of national income, in all of the nations now in trouble than in Germany... Oh, and Canada ... has weathered the crisis better than we have.
The euro crisis, then, says nothing about the sustainability of the welfare state. But does it make the case for belt-tightening in a depressed economy?
You hear that claim all the time. America, we’re told, had better slash spending right away or we’ll end up like Greece or Italy. Again, however, the facts tell a different story.
First, if you look around the world you see that the big determining factor for interest rates isn’t the level of government debt but whether a government borrows in its own currency. ...
What has happened, it turns out, is that by going on the euro, Spain and Italy ... have to borrow in someone else’s currency, with all the loss of flexibility that implies. ... America, which borrows in dollars, doesn’t have that problem.
The other thing you need to know is that in the face of the current crisis, austerity has been a failure everywhere it has been tried...
The moral of the story, then, is to beware of ideologues who are trying to hijack the European crisis on behalf of their agendas. If we listen to those ideologues, all we’ll end up doing is making our own problems — which are different from Europe’s, but arguably just as severe — even worse.

Thursday, November 10, 2011

"Could the ECB become the Central Fiscal Authority?"

Nick Rowe says the ECB needs to step in and save the Euro (I've called for fiscal federalism as a stabilization tool, but Nick is making a different point -- how the ECB can accomplish this on its own by using its powers to act as a central fiscal authority):

Could the ECB become the central fiscal authority?, by Nick Rowe: There is only one way to save the Euro now. The ECB acts as lender of last resort to the 17 Eurozone governments. But nobody would want to act as lender of last resort to a deadbeat, and the ECB wouldn't want to act as lender of last resort to a fiscal deadbeat. With the guarantee of unlimited loans from the ECB, the fiscal deadbeat would have every incentive to keep on borrowing and spending unlimited amounts. It's a mix of: the free-rider problem (because they are only one in 17, and even less than that for a small country); and the Samaritan's dilemma (if they know you are going to help them get out of trouble, they are not going to stay out of trouble).
The Eurozone lacks a central fiscal authority to match the central monetary authority. And it seems to lack the ability to create a central fiscal authority in the normal way. Nobody seems to have the power to exert that central fiscal authority, and force the 17 governments to do what they are told.
But the ECB does have that power. It can say to each of the 17 governments: "We will act as your lender of last resort if and only if you do what we say. If you don't do what we say, we will loudly announce that we will no longer act as your lender of last resort, and the bond markets will make mincemeat of your bonds, and there will be runs on all your banks."
In fact, the ECB is the only body that does have that power. I'm not talking about legal power. It's long past that stage of the game. Good central banks ignore all the rules in an emergency (as Brad DeLong tells us the Bank of England did for a century). The ECB has the de facto power to save any or all of the 17 countries. But it won't use that power unconditionally. It has to make the 17 governments do what it tells them to do. It has the power to do that. "Do what we say, or your country is toast".
The normal question in political macroeconomy is whether the monetary authority should have independence from the fiscal authority. It's time, in the Eurozone, to reverse that question. Should the 17 fiscal authorities have independence from the one monetary authority?
Is this democratic? Of course not. Might it happen? I don't know.

Fed Watch: Endgame Approaching

Tim Duy:

Endgame Approaching, by Tim Duy: Wall Street is again taking Europe seriously, at least for the moment. Today was unpleasant. The most important news of the day is that Germany and France are planning for a new Europe. From Reuters:

Merkel said Europe's plight was now so "unpleasant" that deep structural reforms were needed quickly, warning the rest of the world would not wait. "That will mean more Europe, not less Europe," she told a conference in Berlin.

She called for changes in EU treaties after French President Nicolas Sarkozy advocated a two-speed Europe in which euro zone countries accelerate and deepen integration while an expanding group outside the currency bloc stays more loosely connected -- a signal that some members may have to quit the euro.

"It is time for a breakthrough to a new Europe," Merkel said. "A community that says, regardless of what happens in the rest of the world, that it can never again change its ground rules, that community simply can't survive."

For the Eurozone to work, there needs to be greater fiscal integration. But Germany and France do not see a place for Greece and likely Italy, possibly Spain and Portugal as well, in such a fiscal union. And, in all honesty, it is hard to find fault with such a conclusion. The clearly dysfunctional behavior of the Italian and Greek governments has made it all but impossible to erect a firewall around the crisis at this point. The credibility of the Eurozone decision making process, allready severly weakened by the endless inconclusive summits, is now completely non-existent.

Interestingly, the IMF appears to be holding out hope that a firewall is still possible:

Christine Lagarde, head of the International Monetary Fund, told a financial forum in Beijing that Europe's debt crisis risked plunging the global economy into a Japan-style "lost decade."

"If we do not act boldly and if we do not act together, the economy around the world runs the risk of downward spiral of uncertainty, financial instability and potential collapse of global demand."...

..Lagarde said she was hopeful the technical details on boosting the European Financial Stability Fund (EFSF) to around 1 trillion euros would be ready by December.

How viable is the idea of leveraging up the EFSF now that Sarkozy and Merkel have openly breached the topic of a breaking of the Euro? Do the Europeans really take the Chinese for such fools that they will save the Euro when the economic backbone of the Continent no longer believes it is worth saving?

A wild card in this disaster is the European Central Bank. The calls for action are deafening, yet they apparently fall on deaf ears. I think we all agree that the ECB can at least put a floor under Italy, and arguably should be doing that to prevent what appears to be largely a liquidity crisis from becoming a solvency crisis. They would also send a strong signal that the Eurozone does in fact have a lender of last resort. Make no mistake, they can't stop the blinding painful recession that is about to descend upon Europe. That is already backed into the cake, and the ECB would put the icing on the top by calling for harsh austerity in any nation receiving its backstop. But they could prevent a depression. And everyone believes they will step up to the plate eventually.

But what if they don't? What if Germany and France absolutely forbid it? If Germany and France are already planning for a new Europe, they certainly don't want it to begin with a central bank holding a massive piece of the debt from those nations they intend to eject from the Euro. As it is, they probably already fear that a Greek default is inevitable in the next few months, and the ECB will be left holding the bag on their Greek debt holdings. Why add further to those potential/likely losses?

Now where is the Fed in all of this? Quiet, very quiet. To be sure, they will stand ready to provide dollar liquidity via swap agreements with their foreign counterparts. And will likely expand the balance sheet in the event of sharp deceleration in US economic acivity. But such a deceleration is not likely to be revealed in the near term data. And, interestingly, note that despite all the turmoil, the implied inflation rate via the TIPS market is 1.88 and 1.99 at the 5 and 10 year horizons, respectively. I believe the Fed would like to see clearer deflationary pressures before they engaged in another round of QE.

Brad DeLong pleads with the Fed to get in front of the curve:

The Federal Reserve needs to buy up every single European bond owned by every single American financial institution for cash before the increase in eurorisk leads American finance to tighten credit again and send us down into the double dip.

Here too it is probably already too late. The time to move was this summer.

At a minimum, the Fed could be preparing a credit facility to take European sovereign debt as collateral. Beyond that, I find it hard to imagine the Fed making large scale European debt purchases. After all, what will they define as an American financial instituion? Deutsche Bank has a US financial holding company - would a Fed commitment include all of Deutsche Bank's European bond portfolio? I don't think the Fed is ready to make such distinctions, especially after the public relations beating they took for lending to foreign banks during the US financial crisis.

In my opinion, they did not have a choice - the foreign banks are part of the US banking system and thus needed to be part of the emergency lending facilities. And, of course, the interconnectiveness of the European and US financial sectors argues for exactly what Brad proposes, even it if meant taking European debt off the hands of European banks. But isn't that the ECB's job? I find it hard to see the Fed eager to take on the role of global lender of last resort. Just as I find it difficult to see the US supporting an expansion of the IMF to aid Europe. Europe has both the capital and the lender of last resort to deal with this crisis themselves. They don't need external financing, they need internal rebalancing. Ultimately, the Europeans will need to find the political willpower to solve the crisis. I just don't see much US involvement in the process, either fiscal or monetary. And if such involvement did occur, it would not happen until conditions became much, much worse.

Bottom Line: The tide turned from optimism to pessimism today. Perhaps the opposite happens tomorrow. But ultimately, I believe pessimism will rule the day. The point of no return was reached when Germany and France openly discussed a smaller Eurozone. To be sure, the ECB could still offer upside surprise by serving as the lender of last resort, which would ease the downside pain. I don't anticipate the Fed will take on this role. The Fed is probably still mulling over what they perceive to be the limited US exposure to Europe, just as they did with the US subprime debt. And the relatively painless demise of MF Global probably reinforces that sense of complacency. The Fed will react eventually, but US conditions will need to deteriorate markedly before they do so.

Wednesday, November 09, 2011

Fed Watch: Wall Street Ignoring Europe?

Tim Duy:

Wall Street Ignoring Europe?, by Tim Duy: Ryan Avent is puzzled. He says so:

I have to say, I'm puzzled. Recent developments in the euro zone seem incredibly negative to me. The probability of a reasonably orderly conclusion of the crisis appears to be falling. Yet equities aren't dropping; indeed, they're up from early September. Has the roadrunner sprinted off the cliff but not yet looked down? Or am I missing something?

Avent is trying to wrap his mind around equity market behavior. I wish him the best - I hope he gives me a call if he finds a meaningful answer. All I can say is that we have been here before. Recall 2007:

Sp500

By the middle of 2007 the TED spread was exploding, signaling enormous financial turmoil. Yet equities kept heading upward, fueled by data that was just not that bad coupled with ongoing expectations that a solution was just around the corner. And now we find ourselves in almost the exact same position. Avent is correct, the news out of Europe is abysmal. He is not missing anything. There is no solution, no magic summit at hand. At this point, it is a choice between severe recession and depression. There is no happy ending to this story.

Consider the news from Greece. CR points us to Athens News, which declares the Greek government rudderless. The latest EU demand, that everyone in power sign a commitment to the last bailout proposal, might simply be the straw that broke the camel's back. The key sentence:

The demand came a day after ND issued a nonpaper saying that the party will support the new government’s policies, only to reverse them when the conservatives come to power.

The implication is that the New Democracy party hopes to pull in the next tranche of aid, then default. CR suggests they just say so, and get the default over with. I have to agree - we all know the latest haircut of 50% - not including official debtholders, of course - will prove to be insufficient, as additional austerity measures erodes the government's fiscal position.

And that story is growing throughout the Eurozone. Consider this report:

France announced 65 billion euros of tax hikes and budget cuts over five years on Monday, as President Nicolas Sarkozy seeks to protect the country's creditworthiness in financial markets without killing his chances of re-election in six months time...

...But economists said the government's growth outlook was still too optimistic, even after cutting the forecast for 2012 to 1 percent from 1.75, meaning the latest measures might not be enough for France to meet its deficit reduction goals.

As the periphery moves to austerity, it weakens the core, and the core turns to additional austerity. Which then weakens the periphery. Slow, but vicious, cycle.

And then we move to Italy. From the FT:

Silvio Berlusconi, Italy’s embattled prime minister, pledged last night that he would resign after parliament passes a new financial stability law that will implement fresh austerity measures demanded by the European Union.

Good luck with that - it has obviously worked so well in the rest of the Eurozone. Meanwhile, the 10 year Italian bond rate rose to 6.77 percent, a whopping 497bp premium to Germany. Many believe that 6 percent is the point of no return, and we are well past that mark. Italian bonds might get some relief from Berlusconi's departure, but within three to six months they too will be falling short of their fiscal benchmarks, and bond markets will be forced to react.

Meanwhile, the ECB is effectively on the sidelines. Ed Harrison at Credit Writedowns has been providing some excellent commentary, and believes it is only a matter of time before the ECB brings out the big guns and gives Europe what it needs, a lender of last resort. Which makes perfects sense because that is the only way in which the Eurozone does not fall into depression. That said, ECB members are determined to prove him wrong. From Bloomberg:

European Central Bank council member Jens Weidmann said the ECB cannot bail out governments by printing money.

“One of the severest forms of monetary policy being roped in for fiscal purposes is monetary financing, in colloquial terms also known as the financing of public debt via the money printing press,” Weidmann, who heads Germany’s Bundesbank, said in a speech in Berlin today. The prohibition of monetary financing in the euro area “is one of the most important achievements in central banking” and “specifically for Germany, it is also a key lesson from the experience of hyperinflation after World War I,” he said.

In the United States, we live under the legacy of the 1970's. For Europeans, it is the 1920's. And with that fateful decade in mind, the resistance of certain Eurozone stakeholders - yes, Germany - remains steadfastly in the path of very aggressive monetary policy.

Bottom Line: Yes, Europe is bad. And getting worse. By the time European policymakers reach an agreement, the goalposts have moved. They are literally looking into the abyss, caught like deer in the headlights. And like the US in 2007, they cannot avoid the abyss. And yet, US equities markets hang on, edging upward in the apparent belief - or delusion - that a European financial crisis will not filter back into the US. I hope that is correct, but suspect it is not. And if it not correct, I don't anticipate equities will react until it is obvious corporate profits will suffer.

Tuesday, November 01, 2011

Aftershocks

Tim Duy:

Aftershocks, by Tim Duy: The reality of the worsening European situation came home to roost on Wall Street this week. Last week's "summit to end all summits" offered up only broad brush strokes to begin with, and even those were rapidly erased by plans for a Greek referendum on the deal. A rumor circulated earlier today that the referendum was dead, but that has since been refuted by the Greek government. It appears that either the Greek government collapses or the referendum will occur - and neither outcome is good for market participants looking for certainty in these uncertain times.

Let me suggest this as well - that even if Greece comes back on board with the existing agreement, the damage is already done. Three thoughts today:

A deepening Eurozone recession is inevitable. Even if full-blown financial crisis is avoided, the cost will be continued austerity programs that will sink the Eurozone economy ever deeper into recession. This will only exacerbate the problems facing European banks as nonperforming loans rise, which will be on top of the credit contraction to follow plans to have banks recapitalizing themselves with private money by next summer.

The unintended consequences of the EFSF. The EFSF was already a farce to begin with, underfunded and relying on leverage to cover up a lack of money. The farce continued as European leaders sought handouts from China to fund a project they themselves were not committed to. Then the lack of details within the latest plan is hampering the ability of the EFSF to issue debt. From the FT (hat tip to Zero Hedge):

The bond from the European financial stability facility will seek to raise €3bn ($4bn) and will be in 10-year bonds rather than a 15-year maturity because of worries over demand, say bankers. A 10-year bond is more likely to attract interest from Asian central banks than a longer maturity.

Bankers familiar with the issue said the EFSF had been considering a €5bn issue. However, the EFSF has denied this, saying it had always sought a €3bn issue...

...EFSF officials decided to price this week because market conditions might deteriorate if they hold off any longer, according to bankers.

The bond is expected to price at yields of about 3.30 per cent, about 130 basis points over ­Germany, the European market benchmark. This represents a big mark-up since the middle of September, when existing 10-year EFSF bonds were trading at about 2.60 per cent, only 70bp over Germany.

Now the insurance component of the EFSF is blowing back in their faces. From the FT:

“It is kind of ironic: it is Draghi’s first day. His first decision is ‘yes, buy Italian bonds’,” said Gary Jenkins, head of fixed income at Evolution Securities. He added that the move to make Europe’s rescue fund, the European financial stability facility, issue insurance on new Italian and Spanish debt was deterring buyers: “They have created a situation where the only people buying Italian debt are themselves.”

A trader of Italian government bonds said: “It was meltdown at one point before the ECB came in. There were no prices in Italian government bonds. That is almost unheard of in a big market like Italy. There were just no buyers and therefore no prices.”

By not creating a backstop for previously issued bonds, the Europeans have clearly identified those bonds at risk of default. If the Europeans are not willing to buy or insure the bonds, why should investors? Answer: They shouldn't. Consequently, the ECB was forced to do what it hates, buy Italian debt, and even then yields climbed above 6%, nearing levels that many believe is the point of no return for Italy.

Moreover, one should question the what is the meaning of "insurance" for Europe. I can't imagine the ESFS actually making good on any promises to insure bondholders, as the Europeans appear adept at defining defaults as "voluntary" and therefore not credit events covered by insurance.

Will the ECB be Europe's white knight? I think we all agree that lacking a lender of last resort, Europe has something of a credibility problem. As in, no credibility. And it has been pointed out repeatedly that the ECB could step into this role. After all, we are talking about the future of the Euro, which should be something of a concern for central bankers. And, as noted by Kash Mansori at The Street Light, by guaranteeing a price for Italian debt, the ECB would like have to buy far less than they think. But here is the problem - why should the Italians get an ECB backstop at 6%, while the Irish pay 8% and the Portuguese 12%? Politically, the ECB needs to backstop either everybody equally or nobody. Setting a ceiling on Italian debt alone risks setting off a firestorm of public anger within those nations already struggling under the weight of austerity programs. And note that even if the ECB does come into the fight, the will only do so in return for additional austerity. In other words, they might stave off financial collapse, but not recession.

Bottom Line: No matter how many summits they have, there is no easy out for the Europeans at this point.

Monday, October 31, 2011

"Did The European Deal Just Collapse?"

Tim Duy:

Did The European Deal Just Collapse?, by Tim Duy: To be sure, I have been bearish on Europe. From last week:

I remain something of a Euroskeptic at this point. At best, I think the Europeans will be kicking the can down the road for a few months.

It turns out a "few months" might have been wildly optimistic. It was quickly evident that bond markets didn't show the same enthusiasm equity markets expressed for the supposed deal. That was huge red flag. The second red flag was the Bank of Spain announcing a stagnant 3Q GDP. From the Associated Press:

The Bank of Spain suggested that the flat growth calls into question the government's goal of reducing its deficit to 6 percent of GDP in 2011, from 9.2 percent last year...

...It said domestic demand fell because of lower government spending as a result of deficit-reducing austerity measures taken by regional governments and because of a moribund real estate market. Household and business spending posted small increases. Spain's economic woes stem largely from the collapse of a property bubble.

The Bank of Spain said there is still time to meet the deficit reduction target by the year's end but warned that fresh measures may be necessary.

Yes, you read that right...the Bank of Spain blamed missing deficit reduction targets on fiscal austerity and then suggests additional fiscal austerity as the solution. And as all nations in the Eurozone increasingly pursue fiscal austerity, we can only expect the nascent European recession to deepen. Eventually, the European public will have had enough of the downward spiral. How long will it be before Spain decides to aggressively push for a Greece solution of "voluntary" debt relief?

Finally, a lynchpin in the European debt deal - Greece - apparently isn't ready to abide by the terms of that deal. The public pressure is now too much. From the Financial Times:

Greece’s prime minister unexpectedly announced a referendum to approve a second EU bail-out deal for his austerity-hit country, less than a week after it was agreed with international creditors at a European Union summit...

...One senior EU official told the Financial Times that Mr Papandreou had appeared reticent about the components of the bail-out package during talks at last week’s summit of EU presidents and prime ministers but no one was prepared for the referendum announcement that came “like a bolt out of the blue...

...The vote would probably be held in January, when Greek bondholders were expected to sign up for a voluntary 50 per cent haircut being negotiated with the International Institute of Finance, wrapping up the new bail-out package. One Athens banker said: “This is a worrying decision by the prime minister. It could derail the whole process even before it’s properly started.”

Not only are the details of the grand European plan still in flux, but so are the broad brushstrokes! Clearly, the Greeks have just brought back into play all the uncertainty last week's summit was meant to dispel. It is not unreasonable to think the Greek electorate is more willing to technically default and start from scratch than their leaders. Indeed, shouldn't this be our baseline scenario?

Bottom Line: Last week's European Summit accomplished far less than even the reduced expectations going into last week. The cracks began appearing before the ink was dry. More worrisome is that the Greek leadership didn't even believe they were on board in the first place. Simply put, the world economy is no less fragile than it was a week ago. And in that fragility still lies the recession risk for a still struggling US economy.

Wednesday, October 26, 2011

Fed Watch: Waiting, Waiting, Waiting"

Another post from Tim Duy:

Waiting, Waiting, Waiting, by Tim Duy: US markets are closed, with everyone left waiting for the news from Europe and the 3Q11 US GDP report. Expectations appear to be high for both, but I am considerably more certain the latter will deliver on those expectations. Europe is certainly more interesting. Over the last few weeks, market participants looked to have grasped at every little straw that offered hope on the European story, and it remains to be seen whether or not that will continue when rumours turn to news.

I remain something of a Euroskeptic at this point. At best, I think the Europeans will be kicking the can down the road for a few months. Some specific concerns:

The goalposts are already moving. The Eurozone economy is headed into recession - the combination of fiscal austerity and financial turmoil have already set in motion the inevitable contraction of demand that will soon threaten deficit reduction goals across the continent. And it is only a matter of time before the ratings agencies recognize this as well. The European solution, of course, will be additional fiscal austerity. It didn't work in Greece, and it won't work for the Eurozone as a whole.

The lack of sufficient ECB participation. The German contingent has effectively shut down the ECB. From the Wall Street Journal:

Lawmakers also pressed Ms. Merkel to push banks considered systemically relevant to raise core capital to 9% by a deadline of June 30, 2012 and urged her to insist on an end to the European Central Bank's program of purchasing euro-zone bonds on the open market to prop up weakened euro-zone members as soon as the EFSF is launched. German lawmakers also called for a clear European commitment to the ECB's independence.

The Germans fear the inflationary consequences if the ECB essentially monetizes the debt of the periphery. But the lack of a credible lender of last resort is crippling rescues efforts, and will continue to do so.

When in doubt, turn to financial engineering. The faith in financial engineering never ceases to amaze me. Efforts to leverage up the EFSF are almost comical, and they reveal another problem in this exercise - no one (in particular, Germany) is willing to bring sufficient resources to the table. Wolfgang Munchau:

Leverage can have different economic functions, but in these cases it simply disguises a lack of money.

The whole issue of leverage looks to be little more than a smoke and mirrors effort to make the real firepower of the fund appear to be much greater than reality.

Turning to developing nations for help. If it wasn't so sad, it would almost be funny. Reports of BRIC participation as EFSF investors have been circulated for weeks. The latest version that reportedly sparked today's market rally:

French President Nicolas Sarkozy plans to call Chinese leader Hu Jintao tomorrow to discuss China contributing to a fund European leaders may set up to bolster its debt-crisis fight, said a person familiar with the matter.French President Nicolas Sarkozy plans to call Chinese leader Hu Jintao tomorrow to discuss China contributing to a fund European leaders may set up to bolster its debt-crisis fight, said a person familiar with the matter.

My goodness, have the Europeans learned nothing from the Americans? Sure, we let the fox into the hen house and didn't have the common sense to chase him out a decade ago. The Europeans are now opening the doors and inviting in the fox. Michael Pettis had a long, must read piece on this topic earlier this month:

In fact the very idea that capital-rich Europe needs help from capital-poor BRIC nations to fund itself verges on the absurd. European governments are unable to fund themselves not because Europe needs foreign capital. It has plenty. They are unable to fund themselves because they have unsustainable amounts of debt, a rigid currency system that will not allow them to adjust and grow, and the concomitant lack credibility.

Foreign money does not solve the credibility problem. What’s worse, what would happen if there were a significant increase in the amount of official foreign capital directed at purchasing the bonds of struggling European governments? Without countervailing outflows, the inevitable consequence would be a contraction of the European trade surplus. In fact if Europe began to import capital rather than export it, the automatic corollary would be that its current account surplus would vanish and become a current account deficit.

The idea on the table is for the BRICs to buy into the EFSF, not struggling debt directly. Even so, they need Euros to buy EFSF debt, which will represent a capital inflow into Europe. The periphery nations are struggling to rebalance internally. The strong Euro is not helping matters. Ultimately, additional capital inflows from the BRICs will only add additional strength to the Euro, encouraging further contractionary external adjustment that only complicates the internal adjustment challenges. The Europeans really should be seeking a European solution, not adding more external stakeholders to the fray.

I guess we should all get some good sleep tonight, as tomorrow will be a busy day.

Monday, October 24, 2011

Paul Krugman: The Hole in Europe’s Bucket

Is the euro system doomed?:

The Hole in Europe’s Bucket, by Paul Krugman, Commentary, NYTimes: If it weren’t so tragic, the current European crisis would be funny, in a gallows-humor sort of way. ...
I’ll get to the tragedy in a minute. First, let’s talk about the pratfalls... Greece, where the crisis began, is no more than a grim sideshow. The clear and present danger comes instead from ... Italy, the euro area’s third-largest economy. Investors, fearing a possible default, are demanding high interest rates on Italian debt. And these high interest rates, by raising the burden of debt service, make default more likely. ...
To save the euro, this threat must be contained. But ... here’s the problem: All the various proposals ... ultimately require backing from major European governments, whose promises to investors must be credible for the plan to work. Yet Italy is one of those major governments; it can’t achieve a rescue by lending money to itself. And France, the euro area’s second-biggest economy, has been looking shaky lately... There’s a hole in the bucket, dear Liza, dear Liza. ...
What makes the story really painful is the fact that none of this had to happen. ... Britain, Japan and the United States ... have large debts and deficits yet remain able to borrow at low interest rates. What’s their secret? The answer, in large part, is that they retain their own currencies, and investors know that in a pinch they could finance their deficits by printing more of those currencies. If the European Central Bank were to similarly stand behind European debts, the crisis would ease dramatically. ...
But such action, we keep being told, is off the table. The statutes ... supposedly prohibit this kind of thing, although one suspects that clever lawyers could find a way to make it happen. The broader problem, however, is that the whole euro system was designed to fight the last economic war. It’s a Maginot Line built to prevent a replay of the 1970s, which is worse than useless when the real danger is a replay of the 1930s. ...
The ... European elite, in its arrogance, locked the Continent into a monetary system that recreated the rigidities of the gold standard, and — like the gold standard in the 1930s — has turned into a deadly trap.
Now maybe European leaders will come up with a truly credible rescue plan. I hope so, but I don’t expect it.
The bitter truth is that it’s looking more and more as if the euro system is doomed. And the even more bitter truth is that given the way that system has been performing, Europe might be better off if it collapses sooner rather than later.

Tuesday, October 11, 2011

The Rise of the Renminbi as International Currency: Historical Precedents

Jeff Frankel:

The Rise of the Renminbi as International Currency: Historical Precedents, by Jeff Frankel: All of a sudden, the renminbi is being touted as the next big international currency. Just in the last year or two, the Chinese currency has begun to internationalize along a number of dimensions. A RMB bond market has grown rapidly in Hong Kong, and one in RMB bank deposits. Some of China’s international trade is now invoiced in the currency. Foreign central banks have been able to hold RMB since August 2010, with Malaysia going first.
Some are now claiming that the renminbi could overtake the dollar for the number one slot in the international currency rankings within a decade (especially Subramanian 2011a, p.19; 2011b). ...
The dollar is one of three national currencies to have attained international status during the 20th century. The other two were the yen and the mark, which became major international currencies after the breakup of the Bretton Woods system in 1971-73. (The euro, of course, did so after 1999.) In the early 1990s, both were spoken of as potential rivals of the dollar for the number one slot. It is easy to forget it now, because Japan’s relative role has diminished since then and the mark has been superseded. ...
The current RMB phenomenon differs in an interesting way from the historical circumstances of the rise of the three earlier currencies. The Chinese government is actively promoting the international use of its currency. Neither Germany nor Japan, nor even the US, did that, at least not at first. In all three cases, export interests, who stood to lose competitiveness if international demand for the currency were to rise, were much stronger than the financial sector, which might have supported internationalization. One would expect the same fears of a stronger currency and its effects on manufacturing exports to dominate the calculations in China.
In the case of the mark and yen after 1973, internationalization came despite the reluctance of the German and Japanese governments. In the case of the United States after 1914, a tiny elite promoted internationalization of the dollar despite the indifference or hostility to such a project in the nation at large. These individuals, led by Benjamin Strong, the first president of the New York Fed, were the same ones who had conspired in 1910 to establish the Federal Reserve in the first place.
It is not yet clear that China’s new enthusiasm for internationalizing its currency includes a willingness to end financial repression in the domestic financial system, remove cross-border capital controls, and allow the RMB to appreciate, thus helping to shift the economy away from its export-dependence. Perhaps a small elite will be able to accomplish these things, in the way that Strong did a century earlier. But so far the government is only promoting international use of the RMB offshore, walled off from the domestic financial system. That will not be enough to do it.
[This perspective note summarizes the argument in "Historical Precedents for the Internationalization of the RMB"...] ...

Monday, October 03, 2011

Paul Krugman: Holding China to Account

Improving our trade balance would help with the recovery:

Holding China to Account, by Paul Krugman, Commentary, NY Times: The dire state of the world economy reflects destructive actions on the part of many players. Still, the fact that so many have behaved badly shouldn’t stop us from holding individual bad actors to account.
And that’s what Senate leaders will be doing this week, as they take up legislation that would threaten sanctions against China and other currency manipulators.
Respectable opinion is aghast. But respectable opinion has been consistently wrong lately, and the currency issue is no exception.
Ask yourself: Why is it so hard to restore full employment? ... The answer is that we used to run much smaller trade deficits. A return to economic health would look much more achievable if we weren’t spending $500 billion more each year on imported goods and services than foreigners spent on our exports.
To get our trade deficit down, however, we need to make American products more competitive, which in practice means that we need the dollar’s value to fall in terms of other currencies. Yes, some people will shriek about “debasing” the dollar. But sensible policy makers have long known that sometimes a weaker currency means a stronger economy... Switzerland, for example, has intervened massively to keep the franc from getting too strong against the euro. ...
The United States, given its special global role, can’t and shouldn’t be equally aggressive. But given our economy’s desperate need for more jobs, a weaker dollar is very much in our national interest — and we can and should take action against countries that are keeping their currencies undervalued, and thereby standing in the way of a much-needed decline in our trade deficit.
That, above all, means China. ... And the reality of the unemployment disaster is also my answer to those who warn that getting tough with China might unleash a trade war or damage world commercial diplomacy. Those are real risks, although I think they’re exaggerated. But they need to be set against the fact — not the mere possibility — that high unemployment is inflicting tremendous cumulative damage as we speak.
Ben Bernanke, the chairman of the Federal Reserve, said it clearly last week: unemployment is a “national crisis,” with so many workers now among the long-term unemployed that the economy is at risk of suffering long-run as well as short-run damage.
And we can’t afford to neglect any important means of alleviating that national crisis. Holding China accountable won’t solve our economic problems on its own, but it can contribute to a solution — and it’s an action that’s long overdue.

Monday, September 26, 2011

Paul Krugman: Euro Zone Death Trip

The end of the road for the euro?:

Euro Zone Death Trip, by Paul Krugman, Commentary, NY Times: Is it possible to be both terrified and bored? That’s how I feel about the negotiations now under way over how to respond to Europe’s economic crisis...
On one side, Europe’s situation is really, really scary: with countries that account for a third of the euro area’s economy now under speculative attack, the single currency’s very existence is being threatened — and a euro collapse could inflict vast damage on the world.
On the other side, European policy makers seem set to deliver more of the same. They’ll probably find a way to provide more credit to countries in trouble, which may or may not stave off imminent disaster. But they don’t seem at all ready to acknowledge a crucial fact — namely, that without more expansionary fiscal and monetary policies in Europe’s stronger economies, all of their rescue attempts will fail.
The story so far: The introduction of the euro in 1999 led to a vast boom in lending to Europe’s peripheral economies, because investors believed (wrongly) that the shared currency made Greek or Spanish debt just as safe as German debt. ... But when the lending boom abruptly ended, the result was both an economic and a fiscal crisis. ...
So now what? Europe’s answer has been to demand harsh fiscal austerity,... meanwhile providing stopgap financing until private-investor confidence returns. Can this strategy work?
Not for Greece... Probably not for Ireland and Portugal... But given a favorable external environment — specifically, a strong overall European economy with moderate inflation — Spain ... and ... Italy ... could possibly pull it off.
Unfortunately, European policy makers seem determined to deny those debtors the environment they need. ... And I see no sign at all that European policy elites are ready to rethink their hard-money-and-austerity dogma.
Part of the problem may be that those policy elites have a selective historical memory. They love to talk about the German inflation of the early 1920s — a story that, as it happens, has no bearing on our current situation. Yet they almost never talk about a much more relevant example: the policies of Heinrich Brüning, Germany’s chancellor from 1930 to 1932, whose insistence on balancing budgets and preserving the gold standard made the Great Depression even worse in Germany than in the rest of Europe — setting the stage for you-know-what.
Now, I don’t expect anything that bad to happen in 21st-century Europe. But there is a very wide gap between what the euro needs to survive and what European leaders are willing to do, or even talk about doing. And given that gap, it’s hard to find reasons for optimism.

Monday, September 12, 2011

Paul Krugman: An Impeccable Disaster

The "euro is now at risk of collapse":

An Impeccable Disaster, by Paul Krugman, Commentary, NY Times: On Thursday Jean-Claude Trichet, the president of the European Central Bank or E.C.B. — Europe’s equivalent to Ben Bernanke — lost his sang-froid. In response to a question about whether the E.C.B. is becoming a “bad bank” thanks to its purchases of troubled nations’ debt, Mr. Trichet, his voice rising, insisted that his institution has performed "impeccably, impeccably!" as a guardian of price stability.
Indeed it has. And that’s why the euro is now at risk of collapse. ... At this point countries in crisis account for about a third of the euro area’s G.D.P., so the common European currency itself is under existential threat. ...
Listen to many European leaders — especially, but by no means only, the Germans — and you’d think that their continent’s troubles are a simple morality tale of debt and punishment: Governments borrowed too much, now they’re paying the price, and fiscal austerity is the only answer.
Yet this story applies, if at all, to Greece and nobody else. Spain in particular had a budget surplus and low debt before the 2008 financial crisis; its fiscal record, one might say, was impeccable. ...
So why is Spain — along with Italy, which has higher debt but smaller deficits — in so much trouble? The answer is that these countries are facing something very much like a bank run, except that the run is on their governments rather than, or more accurately as well as, their financial institutions. ...
Now, a country with its own currency, like Britain, can short-circuit this process:... the Bank of England can step in to buy government debt with newly created money. This might lead to inflation (although even that is doubtful when the economy is depressed); but inflation poses a much smaller threat to investors than outright default. Spain and Italy, however, have adopted the euro and no longer have their own currencies. ...
What Mr. Trichet and his colleagues should be doing right now is buying up Spanish and Italian debt — that is, doing what these countries would be doing for themselves if they still had their own currencies. ...
We’re not talking about a crisis that will unfold over a year or two; this thing could come apart in a matter of days. And if it does, the whole world will suffer. So will the E.C.B. do what needs to be done — lend freely and cut rates? Or will European leaders remain too focused on punishing debtors to save themselves? The whole world is watching.