Credit Writedowns Weekly Report, Vol 1 Issue 2: Solutions in Europe?
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Last week’s report was also heavily based on the European sovereign debt crisis. Check it out to see what’s changed.
Charts of the Day
A decision tree done up by Gavyn Davies on what the future of the euro would look like based on different policy responses
Win Thin shows us why people are worried about China. He says slowing in the Chinese economy is inevitable given the deteriorating external environment as well as PBOC tightening measures taken in 2010-2011. The Chinese are now reversing course but the slowing will continue.
This will surprise many. Der Spiegel reports that Germany’s fiscal management is not as “exemplary” as most perceive. It is Finland and Luxembourg which meet the Maastricht criteria.
Below are the five ways now being discussed to tackle the euro zone sovereign debt crisis. I should say that overall, it is still unclear how far along European leaders are in defining a mutually agreeable outcome. Just this morning, I have seen evidence that France and Germany are still far apart on agreeing the details of the plan they plan to bring forward. meanwhile the euro zone finance ministers want to get the IMF involved. frankly, this thing is all over the shop and we won’t know what will happen until right before it does. My money is still on a German-style fiscal integration which would include EU oversight and austerity to be followed by a stronger ECB role and (maybe) Eurobonds down the line. Angela Merkel is still acting as if she is against Eurobonds but we know they have not been ruled out after fiscal integration since even Juergen Stark has said so.
Here’s how Marc Chandler put it earlier in the week.
First, there is a disagreement about whether the ECB should be buying a significant amount of European bonds. Second, there is a disagreement over whether the ECB should declare that is it buying bonds for an extended period or unlimited amounts. Third, the ECB currently sterilizes its sovereign bond purchases. Some want the ECB to refrain from doing this. Fourth, there is a dispute over whether Greece is a unique event.
I anticipate a large enough move toward limited fiscal integration in the coming days that enables the ECB to move toward a full monetisation euro area national debt by the end of the year. Interestingly enough, the initial reaction by currency markets has been euro strength not weakness. Stock markets around the world have rallied as well. That tells me the markets are more concerned about the impact of a euro breakup scenario than any impact of an ECB rescue scenario.
Given the flurry of activity this past weekend in the euro zone, it seems clear that the Europeans have pushed the panic button. I anticipate that some sort of systemic response is likely in order to deal with Italy (and Spain), two large economies that cannot be supported by the existing European financial assistance programs already in place. Below are some of the details that have come to light and my assessment of what is likely to happen
The euro zone finance ministers meet today and tomorrow. Approval of the next tranche of aid to Greece and an agreement on EFSF leveraging is sought. Yet the real deal is still a week away and that is EU summit.
A year ago, we handicapped the likely end games to the European debt crisis. We attributed a 3% chance of a country leaving the union. Although there has been heightened talk of a country leaving and different systems have contingency plans or stress tests to ensure the ability to cope in such an event, no country has left and the knock-on effects of a country leaving, possibly sinking the entire project, do not appear to have been thoroughly thought through by the advocates
What is becoming clearer to almost everyone is that this is now no longer simply a Euro periphery sovereign debt crisis. It has become a full blown crisis of confidence in the Euro itself
I think that we will see a wholesale and government driven process of bank nationalisations and restructuring in the next 6 months in the euro zone. I also think that most southern European economies are ultimately facing both public and private insolvency issues which will need balance sheet write-offs to get solved. It seems to me that, as so many times before, euro zone politicians are once again getting caught out by reality.
Predicting the future of policy making has been and will continue to be key to understanding where this economy is headed – and by extension what your investment portfolio will do. I see austerity as the main policy prescription in Europe and the US, due to fears from the sovereign debt crisis. Policy makers will panic when they see the economic ills their policies create for voters who will revolt in protest. I call it the Scylla and Charybdis of inflationary and deflationary forces in which policy stimulus is removed and then only after everything collapses, do policy makers press the red button; and then they act super-aggressively, leading to wild swings in asset prices, cyclical inflation, currency wars and the like.
I suggest any plan that we are likely to see in the coming days will not be just about Spain or just about Italy; it will be a comprehensive deal that encompasses the whole of the euro zone, Slovenia, Belgium, Austria, you name it. To me, this says that even apart from US objections, an IMF deal for Italy looks less likely whereas a bilateral aid deal followed by ECB rate targeting, monetisation and/or Eurobonds is more likely.
A unilateral exit would be a devastating event for Italy and the euro zone. Inflation would be high but bank and national solvency issues would recede. If the exit were done under these nationalistic pre-conditions of redomination, most of the adjustment burden would fall on foreign creditors. Italy would become export competitive again and could focus on economic growth strategies instead of ones of fiscal adjustment.
This is a rolling crisis wave through the eurozone infecting more countries, closer and closer to the core. As Marshall wrote recently, this is a structural problem. All of the euro zone countries face liquidity constraints and all of them will eventually succumb to the rolling wave of yield spikes one by one until we get a systemic solution: full monetisation and union or break up.
Without a credible intervention this process almost always ends the same way. There is in my opinion a very high probability that within weeks, or months at most, Greece will be forced to freeze bank deposits as a prelude to leaving the euro. Mexico in 1994 and Argentina in 2001 chose the Christmas/New Year holiday season to announce their devaluations. Will Greece follow suit? “If history repeats itself,” footballer Andrew Demetriou once pointed out, “I should think we can expect the same thing again.”
“Faced with a choice between permanent slump and rising debt burdens (as economic contraction and deflation leads to inexorable increases in debt), countries will elect to quit the currency union. At least that route will allow them to print money, recapitalise their banks and escape deflation. Once Spain or Italy opts for this, an unravelling of the eurozone will be unstoppable.”
Solution 1: Fiscal Union
German and French officials seem willing and eager to modify treaties and seek pursue closer integration. As the crisis unfolding, officials have consistently sacrificed ideological stances in the face of economic and political reality. This process is arguably more likely to continue than to be put in reverse.
Boxed in by the ever-worsening sovereign debt crisis, the Franco-German euro zone axis is trying to formulate a policy that both adheres to the German economic orthodoxy without worsening the crisis any further.
Solution 2: Monetisation
As I have been saying at Credit Writedowns, the ECB’s opposition to monetising sovereign debt is not about inflation concerns but rather its resistance to moving into a politicised quasi-fiscal role
As I said in defense of the ECB last week, “central bankers always prefer to force elected officials to make the tough political choices that are the essence of fiscal policy.” The ECB wants this whole problem to be resolved by elected officials. Now clearly, what has happened in Greece and Italy with unelected technocrats being installed has created quite a stir. Nevertheless, I think it’s still the case that getting governments to clear this situation through their legislatures is a more legitimate way of dealing with a crisis.
Solution 3: Eurobonds
The time for this idea has apparently arrived. Die Welt provides more confirmation of what I have seen in two different accounts, first in Austrian daily Der Standard and then on the Spanish website Cinco Dias: Eurobonds are a potential solution.
Neither the current governing coalition nor the German populace is anywhere close to getting where Schröder is. The most Germany will deliver is what’s on the table now: EU fiscal oversight with penalties and potentially expulsion for governments which deviate from the German low deficit vision for a United Europe.
Solution 4: Austerity
According to Spanish website Cinco Dias, France and Germany want to move from a 3% deficit target to balanced budget by the year 2016. This aim points to a clear intention by the two countries to present a deal on fiscal integration and priorities in the coming days
While Spanish Prime Minister-elect Mariano Rajoy was preparing for continued austerity in Spain, his Popular Party colleague, Former Spanish Prime Minister Jose Maria Aznar, was talking to Bloomberg Television about the outlook for his country’s economy and the mandate of the European Central Bank. He spoke to Bloomberg’s Emma Ross-Thomas in Madrid, saying the ECB may be needed to avoid a “disaster”
The acting Belgian Prime Minister Elio Di Rupo officially resigned last Monday night. He had been trying to form a government. But after a serious step forward in October, stalled negotiations led him to go to King Albert II. Apparently, this move and a ratings downgrade got action and now the Belgians have finally formed a government. They
Solution 5: IMF
Lastly, while it triggers a massive relief rally,
it’s just Bigfoot kicking the can way down the road,
as the austerity continues to weaken the euro economy,
now to the point of driving up deficits as GDP growth goes negative.
So bringing in the IMF helps Germany preserve it’s ‘max austerity’ image,
kicks the solvency issue down the road,
and all without the ECB ‘printing money’!
So now let’s see if it actually happens.
According to Austrian daily Der Standard, Italy is to receive a 600 billion euro bailout courtesy of the IMF. Note: the article has what I assume to be a typo, referring to 600 million euros instead of 600 billion. I have fixed that in the translation below. Also note that the ultimate source of this information is La Stampa, an Italian daily newspaper.
Many observers are confused. They cry for the ECB to "man up" and "do what it is supposed to do" and be the lender of last resort. It does have that function for banks, not for sovereigns. The lender of last resort to sovereigns is the IMF.
Britain’s economy is a shambles as the negative impact of austerity has been made plain. Now, mind you, it was already clear from a leaked Greek bailout document that expansionary fiscal consolidation has failed in Greece. But now the OECD’s double dip warning for Britain should make this plain to all.
This time it’s Steve Keen on the hotseat on HARDtalk. Now, Steve is one of the few economists who actually predicted the global financial crisis. But what about the possibility of another Great Depression? That possibility and how to avoid it were the topics of conversation in this 25-minute interview. Great stuff.
While the usual assumption is that current account deficits lead more-or-less directly to currency depreciation, the evidence for this effect is not clear-cut. Implications of this depend on the currency regime. According to the well-known trilemma, government can choose only two out of the following three: independent domestic policy (usually described as an interest rate peg), fixed exchange rate, and free capital flows. A country that floats its exchange rate can enjoy domestic policy independence and free capital flows. A country that pegs its exchange rate must choose to regulate capital flows or must abandon domestic policy independence. If a country wants to be able to use domestic policy to achieve full employment (through, for example, interest rate policy and by running budget deficits), and if this results in a current account deficit, then it must either control capital flows or it must drop its exchange rate peg.
So here we are, with the ECB demanding deflationary austerity from the member nations in return for the limited bond buying that has been sustaining some semblance of national government solvency, not seeming to realize it can’t inflate with its monetary policy tools, even if it wanted to.
The US can run budget deficits that help to fuel current account deficits without worry about government or national insolvency precisely because the rest of the world wants Dollars. But surely that cannot be true of any other nation. Today, the US Dollar is the international reserve currency—making the US special. Isn’t the US special? Let us examine this argument.
Sean Egan, president of Egan-Jones Ratings Co., talked to Bloomberg Television yesterday about the agency’s decision to cut Italy’s credit rating to BB from BB+. The rationale is simply that public debt in Italy is growing while GDP is not. And austerity will make this worse.
“While the need to preserve confidence may imply some continuing (though potentially declining) support for senior debt — given the potential for contagion across the banking system — the rationale for continuing to assume the willingness and ability to provide support for subordinated debt holders is much weaker.”
Famous shortseller Jim Chanos was in Hong Kong and Australia and reported back on what he saw to Bloomberg Television. Copy provided below including the video.
An in-depth (and cynical) look at the current political environment in America, from the Occupy Wall Street protesters to the President’s reaction to the Republican Primary via Omid Malekan, creator of the Quantitative Easing Explained and European Crisis Explained videos
Don’t change the change!
Here’s Steve Jobs from the start-up phase at NeXT after he had been forced out of Apple in 1985. In this video, he is very much the passionate visionary we knew him to be in his second stint at apple, and with less bluster and more of a collaborative flair
This week’s New Yorker magazine features Ian Frazier on Theo Jansen, a Dutch artist who makes kinetic sculptures called Strandbeests that walk along the beach.
In the video below, Frazier discusses the sculptures and how they fit into the tradition of Dutch landscapes. Very cool