Weekly: Moving to disorderly breakup as base case

The events surrounding Spain have caused me to throw in the towel on European policy makers. It is clear to me that the events on the ground are moving too quickly for them to adjust their policy stances enough to prevent more catastrophic outcomes. For that reason, I am moving to a disorderly breakup as a base case for Europe rather than my previous position with only Greece making a coordinated exit as a sure thing.

Previous view

As a reminder of my previous position, a month ago I wrote "The European Endgame is within sight". The gist of that post was that:

While I think we are finally arriving at the changes which presage the endgame, I do not think the events in France and Spain are going to be the catalyst for seismic change in policy responses. More likely, the sovereign debt crisis will impose policy change upon European policy makers after markets seize up and Europe risks breaking apart.

My sense was that European leaders’ commitment to Europe would eventually see them through and that they would be able to improvise temporary makeshift solutions for a while.

My belief all along has been that each nation in the euro zone is committed to its success. The European body politic has grown to support it as indispensible. Moreover, unravelling the euro is a very difficult task. And so, I believe political inertia alone will help see the euro through for most countries unless we see a catastrophic banking system collapse.

This week’s post will go in depth as to why I have changed my view.

Too many moving parts

The most important problem in Europe is that there are too many moving parts for policy makers to move quickly. There are several crises at once: Greece has defaulted and received two packages and may end up exiting the euro zone in a disorderly way. Portugal and Ireland have been bailed out. Spanish banks are about to be bailed out. Spanish and Italian yields are shooting up. And let’s not forget the deficit problem in the Netherlands, France and Belgium. That’s a lot of different problems to contend with given the current economic framework which is based around meeting 3% deficit 60% debt to GDP hurdles, no bilateral aid and no ECB intervention.

At the same time, there are vastly different voices emerging in the crisis. On the austerity side, Germany, the Netherlands, Finland, Austria and Slovakia are hardly talking with one voice. The Finns want collateral for the Spanish bailout. The Slovaks are balking altogether. The Dutch have their own deficit problems and want to relax the Maastricht target timetables. The Germans are having a hard time getting the fiscal pact through the Bundesrat without strings attached by the SPD and the Greens in the form of a bank transaction tax that Britain will not go for and in terms of gold-backed sovereign debt sinking fund.

Meanwhile, France has really moved away from the neoliberal paradigm with a rollback of pension ages from 62 to 60, plans to make firing people more difficult and executive proposed pay caps. I would say this move is more significant than I anticipated and it shows us that achieving consensus between the Germans and the French on policy will be more difficult than expected.

In the periphery, the revolt is increasing with Syriza potentially winning on an anti-austerity line in Greece, Monti objecting to Austria FinMin Fekter’s suggestion that Italy would need a bailout and Rajoy imploring the ECB for help and Ireland looking for bank bondholder haircuts. The only government I have not heard objecting recently is Portugal’s. The positions of leading periphery leaders are moving away from the positions in the core. Again, this makes any kind of resolution more difficult and means any solution will have to be imposed and acceded to by the periphery governments rather than simply agreed to.

Spain

The moving parts problem has always been a flaw of how European decision making gets achieved. But, with the number of crises and the Spanish crisis reaching a critical juncture, it is now clear that this decision making process will likely be fatal.

I recently wrote on Spain, but let me review the difficulty there with a bit more added.

The Spanish banking system is insolvent. House prices are down 30% now from a 2007 peak. And that has put a huge hole in the balance sheets of Spain’s banks. Economist Willem Buiter reckons Spanish property price declines are about half complete. So more losses are coming. If Spain were to bail out its banks in a believable way, it would need hundreds of billions of euros to do so. And that is a strain the sovereign cannot take given escalating debt and continued high deficits without the support of a sovereign lender of last resort.

Europe thinks it has a plan stuffing Spain’s government full with 100 billion euros to lend on to the banks to shore up capital. Some of the details of this plan are still emerging. Here are some highlights:

• Seniority. Bonds issued under the ESM would be senior to existing sovereign debt which makes recovery from that debt harder if the bonds are issued via the ESM. Wolfgang Schaeuble, the German finance minister has said that he prefers the ESM facility as a bailout vehicle over the EFSF. I assume this would lower the interest rate but also negatively impact existing debt yields. If the EFSF were used the interest rates would have to be higher as the debt would not necessarily be senior to existing debt. These are some of the considerations going into how to structure the bailout.
• Penalty rates. Spain could pay 8.5% for bailout funds depending on how the deal is structured. The penalty rate may be associated with the Spanish drawing from the temporary EFSF bailout facility instead of the ESM facility. But, more importantly, Eurostat, the European statistics agency, said Wednesday that it hadn’t decided how much the Spanish sovereign’s debt would rise because it depended on how the loan for the bank bailout would be calculated. If the interest rate on that bailout is too low, the money would be considered a gift rather than a loan and would count against the debt. This is creating problems with what the loan rate should be. It also bears remembering that the Irish don’t want to see Spain get favourable treatment or they will want to renegotiate their own deal.
• Troika occupation. Contrary to claims by the Spanish government that the "line of credit" Spain is receiving is a "victory", in fact the Germans and Brussels are demanding oversight for the 100 billion euros and how it is distributed. Moreover, the Finns have said they want collateral for the money they loan.
• Bank liquidation. According to a spokesman for Competition Commissioner Joaquin Almunia, the EU is saying it prefers to liquidate banks when it’s cheaper for the taxpayer. So, rather than just bailing out these bankrupt financial institutions, the EU may force Spain to sell off their assets in a controlled liquidation. It is not clear what would happen to bondholders in such a scenario. I assume they would be paid only based on the value of the assets liquidated. The Spanish government has accused Almunia of disloyalty and have asked for his resignation.

The market has puked all over this plan. After yesterday’s 3-notch downgrade by Moody’s, yields on Spanish 10-year bonds are now hovering just around 7%. Credit default swaps for Spanish debt are now trading at 605 bps with a 40% chance of default over the next five years. These are the market indications that the Spanish bank bailout package is not credible. This Monday I wrote why:

1. Spanish banks need more. Spanish banks will need much more money than 100 billion euros. So this bailout, while larger than the 40 billion being bandied about last week, is still inadequate by an order of magnitude. 400 billion euros would have been a real bazooka.
2. Spain’s sovereign is still on the hook. The Germans have agreed only to allow a pass-through via the Spanish state bank bad bank fund FROB. This is not a EuroTARP along the lines I said was necessary in late April if Europe wanted to draw a line under the Spanish bank – Spanish sovereign connection.
3. Italy is still suffering contagion. The deal does absolutely nothing for Italy which is next in line for sovereign risk in the euro zone. Any deal Spain gets MUST always keep Italy in mind or it will be a bust. Again, this is why a European-wide bank recap is necessary.

So, Europe needs to come up with something else.

Two possibilities:

1. EU-wide bank recapitalisation scheme via the same EFSF/ESM facilities with burden at EU-wide level
2. ECB rate cap for Spain and Italy at 300 basis points above Bunds

Realistically these are the only things that can get Spain under control. During the Italian crisis I voiced support for a temporary rate ceiling for Italy and Spain as the easiest, longest lasting and least costly policy response because:

the only reason not to buy Italian debt at 2 or 300 basis points over Bunds, or Greek debt at 3 or 400 basis points over Bunds is because those governments are not credibly backstopped by the ECB.

Two weeks ago I mentioned Ambrose Evans-Pritchard’s reviving this scenario. However, I don’t expect this to occur any more because it is too much of a policy shift.

Bank runs

The big problem is the bank runs. Marshall Auerback told me that Spanish banks may be liquidating their sovereign debt positions to deal with bank runs. This is the only good collateral they have and so it makes sense that they would be net sellers. Now, the rise in Spanish government bond yields has been explained on the grounds that the 100 billion euro loan financing would be a loan to the government and that this was not credible.

However, there are two additional problems here. First, using the ESM facility, the bailout would be senior to all other Spanish government bonds. That subordinates outstanding Spanish government bonds and so their yields rose to reflect the higher default risk. If the money comes from the EFSF then this is not a problem.

Second are the bank runs. Marshall wrote me saying:

It might be that the bank run on Spanish banks is that severe they may be under pressure to sell as well assets they have hitherto been loath to sell to meet deposit withdrawals. It may be that the crash we have seen these last few days in Spanish and even Italian bonds is due to a forced liquidation of such assets which have provided these banks with needed high financing margins.  Maybe the bonds they bought under the original LTRO? In other words, the sharp break we have just seen in Spanish bond prices despite better than expected bank recap financing from the EU may be yet more evidence of an intensification of the run on Spanish banks.

It is unknowable at this point what is happening but it makes sense that fire sale prices result due to cash calls that result from a withdrawal of deposits in a bank run.

The point of course is that this is a self-feeding mechanism due to the sovereign-bank linkage. The bank run leads immediately to sovereign distress via the contingent liability bank bailout channel as well as via the asset sales that cause yields to shoot up. In my view, a true lender of last resort would step in here and create an orderly market for those securities as the Fed did in 2008 and 2009 when US banks were selling MBS at fire sale prices for exactly the same reasons – to raise cash due to their being locked out of funding markets. In the US, it was wholesale funding that was the problem. here we are seeing real bank runs via retail deposit withdrawal. A classic lender of last resort role is to step in to make a market in the securities being hit by the distressed selling. But of course the ECB is too dogmatic in its anti-sovereign support stance to do this.

Worst case scenarios?

Dani Rodrick has a fairly good storyline of how these things could proceed.

Consider the following scenario. After a victory by the left-wing Syriza party, Greece’s new government announces that it wants to renegotiate the terms of its agreement with the International Monetary Fund and the European Union. German Chancellor Angela Merkel sticks to her guns and says that Greece must abide by the existing conditions.

Fearing that a financial collapse is imminent, Greek depositors rush for the exit. This time, the European Central Bank refuses to come to the rescue and Greek banks are starved of cash. The Greek government institutes capital controls and is ultimately forced to issue drachmas in order to supply domestic liquidity.

With Greece out of the eurozone, all eyes turn to Spain. Germany and others are at first adamant that they will do whatever it takes to prevent a similar bank run there. The Spanish government announces additional fiscal cuts and structural reforms. Bolstered by funds from the European Stability Mechanism, Spain remains financially afloat for several months.

But the Spanish economy continues to deteriorate and unemployment heads towards 30%.  Violent protests against Prime Minister Mariano Rajoy’s austerity measures lead him to call for a referendum. His government fails to get the necessary support from voters and resigns, throwing the country into full-blown political chaos. Merkel cuts off further support for Spain, saying that hard-working German taxpayers have already done enough. A Spanish bank run, financial crash, and euro exit follow in short order.

In a hastily arranged mini-summit, Germany, Finland, Austria, and the Netherlands announce that they will not renounce the euro as their joint currency. This only increases financial pressure on France, Italy, and the other members. As the reality of the partial dissolution of the eurozone sinks in, the financial meltdown spreads from Europe to the United States and Asia.

Our scenario continues in China, where the leadership faces a crisis of its own. The economy’s slowdown has already exacerbated social conflict, and recent developments in Europe have added fuel to the fire. With European export orders canceled en masse, Chinese factories are faced with the prospect of massive layoffs. Demonstrations begin in major cities, calling for an end to corruption among party officials.

China’s government decides that it cannot risk further strife and announces a package of measures to boost economic growth and prevent layoffs, including direct financial support for exporters and intervention in the currency markets to weaken the renminbi.

In the US, President Mitt Romney has just taken office, following a hard-fought campaign in which he derided Barack Obama for being too soft on China’s economic policies. The combination of financial contagion from Europe, which has already led to a severe credit crunch, and a sudden flood of low-priced imports from China leaves the Romney administration in a bind. Against the advice of his economic advisers, he announces across-the-board import duties on Chinese exports. His Tea Party backers, who were critical in mobilizing electoral support for him, urge him to go further and withdraw from the World Trade Organization.

Over the next few years, the world economy slumps into what future historians will call the Second Great Depression. Unemployment rises to record-high levels. Governments without fiscal resources are left with little option but to respond in ways that will only exacerbate problems for other countries: trade protection and competitive exchange-rate depreciation. As countries sink into economic autarky, repeated global economic summits yield few results beyond empty promises of cooperation.

Few countries are spared the economic carnage. Those that do relatively well share three characteristics: low levels of public debt, limited dependence on exports or capital flows, and robust democratic institutions. So Brazil and India are relative havens, even though their growth prospects are severely diminished as well.

As in the Great Depression, the political consequences are more serious and hold longer-term significance. The eurozone’s collapse (and, for all practical purposes, that of the EU itself) forces a major realignment of European politics. France and Germany compete openly as alternative centers of influence vis-à-vis the smaller European states. Centrist parties pay the price for their support of the European integration project, and are repudiated in the polls by parties of the extreme right or extreme left. Nativist governments begin to kick out immigrants.

For nearby countries, Europe no longer shines as a beacon of democracy. The Arab Middle East takes a decisive turn towards authoritarian Islamic states. In Asia, economic strife between the US and China spills over into military conflict, with increasingly frequent naval clashes in the South China Sea threatening to erupt into a full-scale war.

Many years later, Merkel, who has withdrawn from politics and become a recluse, is asked whether she thinks that she should have done anything differently during the euro crisis.  Unfortunately, her answer comes too late to change the course of history.

A remote scenario? Perhaps, but not remote enough.

I don’t see this as remote in the least. This is the path we are on right now. What we need to see is some sign that European policy makers get it, that they understand that the bank runs have begun. If they don’t act soon, it will be too late and we will be back in 1931 again.