Euro Crisis Links

The difficult choices still facing Europe, Mohamed El-Erian, FT Alphaville.

The beneficial impact of last weekend’s $1 trillion “shock and awe” intervention by Europe to save Greece and safeguard the Euro is fading-even more quickly than officials had feared.

The Euro has weakened dramatically in the last few days. Sovereign risk spreads have started to widen again despite considerable (and noisy) buying by the European Central Bank (ECB). And equity markets have given up part of the dramatic gains that followed the policy announcements.

All of this is the result of two main factors: First, having analyzed the news out of Europe in depth, markets recognize that the liquidity-based approach cannot sustainably address what is at heart a solvency problem.... Second, markets are worried about the collateral damage and unintended consequences of the “shock and awe.” Most importantly, they dislike the extent to which the standing and integrity of the ECB are in the process of being sacrificed....

A key dynamic of the past few years-namely, the serial contamination of balance sheets-is hitting the reality of scarcity. Industrial countries are running out of balance sheets that can be levered safely in order to minimize the disruptive impact of past excesses....

Absent a significant change in the European policy mindset, officials will find themselves pulled even more into multi-round dynamics that support debt with more debt and, in the process, contaminate the good with the bad.

The Very Bad Luck of the Irish. Simon Johnson and Peter Boone at The Baseline Scenario.

With the European Central Bank announcing that it has bought more than $20 billion of mostly high-risk euro zone government debt in one week, its new strategy is crystal clear: We will take the risk from bank balance sheets and give it to the central bank, and we expect Portugal-Ireland-Italy-Greece-Spain to cut fiscal spending sharply and pull themselves out of this mess through austerity.

But the bank’s head, Jean-Claude Trichet, faces a potential major issue: the task assigned to the profligate nations could be impossible. Some of these nations may be stuck in a downward debt spiral that makes greater economic decline ever more likely....

There is no simple escape, but if the government hopes to avoid a sovereign default, the one overriding priority should be to stop bailing out the banks. Instead, the government should wind down existing banks in a “bad bank,” while moving their deposit base and profitable businesses into new, well-capitalized banks that can function without a taxpayer burden. This will be messy, but it is far better than a sovereign default.

Two Choices: Restructure Debts or Debase Currencies. John Hussman.

Presumably, the ECB hoped that the 750 billion euro figure would inspire shock and awe, but after a quick rally on Monday, the markets were neither shocked, nor durably awed, as investors began figuring out that the ECB was essentially promising to buy Euro-debt with Euro-debt, and to defend euros with euros.

In the end, as I've argued repeatedly over the years, monetary policy is only as good as fiscal policy. A central bank does not have wealth of its own. It is a zero-sum entity that can only enrich those from whom it purchases debt by debasing the relative wealth of people who hold the existing stock of currency. If a government insists on running deficits, engaging in wasteful spending, and dissipating public resources to bail out private bondholders, it has to find somebody willing to buy its
debt. If it does not, the central bank buys it, and dilutes the currency by doing so. The situation is particularly insidious when the central bank buys low-quality debt, because there is no taxing authority behind it to provide a basis for confidence in the currency.

The End of Fiscal Sovereignity in Europe. Michael Spence, Project Syndicate.

The eurozone’s immediate challenge is declining fiscal stability in a subset of countries whose credit ratings are falling and debt-service costs rising. Absent external assistance and a credible plan for restoring fiscal order, Greek sovereign debt could not be rolled over, forcing a default, probably in the form of a restructuring of Greek debt. Even with external assistance, many view default as a near certainty, because the arithmetic of restoring fiscal balance is so daunting.

Eurozone membership precludes inflation and devaluation as adjustment mechanisms. An alternative is domestic deflation combined with extreme fiscal tightening – that is, a period of slow or negative growth in wages, incomes, and some prices of non-traded goods. But deflation is painful and cannot realistically be pursued for political reasons....

If the EU wants a monetary union in which sovereign debt is relatively homogenous with respect to risk, fiscal discipline must be similarly homogenous. But that also means that it will need a more robust mechanism for countercyclical responses to
shocks.... That will involve a loss of full fiscal sovereignty, but facing up to that reality is required to sustain the monetary union.

But, as Martin Feldstein says in The Washington Post (For a solution to the euro crisis, look to the states):

There is now political consensus in Europe that new rules are needed to prevent large deficits, but there is no agreement on what should be done. The European Commission ... proposed last week that the national budgets of each country be examined by the others before they are approved.

It would clearly be anathema to the German government to have its spending and tax policies approved by France, let alone by Greece and Portugal.

I just don't see that changing.

Return to the abyss. Nouriel Roubini, Project Syndicate.

History ... suggests that financial crises tend to morph over time. Crises like those we have recently endured were initially driven by excessive debt and leverage among private-sector agents... This eventually led to a re-leveraging of the public sector as fiscal stimulus and socialization of private losses – bail-out programs – caused a dangerous rise in budget deficits and the stock of public debt.

While such fiscal stimulus and bailouts may have been necessary to prevent the Great Recession from turning into Great Depression II, piling public debt on top of private debt carries a high cost. Eventually those large deficits and debts need to be reduced through higher taxes and lower spending, and such austerity – necessary to avoid a fiscal crisis – tends to slow economic recovery in the short run. If fiscal imbalances are not addressed through spending cuts and revenue increases, only two options remain: inflation for countries that borrow in their own currency and can monetize their deficits; or default for countries that borrow in a foreign currency or can’t print their own.

Thus, the recent ... global financial crisis is not over; it has, instead, reached a new and more dangerous stage.... Governments that bailed out private firms now are in need of bailouts themselves. But what happens when the political willingness of Germany and other disciplined creditors – many now in emerging markets – to fund such bailouts fizzles? Who will then bail out governments that bailed out private banks...? Our global debt mechanics are looking increasingly like a Ponzi scheme.

Enough said.