December 10

Europe's inevitable haircut. Barry Eichengreen.

What once could be dismissed as simply a Greek crisis, or simply a Greek and Irish crisis, is now clearly a eurozone crisis. Resolving that crisis is both easier and more difficult than is commonly supposed.

The economics is really quite simple. Greece has a budget problem. Ireland has a banking problem. Portugal has a private-debt problem. Spain has a combination of all three. But, while the specifics differ, the implications are the same: all must now endure excruciatingly painful spending cuts.

The standard way to buffer the effects of austerity is to marry domestic cuts to devaluation of the currency. Devaluation renders exports more competitive, thus substituting external demand for the domestic demand that is being compressed.

But, since none of these countries has a national currency to devalue, they must substitute internal devaluation for external devaluation. They have to cut wages, pensions, and other costs in order to achieve the same gain in competitiveness needed to substitute external demand for internal demand.

The crisis countries have, in fact, shown remarkable resolve in implementing painful cuts. But one economic variable has not adjusted with the others: public and private debt. The value of inherited government debts remains intact, and, aside from a handful of obligations to so-called junior creditors, bank debts also remain untouched.

This simple fact creates a fundamental contradiction for the internal devaluation strategy: the more that countries reduce wages and costs, the heavier their inherited debt loads become. And, as debt burdens become heavier, public spending must be cut further and taxes increased to service the government’s debt and that of its wards, like the banks. This, in turn, creates the need for more internal devaluation, further heightening the debt burden, and so on, in a vicious spiral downward into depression.

So, if internal devaluation is to work, the value of debts, where they already represent a heavy burden, must be reduced. Government debt must be restructured. Bank debts have to be converted into equity and, where banks are insolvent, written off. Mortgage debts, too, must be written down.

Default, delusion and deceit (and other ways to spring the debt trap). Roger Bootle of Capital Economics, in the Telegraph.

There are five ways of escape [from the debt trap].

First, try to muddle through and hope that years of sustained economic growth will cause the weight of these debts to fall and for the burden to go unnoticed amidst increasing prosperity, so that it is unclear who has picked up the tab. This is far and away the best solution – if you can manage it. But in the vulnerable countries GDP is struggling – or even contracting.

Second, engineer a bout of inflation to reduce the real value of the liabilities. In this way just about everyone in society will pay – but hopefully no one will notice. (Being able to devalue your currency potentially helps you achieve both the first and the second routes.) The trouble is that even if this solution were available for the eurozone as a whole, for each embattled member country it is not, as they do not have their own money.

Third, force those who caused the problems and gained from the years of extravagance to cough up. That would mean the bankers, property developers and politicians. This seems the fairest solution, but it is also the least likely. And, believe it or not, even they do not have enough dosh.

Fourth, slash government spending and make current and future taxpayers pick up the tab. This is the way that Ireland and Greece are trying to go. The trouble is that the situation may be so far gone that attempting a solution this way is impossible. It may even be so deflationary that it proves to be counter-productive.

The fifth way is to default. Perhaps you can make someone not involved in the process by which the government gets elected take a good part of the hit. This is where Johnny Foreigner comes in. You say: "Sorry old chaps, but that money that you thought we owed you is now 'restructured'. In the words of Monty Python, it is an ex-loan."

This is what is going to happen. Huge amounts of money are going to be lost. At the moment, the prospective losers can afford it. But coming up in the lift are Portugal, Belgium and Spain. And then Italy. This looks eerily like the build-up to the financial crisis of two years ago. Perhaps the bail-out of Ireland is the Bear Stearns moment. Spain, or Italy, could be the Lehman moment.

Eclectica Fund: Manager Commentary, December 2010. Hugh Hendry.
subtitled "There are no policy remedies for debt deflation"



other fare:
The decline and fall of the American Empire. Alfred McCoy
also on Salon, provocatively but dumbly entitled How America will collapse (by 2025), and which led a colleague of mine to say, when grabbing the article off the printer, "Oh, this has you written all over it!" Well, maybe so, but I don't believe in collapse, per se; however, its hard to argue with the notion that the debt situation is onerous, or that unfunded liabilities will be a serious challenge, or that climate change and peak oil present potentially problematic possibilities, and that geopolitics and terrorism are serious risks, and even the internal socio-political-economic atmosphere, with high unemployment and the Tea-Partiers, etc., is difficult; so there are some very ominous impediments to the continuation of American "exceptionalism", and each of those issues are ones I find of significant (not just academic?) interest, even if only to acknowledge as risks to our outlook

December 1

QOTD:

Politics is the art of looking for trouble, finding it everywhere, diagnosing it incorrectly and applying the wrong remedies. Groucho Marx.

Edward Harrison summarizes Bill Gross' latest, and offers some of his own views, including:

There are four ways to reduce real debt burdens:

• by paying down debts via accumulated savings.
• by inflating away the value of money.
• by reneging in part or full on the promise to repay by defaulting
• by reneging in part on the promise to repay through debt forgiveness

Right now, everyone is fixated on the first path to reducing (both public and private sector) debt. I do not believe this private sector balance sheet recession can be successfully tackled via collective public sector deficit spending balanced by a private sector deleveraging. The sovereign debt crisis in Greece tells you that. More likely, the western world’s collective public sectors will attempt to pull this off. But, at some point debt revulsion will force a public sector deleveraging as well.

And unfortunately, a collective debt reduction across a wide swathe of countries cannot occur indefinitely under smooth glide-path scenarios. This is an outcome which lowers incomes, which lowers GDP, which lowers the ability to repay. We will have a sovereign debt crisis. The weakest debtors will default and haircuts will be taken. The question still up for debate is regarding systemic risk, contagion, and economic nationalism because when the first large sovereign default occurs, that’s when systemic risk will re-emerge globally.

Ireland's reparation burdens. Barry Eichengreen.

The Irish “rescue package” finalized over the weekend is a disaster. You can say one thing for the European Commission, the ECB and the German government: they never miss an opportunity to make things worse.

The rough politics of European adjustment. Michael Pettis.

I have no doubt that enormous amounts of scotch tape, paper clips, and chewing gum are going to be deployed quickly to hold the whole thing together, and that perhaps in a week or two we will be all throwing sighs of relief as policymakers firmly announce that Europe was put to the ultimate test and proved itself manfully. But does that mean we can stop worrying – was this really the ultimate test? No, of course not. If previous history is any guide, this crisis will re-emerge in different places every few months until it is truly resolved...

Unfortunately it is going to require a lot more than emergency liquidity loans, no matter how plentiful, to arrive at a final resolution. These loans simply paper over the financing gap until the next big refinancing exercise, and each new loan effectively shortens the duration of the debt or claims a higher level of seniority, so that the capital structure becomes increasingly risky. As the capital structure becomes riskier, it takes a smaller and smaller event to set off the next crisis.

Hangover theory and morality plays. Steve Waldman. 

Austrian-ish “hangover theory” claims, plausibly, that if for some reason the economy has been geared to production that was feasible and highly valued in previous periods, but which now is no longer feasible or highly valued, there will be a slump in production.... There is no school of economic thought I know of that suggests increased prosperity and consumption in and of themselves require a painful purge. The claim is that some patterns of economic activity create the appearance of prosperity and enable temporary consumption that cannot be sustained, and that moving from a period during which such patterns obtain to a more “sustainable pattern of specialization and trade” involves adjustments that are difficult.... 

It is not technocratic economists who will win the day and pull us out of our cul-de-sac, but angry Irishmen and Spaniards who challenge, on moral terms, the right of German bankers to impose vast deadweight costs on current activity because they lent greedily into what might easily have been recognized as a property and credit bubble.

European Leaders Should Focus on the Banks, Not the Sovereigns. Peter Atwater.

The market is saying “when” not “if” any more. To stop the spreading contagion, European leaders need to stop focusing on the sovereigns and start focusing on the banks. As we have already seen, troubled sovereign nations can be kept alive for an extended period of time, but banks can’t. But rather than growing sovereign double leverage even further -- in which a troubled nation, like Ireland, borrows from the EU to put equity capital into its banks -- if the EU is serious about stopping the growing banking contagion, it is going to have to consider its own pan-European TARP/FDIC program for Europe’s largest banks. And whether Europe has the stomach for that we’ll soon find out. But until Europe divorces banking strength from sovereign strength, they will both go down together.

Bankers gone wild... in Ireland AND Germany. Marshall Auerback.

Much ink has been spilled in the press over the Irish problem and the laxity of the country’s southern Mediterranean counterparts in contrast to the highly “disciplined” Germans. But perhaps we have to revisit that caricature. Not only has the Irish crisis blown apart the myth of the virtues of fiscal austerity during rapidly declining economic activity, but it has also illustrated that Germany’s bankers were every bit as culpable as their Irish counterparts in helping to stoke the credit bubble.....

All of the rescue plans that have been introduced in Ireland or Greece thus far rest on the assumption that, with more time, the eurozone’s problem children could get their fiscal houses in order — and Europe could somehow grow its way out of trouble. But the fiscal austerity being offered as the “medicine” is turning out to be worse than the disease. It has exacerbated the downturn and unleashed a horrible debt deflation dynamic in all of the areas where it was reluctantly implemented.

‘Insolvent’ Portugal Needs Loans Soon, Buiter Says. Bloomberg.

“Despite the recent drama, we believe we have only seen the opening act, with the rest of the plot still evolving,” Buiter wrote. “Accessing external sources of funds will not mark the end of Ireland’s troubles. The reason is that, in our view, the consolidated Irish sovereign and Irish domestic financial system is de facto insolvent.”

Why the Irish crisis is such a huge test for the eurozone. Martin Wolf, FT.

So what, against this background, needs to be done by individual countries and the eurozone? Not what was done in Ireland, is one answer. The Irish banking system is worse than too big to fail; it is too big to save. The first duty of the state is to save itself, not to load its taxpayers with obligations to rescue careless lenders. If the eurozone is not a “transfer union”, that has to work both ways: taxpayers of one state should not rescue those of others from having to save their banks from their follies.

The Irish state should have saved itself by drastic restructuring of bank liabilities. Bank debt simply cannot be public debt. If bank debt is to be such debt, bankers should be viewed as civil servants and banks as government departments. Surely, creditors must take the hit, instead.

That leaves the sovereigns. What is needed here, as eurozone leaders recognise, is a combination of generous funding with restructuring: the former is to reverse self-fulfilling panics; the latter is to recognise the realities of insolvency. Managing this combination would be very tricky.

Endgame. Eurointelligence.

The EU’s credibility is sinking with each agreement. We are now fast approach default time... We at Eurointelligence consider a default of Greece, Ireland, and Portugal a done deal. The question is only now whether Spain can scrape through.

Can the eurozone afford its banks? Robert Peston, BBC.

For Europe's very biggest banks, the ratio of their assets to their equity capital is 50% greater than for the UK's banks and 100% in excess of the so-called leverage ratio of big US banks, according to Bank of England calculations. Or to put it another way, Europe's giant banks appear to be taking far bigger financial risks than US and UK banks in relation to the reserves they retain as protection against potential losses.

So here's the big question. O'Neill may well be right that a reformed, integrated eurozone could cope with the aggregated sovereign debts of its members. But it is altogether another question whether even Germany could afford to underwrite the liabilities of the eurozone's monster banks, if creditors started to seriously question whether those banks have sufficient capital.

If Ireland doesn't take the bailout. Gonzalo Lira.

the problem in Ireland really isn’t so much the state’s deficits—rather, it’s the state’s guarantees of the Irish banks. That is what led to this mess. Yes, the Irish public sector is bloated, but it’s the banks that are busting the fiscal budget.

The Irish government allowed the banks to grow too big for too long, and to get mixed up in too many dicey deals—and so when the crisis hit in 2008, instead of letting them fail, Brian Cowen and his Fiana Fáil government backstopped those banks.

Much like in the United States in 2008, the Irish confused an insolvency issue with a liquidity issue. They thought their banks were having a cash crunch, when really, they were broke.

Cowen is reaping what he sowed: Even if the 2008 crisis had been a cash crunch and not an insolvency issue, Cowen never should have backstopped those banks—not when their combined liabilities were twice the GDP of Ireland...

Right now, the Irish people know that they are footing the bill so that British, German and American banks don’t suffer for having been foolish enough to be caught with Irish bank bonds. Rightfully, the Irish people are pissed.