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from The Great Debate UK:

Germany should be happy to let Greece go

When the Greek crisis began, there was much talk of contagion as the greatest short-term risk. In my view, this worry is almost irrelevant because bondholders are in any case facing a haircut of over 70%, so the question of default or bailout is now merely a technical detail.

From a longer term perspective, there is also little reason for the Germans to panic over a Greek default, even if it ultimately leads to the disintegration of the euro zone. The line peddled by a number of commentators and politicians that Germany has “done very well out of the euro zone” begs the question of how well it would have done without the euro zone, a question to which I do not know the answer – but nor does anyone else.

The implicit or explicit claim is that, with floating exchange rates, German trade would have suffered as the DM appreciated against the currencies of its neighbours. This is nonsense, a case of how, in the world of popular economics – what one colleague famously called D-I-Y economics – exchange rates occupy a position of exaggerated importance (If those who study the subject were given the same importance, I’d have had a peerage by now).

If exchange rate appreciation were so damaging and depreciation so beneficial to a country’s trade, the Swiss would by now be the poorest country in Europe and the Italians the richest. The reality is that, while there may be short term dislocations, the effect of changes in the value of a currency are ephemeral. Devaluations are self-defeating because they push up costs until the country’s terms of trade are back where they started, and the opposite for appreciations: a rise in the value of a country’s currency makes its imports cheaper, reducing its inflation rate and restoring its competitiveness as time passes. The process of adjustment seems to take some six or seven years, which might seem a window of opportunity worth seizing for opportunistic devaluation. The fly in the ointment, however, is that the more rapidly a currency depreciates, the more agents in the economy wise up and start anticipating the next depreciation, speeding up the adjustment and thereby narrowing the window of opportunity for exporters.

In other words, exchange rate flexibility smoothes the road, but does nothing whatever to change the destination. Moreover, the effect of exchange rate changes is smallest for countries with the most efficient labour markets, which includes Germany ever since its reforms of ten years ago, so there is every reason to suppose that it would adjust quickly anyway, just as it did in the 1970’s and 1980’s when the DM rose in value almost continually without seriously damaging the country’s competitiveness.

As far as Greece is concerned, making it competitive inside the euro zone will require a so-called internal devaluation – mainly a reduction in wages – whereas outside the euro zone a relaunched drachma could be allowed to float downward. The only difference is that in the former case, Greek workers will have to get by on fewer Euros than they have been used to, whereas outside the euro zone they would be paid in devalued drachmas, which would mean a cut in their living standards of the same order of size (is there such a thing as a Hobson’s Choice between Scylla and Charybdis?).

For Germany (and for the rest of Europe, including Britain), the real danger is that euro zone disintegration might be followed by the collapse of the single market, the only truly valuable component of the EU edifice. As a nation very reliant on its external trade, Germany needs market access – no reasonable person wants to go back to a world of protectionism, quotas and  non-tariff  barriers to trade, but it is an ever-present threat as populist politics take hold in Europe. But even then, the German carmakers have demonstrated in the last couple of years how capable they are of compensating for sales lost in Europe by higher volume in the emerging markets of Asia and Latin America, and there is every reason to suppose that the formidable German capital goods sector will prove just as adaptable.

from Breakingviews:

EU needs contingency plan to handle Greek blow-up

By Hugo Dixon

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

The euro zone needs a contingency plan to handle a potential Greek blow-up. The latest game of brinkmanship being played in Athens will probably end in a fudge – that’s how such games normally resolve themselves. But if it doesn’t, Greece’s banks will go bust and the rest of the euro zone will need a plan to prevent a panic in its own banking industry.

The hardliners in Europe, led by Germany, have virtually lost patience because of the Greek government’s inability to deliver on its promises. The fact that the next tranche of bailout cash is supposed to be a super-sized 80-90 billion euros seems to have made the lenders even more determined to secure reforms to make the economy more competitive. This is serious money, after all. The Greek politicians, meanwhile, are reluctant to force the voters to drink any more unpleasant medicine - especially given that there could be a general election in April.

But is the rest of Europe really prepared to pull the plug? Doing so wouldn’t just mean that the Greek government would go bust, as it would be unable to pay a bond that comes due in March. It would also mean that the country’s banks, which are stuffed with their government’s debt, would go belly up.

If the Greeks were the only ones who would suffer from such a catastrophic bankruptcy, their partners could afford to hang tough.But such a scenario would probably provoke runs on banks in the rest of the euro zone - especially weak economies such as Portugal, Ireland, Spain and Italy. The European Central Bank would, again, have to ride to the rescue by flooding the system with liquidity.

Helping banks deal with an all-out panic wouldn’t be easy. After all, the ECB is only supposed to provide liquidity in return for adequate collateral. And, in some cases, banks have run out of such eligible assets. This is why the ECB has already authorised national central banks to provide so-called emergency liquidity assistance to their country’s banks in return for lower quality collateral.

from Global Investing:

Base, worst and best case scenarios from Coutts

UK private bank Coutts (established in 1622, the year of the Glencore Massacre and two years before the Bank of England was founded) has been very bearish.

It still attaches a high, 25 percent chance to a partial or complete euro zone breakup and has been recommending its investors to position very defensively.

The chart below shows their base-case assumptions of S&P 500 index at 1,300 (about 3% below the current level), along with best and worst case scenarios.

"Our base-case scenario – where the euro zone manages to hold together this year while experiencing a mild-to-normal recession – sees fair value for the S&P 500 at around 1300, with a possible trading range of 1170 to 1430," Coutts says.

"However, within our base-case scenario we expect periods when euro zone crisis fears flare up and a break-up gets partially priced in, although ultimately avoided."

During these uncertain times, like last September, VIX could go up to 47, which would imply a potential decline in U.S. equities of roughly 10% from current levels. This in turn would create an opportunity to add to U.S. equities at good value.

from Breakingviews:

A Van Winkle return to Davos and to real problems

By Rob Cox The author is a Reuters Breakingviews columnist. The opinions expressed are his own.It was well past midnight in late January 2000 when an investment banking contact called my Davos hotel room to share the latest details on Vodafone’s hostile bid for Mannesmann. That was news, but the huge hostile takeover was no longer the largest deal in history. It had been displaced a few weeks earlier by the agreed merger of AOL and Time Warner. Such was the talk of the World Economic Forum. The great and the powerful had gathered together to celebrate the success of business and, especially, of finance.

Exuberance over technology and venture capital was almost limitless back in 2000, thanks to the seemingly limitless rise of the tech stocks. Dotcom startups were all the rage. When Japanese Internet mogul Masayoshi Son finished one panel, he was assailed by a gaggle of entrepreneurs waving business plans for him to peruse. In full disclosure, this columnist two weeks later signed up to establish the online financial commentary business that eventually became Reuters Breakingviews.

Coming back to this gathering 12 years later is a Rip Van Winklerian experience. The old world and its little worries look positively quaint. Back then, at what in retrospect proved to be the height of the Great Moderation, business was booming, the Nasdaq still had another 20 percent or so to climb, companies were merging like mad; everything looked rosy. President Bill Clinton parachuted in to give a victory lap. Even the demonstrations that took place against neoliberalism and world trade now look quaint. Defacing a McDonald’s is a far cry from overthrowing governments.

The economic moderation turned out to be built on financial excess. That AOL deal – hailed as visionary by all the delegates of 2000 – has become the poster child for foolish corporate finance. The Nasdaq is a third lower than 12 years ago (before adjusting for inflation). And the banks – what can I say? From triumph to tribulation.

The political world also looks much more treacherous. Geopolitics has not yielded to the irresistible forward march of free market capitalism, and peace no longer looks like something to be taken for granted. The 9/11 attacks spawned wars in Afghanistan and Iraq – the kinds of conflicts that in 2000 were supposed to be a thing of the past.

The World Economic Forum has changed with the times. The rise of the BRICs has brought greater diversity to the audience, which is a good thing. It has also brought many more people – so many, in fact, the organizers have expanded their caste system. There is now a dizzying number of different badges, each offering differing levels of access and status. It’s much easier to be here and still be excluded from the elite – much like the feeling of many of the world’s dispossessed.

The most striking difference, though, is in the increased complexity and severity of the questions confronting the collection of top business people, politicians, investors and academics. Europe’s sovereign debt crisis keeps trundling forward, bringing to the fore thorny challenges to sovereignty, the role of central banks and the solvency of nations. Instead of Clinton smiling from the podium, this year’s keynote address came from the troubled German Chancellor Angela Merkel, the leader with the most cards at the debt crisis table.

from Breakingviews:

2012: another year of living euro-dangerously

By Ian Campbell The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Fear of euro zone breakup became the world’s leading terror in 2011. That calamity can be avoided in 2012, even if the zone may well shrink later. This year’s global question is whether the world can keep growing while Europe ails. Probably it can, but uneasily.

Evolution of the European crisis will again drive markets in 2012. Italy may provide the year’s first big test. The euro zone’s third-largest economy has over 200 billion euros in debt to refinance and currently faces 7 percent yields despite some European Central Bank bond buying. The risk of a blowout in spreads is high.

The markets fancy the easy option to avoid that: large-scale bond buying by the European Central Bank. Germany, and the ECB, are reluctant. Such purchases are against the ECB’s rules, might encourage debtors to soft-pedal on fiscal and structural reform and could bring future losses to the ECB and its member central banks. The Dutch central bank has put provisions aside for that very purpose.

Germany and the ECB think euro zone governments should support their peers, using funds raised through the EFSF or ESM or obtained from the IMF. But this route has a blatant cost, burdening core economies that are at risk themselves of ratings downgrades – as France currently laments.

The best option is the simplest – Italy, a rich country which has long had excessive debt but also has high private savings, should help itself more. The proposed spending cuts of the new Italian government of Mario Monti amount to only about 2 percent of GDP over three years, less than Ireland is contemplating in one year. It might take a financing emergency in 2012 and a passive ECB to push Italy towards tough but fruitful change.

Even Italian progress would leave Europe with continuing serious problems. In the euro periphery of Portugal, Ireland, Greece and Spain, the problems have different roots: deficits and debts have worsened since formation of the euro. Despite one bailout, Ireland has among the worst public finances in Europe. It will need more help. The other three have large fiscal and trade deficits, look uncompetitive and may need external support for years. Supporting the periphery will test Europe. Years of austerity will test the periphery. Eventually one or more of these economies may leave the zone – and creditors – behind. But the euro itself should survive.

from James Saft:

Europe ignores credit dynamics

James Saft is a Reuters columnist. The opinions expressed are his own.

Europe's rule-based approach to fiscal reform will fall short because it effectively ignores the dynamics of credit markets, which laid the tracks along which this train wreck traveled.

Europe moved last week to impose some discipline on its member states' fiscal houses, choosing a rule-based fudge rather than the fiscal union that a common currency probably ultimately needs. It will thus take discretion away from member states, pre-committing them to austerity measures during tough times, while doing very little to address the malfunctions in the banking system which create destructive credit bubbles in the first place.

Reforming Europe's fiscal framework without addressing the financial system which created all of the credit is like having alcoholics take ever more severe pledges of sobriety and penalties but still allowing them to own cocktail lounges.

To be sure, some sort of reform is welcome. The past decade has provided ample evidence that the previous framework was easy to game for states without sufficient discipline.

That said, while the shambolic arrangements of the euro zone have hamstrung attempts to react to the crisis, the means by which euro zone states got themselves into trouble are varied.

There is, however, one common denominator - a credit bubble was a necessary precondition to the borrowing which now leaves various European sovereign borrowers suspect.

from Lawrence Summers:

It’s time for the IMF to step up in Europe

By Lawrence Summers The opinions expressed are his own.

European leaders will meet today for yet another “historic” summit at which the fate of Europe is said to hang in the balance. Yet it is clear that this will not be the last convened to deal with the financial crisis.

If public previews from France and Germany are a guide, there will be commitments to assuring fiscal discipline in Europe and establishing common crisis resolution mechanisms. There will also be much celebration of commitments made by Italy, and a strong political reaffirmation of the permanence of the monetary union. All of this is necessary and desirable, but the world economy will remain on edge.

Given that Europe is the largest single component of the global economy, the rest of the world has a stake in helping to avoid major financial accidents. It also has a stake in aiding continued growth in Europe and ensuring that the European financial system supports investment around the world – particularly as cross-border European bank lending dwarfs that of banks from any other region.

Now is also a historic juncture for the International Monetary Fund. The focus of the policy response to the crisis must now shift from Brussels and Frankfurt to the IMF’s boardroom.

From the problems of the UK and Italy in the 1970s, through the Latin American debt crisis of the 1980s, the Mexican, Asian and Russian financial crises of the 1990s, the IMF has operated by twinning the provision of liquidity with strong requirements that those involved do what is necessary to restore their financial positions to sustainability. There is ample room for debate about the precise policy choices the fund has made in the past. But, the IMF has consistently stood for the proposition that the laws of economics do not and will not give way to political considerations. At key points the IMF has offered prescriptions, not just for countries in need of borrowed funds, but also for those whose success is systemically important for the global economy.

Christine Lagarde, the head of the IMF, highlighted the seriousness of problems in Europe to members of the international financial community assembled in Jackson Hole in August. She pointed to capital shortfalls in the European banking system and the need for adjustment to be carried on in ways that were consistent with continuing growth. Now, the IMF needs to speak and act on several fronts.

from Global Investing:

Deutsche’s investment themes for 2012

We just finished our three-day Reuters 2012 Global Investment Outlook summit in London, New York and Hong Kong, where prominent money managers have discussed their outlook for next year. (For more click here)

Deutsche Bank Private Wealth Management (whose official was also a guest at the summit) is telling its clients the following 10 investment themes for next year.

1. Safe may not be safe Don’t react to uncertainty by automatically taking refuge in traditional safe havens such as cash, sovereign bonds, real estate or precious metals as they may prove less safe than they appear.

2. Walk before you run Build up holdings gradually, first focusing on “equity lite” type holdings

3. Ready, steady... go? When we get some clarity on euro zone resolution, not only equities and bond markets will start to have a different momentum.

4. Be nimble, but with a safety net Consider resorting to regular, dynamic portfolio rebalancing to adjust to economicand market developments.

5. Reason should dominate emotion Avoid an emotion-driven response that is likely to result in wrong investment decisions, andwrong timing, and make sure that reason always dominates the decision-making process.

from Breakingviews:

UK banks need government to solve funding squeeze

By George Hay The author is a Reuters Breakingviews columnist. The opinions expressed are his own.The Bank of England is tooling itself up. The UK central bank announced on Dec. 6 a new facility to help domestic lenders if the euro zone crisis causes a fully-fledged freeze in short-term funding markets. But banks may still need more help.

The BoE already has two ways to combat liquidity squeezes. It allows banks to borrow against liquid collateral for three or six months through its Indexed Long-Term Repo (ILTR) auctions. And it allows desperate banks to swap illiquid collateral for gilts for up to a year via its Discount Window Facility (DWF) – in return for a fat fee and big haircuts.

In some senses, the new Extended Collateral Term Repo facility (ECTR) is a halfway house. It uses a similar auction structure to the ILTR but allows banks to pledge DWF-style collateral for a minimum fee of 125 basis points over the BoE’s base rate. As such it goes some way to filling the gap left by the now-defunct Special Liquidity Scheme (SLS), the crisis facility which allowed UK banks to swap illiquid mortgage-backed securities for liquid Treasury Bills for a period of up to three years.

However, the ECTR will only last for thirty days at a time. That may help avoid a collapse, but won’t provide much long-term reassurance. Contrast the BoE’s approach with the European Central Bank, which is currently being pressured to offer facilities that last for two or even three years. Even though the UK is not in the euro zone, its banks are suffering from the same long-term funding drought as their rivals on the continent. That’s worrying because, according to the BoE’s own figures, UK lenders have to roll over 140 billion pounds of term funding next year.

But the central bank has rightly judged that providing long-term bank funding is not its job. That is a task for the UK government, which could re-open its Credit Guarantee Scheme, a 250 billion pound programme that allowed banks to weather the 2008 crisis by issuing new long-term debt insured by the state.

Unlike many European countries, a UK sovereign guarantee still carries credibility – 10-year gilts are currently yielding just 2.3 percent. Now that the BoE has donned its fire-fighting kit, HM Treasury should tool up as well.

from Breakingviews:

Governments are now world’s financial engineers

By Antony Currie and Agnes T. Crane The authors are Reuters Breakingviews columnists. The opinions expressed are their own.

The last financial crisis was supposed to have killed off financial engineering. It certainly seems to have for the most part turned excess leverage and overly complex borrowing structures into a pariah. But Western authorities have embraced them with gusto.

Recent responses to the mess in Europe provide the latest examples. The European Financial Stability Facility, or EFSF, plans to employ a design that mimics credit derivatives, something European leaders have publicly skewered the private sector for using, to help the fund get a bigger bang for its buck. But with the future of the euro zone up in the air, engineering can’t make up for investor skepticism. The fund may raise just 700 billion euros, barely a third of the most optimistic earlier estimates.

Greece’s bailout, meanwhile, offers a sleight of hand to make investment bankers proud. The current package secures a manageable interest rate for the country, but only by forcing it to invest a chunk in safer bonds than its own.

In fact, many policy responses since the bust have been built with tools used during the heady bull-market days. In 2007, U.S. Treasury Secretary Hank Paulson wanted to relieve banks of problems caused by structured investment vehicles by creating a Super-SIV to mop them up. It never got off the ground.

Later efforts to help banks offload dodgy assets or fund new deals - PPIP and TALF, for example - required elaborate architecture and large doses of debt. They ended up being much smaller than initially touted.

The U.S. government has even adopted the worst of private-market practices in subprime mortgages. Not only does the Federal Housing Administration require minimal down payments, it has piled on leverage. Its capital reserves are just 0.24 percent, a staggering 417-to-one ratio that makes Bear Stearns and Lehman Brothers look ultra-conservative.