Felix Salmon

Addressing Europe’s risks

By Felix Salmon
May 30, 2012

What exactly does the EU’s José Manuel Barroso mean, when he says today that the EU should move towards “a full economic union”, which would include “a banking union with integrated financial supervision and single deposit guarantee scheme”? In a simultaneous EC report, there was also talk of “direct recapitalization by the ESM (European Stability Mechanism)” when banks run into solvency issues.

The big idea here is simple, and relatively easy to understand. Banks in Europe’s peripheral countries, most importantly Spain, are understandably seeing their deposits move to countries like Germany, where there’s no risk of devaluation. But that kind of a slow bank run — Mohamed El-Erian calls it a “bank jog” — inevitably weakens those banks’ balance sheets, and the straitened PIIGS governments are in no position to shore up their banking systems with billions of euros in bailout money.

Here’s Mohamed’s suggestion, which seems to be extremely close to what the EC is now signing on to:

An incredibly disruptive situation could be avoided if Greek depositors were given quick access to a region-wide (as opposed to just national) deposit insurance scheme that is unambiguously supported by the fiscal authorities in the strongest eurozone countries. This would need to be coupled with even larger liquidity support from the European Central Bank, along with direct capital injection into the Greek banks from regional funds (e.g., the European Stability Mechanism, or ESM) and multilateral institutions (namely the International Monetary Fund).

I have a funny feeling that this is exactly what’s going to happen, but that implementation is going to be carefully timed so that it happens after Grexit, and not before. First you wait for Lehman Brothers to go bankrupt, then you give investment banks full access to the Fed discount window.

The problem is that deposit-guarantee schemes need to be tested before they’re trusted. Even with an EU-wide guarantee in place, at the margin German banks are always going to be safer places to put your money than Irish banks — and of course a guarantee would only cover relatively small six-figure retail deposits, it wouldn’t cover the huge corporate cash balances which only the most foolish of corporate treasurers would still consider leaving on deposit at, say, Bankia.

All of which is to say that although the degree of risk and uncertainty in Europe is high and can come down, there’s also a limit to how far it can come down. As Walter Russell Mead masterfully explains, Europe’s politics — much of which are playing out at the national level within multi-nation states — will inevitably and fatally trump whatever theoretical economic union the Eurocrats attempt to put in place. And because that risk is now so clear, the one thing that no one has to worry about is the kind of complacency where enormous systemic risks build up quietly without anybody noticing or worrying about them.

That’s the point that Nassim Taleb was trying to make in his Montreal speech yesterday — a speech which got reported by Bloomberg as simple investment advice. I know Nassim reasonably well, and I can promise you that he would never say that he “favors investing in Europe over the US” — he has nothing but disdain for anybody who makes such grand and stupid pronouncements. He would be happy, however, to reprise the theme of of his Foreign Affairs article last year, on the subject of “How Suppressing Volatility Makes the World Less Predictable and More Dangerous”. Clearly, the US is much better at suppressing volatility than Europe is, right now.

That essay has disappeared behind a paywall now, but I excerpted a bit of it here:

A robust economic system is one that encourages early failures (the concepts of “fail small” and “fail fast”)…

Consider that Italy, with its much-maligned “cabinet instability,” is economically and politically stable despite having had more than 60 governments since World War II (indeed, one may say Italy’s stability is because of these switches of government).

During the global economic crisis, the US was happy to see many more domestic bank failures than Europe was — and on top of that was happy to put its big automakers into bankruptcy. Those decisions served America well. Now, Taleb’s saying, the tables are turned: the volatility in Europe has become unavoidable, while the US appears to be a beacon and a safe haven. And whenever you achieve safe-haven status, the short-term benefits (the 10-year Treasury bond now yields just 1.65%, which more or less amounts to the markets begging the US government to borrow more) are always offset by hidden tail risks which tend to bite very hard indeed when they finally materialize.

None of which, of course, is or should be taken as investment advice. A long-Europe, short-US trade would be highly risky right now, with a greater-than-even probability of losing money. Now back in his trading days, Taleb specialized in putting on trades with a greater-than-even probability of losing money: he reckoned those trades were generally underpriced, and that the amount you made in the minority of cases where the bet paid off could more than cover the amount you lost in the majority of cases where it didn’t. But Taleb’s not a trader any more, and in any case none of that kind of sophistication made it into the Bloomberg article.

If you want a safe place to put your money, the conventional wisdom remains correct: Germany and the US are definitely safer than Spain and Greece. Nassim’s new book isn’t going to help you find a new, undiscovered safe haven. But it might serve to remind you that the stronger you think a political economy is, the more violently it tends to break.

4 comments so far | RSS Comments RSS

Taylor Cowen is also pointing out the political vacuum at European Level (http://www.nytimes.com/2012/05/27/busin ess/economy/in-the-euro-zone-a-lethal-va cuum-economic-view.html)

No doubt politics in Europe has returned to ‘national level’. Given that Italy does sound attractive despite multiple governments. I think French will be able to pull through in any eventuality as well as Germans for no doubt.

Spain is an issue and the real issue there is fissures within regions and unhealthy relationship with the Madrid center. This is a great opportunity for the federal gov. to enforce some discipline here; but again as Greece shows – unless People themselves are convinced of it, it is not going to happen. Meaning Spaniards (especially Basque & Catalina residents) need to realize the value of co-operating with the federal gov. That is why any outside investor would be hesitant here.

Meanwhile with Greece, Felix is right – El Erian plan would indeed come only after ‘Greece exit’ and that is how it should be. With SYRIZA, Greece is on one of the most dangerous political paths – you can always have ‘free ride’. That is dangerous for any conglomeration of nations and now is the time to call ‘bluff’ of that. That is where ‘decisive leadership’ of nations of Europe will be displayed – Germany in particular along with rance & Italy. Spain is lot on the receiving end to provide any heft. Italy gets that heft because of Monti. The longer he stays, better for Italy and better for Europe.

As Hugo Dixon rightly said (http://blogs.reuters.com/hugo-dixon/201 2/05/28/hugo-dixon-greece-needs-to-go-to -the-brink/); we need SYRIZA and that whole mentality ‘buried’ fully for Greece or Europe to rise again.

So I would say the bet to go long on Europe will be the moment when Germany and Europeans have kicked out SYRIZA led Greece. (I doubt Greeks would have wisdom to dodge the bullet of SYRIZA.) Sure, some uplift would erode the profit then; but then the chance of ‘knife falling down further’ is lot less at that point.

For Taleb to point importance of volatility is the logical expression of his Philosophy so far. This is marvelous and great that folks recognizing all these things so explicitly. The only point I would add to Taleb analysis is he may be downplaying the ‘uncertainty’ indicated by John Boehner when he thundered debt dram redux. Never underestimate the potent formulation of Ryan-Romney-Boehner-Tea Party to rock America’s Economy. That will be almost certainty if Obama gets re-elected.

Posted by umeshgeeta | Report as abusive

Only thing is I would not be surprised to see Spain forced out before Greece, such is the predictability of crises.

Posted by MyLord | Report as abusive

In Barroso’s idea, doesn’t integrated financial supervision just become the next Euro-wide scheme that breaks down due to political pressure?

It’s easy to foresee the political uproar if/when largely foreign bank regulators tell Portuguese banks that they have to risk-rate Portuguese government bonds as riskier than German government bonds, or express concerns about amend and extend policies of a bank toward one of its country’s national champions, or have regulatory concerns about aggressive lending in a country’s overheated property market, etc. Basic banking regulation will soon fall apart as politics require regulators to pretend that every country should be treated the same.

Posted by realist50 | Report as abusive

@umeshgeeta; Greetings from Sparta,

All those words just to describe a EU Ponzi Scheme Fiasco. Be warned, all 300 of us are marching north.

Posted by GMavros | Report as abusive

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