Felix Salmon

Why Richard Koo’s idea won’t save the Eurozone

Felix Salmon
Apr 16, 2012 23:13 UTC

A lot of people were looking forward to Richard Koo deliver his paper at INET last week; it comes with associated slides, here. Koo is the intellectual father of the idea of the balance-sheet recession — an idea which was born in Japan, has increasingly been adopted in the US and the UK, and which is now gaining traction in the Eurozone.

Koo’s diagnosis that Europe is in a balance-sheet recession, which he defines as a post-bubble-bursting state of affairs where individuals and companies choose to pay down their debts rather than borrow money, even when interest rates are at zero. That certainly seems to be the problem in Spain; Koo’s charts can be hard to read, but what you’re seeing here is a massive borrowing binge by the Spanish corporate sector — the dark-blue line — suddenly turning into net savings after the crisis hits. And to make matters worse, Spanish households — the red line — did exactly the same thing. As a result, the government had to run a massive deficit after the crisis; the four lines always have to sum to zero.


In this kind of a recession, monetary policy — reducing rates to zero — doesn’t work. And tax cuts don’t work either: they just increase household savings. You need government spending, at least until the economy has warmed up to the point at which companies and individuals start borrowing again. And the good news is that in a balance sheet recession, government spending is pretty much cost-free, since interest rates are at zero.

That’s the good news in Japan and the US and the UK, anyway. But it’s not the case in Spain. This is a big problem with the single currency, as Koo explains: it encourages capital to flow in exactly the wrong direction.

When presented with a deleveraging private sector, fund managers in non- eurozone countries can place their money only in their own government’s bonds if constraints prevent them from taking on more currency risk or principle risk.

In contrast, eurozone fund managers who are not allowed to take on more principle risk or currency risk are not required to buy their own country’s bonds: they can also buy bonds issued by other eurozone governments because they all share the same currency. Thus, fund managers at French and German banks were busily moving funds into Spanish and Greek bonds a number of years ago in search of higher yields, and Spanish and Portuguese fund managers are now buying German and Dutch government bonds for added safety, all without incurring foreign exchange risk.

The former capital flow aggravated real estate bubbles in many peripheral countries prior to 2008, while the latter flow triggered a sovereign debt crisis in the same countries after 2008. Indeed, the excess domestic savings of Spain and Portugal fled to Germany and Holland just when the Spanish and Portuguese governments needed them to fight balance sheet recessions. That capital flight pushed bond yields higher in peripheral countries and forced their governments into austerity when their private sectors were also deleveraging. With both public and private sectors saving money, the economies fell into deflationary spirals which took the unemployment rate to 23 percent in Spain and to nearly 15 percent in Ireland and Portugal.

With the recipients, Germany and Holland, also aiming for fiscal austerity, the savings that flowed into these countries remained unborrowed and became a deflationary gap for the entire eurozone. It will be difficult to expect stable economic growth until something is done about these highly pro-cyclical and destabilizing capital flows unique to the eurozone.

The solution to this problem is eurobonds. If all the eurozone countries funded themselves jointly and severally, then the yields on European government debt would be very low, and there would be no fiscal crisis in Spain.

But that’s not the solution that Koo provides to the problem that he quite correctly diagnoses. Instead, he said at the INET conference that the way to bring Spanish government bond yields down would be to massively decrease the number of people allowed to buy Spanish bonds.

This doesn’t make any sense to me at all. After all, in any market, the greater the number of potential buyers, the higher the price. But I’ll let Koo try to explain:

Eurozone governments should limit the sale of their government bonds to their own citizens. In other words, only German citizens should be allowed to purchase Bunds, and only Spanish citizens should be able to buy Spanish government bonds. If this rule had been in place from the outset of the euro, none of the problems affecting the single currency today would have happened.

The Greek government could not have pursued a profligate fiscal policy for so long if only Greeks had been allowed to buy its bonds, since private-sector savings in the country was nowhere near enough to finance the government’s spending spree…

The new rule will also resolve the capital flight problem by preventing Spanish savings from flowing into German Bunds. This will prompt Spanish fund managers facing private sector deleveraging to invest in Spanish government bonds, just as their counterparts in the US, UK or Japan must buy bonds issued by their own governments. That would allow Spanish government bond yields to come down to UK—if not to US—levels. With low bond yields and high bond prices, talk of a sovereign debt crisis would also disappear.

It’s absolutely true that a lot of Spanish fund managers, in a flight-to-quality trade, are buying up German and Dutch government bonds. It’s also true that Koo’s proposed rule would prevent them from doing that. But it’s emphatically not true that if they couldn’t buy German or Dutch government bonds, they would buy Spanish government bonds instead.

I asked Koo about this, in Berlin, and the conceptual problem quickly emerged. On the one hand, Koo is careful not to say that he wants fully-fledged capital controls preventing Spanish fund managers from investing abroad at all. He’s confining his proposal just to government bonds, and is not including corporate bonds, equities, structured credit, or anything else that Spaniards can currently invest in. But, he still thinks that this one rule would, single-handedly, take the 6% of GDP that the Spanish private sector is currently saving, and divert it directly into the Spanish government bond market, sending yields there plunging.

It wouldn’t.

The fact is that when money flows into US Treasuries or JGBs or Gilts during a balance-sheet recession, that has absolutely nothing to do with the fact that they’re government bonds, and absolutely everything to do with the fact that they’re the dollar- or yen- or pound-based securities with the lowest perceived credit risk. If you ban Spanish institutional investors from investing in Bunds, then they’ll just buy something else with extremely low credit risk instead — AAA-rated corporate bonds, perhaps, or covered mortgage bonds from somewhere in the north, or some other kind of highly collateralized structured credit instrument. None of those things might have quite the degree of liquidity that Bunds can offer, but they’re still safer than Spanish government debt right now.

Koo is absolutely right that the flow of savings out of Spain is doing absolutely gruesome things to the Spanish economy: you can’t possibly grow when your companies and households are paying down debt, and all your national savings are fleeing the country. So maybe there’s a case for fully-fledged capital controls. But Koo’s weak-tea version would only serve to decrease, rather than increase, demand for Spanish government bonds. Their price would go down, their yields would go up, and Spain would be in an even worse position than it’s in now.


Euro or dollar system doesn’t require the four figures to add up to zero. Under these currencies new money is created when new credit is created. This is called credit expansion. Conversely, under credit contraction the total amount of credit and therefore the total amount of money in the currency system decreases.

Therefore, when private sector chooses to pay back their debt ie. deleverage, there is no need for Gvt to step in and start to borrow. Unless of cource the policy makers don’t want the credit contraction to happen.

Posted by Eskola | Report as abusive

The Europe debate

Felix Salmon
Apr 10, 2012 01:00 UTC

Remember the Krugman vs Summers debate last year? That was fun, in its own way. But this year’s Munk Debate looks set to be simply depressing. The invitation has the details: the motion is “be it resolved that the European experiment has failed”. And I’m reasonably confident that the “pro” side — Niall Ferguson and Josef Joffe — is going to win.

That’s partly because Ferguson has the public-speaking chops to dismantle his meeker opponents, Peter Mandelson and Daniel Cohn-Bendit. Ferguson is likely to go strongly for the jugular, while Mandelson and Cohn-Bendit will noodle around ineffectually, hedging their conclusions and sacrificing rhetorical dominance for the sake of intellectual honesty.

You can see this, already, in the invite. Each speaker is introduced with a one-liner; Ferguson says that Europe is conducting “an experiment in the impossible”, while Mandelson says that Europe is, um, “getting there” and that the world is “very impatient”. Cohn-Bendit is weaker still: his quote, “We need a true democratic process for the renewal of Europe, in which the European Parliament has to play a central role,” seems to imply that Europe really is doomed, since there’s no way that the European Parliament is going to play a central role in anything, except perhaps an expenses scandal.

It wasn’t all that long ago that public intellectuals could make a coherent case that European union, both political and monetary, was and would be a great success story. In the wake of Greece’s default, however, and credible beliefs that Portugal is likely to follow suit, disillusionment and pessimism is the order of the day. The era of great European statesmen is over; in their place, we have David Cameron.

I was a believer in the European experiment; indeed, I thought it had a kind of grand historical inevitability to it, and that a strong whole could be made up of vibrant and disparate parts. And from a big-picture historical perspective, Europe is indeed a success: a bloody and war-torn continent has transformed itself into a political union where it’s unthinkable and impossible for one member state to invade another. But if by “the European experiment” we mean the euro, that’s been a disaster, and virtually everybody in Europe would have been better off had it never existed.

In this, curiously, the broad European population was much more prescient than the educated and political elites, who in large part imposed the euro on their unthankful and unwilling countries. Mandelson is a key member of that elite, and he was wrong about the euro and about the advisability of the UK joining it. It’s going to be very hard indeed for him to persuade an audience of Canadians that this time he’s right. Or, for that matter, that they should in any way welcome the prospect of a monetary union with Iceland.


Agreed, Fifth, that was PART of the subprime problem. Only the tip of the iceberg, though.

That Paul Mason report cites legitimate suffering, but consider the cause? Unemployment, divorce, unemployment. You can add medical bills to that list if you like. This story, at least, didn’t blame any of it on foreclosure. Rather, it is part and parcel of the greater recession/depression.

Europe definitely embraces a greater degree of socialism than the US — that is both your strength and your weakness.

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Why Europe’s crisis can’t be averted

Felix Salmon
Jan 26, 2012 11:59 UTC

I got a glimpse this morning of what Lance Knobel calls Davos’s “class distinctions, even if you have a white badge” — I was invited to a breakfast meeting under the auspices of something called the Industry Partnership Meeting for Financial Services. Which reminds me of that great line from In the Loop :

What you have to do is you’ve got to look for the ten dullest-named committees happening out of the executive branch. Because Linton is not going to call it “The Big Horrible War Committee”. He’s gonna hide it behind a name like “Diverse Strategy”, something so dull you’re just gonna want to self-harm.

This morning’s breakfast appears nowhere on the official Davos program, but because it was an exclusive by-invitation-only event, it managed to become by far the most high-powered session I’ve yet seen, with a large number of shiny-hologram badges and more big-name economists and central bank governors than you’d think possible. They came because this really was an interactive session, where they can talk in a serious and structured way with each other at a very high level.

This being the WEF, there was lip service paid towards the idea that a group of smart and powerful people, if you get them all in the same room, could come up with ways for the international community to improve the state of the world. But the actual participants didn’t show any sign of believing that: they were insightful with respect to diagnosing the state of the world, tentative in proposing solutions, and downright skeptical when it came to handicapping the likelihood that any of those solutions might actually be implemented.

And indeed there was a strong strain of thought which basically said that we already have the optimal level of international cooperation, and that more would not necessarily be better. Consider the two major currencies of the world: while the euro/dollar exchange rate has certainly been volatile over the course of the crisis years, it hasn’t moved as much in total as it did before the crisis, and there’s no sense at all in which we have had a currency crisis. To a very large degree, this is a function of successful international cooperation: the world’s major central banks all talk to each other regularly, and when they needed to do so they quietly and efficiently opened up unlimited swap facilities with each other. Those swap facilities didn’t cost money, in terms of government budgets, but they were an incredibly effective crisis-fighting tool.


Effectively, the unlimited swap lines have solved most of the global liquidity problems, and have prevented the otherwise very scary prospect that a liquidity run could become a self-fulfilling insolvency process. But that of course doesn’t mean that the world’s economies are all solvent. And so the question then arises: if you want to attack solvency rather than liquidity, is international cooperation (i.e., giving the IMF a massive fiscal bazooka) the best way to do so? And the answer there seems to be no. The biggest solvency problems are the problems within the Eurozone, and it is ultimately Europe’s job to get the necessary cash together if it wants to avert a series of fiscal crises.

Germany and other big northern European countries are running very large trade surpluses: they can remit cash to the periphery if they have the political will to do so. And if they don’t have the political will to do so, there’s no way in which the US, China, and the rest of the world can or should step in to try to save the likes of Greece and Portugal.

This kind of thinking is very much in line with the realism, or fatalism, which I’ve seen a lot of in Davos this year. If you control your own currency — if you’re the US, or China — then ultimately you control your own fate, and you only have yourself to blame if you go belly-up or suffer a major crisis. Certainly the rest of the world won’t come to your rescue. That’s one reason why China has such enormous foreign reserves: it needs them as insurance against a crisis. And it also explains why the yuan is not convertible, and there’s a waiting list of 800 companies who want to go public on Chinese stock exchanges but aren’t being allowed to do so: the Chinese government is keeping tight control of its economy and the way that its companies are financed, because once you lose that control, it’s impossible to regain.

In Europe, of course, the politics of transfer payments are much more fraught — and also much harder to understand. One very senior economist told me as we exited the meeting this morning that he too was decidedly unclear on the details of how TARGET2 works, even though he’s meant to be an expert on such things and he knew that it was crucially important. Similarly, while it’s surely very germane and important that the Bundesbank has more reserves than the ECB, what that means in practice is not at all obvious.

Politically, we still seem to be very far away from a fiscal solution to Europe’s problems, and the baseline scenario has to be that we’re not going to get one — ever. The result is likely to be a series of countries exiting the euro, and/or the “East Germanification” of much of Europe’s periphery: flows of money and human capital away from countries like Greece and Portugal, and towards the more prosperous countries with healthy economies and substantial trade surpluses. Essentially, those countries would become holiday resorts for the north, with all the real economic activity being concentrated in more prosperous nations. If you’re a smart young Spaniard, it’s much more attractive to seek your fortune in the UK than it is to take your chances in a deflating country with a stratospheric youth-unemployment rate.

Certainly there seems to be no belief at all, even among the well-intentioned technocrats at Davos, that coordinated international action will or should solve this particular crisis. And the inevitable conclusion is that the crisis is not going to be averted: it’s only going to get worse. It’s a very scary prospect — but one which it’s very important for global elites to come to terms with. And that’s exactly what they’re doing in Davos this week.


Enough with this misery. Europe has probably turned the corner. Fiscal consolidation is now well underway. See the IMF’s latest report on global fiscal developments:


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Greece’s endgame looms

Felix Salmon
Jan 18, 2012 01:02 UTC

The big deadline in Greece is March 20 — that’s when the country has a €14.4 billion bond maturing that it can’t afford to repay. So Greece and its creditors are playing chicken with each other right now. Both want to do a deal, which would involve a cash payment of about 15 cents on the euro being paid out by a rescue committee comprising the EU, the IMF, and the ECB. Existing bondholders would get shepherded into new debt which would be worth less than the old debt but at least would remain current, while Greece would avoid the parade of horribles associated with a “hard default”, with its banks retaining access to funding from the international community in general and the ECB in particular.

The logical outcome, then, is that a deal gets done — probably along the lines that Marathon Asset Management CEO Bruce Richards sketched out to Peter Coy today. Richards’s math is a bit hard to follow:

The new bonds will probably pay annual interest of 4 percent to 5 percent and have a maturity of 20 years to 30 years, Richards said. They may trade for about half of their face value, he predicted. Altogether, the net present value of the deal for the bondholders will be about 32 cents on the euro, he estimated.

This doesn’t add up: if face value is 50 cents on the euro, then half that would be 25 cents; add in 15 cents of cash, and you get a total of 40 cents on the euro, not 32.

Update: OK, I understand how the math works now. The headline 50% haircut includes the 15 cents in cash: it’s 35 cents in bonds plus 15 cents in cash for a total of 50 cents. If you value the 35 cents in bonds at 50 cents on the dollar, then the bonds are worth 17 cents; add that to 15 cents in cash, and you get a total of 32 cents. Note that Greece, in this scenario, is getting a 65% face-value haircut, rather than a 50% haircut, and is getting coupon relief as well — all in all, Greece is swapping bonds it issued at par for new instruments worth 17 cents on the dollar. Which is an 83% NPV haircut. You can see why the market might object to a haircut that big.

But either way, the market is saying that a deal along those lines isn’t going to fly. The March 20 bonds are currently bid at 42, offered at 44, and no one is going to accept a deal worth 32 cents or even 40 cents if you can just sell those bonds outright for 42 cents. And similarly, no one buying the bonds right now at 42 is going to accept any deal at 32.

And it’s much harder to reach a deal now than it was a few months ago, because many of Europe’s biggest banks have quietly sold their holdings of Greek debt to aggressive hedge funds.

Even if a deal is done, remember that the people sitting on the other side of the table are the IIF, the hapless and toothless trade body representing the big banks without really being able to commit them to anything. And if the IIF can’t deliver the banks, it certainly can’t deliver the hedge funds, which are much less susceptible to arm twisting moral suasion.

As a result, we’re not going to see all $14.4 billion of bonds tendered in to any exchange — and there’s an extremely high chance that there will be enough holdouts to trigger Greek CDS contracts. That’s not the end of the world, although many people seem to think it would be; Greece is defaulting, so it stands to reason that default swaps would be triggered.

My expectation is that there will be an exchange; that it won’t be particularly successful; that it will trigger CDS; but that all the same it will be good enough for the EU, which will stump up its €30 billion and keep the can going on its bumpy path down the road. A bunch of hedge funds will be left with a large amount of defaulted Greek debt, and will start all manner of litigation, which will go nowhere for the foreseeable future. And no, there’s no way that Greece will pay those hedge funds just so that it can avoid the CDS being triggered.

Richards will be fine: he’ll tender into the exchange, get the cash and the bonds he’s expecting, and probably sell them at a small profit. Banks who lent to Greece at par will have to take very large losses. And the holdouts will start complaining loudly about the sanctity of contracts to anybody willing to listen, which will be a very small group of people indeed.

Frankly, it’s taken much longer than I thought for the actual default to arrive — seeing as how it was clearly signalled by Greece as long ago as July. That default would have been positively painless compared to this one. But at least we have a date, now. Greece will officially default on March 20. The only question is whether the EU will continue to fund the country after that date. For the sake of the euro zone, we had better all hope the answer is yes.


Cmon… Greece and the EU will kick the can down the road. They changed the rules before, because they made the rules. They will change them again! Default is not a DEFAULT! no CDS, youre screwed!

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S&P downgrades Europe

Felix Salmon
Jan 14, 2012 03:27 UTC

S&P brought its hammer down on Europe today, with nine — count ‘em — downgrades of euro zone countries. The removal of France’s triple-A has been getting most of the headlines, but for me the bigger news is the fact that Portugal has now been downgraded to junk status.

Both of those moves, however, are pretty standard for ratings agencies in general and for S&P in particular: a slightly belated recognition of what has long been obvious to the rest of us. If anybody really thought that French sovereign debt was risk-free, or that Portugal, with its ten-year bond yielding somewhere north of 1,000bp north of Bunds, was investment grade, then they have surely been living under a rock for the past couple of years.

There’s one area, however, where S&P’s actions are going to have a significant and far from positive effect — and that’s the European Financial Stability Facility, or EFSF. The way that the EFSF is structured, its credit rating is particularly reliant on the ratings of the euro zone’s biggest sovereigns. Here’s how S&P put it back on December 6:

Based on EFSF’s current structure, were we to lower one or more of the current ’AAA’ ratings on EFSF’s guarantor members, all else being equal, we would lower the issuer and issue ratings on EFSF to the lowest sovereign rating on members currently rated ‘AAA’.

What this means is that Europe now faces a choice. On the one hand, it can restructure the EFSF so that it retains its triple-A credit rating. That would almost certainly involve shrinking the EFSF in size. Or, it can be sanguine about the EFSF downgrade and just let it happen. But that’s not a pleasant outcome either, given that everybody’s bright idea, when it comes to Europe’s sovereign bailouts, is to leverage the EFSF to some multiple of its present size. Leveraging a triple-A EFSF is hard enough; leveraging a double-A EFSF is pretty much impossible.

My guess is that the EFSF is going to get downgraded very soon — quite possibly on Monday. There’s actually not much point in Europe restructuring it so that it retains its triple-A: the political cost would be huge, and the benefit would be entirely hypothetical. (In theory, the financial markets are happy to lever up triple-A-rated assets. In practice, if those assets are European sovereign debt, not so much.)

Some small part of me thinks it’s a jolly good thing that the world is losing its store of triple-A assets. They’re dangerous things, precisely because we’re given to understand that they’re risk-free. But in this particular context, there are very few ways that today’s news can help Europe, and there are many, many ways that it can hurt. Not least when it comes to the amount of capital that Europe’s banks need to squirrel away against their stocks of sovereign debt.

Europe’s a risky continent; S&P is simply making that fact a little more obvious. In an ideal world, S&P’s opinions wouldn’t carry any more weight or importance than anybody else’s. But this isn’t an ideal world, and they do. And countries like France, which don’t control their own money supply, aren’t as immune to ratings-agency actions as the US turns out to have been.

The immediate ramifications of this announcement, in terms of global stock market reactions, aren’t important. And it’s even possible that if it accelerates the move away from the EFSF and towards the ESM, we could find a little bit of silver lining here. But the fact is that Europe is more fragile, now — more susceptible to changes in sentiment or genuine exogenous shocks — than it was yesterday. And that cannot be a good thing.


You have to wonder what people like ‘theyenguy’ did for an outlet before blog commenting came into widespread use. Were they the guys who liked to wonder around downtown with a sign reading “The End is at hand” and talking loudly to themselves like a paranoid schizophrenic?

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Can financial innovations help the eurozone?

Felix Salmon
Jan 10, 2012 22:13 UTC

For all that financial innovation has got itself a pretty bad name recently, there’s no shortage of people with bright ideas as to how to address the euro crisis. Robert Barro is one. He thinks the euro should be phased out entirely, and has a plan for how to do just that:

Germany could create a parallel currency—a new D-Mark, pegged at 1.0 to the euro. The German government would guarantee that holders of German government bonds could convert euro securities to new-D-mark instruments on a one-to-one basis up to some designated date, perhaps two years in the future. Private German contracts expressed in euros would switch to new-D-mark claims over the same period. The transition would likely feature a period in which the euro and new D-mark circulate as parallel currencies.

Other countries could follow a path toward reintroduction of their own currencies over a two-year period. For example, Italy could have a new lira at 1.0 to the euro. If all the euro-zone countries followed this course, the vanishing of the euro currency in 2014 would come to resemble the disappearance of the 11 separate European moneys in 2001.

Is this workable? It all depends, I think, on the degree to which contracts could and would be switched over to German law during the two-year period of parallel currencies. While many people might be happy to see their euros converted to Deutschmarks at a rate of one to one, many fewer would be happy to see their euros converted to lire at the same rate. Which means that there would have to be some serious coercion — and a lot of court cases, too — before people holding euro contracts in Italy were forced to see those contracts redenominated in lire.

So while Barro is correct that this approach would help solve the sovereign debt problem, by allowing the likes of Italy to simply print new money to pay off their debts, it would also be a legal nightmare, as every contract turned into a fight between creditor and debtor over which currency it should become. The creditors, of course, would all want the contract to become Deutschmarkized, while the debtors would probably all want their debts to be converted to drachmas at that one-to-one rate. Given that the whole point of European monetary union was that it would become a single monetary union, trying to break it up into 17 component parts is certain to be a legal and logistical nightmare.

Would it be easier, then, to come up with a clever way of keeping the eurozone together? Because Jed Graham has one of those: he calls it Safeguard bonds, which is actually an acronym: Sovereign Approvable First-loss EFSF-Guaranteed Upfront Automatically Recallable Debt.

Graham’s idea is not that easy to understand, so I called him up and asked him to explain it to me. Basically, if countries signed up for a fiscal austerity program, they would be allowed to issue a certain quantity of Safeguard bonds, which would be guaranteed by the EFSF. Then, if at any point they broke free of their fiscal constraints, they would have to pay down 10% of the bonds, immediately, in cash. If you held €1,000 in Italian Safeguard bonds and the country ended up borrowing too much money one year, then Italy would automatically pay you €100 for 10% of your holding, and you’d be left with €100 in cash and €900 in Safeguard bonds; failure to do so would constitute an event of default.

The idea is that this would act as a real fiscal constraint: if a country were to avail itself of this facility, it would then be in a position where any fiscal slippage would be very expensive — because it would have to borrow at a very high rate to make the bond payment. Meanwhile, the EFSF-guaranteed bonds would trade at much lower yields, because of that EFSF guarantee, and because, under Graham’s plan, the ECB would step up and guarantee all Safeguard bonds in the event that EFSF monies ran out.

Because Safeguard bonds would be long-dated and very cheap, countries would have every incentive to use them to fund their current deficits — and thereby lock in fiscal constraint for the next 30 years.

It’s an intriguing idea, but technically extremely difficult to put together — these things are a bit like reverse CoCo bonds, in that they actually punish the issuer when the issuer gets into trouble. And, of course, as such they’re extremely pro-cyclical, if they ever get triggered. If a country suffers a nasty recession and sees its tax revenues fall a lot, the Safeguard bonds would get triggered and it would have to find a lot of extra cash just when it could least afford it.

I’m reminded of a clever idea that the World Bank had in the between 1999 and 2001, called the Rolling Reinstatable Guarantee. It was meant to be a way for the countries that used it — Thailand, Argentina, and Colombia — to reduce their borrowing costs by putting in place a World Bank guarantee which would cover the next coupon payment. In the event of a default, the World Bank would have to make the coupon payment, the country would have to pay the World Bank (because the Bank is a preferred creditor), and then the guarantee would get reinstated. Rinse and repeat.

When put to the test in the Argentine default, however, the mechanism didn’t work. And in general whenever people attempt to solve deep economic problems with the application of clever financial ideas, they fail. The eurozone might break apart, or it might stay together. But either way, financial innovations like these are not going to make much of a difference.


Mr. Salmon is certainly correct to point out the danger of pro-cyclicality, but he regrettably (and unconstuctively) assumes that Safeguard bond triggers would have to be designed in a way that is extremely pro-cyclical, which would indeed be self-defeating.

As I note, the triggers built into the bond contracts would have to be designed with the utmost care in consultation with the IMF. The triggers (likely some combination of debt-to-GDP and fiscal balance) could be moving targets and would need to have some degree of flexibility built in based on economic conditions.

The technical challenge of setting appropriate triggers is not a minor one, but nor is it rocket science, and past experience such as the World Bank guarantee program Mr. Salmon references would inform the process.

The importance of the idea of Safeguard bonds is that it changes the discussion from a question of whether it is politically possible to provide an adequate lifeline to at-risk sovereigns to a focus on exactly how such a lifeline can be provided in a way that balances both political and cylical concerns.

Mr. Salmon also is off-base when he casts Safeguard bonds as an “attempt to solve deep economic problems with the application of clever financial ideas.”

Safeguard bonds address urgent political problems, not economic ones, though they could give troubled nations some breathing space to address their economic problems by bringing down interest costs while putting the monetary union on path toward a more workable fiscal union.

Mr. Salmon says casually: “The eurozone might break apart, or it might stay together.” Yes, but Safeguard bonds, by providing an answer to the political question of how the ECB can provide adequate (and somewhat proactive) support to stem the crisis, could avoid the potential of another nasty leg down and would improve the odds of long-run success.

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Where will the ECB’s billions go?

Felix Salmon
Dec 22, 2011 14:50 UTC

The market has had a full day now to digest the results of the ECB’s debt auction, and Floyd Norris, for one, is wildly enthusiastic about them. The ECB’s strategy, he writes, “may be enough to stem the European crisis for at least a few years, and go a long way to recapitalizing banks in the process”.

Norris’s bullishness is based on what you might call the Sarkozy trade — the idea that a huge amount of the ECB’s new lending will end up being invested in Eurozone government debt. He calls it “an obvious, virtually risk-free, option” for the banks who borrowed ECB funds:

It would be nice if some of it were lent to the private sector to spur growth and investment. But the logic of putting it in two- or three-year government notes is obvious.

Well, it’s not that obvious. Here’s the math: if you take all the new ECB money which entered the market yesterday and subtract out all the maturing ECB debt which needed to be rolled over, you end up with some €210 billion in new funds — a number which is startlingly close to the €230 billion of European bank debt which is coming due just in the first quarter of 2012.

And for the time being, the ECB is the only entity in the world willing to lend European banks €230 billion. Which means that the prudent course of action, for Europe’s banks, is to use this ECB money to pay down their own debts. Doing so would address a big funding risk, and would also help derisk their balance sheets in the eyes of the world and of Basel.

The big question, then, is how long the ECB is going to be doing this kind of thing. If this operation is a signal to the market that the ECB will be the lender of last resort to European banks for at least the next couple of years, then the banks don’t need to worry so much about their own financing needs and can lock up the funds in two- or three-year government bonds as Norris and Sarkozy anticipate. On the other hand, if this is more like Federal Reserve quantitative easing — something designed to be temporary rather than quasi-permanent — then banks will be looking to help themselves before they help others.

Gavyn Davies, for one, is clear on this point: “we should call a spade a spade,” he writes. “This is quantitative easing on a significant scale.” And he has the chart to prove it:


I suspect that the ECB is not going to be happy seeing this line rise indefinitely. The Federal Reserve’s balance sheet is bloated enough, after two rounds of QE, and it now stands at $2.85 trillion. The ECB is just getting started on this round — the next disbursal of 3-year debt comes in February — and already its balance sheet is well over $3 trillion and rising.

Greg Ip has been talking to the ECB, and has come back from a trip to Europe with a blog post saying that its lending is “eternal and infinite”. Which carries its own risks:

The longer Europe muddles through, the more banks’ demands on the ECB will grow. Even if the ECB can, legally, become the sole source of funding for peripheral euro-zone banks, is that sustainable politically? At some point won’t the leaders realise that lacking all private-sector confidence, their banks can no longer finance a growing economy? At that point, they will conclude the euro is not sustainable and prepare to exit, and the ECB’s limits will have been reached.

So there’s clearly a limit somewhere. If I were running a European bank, I’d fill up on ECB lending now, when it’s plentiful, because you never know for sure when that limit might be reached. That’s what happened yesterday. But I’d definitely think twice before turning around and lending it all back out again to Italy or Spain. Yes, that trade is a profitable one. But the one thing that European banks need more than anything else right now is liquidity. Profits come second.


Are we having 3 zero’s too many in the graph?

Posted by jmv2010 | Report as abusive

Why ECB lending won’t solve the euro crisis

Felix Salmon
Dec 17, 2011 20:18 UTC

“By this time next week,” says Simone Foxman, “the euro crisis could be over”; she obviously doesn’t think much of Fitch’s analysis, which concludes that “a ‘comprehensive solution’ to the eurozone crisis is technically and politically beyond reach”.

I’m with Fitch on this one. But it’s worth looking at the bull case for the eurozone, as spelled out by the likes of Foxman and Tyler Cowen. At heart, it’s pretty simple:

  1. The way to solve the euro crisis, at least for the next couple of years, is for the ECB to act as a lender of last resort.
  2. The ECB is, quietly, doing just that — specifically by lending money for as long as three years against a much wider range of collateral than it accepted in the past.
  3. Even though that money is going to banks rather than sovereigns, the banks will borrow as much as they can, at interest rates of about 1%, and invest the proceeds in Spanish and Italian debt yielding more like 6%, in a massive carry trade.
  4. Which means that the ECB is, effectively, printing hundreds of billions of euros and lending it to distressed European sovereigns after all.

This, at least, is how Nicolas Sarkozy has been spinning things:

“Italian banks will be able to borrow [from the ECB] at 1 per cent, while the Italian state is borrowing at 6-7 per cent. It doesn’t take a finance specialist to see that the Italian state will be able to ask Italian banks to finance part of the government debt at a much lower rate.”

But look at the headline of the article that quote appears in: “EU banks slash sovereign holdings”. Here’s a taster:

Europe’s banks have slashed their holdings of sovereign debt issued by the peripheral nations of the eurozone, selling €65bn of it in just nine months…

BNP Paribas cut its holdings by the most, shedding nearly €7bn of the sovereign debt of Greece, Italy, Ireland, Portugal and Spain and leaving it with €28.7bn as at end-September. Deutsche Bank’s €6bn reduction was by far the biggest in percentage terms (66 per cent) and left the bank with just €3.2bn of GIIPS exposure.

My feeling is that, at the margin, banks are going to continue to reduce their holdings of PIIGS debt, rather than decide to follow in the footsteps of MF Global. But don’t take my word for it:

Senior bankers say they will cut further, despite pressure to use newly available, longer-term ECB loans to buy government debt as part of an officially-sanctioned carry trade.

“When investors are constantly asking what you have on your books and the board is asking you to reduce your exposure, it doesn’t really matter about the economics of the trade,” said the treasurer of one of Europe’s biggest banks. “Am I going to buy Italian bonds? No.”

That view echoes comments from UniCredit chief executive Federico Ghizzoni, who this week told reporters at a banking conference that using ECB money to buy government debt “wouldn’t be logical”. The bank had traditionally been one of the biggest buyers of Italian government bonds, with almost €50bn on its books.

Cowen says that “public choice mechanisms will operate so that desperate governments commandeer their banks to make this move, whether the banks ideally would wish to or not” — and normally I’d be inclined to agree with him. Sovereign borrowing always crowds out other forms of bank lending, when a national government decides it really needs the money.

But in this case, it’s not going to happen. Why? For one thing, the main tool that governments can use has already been deployed: if banks load up on sovereign debt, it carries a lower risk weighting under Basel rules and therefore makes their risk-adjusted capital ratios look more attractive. But that’s been the case for decades now, and it can’t be beefed up at all. Meanwhile, bank regulators and investors are looking at a lot of other ratios too, like total leverage. And as we saw with MF Global, they’re hyper-aware of European sovereign exposures these days. Any bank wanting to be considered healthy will stay well away from Spanish and Italian debt.

On top of that, the financing needs of Spain and Italy are much bigger than their respective national banks can fill — especially in the context of those banks trying to deleverage, and seeing their deposit bases move steadily to safer European countries. While national governments are reasonably good at twisting the arms of their own domestic banks and forcing those banks to lend to their sovereigns, they’re much less good at twisting the arms of foreign banks and getting them to do the same thing. Is there any way at all for the Italian government to persuade French banks to lend to it? No.

And more generally, the national debt of big European sovereigns like Italy and Spain is so enormous that it has to be held broadly, in bonded form, by individuals and institutions. Banks alone won’t suffice. Greece is small enough that most of its debt can be held by banks. Italy, not so much.

There’s an argument that it doesn’t really matter whether the banks buy Italian and Spanish debt or not: the main thing that matters is that the ECB is printing money, which is entering the system via the banking system, and which will ultimately find its way into sovereign coffers one way or another, especially since there’s precious little demand for commercial bank loans these days. But I don’t buy it: there’s a virtually infinite number of potential investment opportunities around the world, and there’s no good reason to believe that the ECB’s cash is going to wind up funding Italy’s deficit rather than, say, getting invested in Facebook stock.

If Europe’s banks use ECB cash to deleverage and buy back their own high-yielding debt securities, the investors getting that money are not going to automatically buy sovereign bonds with the proceeds. Especially since those investors don’t care at all about Basel risk weightings.

So much as I’d love Sarko’s dream to come true, I don’t think it’s going to happen. The eurozone’s sovereign crisis is here to stay.



There are many who view the wonton printing of money as heresy. They call for the gold standard which by its very nature limits the money supply. There is a major fault with this argument: There is not enough gold to go around.

Think about what a central bank does. It creates (prints) money that facilitates transactions. As the economy grows, more money is needed. What is a sovereign bank to do? Tax the populace to get money to buy more gold so they can print more money? Not very efficient. And what is other countries have a gold standard? The accommodate everyone, the price of gold will go through the roof. This causes banks to impose more taxes to get the money to buy the gold…..

You get the idea. The gold standard is not the answer.

Posted by WallStreetDude | Report as abusive

Should we care about euro/dollar?

Felix Salmon
Dec 14, 2011 18:33 UTC

There’s a lot of chatter right now about the euro, which is now worth less than $1.30. That’s a reasonably big fall: it was as high as 1.3385 on Monday. But it’s worth keeping things in perspective. Here’s a five-year chart of EURUSD, or the value of one euro in dollars:


The main thing to notice here is the volatility: we’re basically back to exactly where we were five years ago, but we’ve had a very bumpy ride along the way. Going forwards, it seems sensible to expect that there will be more of the same: currencies going up and down in a fundamentally unpredictable manner.

The second thing to notice is how tiny a move from 1.33 to 1.29 really is, in the grand scheme of things. Is EURUSD volatile right now? Yes — but it’s been this volatile for years. There’s really nothing new or different or important going on.

The third thing worth noticing is that news reports nearly always talk in terms of currencies weakening rather than strengthening. If EURUSD goes down, then that’s always a reaction to the latest eurocrisis, whatever it might be. On the other hand, if EURUSD goes up, that’s never taken as a sign of strength in Europe: instead, we get bombarded by stories about the weak dollar, normally accompanied by doom-laden prognostications about the US economy.

For all that it’s a tempting narrative, however, currency moves should not be taken as some kind of market referendum on the health of a given economy. In the Wall Street Journal, Richard Barley has ventured that “the euro may now have become the main indicator of the depth of the currency bloc’s crisis” — but in truth there’s no good reason that should be the case. And it’s an unprovable assertion, too: the minute that the euro rises as the crisis gets worse, Barley can simply declare that something else has replaced it as the indicator to look at.

Let’s say that the eurozone is going to fracture, with weaker countries like Greece leaving the currency and returning to the drachma. Would that be good or bad for the value of the euro? It’s hard to tell. The rump eurozone would be stronger, and currencies can do pretty well during a crisis, depending on how the central bank reacts. After all, in the short term, currency flows are largely a function of interest rates, which are set by central banks: money goes to where it can earn the most interest.

And in the longer term, no one really has a clue what might happen. Four years ago, Bloomberg caused a global stir when it reported that supermodel Gisele Bundchen was insisting on being paid in euros, on the grounds that the dollar was simply a bad bet. The value of the euro back then? $1.45. And of course Bundchen looked smart, for a while — until the euro fell off a cliff a few months later.

Right now, there are similar stories doing the rounds about Metallica, who are reportedly bearish on the euro. They, too, are likely to look smart until they look stupid.

The main thing to remember here is that the European Union is still an economic powerhouse, with 27 countries pumping out trillions of dollars’ worth of domestic product every year. All those goods and services are worth real money, no matter what happens to the political union. And the European Central Bank is incredibly reluctant to print money, which means that the chances of the euro being eroded by inflation are even lower than the chances of the same thing happening to the dollar.

For the foreseeable future, then, we can expect the euro to rise and fall in its now-standard pattern of unpredictable volatility. If a period of the euro falling happens to coincide with a period of especial crisis in the eurozone, then we can also expect a spate of stories extracting spurious causation from a random correlation. And similarly, if a period of the euro rising happens to coincide with bad economic data in the US, then we’ll all be told that the dollar is weakening on a deteriorating growth outlook.

What does this mean for the 99.9% of us who don’t play the currency markets? If you’re an international traveler, then visiting Europe just got a bit cheaper. If you’re not, then you can probably ignore currency rates altogether. And if you’re concerned that the crisis in Europe is going to tip the world into another global recession, then if I were you I’d look at European interbank lending rates and sovereign debt yields to get an indication of how bad things are. The euro/dollar exchange rate is just too noisy to be able to tell you much of anything.


I’d also add that the value of a currency isn’t always enhanced when rates go up – the current strength of the Swiss Franc for instance when it climbed against most G20 currencies was to do with security and perceived risk (of other currencies). The interest rates are amazingly low for such a high value, and the press and corporates were complaining about if for ages before the SNB stepped in.

You are right to look at the strength of the underlying economy of a currency area, be it single country or zone, specifically whether that country or zone is a net importer or exporter. Net importers generally lose currency value over time, net exporters generally gain value over time, all else being stable.

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