The Great Debate UK

from The Great Debate:

The abyss and our last chance

By Carlo De Benedetti The opinions expressed are his own.

In a magnificent book published a few years ago Cormac McCarthy imagines a man and a child, father and son, pushing a shopping cart containing what little they have left, along a back road somewhere in America. Ten years earlier the world was destroyed by a nameless catastrophe that turned it into a dark, cold place without life.

There is no history and there is no future. But there is an objective: to head south toward the sea. Mythical places, only vaguely perceived, where there might be salvation. The father is getting older and is ever more weary. But he has the child with him. And he has his objective. He wants to take him southward to the sea. Toward a future that may still be possible.

Today, is the western economy, in particular the Italian economy, that world destroyed by an Apocalypse? Are we pushing that cart, containing the few things we have left, toward a mythical sea of which we know nothing, or even what it is like or where it is?

Re-reading the book I was tempted to think this. To think that those pages, written in 2006, were in some way a prophesy of what we are living through today. Never before has an entire productive system, our own, been so fundamentally questioned.

I have been convinced for some time now that the huge financial crisis of the last few years is the litmus test of a deeper crisis to do with the universal economic order that has lasted through the centuries, with a shift of the balance of world wealth toward new countries.

The euro zone marriage is over

By Laurence Copeland. The opinions expressed are his own.

Under the Arc de Triomphe, tourists can gaze up at the engraved list of Napoleon’s great victories: Austerlitz, Jena, Wagram… Perhaps a similar triumphal arch should be built in Brussels to commemorate the string of victories won by a tiny band of heroic Eurocrats over the mass of their combined electorates: Rome, Maastricht, Lisbon, Wroclaw, and now Berlin, where, to nobody’s surprise, the integrationists in the Bundestag have easily seen off the opposition to their plan to bolster the EFSF. Cue the now-familiar backslapping in Europe after each of their knife-edge victories over the forces of democracy.

The starting point for these Eurocrats/integrationists is that the popular will is simply an obstacle on the road to the ultimate destination of a United States of Europe. Whenever they encounter one of these inconvenient roadblocks, they fume, argue among themselves about the merits of alternative routes until they finally swerve triumphantly round the obstacle, congratulating each other for their ingenuity and skill.

The trouble is that this game gets more dangerous at each stage. In the present case, it is reported that three out of four German voters is opposed to supporting Greece and co., and they’ve not even started paying for it yet. Moreover, it is not as though the largesse is going to create a reservoir of gratitude alongside the Mediterranean – far from it. Judging by reactions in Greece, the outcome will be a legacy of bitterness for decades to come.

It is important to realise that arguments about the cost of saving the euro zone are ultimately sterile, because under current conditions there is no limit to the commitment that the Germans are being asked to make – a point which is not lost on people in Germany. The €440bn additional funding for the EFSF sanctioned by the Bundestag is simply a first instalment, sufficient to cover the cost of propping up the bond markets on the assumption that it will prevent contagion from the Greek imbroglio – which, of course, there already is aplenty. It is several months too late to stop the panic spreading beyond the original porcine four – Portugal, Ireland, Greece and Spain – to engulf Italy and even to some extent France. Back-of-the-envelope calculations (which is as much as it is worth doing) suggest that the amount needed could be of the order of €2 trillion or more, equivalent to about 80 percent of Germany’s national income.

This may seem an enormous sum of money, but it is merely the downpayment on a potentially unending stream of subsidies in the nightmare transfer union scenario, as the Greeks slide back into their old, profligate ways, the Spanish continue to resist labour market reform, and the Italians replace the Berlusconi government with an administration stuffed with ageing ex-Communists.

How long will the Germans carry on financing this orgy? Like a bishop at a Berlusconi bunga-bunga party, they will either explode in a destructive rage or find the temptation to join in irresistible.

Has Ireland de-coupled from the periphery?

By Kathleen Brooks. The opinions expressed are her own.

Ireland is on a wave. After a bad patch and a massive loss of confidence eventually it looks like it has turned a corner and we can start to believe that there may be brighter times ahead. Of course, I could be talking about the Irish rugby team who had a stunning win over Australia at the rugby World Cup in New Zealand. But the economy isn’t doing too badly either.

Data last week showed that the economy grew by a respectable 1.6 percent in the second quarter, after expanding by an even better 1.9 percent in the first three months of this year. This beats the dismal growth rates in the UK and the euro zone, which both came in at 0.2 percent in the three months to June.

More importantly to Dublin, however, has been the drop in Irish bond yields. In recent weeks it has bucked the trend of other euro zone countries with dodgy financials who have seen their bond yields rise, instead its 10-year yield has fallen from a high of 14 percent in July to 8.7 percent at the end of last week. In contrast, Greek yields have risen more than 10 percent over the same period.

So, as ironic as it may seem, during the current period of market turmoil when stocks and other risky assets experienced heavy losses, Irish bond yields were one of the few winners out there along with the dollar and the yen. This is an about turn, back in November when Ireland applied for bailout funds its position was considered so precarious that it caused a wobble in the euro more severe than the decline we have seen in September.

But while officials in Dublin might not be allowing themselves to have grand ideas that Ireland could turn into the next safe haven they will be delighted that their bond yields have fallen as this not only lowers their costs of funding, but also brings them one step closer to achieving their goal of re-entering the capital markets in 2013. The cost to insure Irish debt from default has also fallen by more than 100 basis points over the past few weeks, which suggests investors are more confident that Ireland has stepped back from the edge of the default.

So what has Ireland done right? Growth in the second quarter was driven primarily by exports, which expanded by a whopping 23.9 percent between the second quarter of 2010 and 2011. The industrial (excluding construction) forestry, fishing and agriculture were the only sectors to see positive annual growth rates, but that is still not bad for an economy that just seven months before had to go cap in hand to the IMF and EU for a bailout loan.

from Felix Salmon:

When fractured politics kills economic solutions

Michael Cembalest's note explaining the EU Mess with lego seems to have touched a nerve, and while a part of that is due to the lego, I like to think that some of it is due to the fact that actually the diagram does very well what few other explanations have done -- which is explain just how messy and multipolar the euro crisis really is.

Cembalest's diagram includes a dozen different stakeholders, each trying to fob off the burden of the euro crisis onto someone else. (The single noble exception here are the opposition parties -- the Social Democrats and the Greens -- in Germany.) It's all too easy, looking at Europe from across the pond, to divide the entire continent into two halves: a profligate south, spending beyond its means, piggybacking on the rich north, which doesn't want to bail them out.

But of course it's a lot more complicated than that. For starters, there's the fight between the ECB, which wants a fiscal solution to the crisis, and pretty much everybody else, who wants the ECB to grow up, stop worrying about nonexistent inflation, and help save the euro zone by printing euros. There's the question of whether and how much shareholders in banks should help pay for the bailout; a separate question about banks' bondholders; and yet another question about sovereign bondholders. Within the northern countries, Finland has staked out a particularly extreme stance, saying that it won't lend any money to anyone unless it's collateralized. And then there's the Bundesbank, which is particularly keen on imposing a painful regimen of austerity and structural reforms on countries which desperately need growth.

Or, to put it another way: European economic union has failed because European political union doesn't exist. There's no political body empowered to make decisions on behalf of the whole, and nor is there an executive able to issue debt on behalf of the whole. Hence the EFSF -- a special purpose vehicle partially guaranteed by 16 different states including both Malta and Cyprus, incorporated under Luxembourgish law, and funded by the German Finanzagentur, in a structure which makes CDOs look downright simple. I'm sure it seemed like a good idea at the time, but you can hardly blame Europeans for being suspicious of such a creature.

As a result of all this politics, one thing is certain: we won't get the best solution, as dreamed up by technocrats. Mark Dow, for instance, a former Treasury and IMF technocrat turned hedge-fund manager, has a solution to the problem that I like a lot: it's far from painless, but it addresses the issue rather than doing any of the proverbial can-kicking, and it's aimed at jumpstarting growth rather than trying to rely on austerity measures to do anything but make the situation worse.

Dow's solution involves cutting loose Greece and Portugal, and probably Ireland too. The first two, certainly, need a devaluation if they're going to regain economic growth -- and so they should be allowed to devalue and default. Depositors in domestic banks would of course need to be kept whole; this might be reasonably expensive. And other European banks would lose a lot of money on the default, upon being forced to accept a hefty haircut on their holdings. So concurrently with cutting loose Greece and Portugal, there would need to be a massive recapitalization of the entire European banking sector -- probably something on the order of a trillion euros or more. That would hurt bank shareholders, but keep the bondholders pretty much intact. "Shock and awe, writes Dow, "tired though this cliché has become, needs to be the overarching inspiration."

As for Spain and Italy, they're big industrial countries and can regain growth while remaining part of the euro -- just so long as they can borrow relatively cheaply. Enter the ECB, committing to lend unlimited amounts of money to them, so long as they implement structural reforms, at a low rate of about 5%. Inflation risk, right now, is the least of our worries; if even the Swiss are happy to print unlimited amounts of money, then the ECB, in a much bigger crisis, should be too.

from Felix Salmon:

Europe’s lethal uncertainty

As markets plunge again today, ostensibly on existential worries about the eurozone, you might want a plain-English explanation of what the root of the problem is. And John Lanchester is a great place to turn for such things:

On 16 August, Nicolas Sarkozy and Angela Merkel had an emergency meeting to decide what to do about the Eurozone crisis. After it, they gave a press conference at which they spoke in platitudes about the need for Europe to improve its ‘economic governance’, avoiding all specifics. They precisely and explicitly ruled out the only two things which would have helped: the creation of ‘eurobonds’, i.e. debts backed by the full economic weight of all the countries inside the eurozone; and the extension of the €440 billion European Financial Stability Facility. It’s easy to see why they did this, and their reasons are entirely to do with the domestic unpopularity of giving more aid to the indebted and severely struggling ‘Club Med’ countries of Southern Europe. Unfortunately, Merkel and Sarkozy’s inaction is a recipe for certain disaster. Everybody and his cat knows that the eurobond is the only way out of the crisis for the eurozone in the medium term; as for the necessary size of the short-term bailout facility, Gordon Brown’s guesstimate was €2 trillion. That ‘could have convinced the markets that Europe meant business’. Huge, sustained and manifestly undeflectable government intervention on that scale is the only thing which will cause the speculators and hedge-funders and ‘hot money’ types to back off. Instead, nothing.

Lanchester's full essay is well worth reading, and helps to put today's news in perspective. When Mario Draghi says that Europe needs to “make a quantum step up in economic and political integration,” he's basically agreeing with Christine Lagarde that Europe's nations need to stand together. And when elected leaders signally fail to say the same thing, markets fall.

Meanwhile, amazingly, the Greek bond exchange is still far from a done deal, and Landon Thomas does his best to try to explain how Europe's banks are being pushed to accept it:

This week, bankers representing the Greek government — Deutsche Bank, BNP Paribas and HSBC — have been explaining to investors why it is in their interest to trade in their decimated Greek bonds, take a 21 percent loss and accept a new package of longer-dated securities with AAA backing...

With the price of Greek debt trading in some cases at 50 cents on the dollar — even lower than when the bailout deal was announced in July — the 21 percent haircut seems to be quite a bargain.

As a bonus, the new bonds would be governed by international law, rather than Greek law. That is a significant alteration of lending terms that would strengthen the negotiating hand of the bondholders if Greece eventually concluded it had no alternative but to default — even after this latest bailout.

The math isn't quite as simply as Thomas implies -- if you take a 21% haircut on a bond, the new instrument is not automagically going to be worth 79 cents, even if it does have "AAA backing". That backing will be in the form of long-dated zero-coupon collateral which is hard for bondholders to extract, and the new debt will still have a low credit rating and a large amount of default risk baked in.

But the governing-law part of the deal is important. Thomas cites (but doesn't link to) Lee Buchheit's important paper on that topic. Basically, current Greek debt is in many ways worthless to bondholders: if and when Greece defaults, they have no legal recourse. But if the exchange goes through, then the new Greek debt will give bondholders real teeth in the event of default.

Germany at the crossroads

By Laurence Copeland. The opinions expressed are his own.

Baby-boomers like me, who grew up in the shadow of World War II, have to acknowledge with gratitude that the Germany which again dominates Europe is in most respects a model democracy – multiracial, prosperous and contented. However, there is one worrying aspect of the German mentality which seems to have survived intact from its unhappy history, and it is an aspect which is likely to be tested to the full in the coming weeks and months.

From the moment when the Maastricht Treaty was dreamed up in the early 1990s to the inception of the euro zone in 1998, Germany had any number of opportunities to kill the project off and indeed, time and again, policymakers in Bonn or Berlin or Frankfurt voiced their reservations in public. The Bundesbank, in particular, with its overwhelming prestige, spoke out forcefully against what it saw as the dangers of premature monetary union.

Yet, while Tony Blair, who dared to take Britain to war in Iraq in the face of overwhelming public opposition, nonetheless baulked at taking his country into the euro zone without a referendum, and while France actually had one (which the pro-Maastricht side only won by a whisker), Germany’s leaders felt no such need. On the contrary, Chancellor Kohl famously rejected the idea of consulting his electorate on the grounds that, if the opinion polls were to be believed, he would almost certainly lose.

What is it about the Germans that makes them willing blindly to follow a leader, even though they fear he is taking them over a cliff? Am I alone in finding this a worrying national peculiarity?

I raise this question now because the problem of what to do about Greece means that Germany stands at another fork in the road. Forget the technicalities and the small print, important though they are, and focus on the critical issue of principle which precedes it: is Germany going to give in and allow some form of fiscal integration to be introduced by the front door (unlikely), by the back door, the tradesman’s entrance or the catflap? It is coming under increasing pressure to do so from all sides – euro-politicans, commentators, economists, right-thinking or unthinking members of the chattering classes – in fact, almost everyone except those who will end up footing the bill i.e. the taxpayers of Germany itself, who for some obscure reason are a lot less enthusiastic.

This may be the last chance for Germany. One shudders to think what will happen if Germans are saddled with supporting the rest of Europe in perpetuity – which is what is involved, as Frau Merkel seems only too well aware.

from Felix Salmon:

Lagarde leads from the front on Europe

Going into the Jackson Hole conference, everybody was breathlessly awaiting Friday's speech from Ben Bernanke, which turned out to be incredibly boring. The most important speech of the meeting, by far, came on Saturday, and came from the new head of the IMF, Christine Lagarde. In decidedly undiplomatic prose she came right out and said what needed to be done:

Two years ago, it became clear that resolving the crisis would require two key rebalancing acts—a domestic demand switch from the public to the private sector, and a global demand switch from external deficit to external surplus counties... the actual progress on rebalancing has been timid at best, while the downside risks to the global economy are increasing...

I would like to delve deeper into the different problems of Europe and the United States.

I’ll start with Europe...

Banks need urgent recapitalization. They must be strong enough to withstand the risks of sovereigns and weak growth. This is key to cutting the chains of contagion. If it is not addressed, we could easily see the further spread of economic weakness to core countries, or even a debilitating liquidity crisis. The most efficient solution would be mandatory substantial recapitalization—seeking private resources first, but using public funds if necessary. One option would be to mobilize EFSF or other European-wide funding to recapitalize banks directly, which would avoid placing even greater burdens on vulnerable sovereigns...

The United States needs to move on two specific fronts.

First—the nexus of fiscal consolidation and growth. At first blush, these challenges seem contradictory. But they are actually mutually reinforcing. Credible decisions on future consolidation—involving both revenue and expenditure—create space for policies that support growth and jobs today. At the same time, growth is necessary for fiscal credibility—after all, who will believe that commitments to cut spending can survive a lengthy stagnation with prolonged high unemployment and social dissatisfaction?

Second—halting the downward spiral of foreclosures, falling house prices and deteriorating household spending. This could involve more aggressive principal reduction programs for homeowners, stronger intervention by the government housing finance agencies, or steps to help homeowners take advantage of the low interest rate environment.

The diagnosis of what needs to be done in the U.S. is spot-on. Revenues have to be raised -- in the future, not yet. Mortgage principal needs to be reduced. And the government needs to help the private sector translate low interest rates into growth, because right now it's looking like a deer in the headlights and refusing to take advantage of them.

But it's Lagarde's diagnosis of her native Europe which is proving highly controversial. Anonymous "officials", quoted in the FT, rapidly said that she had it all wrong:

Officials said Ms Lagarde’s comments missed the point of banks’ current difficulties. “The key issue is funding,” said one experienced central banker. “Banks in some countries have had trouble securing liquidity in recent weeks and that pressure is going to mount. To talk about capital is a confused message.

This is simply delusional: anybody who knows anything about banking knows that the distinction between a liquidity problem and a solvency problem is not nearly as clear-cut as this makes out. Indeed, if there weren't any worries about European banks' solvency, then they wouldn't have any kind of liquidity problems. If a bank has "trouble securing liquidity," any responsible regulator must take that as a message that the markets are worried about that bank's solvency -- especially if the problems are happening, as these ones are, in a broader global context where liquidity remains abundant.

And if the markets are worried about a bank's solvency, then that bank's solvency is what must be addressed -- perception is reality in such matters.

from Felix Salmon:

Larry Summers’s inadequate plan for Europe

Larry Summers reckons that "with last week’s tumult in Italian markets, the European financial crisis has entered a new and far more dangerous phase"; he's right about that. But his prescriptions for what must be done, laid out in the second half of his column, are a mess. For one thing, they're impossible to implement from a political perspective. For another, they contradict Summers's own diagnosis of what the problem is, as laid out in the first half of his column. And in any case they're a textbook case of too little, too late: even if implemented they wouldn't actually fix the problem.

Summers is quite right, in the first half of the column, to write this:

The approach of lending more and more from the official sector to countries that cannot access the market at premium rates of interest is unsustainable. The debts incurred will in large part never be repaid, even as their size discourages private capital flows and indeed any growth-creating initiative.

It's hard to see how he can square that with his prescription in the second half of the column:

First, for program countries. Interest rates on official sector debt will be reduced to a European borrowing rate defined as the rate at which common European entities backed with joint and several liability by all the countries of Europe can borrow. A default to the official sector will not be tolerated so there is no reason to charge a risk premium, since charging a risk premium needlessly puts the success of the whole enterprise at risk.

Somehow, Summers has magically gone from "the debts incurred will in large part never be repaid" to "default to the official sector will not be tolerated so there is no reason to charge a risk premium," without ever explaining how he got there from here.

It seems, here, that Summers has gone effortlessly from "you can't just extend and pretend that there won't be any default to the official sector" to "let's extend and simply declare that there won't be any default to the official sector."

Units and unities: can currency change really resolve the Greek tragedy?

As the Greek tragedy goes into what looks like its final act, there is increasing talk of the country leaving the euro zone and refloating the drachma. Perhaps the Athens street mobs favour this “solution”, but what would it involve, and would it work?

It is a bizarre situation, without precedent as far as I am aware (though I am no economic historian). Usually, new currencies are introduced to replace old ones which have become discredited (typically after hyperinflation), whereas here we are talking about the absolute opposite: abandoning the euro because it is too strong, in favour of a new drachma, which will be a weak currency by design – rather like launching a ship, in the hope it will sink!

Equally bizarre is the fact that many people seem to think this course of action will somehow be less painful for ordinary Greeks than the austerity measures being demanded by the IMF, EU and ECB. But just consider what is involved.

The immediate problem would be the changeover mechanism. New currency launches take time, normally many months or even years, so even if this reversion to the drachma can be rushed through at Olympic speed, we must surely be thinking of January 2012 at the very earliest. But what happens in the interim? The situation could be completely unmanageable.

In the first place, Greek savers are not going to wait around while their cash, bank deposits and other assets are forcibly converted into drachma (and their banks go bust too). Instead, they are going to do everything in their power to put them beyond the reach of the Greek monetary authorities, which may simply be a matter of moving their accounts to foreign banks, if they haven’t already done so, or possibly something more sophisticated or devious. (In any case, you can be sure middle-class Greeks will already have had years of practice at hiding funds from the taxman).

In fact, since, legally or illegally, euros will continue to circulate long after a new currency is launched, the only feasible way to refloat the drachma is in a dual-currency regime in which, at least initially, drachma are only used for transactions involving the government and nationalised industries. So, for example, civil service salaries and welfare payments could be paid in drachma, which would then be accepted by the government-owned utilities, and presumably by banks, which would have to be nationalised, de facto if not de jure. The private sector would then use drachma alongside euros, which would for the foreseeable future remain the currency of choice for all their big-ticket transactions.

Post-hyperinflation experience in Latin America, Israel and Eastern Europe suggests that this sort of dual-currency scenario can be as stable and durable as any other type of regime in the unstable world of international monetary arrangements.

from Felix Salmon:

Could the EFSF engineer a Greek restructuring?

We're now close enough to a Greek default that the likes of Daniel Gros are coming up with schemes for how to avoid such a thing:

The European rescue fund -- European Financial Stability Facility, or E.F.S.F. -- should offer holders of Greek paper an exchange into E.F.S.F. paper at the current market price. Banks could be "induced" by regulators to accept the offer.

The E.F.S.F. could then be the only remaining creditor of Greece and propose a bargain to the country: “We write down the nominal value of our claims (say, 280 billion euros) to the amount we paid (say, 150 billion euros) and extend all maturities (at unchanged interest rates) by five years provided you (Greece) agree to additional adjustment efforts (and asset sales)."

This should be too good of a bargain for Greece not to accept since it avoids default and saves the country 130 billion euros. While the E.F.S.F. exchanges the stock of Greek bonds, the International Monetary Fund could finance the remaining deficits in the usual way, with bridge financing until the fiscal adjustment is completed.

Greece would then be left with some I.M.F. debt and the 150 billion euros it owes to the Europeans. Together, this would be about 85 percent to 95 percent of its gross domestic product, which is not far from that of France. It would be high but manageable.

The losses that would be taken by Greece's private-sector creditors -- €130 billion or so -- would be small enough to avoid large-scale bank insolvencies, at least outside Greece itself. (What would happen to Greek banks is far from clear.) But it's not at all clear how this regulatory "inducement" could work.

One problem here is that unless they're Goldman Sachs, banks don't mark all their assets to market every day: the current secondary market price might be a more reliable guide to value than anything else, but that doesn't make it infallible or even in the right ballpark. And of course the minute that the EFSF or anybody else starts treating the market price as some kind of holy benchmark, you can be sure that the market price will start rising dramatically.

A bigger problem is that the market price is a marginal price, being set between a relatively small group of speculative investors with pretty short-term time horizons. (That's why it's fine for Goldman to mark to market: when it holds securities it does so on a speculative basis and with a short-term time horizon.)

There's an enormous group of investors who would never buy Greek debt for anything near the current price, and there's an equally enormous group of investors who would never sell it at these levels. Those investors, obviously, don't trade with each other: they simply don't participate in the market for Greek debt. But Gros's idea is to drag them into the market against their will, tell them that they're wrong to stay out of it, and force them to sell at a price they would never normally agree to. Regulatory strong-arming can be effective, but this would be a very tough sell indeed -- and indeed would violate the very spirit of markets, where trades are voluntary and done in the knowledge that most investors aren't actually interested in trading at the current market price.

The point here is that Gros's plan would never work if the EFSF simply bought up Greek debt in the secondary market -- it could never buy enough to move the needle, and if it started buying extremely aggressively, then the price would necessarily rise sharply. So it's the element of coercion here which is central to the Gros scheme.