Can China peg the euro to the dollar?

China has $3 trillion in external reserves (and growing). China is the world’s exporter and investor of last resort. China’s vast reserves are an artifact of its monetary policy: the dollar peg. To prop up the dollar versus the yuan, China must continually buy dollars.

The other big currency in the world is the euro. The relationship of the yuan to the euro is of course identical to the relationship of the dollar to the euro. When the dollar is weak vs the euro, that’s good for China. When the euro is weak vs the dollar, that’s bad for China.

Lately the euro has been weakened by the sovereign debt crisis. It is not in China’s interest for Europe to have a financial crisis, or for the euro to collapse in value. China has said that it will buy the bonds of the troubled eurozone members.

But here is an intriguing question: Does China have the resources to peg the euro to the dollar, in effect resurrecting Bretton Woods by creating a global dollar zone?

Obviously, the ECB could fight such a policy. However, it would not be easy, and more importantly, it might not be in Europe’s interest to fight such a policy. (And the ECB does not have an exchange rate policy.) The ECB would be free to conduct its monetary policy free of foreign exchange concerns, while the People’s Bank would do the heavy lifting of maintaining the euro-dollar peg. (The Fed could make this difficult, but it does not have any exchange-rate anchors or policies either.)

How would this work? First of all, the People’s Bank would never admit that it was targetting a dollar-yuan-euro peg. It would simply buy or sell euros or dollars as necessary. Yes, George Soros could push hard against the People’s Bank, but he doesn’t have $3 trillion. The Chinese would win, so long as they are prepared to stand with an open bid for euros at their preferred exchange rate.

The forgoing is more of a thought-exercise than a prediction, but I am sure that it has already occurred to the Chinese that they may want to informally add the euro to their “price support” program.

Europe must protect government bondholders

Klaus Regling is the head of the European Financial Stability Facility. He recently published an op-ed in the FT titled “EMU’s critics will eat their words again”.

In the column, he does his best to advance the argument that EMU will survive without fiscal union. It is more of an assertion than an argument. He then goes on to state the following (emphasis added):

A monetary union needs a safety net to respond to a crisis. The European Council decided therefore to prepare a permanent crisis resolution mechanism, called European Stability Mechanism (ESM). It will be established in 2013, and will be based on the temporary resolution mechanism, the European Financial Stability Facility (EFSF). The key difference between the two will be the involvement in the future permanent mechanism of private creditors in a crisis resolution on a case-by-case basis. It will follow established IMF policies, which means that debt reduction would be required in cases of insolvency. This will be rare. No industrialised, advanced economy has defaulted since the second world war. The ESM would, as does the EFSF, provide loans – under strict conditionality – to euro area countries that lose access to markets.

This is the problem, which he does not even acknowledge: unless the ESM exists to backstop private creditors, it serves no purpose. It is like a guarantee that is good unless called upon.

The EU will learn next year that the ESM and austerity will not have restored investor confidence and that the markets remain closed to Greece, Ireland and Portugal. At that point it will have to choose between lending with strict conditionality or to involve private creditors in the resolution. My prediction (my hope) is that they will blink, and bail out the bondholders.

One recent ray of hope: China says that it will buy the bonds of the peripherals when they re-enter the market. China exports to Europe, and doesn’t want a European debt crisis. So just as they lend to the US to finance Chinese imports, they would do the same for Europe. If true, this is not trivial. China has almost $3 trillion in foreign exchange reserves. They desire to diversify their currency exposures, and so investing in the government (and bank?) debt of the peripherals serves a number of useful purposes.

Is there a "muddle through" scenario for Europe?

I may have been too confident that the eurozone will inevitably break up.

It may be that Germany and France will indeed “guarantee” the peripheral countries, such that maturing government debt will be backstopped by the EFSF, and maturing bank liabilities will be funded by the ECB on the basis that the banks are backstopped by their governments which are in turn “guaranteed” by the EFSF.  Then, as the peripherals balance their budgets, market access would resume.

If the markets remain closed to the peripherals and their banks, the next step would be fiscal union and the issuance of union debt. There is a body of opinion (in Europe) that this is exactly what will happen, because the alternative is supposedly worse. The French fall into this category, but Germany does not, not yet.

Fiscal union will require a new eurozone treaty, and a national debate in Germany on this issue.  Fiscal union is unpopular with German voters, but if it becomes necessary to save the euro, it is possible that that the two main parties will bite the bullet.

So what I am saying is that there is the possibility that the euozone will muddle through without default or redenomination. It is difficult to predict which outcome is more likley, because they are both hard to imagine. And the “muddle through” scenario only works if the peripherals implement their austerity plans to Germany’s satisfaction. That will be hard. Given the degree of pain that these countries suggests that their voters may give up before Germany does.

Does Germany really want a European financial crisis?

The Irish, Greek, and Portuguese banks are losing (have lost)  access to the debt, repo and interbank markets. They are dependent upon the ECB to provide them with funding as their short and long term debt matures. It is very unlikely that the markets will reopen, irrespective of the receipt of EU rescue funds. Germany’s insistence that creditors lose money in the event of a bailout has nailed shut the door to the capital markets.

The ECB is very uncomfortable about becoming the largest creditor to these countries and their banks (ECB loans are secured by the peripherals’ bonds, which are risky due to the German “bail-in” scheme).

The ECB’s emergency funding expires in mid-January, and board members are publicly advocating that the funding scheme expire on schedule, thus hanging the peripherals out to dry.

If the peripherals lose access to the ECB, they and their banks will have no choice but to default, imposing large costs on their creditors, including the ECB. This would create a world financial crisis on the scale of 1931.

Someone in Germany is going to have to blink between now and January.

Will the Irish rescue plan work?

Here is what I expect to be the EU’s Irish rescue plan:

• The EU lends Ireland around EUR 100B to recapitalize its banks;
• This “allows” the ECB to continue to lend to the banks;
• Ultimately, the banks regain market access and all is well.

Here is what I see as the problem with this plan: it will ultimately result in the ECB becoming the Irish banks’ sole creditor; and it will expose the ECB to perhaps EUR 200B of Irish bank exposure. Also, I don’t expect the Irish banks to regain market access without a credible guarantee from a AAA rated entity (either the ECB or the EFSF).

Eire vs the ECB

The ECB reports that it has lent EUR 130B to the Irish financial sector, which is roughly 25% of its total claims on banks. This exposure continues to grow as Irish banks’ market liabilities mature and are unable to be refinanced in the interbank or bond markets.

The ECB is now not only Ireland’s lender of last resort, it is Ireland’s only lender. The Irish banking system is a colony of the ECB and lives or dies by the decisions of the ECB’s board. Already, Axel Weber, a member of the board and the head of the once-and-future German central bank, has called for the orderly default of eurozone banks. Presumably, he is referring to Ireland's three major banks. (Which is interesting coming from Germany, which has half of its banking system on life-support. I guess he means that only non-German banks should be allowed to default.)

ECB president Trichet is the man in the middle. He wants the EU to bail out Ireland so that he can continue to lend to its banks. The Germans, by contrast, seem to have concluded that Ireland is not too big to fail, or at least Irish banks aren't too big to fail. Is Germany conditioning an Irish bailout on allowing Irish banks to default on their bonds? Could they really be that stupid?

The board meetings at the ECB in Frankfurt must be quite lively as the life and death of European countries is debated.

But what if Ireland plays chicken with the ECB? What if the Irish government refuses to apply for a bailout but continues to borrow from the ECB, this making the ECB’s exposure to Ireland a solvency and credibility problem? This why everyone in continental Europe is leaning on Ireland to apply.

But the only European organ that can make Ireland apply is the ECB, and it may well be that its threats to pull the plug will not be taken seriously by the Irish government. It certainly looks as if this is the case. The EU, which meets on Wednesday, cannot force the Irish to apply for a bailout. Their only leverage is the ECB.

This is truly global brinksmanship. Who will prevail? My money is on the ECB. I’d expect Ireland to submit by the end of the week.

Germany's euro dilemma

Germany entered the EU and then the euro for political reasons: peace with its neighbors, reunion with the GDR, and international respectability. It made clear, when it joined the euro, that it was not a fiscal union, and that it would not have to bailout other euro members.

As events on the periphery are playing out, Germany is clearly on the hook for bailout money via the EFSF mechanism. This is very unpopular in Germany.

Recently, Merkel forced the EU to agree that bondholders would have to take haircuts in the event of a rescue by the EU. This spooked the markets, which forced the EU to make a statement “clarifying” the policy, and emphasizing that the revised scheme would not take effect until 2013.

Despite the “clarification”, the markets remain spooked and peripheral government bond yields remain in deep junk territory. In other words, the EU is saying “these bonds are guaranteed” and the bond market is saying “no they’re not”. (I agree with the bond market.)

But getting back to Germany and its motives. It would be very difficult to hold the EU together if Germany left the eurozone. But what if the eurozone craters on its own?

The Germans are not stupid. They can see where events are headed: either Germany agrees to play sugar-daddy for the entire eurozone, or the eurozone breaks up. I wonder if this is what the Germans want. They would get their DM back without paying a political penalty.

Can the EU stop the run on Irish banks?

Here’s a question: Will a rescue plan for Ireland stop the run on Irish banks?  I wonder. I wonder whether the Irish banks can regain market access without a credible guarantee from someone rated AAA with deep pockets. But who would this be? Not Germany and not the ECB.

How about the AAA-rated European Financial Stability Fund? No. It only lends to governments. So the EFSF will guarantee Ireland and the  ECB will fund the banks. Irish banks already owe the ECB EUR 130B, and Trichet is very unlikely to grow this exposure without a guarantee.

Recapitalizing the banks will not be sufficient for the market to reopen. No sane banker wants to increase his exposure to Ireland, period. Europe will soon discover that Anglo-Irish, Allied Irish and Bank of Ireland are, yes, too big to fail.

The ECB holds all the cards with Ireland

The FT reports today that “Behind the scenes, the ECB has put pressure on Dublin to take steps within days that would provide an urgently needed boost to confidence in Ireland’s public finances and struggling banking system”.

This means that, despite Dublin’s reluctance to apply for an IMF/EU bailout, Ireland would have no choice if the ECB closed its discount window to Irish banks. Judging from the FT story, it is threatening to do so.

Irish bailout tomorrow?

The FT reports that “European ministers were this weekend deliberating whether Ireland needed European Union aid ahead of Monday’s reopening of financial markets”.

Since the Irish Treasury has sufficient funds to last into the middle of next year, my read is that it does not have sufficient resources to handle a run on its banking system. (Ireland guaranteed all bank deposits two years ago.)

My prediction is that Ireland will need to be bailed out tomorrow, since this leak will only intensify the run. I have a feeling that the ECB may have conditioned further liquidity assistance on a EU backstop of Ireland’s credit.

An Irish bailout will shock the system, and will make life harder for the banking systems of the other PIIGS. It will also place the ECB in an almost impossible position. Events could move swiftly in the coming weeks.

How bad is the Irish liquidity squeeze?

I am trying very hard to get my head around the Irish situation (see FT story below).

Is there a run on the Irish banking system and, if so, what stands between the banks and default? I assume that the ECB will continue to lend to Irish banks against Irish government bonds, but how much liquidity is needed and how much Irish exposure can the ECB take on?

What would be the terms of an IMF/EU bailout? Will Anglo-Irish Bank bondholders be protected? Will Merkel bail out Anglo-Irish? Will Trichet?

Will Irish government bondholders (the largest of which is most likely the ECB) be haircut?

I’ll bet euros to scones that the conference call wires are burning up in Brussels, Frankfurt, Berlin and Paris right now. “Europe” will have to come up with a solution to the Irish bank liquidity problem very quickly.

My best guess: the ECB will bridge the Irish banks pending the IMF/EU bailout. But, if the Germans say no, look out!

FT: Bond sell-off takes Ireland closer to tipping point

In the eyes of bond market investors, the prospect of an Irish bail-out, similar to that of Greece, is growing by the day. Yields on Ireland’s 10-year sovereign debt saw their biggest one-day surge since the launch of the euro on Wednesday, jumping more than half a percentage point to 8.64 per cent.
The extra cost of borrowing over the “risk-free” rate of Germany spiked to 6.19 percentage points, also a record since January 1999.
At the heart of the volatility in the eurozone bond market, according to investors, was a decision by one of Europe’s biggest clearing houses, LCH.Clearnet, to require banks or institutions wanting to use Irish bonds as collateral in the repurchase markets to raise cash to pay an extra margin of 15 per cent.
This, traders said, forced Irish banks to sell government bonds as they scrambled to raise the cash to meet the new margin requirements, sending a shudder through the market. The latest market moves comes at an awkward time for Dublin and the rest of the eurozone as financial markets move to price in renewed fears that one of the peripheral countries of Ireland, Portugal and Greece could default on their debt.
Don Smith, economist at Icap, said: “Irish bond yields keep on rising and today was yet more bad news. Investor confidence has been shaken in Ireland and the move by LCH.Clearnet is a very bad sign. It is potentially a tipping point that the Irish may find difficult to recover from.”
The repurchase, or repo, markets allow banks to access cash quickly and is fundamental to the way the banking system operates. In this market, banks sell their holdings of bonds to other banks in exchange for cash and a commitment to buy the bonds back for a marginally higher price at a determined point in the future.
At times of stress, banks can find themselves shunned by their peers because of fears over their solvency or else fears over the riskiness of the bonds that are being sold and repurchased.
Ireland, after the collapse of its property market in 2008, was one of the first eurozone countries to address the hole created in its public finances. But while bond markets reacted favourably at first, sentiment has since turned negative as the scale of its banking sector problems has been exposed
The LCH.Clearnet move means market participants would have to deposit cash with the clearing house equivalent to 15 per cent of their transaction as an indemnity against the risk of default. Market participants estimate that Ireland’s banks could have anywhere between €4bn and €8bn of bonds cleared through LCH.Clearnet.
One large hedge fund manager estimated that the banks would have to lodge between $1bn and $1.5bn in cash with LCH.Clearnet in order to avoid default and the forced unwinding of repo transactions. Some banks dumped bonds into the market in order to raise cash and buy other bonds that they could still repo.
The cost of insuring Irish government bonds against default, measured by credit default swaps, did not rise as sharply, however. Some participants, such as hedge funds, tried to exploit the arbitrage opportunity thrown up by this.
Any further impact may be limited. Some traders expect Irish bond yields will stabilise. If Ireland’s banks have been able to close out enough of their LCH.Clearnet repo transactions, they can turn to the European Central Bank, which only has a 5 per cent haircut.
“This has been a technical rather than a fundamental move,” said one macro hedge fund trader. But Ireland’s fundamental problem of anaemic economic growth and a troubled banking system that may need an increasing amount of money – more than a projected €50bn – to save it from collapse remains.
Even, if Irish bond yields have overshot, traders were drawing comparison with Greece in the run-up to its €110bn bail-out by the European Union and the International Monetary Fund.
As one fund manager said: “Economic reality will catch up with Ireland. Maybe in the new year. Then, it may well have to turn to the international community for help.”

Is BofA "at the tipping point"?

We still have two very large and potentially weak banks, which are also our two largest banks with combined assets of $4.3 trillion (that’s trillion). I am of course referring to Citigroup (C) and Bank of America (BAC). Their loan and derivative portfolios are impenetrable (perhaps for the best). Right now, the attention is focused on BAC. But both of these banks’  stocks are under pressure: BAC has been below $20 for two years and is now $12.30 ($52 in ‘07); C has ben below $5 for two years and is now $4.30 ($55 in ‘07).

Jonathan Weill (Bloomberg) is wondering whether BAC will need a second recapitalization. I think that this could be a legitimate question, although now, thanks to the mad scientists at the FASB, it is almost impossible to calculate “preprovison income” and thus judge underlying profitability in relation to credit costs. We do not need another banking crisis; I hope we won’t have one.

When we ask ourselves, who were the real miscreants, we might suggest Ken Lewis (who bought both CountryWide, a toxic mortgage disaster, and Merrill, epicenter of the Super-Senior Mezzanine CDO explosive device) and Chuck Prince who decided to turn up the CDO risk dial on the advice of Bob Rubin).

Bank of America Edges Closer to Tipping Point

By Jonathan Weil - Nov 3, 2010
Bloomberg Opinion
It was only last April that Bank of America Corp. was making fools out of the doomsayers who had called for its nationalization a year earlier. Taxpayers had gotten their bailout cash back. Investors who bought its shares at the bottom were making a killing. Government leaders lauded the company’s rescues, both of them, as a great success.
Now the bank may be on the verge of trouble again. Its stock has fallen 41 percent since April 15. Mortgage-bond investors are demanding untold billions of dollars in refunds. The foreclosure fiasco is metastasizing. A member of the Troubled Asset Relief Program’s oversight panel, AFL-CIO attorney Damon Silvers, openly worried at a hearing last week about the risk that Bank of America might need another bailout.
A few more months like the last one, and we may be wishing Bank of America had never returned its $45 billion of TARP money.
You wouldn’t know there’s anything wrong with Bank of America by an initial look at its balance sheet. The company showed common shareholder equity, or book value, of $212.4 billion as of Sept. 30. And its regulatory capital ratios have risen steadily throughout the year.
Tipping Point
Judging by its shrinking stock price, though, investors are acting as if Bank of America is near a tipping point. Its market capitalization stands at $115.6 billion, or 54 percent of book value. That’s the second-lowest price-to-book ratio among the 24 companies in the KBW Bank Index, and well below the 76 percent ratio the company was at in October 2008 when it landed its first round of TARP dough. Put another way, the market is saying there’s a $96.8 billion hole in Bank of America’s balance sheet.
When I asked Jerry Dubrowski, a Bank of America spokesman, about the disparity, he said: “I’m not going to comment on the book value and the stock price.”
It may be the shares are a bargain at $11.52, if the company’s books are right. Another plausible scenario is that Bank of America’s management, led by Chief Executive Officer Brian Moynihan, has lost so much credibility with investors that the stock’s decline might start feeding on itself.
The problem for anyone trying to analyze Bank of America’s $2.3 trillion balance sheet is that it’s largely impenetrable. Some portions, though, are so delusional that they invite laughter. Consider, for instance, the way the company continues to account for its acquisition of Countrywide Financial, the disastrous subprime lender at the center of the housing bust, which it bought for $4.2 billion in July 2008.
Goodwill Purchase
Here’s how Bank of America allocated the purchase price for that deal. First, it determined that the fair value of the liabilities at Countrywide exceeded the mortgage lender’s assets by $200 million. Then it recorded $4.4 billion of goodwill, a ledger entry representing the difference between Countrywide’s net asset value and the purchase price.
That’s right. Countrywide’s goodwill supposedly was worth more than Countrywide itself. In other words, Bank of America paid $4.2 billion for the company, even though it thought the value there was less than zero.
Since completing that acquisition, Bank of America has dropped the Countrywide brand. The company’s home-loan division has reported $13.5 billion of pretax losses. Yet Bank of America still hasn’t written off any of its Countrywide goodwill.
Dubrowski, the company spokesman, declined to comment when I asked him why not. In its latest quarterly report with the SEC, Bank of America said it had determined the asset wasn’t impaired. It might as well be telling the public not to believe any of the numbers on its financial statements.
No Surprise
Combine that with Bank of America’s reaction to the robo- signer scandal. (Working on it! Wait, halt foreclosure sales! No, restart them! Whoops, still checking records!) Add in the $141.6 billion of home-equity loans on Bank of America’s books, the real value of which is unknown. And it should be no surprise that the company’s stock price has been plunging.
So, does Bank of America need to issue new common stock to raise capital? Its executives say no. They point to the usual regulatory benchmarks, as well as their own calculations of tangible common equity. This is a bare-bones capital gauge, showing a company’s ability to absorb future losses, which excludes preferred stock and most intangible assets.
Using Bank of America’s $129.5 billion figure for tangible common equity, though, that’s still about $14 billion more than the company’smarket cap. So the market isn’t just discounting the intangibles, most of which don’t count in regulatory capital. Investors are wary of the company’s other numbers, too.
Artifice of Strength
The tough part for Bank of America executives is that the company’s future may be out of their hands. Writing off more worthless assets or boosting reserves for future losses might help their credibility. (The bank wrote off $10.4 billion of goodwill unrelated to Countrywide last quarter.) Or, the market might perceive such moves as a sign that the artifice of strength is broken. It’s hard to tell.
As for the government’s too-big-to-fail guarantee, it’s probably still there. But who knows? Republicans have won back the House. The answer is up in the air.
The only certainty is there is none, aside from the knowledge that Bank of America’s top executives have no idea what goes on inside the bowels of their company. For all we know the stock could double, or be a donut. The fate of the financial system hangs in the balance. Once again, we’re all on the hook.
(Jonathan Weil is a Bloomberg News columnist. The opinions expressed are his own.)

Martin Wolf demolishes the gold standard

Could the world go back to the gold standard?

Martin Wolf, FT
During any period of monetary disorder — the 1970s, for example, or today — a host of people calls for a return to the gold standard. This is not the only free-market response to the current system of fiat (or government-made) money. Other proposals are for privatising the creation of money altogether. But the gold standard is the classic alternative to fiat money.
It is not hard to understand the attractions of a gold standard. Money is a social convention. The advantage of a link to gold (or some other commodity) is that the value of money would apparently be free from manipulation by the government. The aim, then, would be to “de-politicise” money.
The argument in favour of doing so is that in the long-run governments will always abuse the right to create money at will. Historical experience suggests that this is indeed the case.
So why choose gold? It is, after all, an impossibly inconvenient means of exchange. But gold has a lengthy history as a widely-accepted store of value. If one is looking to reinstate a pre-modern monetary, gold is the obvious place to start.
After the experience of the last three decades the monetarism of Milton Friedman is no longer a credible alternative. It was abandoned for two simple reasons: first, it proved impossible for monetarists to agree on what money is; and, second, the relation between any given monetary aggregate and nominal income proved unstable.
Again, recent experience suggests that we can no longer be so confident that delegation to independent central banks protects against severe monetary instability. That system permitted a gigantic increase in credit, relative to gross domestic product. It is equally clear that governments do not wish to see this edifice collapse, for understandable reasons. This being so, the ultimate solution may be to increase nominal incomes, via inflation. Indeed, several economists recommend this. If that did happen, it would support those who argue for abandonment of the modern experiment with fiat money.
So would the gold standard be the answer? We would need to start by asking what a return to the “gold standard” might mean.
The most limited reform would be for the central bank to adjust interest rates in light of the gold price. But that would just be a form of price-level targeting. I can see no reason why one would want to target the gold price, rather than the price of goods and services, in aggregate.
The opposite extreme would be a move back into a world of metallic currency. But money in circulation will continue to be predominantly electronic, with a small quantity of paper, as today. That is the only convenient way to run a modern economy.
Finally, a return to the Bretton Woods system, in which the US promised to convert dollars into gold, at a fixed price, but only for other governments, would lack any credibility, since there would then be no direct link between gold stocks and the domestic money supply.
With these possibilities eliminated, the obvious form of a contemporary gold standard would be a direct link between base money and gold. Base money — the note issue, plus reserves of commercial banks at the central bank (if any such institution survives) — would be 100 per cent gold-backed. The central bank would then become a currency board in gold, with the unit of account (the dollar, say) defined in terms of a given weight of gold.
In a less rigid version of such a system, the central bank might keep an excess gold reserve, which would allow it to act as lender of last resort to the financial system in times of crisis. That is how the Bank of England behaved during the 19th century, as explained by Walter Bagehot in his classic book, Lombard Street.
So what would be the objections to such a system? There are three: difficulties with the transition; instability; and lack of credibility.
The biggest transition problem is the mismatch between the value of official gold holdings and the size of the monetary system. The value of gold held by central banks is apparently about $1,300bn, while global deposits of the banking system were about $61,000bn in 2008, according to the McKinsey Global Institute. To survive the slightest financial panic, the ratio of gold to bank money would need to be perhaps an order of magnitude higher.
One obvious objection is that this would generate huge windfall gains to holders of gold. More important, if policymakers set this initial price wrong, as they certainly would, they could unleash either deflation or inflation: the latter is far more likely, in fact, because private holders would start selling their gold to the central banks at such a high price. Apparently, about 90 per cent of gold is now privately held. So the expansion in the monetary base could be enormous.
Moreover, gold reserves are distributed quite erratically around the world. So some currencies would have to experience inflation and others severe deflation. A similar problem explains why it was impossible to recreate the gold standard after the First World War: too much of the world’s gold reserves were then held by the US.
What, then, about the problems of the steady state? One obvious point is that we would be back to the world in which the balance of payments would be settled by physical shipment of gold or, as it was later, by movements within central bank vaults. That would, at the least, be absurd.
A far more important problem is that of financial stability. Economists of the Austrian school wish to abolish fractional reserve banking. But we know that this is a natural consequence of market forces. It is wasteful to hold a 100 per cent reserve in a bank, if depositors do not need their money almost all of the time. Banks have a strong incentive to lend some of the money deposited with them, so expanding the aggregate supply of money and credit.
The government might seek to impose narrow banking: banks would have to back any deposits with notes or reserves at the central bank. But entrepreneurs could then create quasi-banks (let us call them “shadow banks”). These would hold deposits in the safe narrow banks and offer higher returns to customers, because they lend out surplus reserves for profit.
Such a system is unstable. In good times, credit, deposit money and the ratio of deposit money to the monetary base expands. In bad times, this pyramid collapses. The result is financial crises, as happened repeatedly in the 19th century. To prevent this one would have to move into the world of limited purpose banking recommended by Larry Kotlikoff, in which no financial institution would be allowed to promise redemption at par unless it held matching assets.* If so, the pure gold standard would require abandonment of the current banking system altogether.
A further danger is that the response to all shocks would have to come via nominal wage and price flexibility. A less obvious point is that the gold standard does not guarantee price stability. Depending on the supply conditions for gold, the price level might move up or down. In the long-run, however, the price level would probably tend to fall (because the supply of gold fails to keep pace with global activity). Such a world of trend deflation is liable to depressions if or when the equilibrium real rate of interest is less than the rate of deflation.
Another and, in my view, even more serious, threat to the stability of any gold standard regime is international. A peg to gold may prove radically destabilising for any currency if other significant countries failed to sustain domestic monetary and financial stability. There could then be floods of gold into or out of a currency that is well managed. The monetary and financial consequences could be dramatic, with severe deflation one obvious threat. This is precisely what happened in the interwar years, with the chaos emanating mainly from the US.
Finally, there is the fundamental problem of credibility - or rather lack of it. As Bennett McCallum of Carnegie Mellon University also notes in the Cato Journal, the forces that now demand inflation from time-to-time would demand a change in the gold weight of the currency as happened in the 1930s. “Historically”, he notes, “the gold standard provided a reasonable degree of price level stability over long spans of time because the population at large had at that time a semi-religious belief that the price of gold should not be varied but should be maintained ‘forever’.”
That faith has perished. Moreover, everybody knows it has perished. So whenever the economy was in difficulty, the only question would be how soon the gold price would be changed or the link abandoned.
In short, we cannot and will not go back to the gold standard. As L.P. Hartley wrote, “The past is a foreign country: they do things differently there.” We cannot live in the 19th century. It is foolish to pretend that we can.

The "Merkel mechanism" agreed at EU summit

At the EU summit last month, the member states agreed to Germany’s proposal that, in future bailouts, bondholders may face maturity extensions or principal haircuts. In other words, Germany will not the the lender or guarantor of last resort for the union.

It is unclear to me whether this is political window-dressing for German voters, or is instead for real. It is also unclear whether this plan supersedes the bailout plan agreed in May (which had no bail-in provisions).

Despite the uncertainties listed above, I can only observe that an official contemplation of  bond defaults by eurozone member states substantially increases the riskiness of bonds issues by the peripheral states. Until now, there remained at least the possibility of a full bailout or guarantee. This possibility now appears to be ruled out.

In view of the fact that the weakest of the peripherals have lost access to the debt markets, and that their austerity plans keep needing to be revised, it is hard to make the case that Greece, Ireland and perhaps others will not ultimately default.

It should also be observed that the so-called “private investors” who will be asked to “contribute” to the restructuring process are mainly large eurozone banks. Which means that European taxpayers will have to bailout the banks. In the end, the French and German taxpayers will still be on the hook for the eurozone mess.

The backlash against the Fed

The “institutional credibility” of the Fed is being tested by the global outcry over QE2. This is very bad news for four reasons: (1) it is making the Fed a political football in Congress; and (2) it provides ammunition to the hawks who place “credibility” over the dual mandate (i.e., emphasizing inputs over outcomes); (3) it weakens Chairman Bernanke’s power within the FOMC; and most importantly, (4) it will limit the ability of the FOMC to take further actions to spur nominal growth.

I had somehow assumed that the Fed could adopt QE (or even better, outcomes targetting) with little controversy. That has proven to be an incorrect assumption.

There is now a barrage of criticism of QE2  by finance ministers in Europe, Asia and Latin America. I should add that this criticism is of the Obama administration’s  alleged decision to pursue a “weak dollar” policy, which is false and which ignores the Fed’s independence. QE2 was neither an Obama nor a Geithner decision. But it is to the president’s credit that the defended the policy yesterday.

Domestically, the Fed is under attack by hard-money economists, conservative media (esp. the Wall Street Journal) and by Tea Party republicans, including now Sarah Palin of all people.  While it is too soon to know to what extent the House republican leadership understands and respects the Fed’s independence, there will certainly be pressure for hearings about the Fed’s “inflationary” and "weak dollar" policies.

This state of affairs is very disappointing. It lowers my expectations about the ability of the Fed to engineer a higher level of nominal growth, which is bad for employment growth and corporate earnings.

Ben is a heretic!

Here they come, the antedeluvian thinkers who have learned nothing since 1931:
Federal Reserve Chairman Ben S. Bernanke’s decision to pump a further $600 billion into the economy shows his grasp of economics is weak, said investor Jim Rogers, chairman of Rogers Holdings.
“Dr. Bernanke unfortunately does not understand economics, he does not understand currencies, he does not understand finance,” Rogers, 68, said in a lecture at Oxford University’s Balliol College yesterday. “All he understands is printing money.”
“His whole intellectual career has been based on the study of printing money,” he said. “Give the guy a printing press, he’s going to run it as fast as he can.”
The Fed said Nov. 3 it will buy an additional $600 billion of Treasuries through June, in a bid to reduce unemployment and avert deflation. While Bernanke’s near-zero rates and $1.7 trillion in asset purchases helped end the recession, the Fed said progress has been “disappointingly slow” in bringing down joblessness that is close to a 26-year high.
“Debasing your currency has never worked,” Rogers said.