Greek Air Force motto: "We Do Our Part"

The Greek Air Force (no jokes please) is now on strike. 

A former (Spanish) colleague of mine at Moody's used to divide countries into two categories: serious and unserious. When someone wanted to upgrade an Argentina, he would say "They are not a serious country." 

Well, I don't think that there is any military in the world that has ever gone on strike (although it is true that certain unserious European militaries are unionized, but "peace is their profession").

So Greece now suggests that there should be three country categories instead of two: serious, unserious, and Hellenic. 

The Dow can't ignore Europe

I don't think that the American stock market (Mr. Dow) has incorporated the full import of the European financial crisis. 

Worst case, we are looking at a wave of sovereign defaults, a collapse of a series of government bond markets, instantaneous fiscal consolidation, deflation, and sharp decline in nominal and real GDP (over there, and I don't just mean Club Med, I mean the EU). 

Given globalization, as Japan remains becalmed, China slows, and Europe tanks, it's awfully hard to be bullish on anything but US Treasuries. I really don't see how gold benefits from deflation--that is a correction waiting to happen. (We could easily see gold go below $1000.)

 I see a big global selloff that will get the Dow Dow below 10,000. I felt the same way in September of 2007, but back then I believed that big rate cuts would fully offset the subprime crisis (because I didn't understand that we were facing a national secular deleveraging). This time, there is no Fed for Europe (well, there is, but it's brain dead). 

So what is the bull case for global growth? I'd bet double dip 75, growth 25.

Europe is to big to fail...but

It is now obvious that Southern Europe is too big to fail. But it is not clear exactly who is supposed to fund the bailout. 

First of all, Germany can't guarantee all of the sovereign bank debt in the EU, and Brussels itself has no financial resources whatsoever. The EU is a club, not a country.

So who is the lender of last resort for Spain and Italy? 

Well, it's not the IMF. The IMF has limited resources. It can come up with packages in the $50 billion range for large countries, but this is too small for a country like Spain. The IMF has been a big help in the Baltics, but now we're talking about real countries.

As I have said before, the ECB has a EUR 2 trillion balance sheet. It is big enough, but politically, the Germans are not going to turn the ECB into a development bank without a fight. And they have a veto.

Which leads us back to the IMF. It is in everyone's interest that Europe does not have a wave of sovereign (and bank) defaults, plunging the world into an unthinkable crisis. Therefore, Greece has morphed from a eurozone crisis to a global crisis which includes the US, Japan, and China. 

I think it is necessary for the IMF to be dramatically recapitalized, and for it to access the debt markets like the World Bank. It needs a trillion dollar balance sheet. Simultaneously, Europe needs a regional IMF with serious resources as well. But time is of the essence.

Europe's Plan A is to bridge Greece into 2011 and to pray to the eurogods that Spain, Portugal and Ireland retain market access (doubtful). If that doesn't work, time is very tight, while an IMF recap and the creation of an EMF simply can't happen quickly. 

Before this is over, the IMF will be bigger and Europe will probably have an EMF. But not soon enough to forestall a series of crackups that could make Lehman look like a fender-bender.

Investment conclusion: good for Treasuries, the dollar, the yen. Bad for global equities, the euro, and any other investment that begins with the letters eur. Probably bad for sterling as well (they're in Europe).

Return of the drachma?

Readers will note that I think Greece will default. In a previous post I wondered whether they would also repudiate their external debt.

But there is a second option, which would be to exit the euro and unilaterally redenominate its debt (and all domestic debt) into drachma. This doesn't avoid default, but it does get Greece back to the status quo ante bellum, with monetary sovereignty and the freedom to inflate away its problems. 

Of course there is also a third option: default, repudiate, and redenominate. Argentina did this in 2001 and it worked.

Carl Levin and the Wall Street witchhunt

Let me get this straight. Jimmy Cayne and Dick Fuld are bad people because they lost billions and drove their firms over the cliff. I get this. If you are a Wall Street CEO you are supposed to hedge your bets, take prudent risks, make money and remain solvent.

But now I learn that Lloyd Blankfein is a bad person because he...hedged his bets, took prudent risks, made money and remained solvent. He repaid his TARP money with interest, and the government made a nice profit on the warrants they took on Goldman stock. 

His other crime is "profiting from the financial collapse". If this is a crime, then I guess Cayne, Fuld, Pandit, O'Neal and the rest are heroes because they lost billions during the collapse. I don't want to be rude, but does Carl Levin have even a clue?

Can the ECB bail out Southern Europe?

Unlike the Fed, the ECB does not have a growth or stability mandate. The hawkish Germans insisted that its charter focus exclusively on price stability. To my knowledge there are no doves on the ECB's board. 


But despite this, would it be prudent for the ECB to stand idly by while the dominoes fall in Southern Europe? If the contagion spreads to Portugal, Spain, Italy and Ireland, eurozone nominal GDP will fall,  prices will fall, and the euro will collapse. 


Bernanke, speaking of the Great Depression, famously said "We [the Fed] did it. It was our fault." Does Trichet want a European collapse to be his historical legacy?

Today's FT:

“We have gone past the point of no return,” said Jacques Cailloux, chief Europe economist at the Royal Bank of Scotland.“There is a complete loss of confidence. The bond markets are in disintegration and it is getting worse every day. The ECB has been side-lined in the Greek crisis so far but do you allow a bond crash in your region if you are the lender-of-last resort? They may have to act as contagion spreads to larger countries such as Italy. We started to see the first glimpse of that today.”

Mr Cailloux said the ECB should resort to its “nuclear option” of intervening directly in the markets to purchase government bonds.

This is prohibited in normal times under the EU Treaties but the bank can buy a wide range of assets under its “structural operations” mandate in times of systemic crisis, theoretically in unlimited quantities.

Mr Cailloux added: “This feels like the banking crisis in late 2008 post-Lehman, though it has not yet spread to other asset classes. The ECB will have to act it if does.”

I would add that the consolidated assets of the ECB and its member central banks is EUR 2 trillion, which should leave considerable room for offsetting asset sales in order to sterilize the monetary impact.

The debt market gives up on Greece

The debt markets are closing for Greece as it sinks in that its debt trajectory is unsustainable, whether or not it receives the EU/IMF rescue package. The FT reports today: 

Greek two-year bond yields jumped more than 3 percentage points to more than 18 per cent Wednesday morning amid growing nervousness about the state of the country’s deteriorating public finances. 

Greek two-year bond yields are now the highest in the world, more than even the weakest emerging market economies such as Argentina and Venezuela. 

The extra premium Greece must now pay over Germany, Europe’s benchmark economy, for two-year debt is more than 17 per cent, an unsustainable level. 

Gary Jenkins, head of fixed-income research at Evolution, said: “Greece cannot afford to pay yields this high as the interest rate charges would be so great, the country’s public debt would continue to rise until the economy collapsed.” 

Greek 10-year yields also rose more than a percentage point to 11.034 per cent.

"What's the phone number for Europe?"

Henry Kissinger, who I guess was a eurosceptic, once famously asked when someone mentioned Europe, "Oh, what's the phone number for Europe?" That was 35 years ago. There still isn't a phone number for Europe, as Gideon Rachman of the FT explains below (3/26/10). (And dollars to doughnuts, neither Obama nor Biden have a clue who these two guys are.)

Barroso versus Van Rompuy

At European summits, it is easy to get the mistaken impression that the arguments are all about finding the correct policies or defending national interests. I suppose, sometimes, that is the case. But more often that not, it seems to come down to personality politics. I was struggling earlier today to understand why the French had been so reluctant to involve the IMF in the putative rescue of Greece. 

In my innocence, I thought it might have something to do with a French preference for a “European solution”. But then a French colleague explained to me. It’s simply that Nicolas Sarkozy sees Dominique Strauss-Kahn, the head of theIMF, as a potential rival in the next French presidential election. So he doesn’t want to agree to anything that might make Strauss-Kahn look good.

There is a similar ludicrous jostling going on between José Manuel Barroso, the president of the European Commission, and Herman Van Rompuy, the first appointee to the new post of president of the European Council. In theory, the two men work closely together. In practice, they are shaping up as bitter rivals. 

So, after today’s European summit, aides to the two presidents were busily trying to round up journalists for rival briefings - as each man jostled to show that he spoke for Europe. Now I am at the Brussels Forum of the German Marshall Fund, which is a big transatlantic conference. Barroso is speaking downstairs as I type. Then, over dinner, we get a speech by Van Rompuy. Sparkling stuff, in both cases, I’m sure.

Do these guys have any idea how ridiculous this makes them look? I suspect they probably do - they just can’t help themselves. In the lobby of the conference hotel, I just bumped into some official Americans who had been to see senior people at the commission. They had delicately raised the question of which of the two European “presidents” would represent the EU at future international summits. 

“Oh that’s all settled,” they were told, “they’re both going.” With enormous self-restraint, the Americans apparently refrained from laughing out loud, or banging their heads against the wall. Meanwhile European officials still maintain, with a straight face, that the Lisbon Treaty has “simplified” Europe’s structures.

When will Germany leave the euro?

It will be hard for Southern Europe to leave the euro because this can only be done by simultaneous default and loss of market access (a future of grindingly balanced budgets, or Latin American economic policy). Their Ruritanian currencies would plummet against the euro (in which their debt is denominated). In the end, they will have to leave the euro, but it will be very ugly.

But what stops the North from leaving? And, in particular, Germany. The Germans never wanted to give up the Mark in the first place. The Neue Deutche Mark, issued by the Neue Bundesbank, would become its old self again: the hardest major currency in the world. Germany's debt would still be denominated in euro, which is no problem if the DM is strong, as of course it will be. No more membership in a club that has lost its prestige (a prestige due in no small part to the ECB's location in Frankfurt). Germany could politely ask the ECB (whatever is left of it) to move to Brussels (or Palermo). 

I'm not joking. Right now there are a lot of Germans (in Merkel's party) who are looking at Germany's aging demographics and debt trajectories and asking: "Why do we have to consolidate the rest of Europe onto our balance sheet? Why will we have to save and cut back while the southerners party on? We have barely enough for our retirement, but not enough for every Mediterranean family."

The WWII guilt thing is getting a bit tired when that entire German generation is dead and Germany has been a model European citizen for over half a century. I doubt that many young Germans have any interest in perpetual "friend payments" to countries that have no self discipline and don't like Germans.

So it may be in everyone's interest to call a halt to monetary union. But what a mess! This unravelling will be much worse than getting out of the gold standard because that was an "gentleman's agreement", not a contract, and they didn't have entitlements in 1933.

Is the ECB broke?

The ECB will not disclose its exposure to Greek government collateral, but, according to Moody's, Greek banks had about EUR 70 billion in ECB funding at the end of March. 


That's an interesting number because the total equity in the consolidated Euro System is--wait for the answer!--EUR 70 billion. 

So when Greece defaults and Greek banks fail to post additional collateral, will the ECB decide to (a) disclose its exposure and (b) mark down its exposure? Could this make the ECB insolvent? Probably not.

Does it matter whether the ECB is solvent? The answer is: practically, no, unless third parties decide to care, which they shouldn't. The ECB has an unlimited ability to create money, whether it is solvent or not. 

But it would be ever so slightly embarrassing to the Jean-Claude Trichets of this world if the ECB needed to raise equity.

Should Greece repudiate its external debt?

In downgrading Greece to BB+, S&P raised the issue of severity of loss in the event of a restructuring. S&P estimated a recovery rate of 30% to 50%.

 

Severity of loss for sovereign defaulters is very difficult to predict. A crucial question is whether Greece could avoid a default judgement by obtaining creditor approval of a "distressed restructuring" in which existing bonds are exchanged for long-maturity, low-yield substitutes. This would be the most esthetically pleasing form of resolution.

 

But some economists have argued (and I agree) that Greece's debt burden is too high to successfully restructure. In all likelihood, no matter how Greece is resolved, it is going to lose access to the external debt markets and will be forced to balance its budget overnight. Under such circumstances (along with with who knows what kind of political turmoil), what will be the incentive for Greece to continue to service its restructured external debt? 

 

Recent defaults (Argentina, Ecuador) suggest that creditors have really no meaningful recourse to the courts in the event of default. It would appear that the only downside to outright repudiation would be permanent loss of market access (although even that may not be true, as Argentina is attempting to show). 

Needless to say, the EU and the ECB would be quite cross at Greece, but it appears very difficult to expel an EU member. The ECB, which would lose billions in the event of  a Greek default, would be an unlikely lender to Greece or its banks. But that door is already closing.

My prediction is that Greece would begin by seeking to restructure its external debts (next month), but within a year or so will default permanently, resulting in a worse recovery rate than S&P has suggested.

The guns of May

It would certainly be ironic if Greece defaults in May due to the timing of a regional German election:


Opposition parties blame electoral politics for Berlin's lack of haste to help Greece. Ms. Merkel's party faces a tight regional election in the state of North Rhine-Westphalia on May 9. With German aid for Greece deeply unpopular in Germany, early commitment to bail out the debt-burdened Mediterranean country could change the minds of some voters and could cost Ms. Merkel her majority in the upper house of Parliament. (WSJ)

Thinking through a Greek debt restructuring

The NYT website has a new story today about the increasing risk of a Greek debt restructuring, with opinions about how it would work.


Carl Weinberg of High Frequency Economics proposes converting all Greek bonds due until 2019 into a pool that would be refinanced with 25-year bonds. Assuming a 4.5 percent interest rate, this plan would cut Greek financing requirements by some 60 percent, or €140 billion, he estimates.

Daniel Gros of the Center for European Policy Studies has proposesd extending the maturity of existing notes by five years, at the same interest rate. In other words, a 5-year bond paying 6 percent annual interest would become a 10-year bond, still paying 6 percent interest.

I think something along these lines is inevitable due to the arithmetic of Greece's debt maturities. However, a rescheduling would mean that Greece would lose market access and would have to balanced its budget immediately (aside from any credit provided by the EU and the IMF).

Banks holding rescheduled bonds would have to mark them to market unless provided with accounting forbearance which is very unlikely.

An interesting question is how the ECB would treat the billions in Greek bonds that it holds as collateral against loans to (mostly Greek) banks. It would like as though the ECB could take some big losses on these bonds, because the banks won't be able to repay the loans.

How would these rescheduled bonds be rated? Presumably at the bottom of the scale.

This could be bigger than Lehman. Head for the hills!

"Where do they find these people?"

There is a wonderful scene in the movie "The Queen" in which Tony Blair gets off the carphone with the Palace and turns to his assistant and says "Where do they find these people?". I am reminded of this when I read in the WSJ that the deflationist "hicks from the sticks" (a/k/a the regional Fed presidents) are pressuring Bernanke to unwind the TALF: 

Some Fed officials are pushing for a more aggressive approach. In April, Narayana Kocherlakota, president of the Minneapolis Federal Reserve Bank, called for monthly sales of $15 billion to $25 billion to eliminate the Fed's mortgage holdings within five years. "It is likely the Fed will have to sell a nontrivial amount of its MBS holdings," he concluded. Some Fed policy makers, among them Charles Plosser of Philadelphia , Jeffrey Lacker of Richmond and Kevin Warsh at the Fed board, are sympathetic .

Whose idea was it to allow local bankers to elect the regional presidents, and more critically, whose idea was it that these country club bankers should sit on the FOMC? Compare this with the UK MPC where the members are all serious economists including an American!

Can you imagine a British economist on the FOMC? 

Where are the serious guys: Barry Eichengreen, Peter Temin, Ronald McKinnon, or, for that matter, Paul Krugman? Why do we keep our smartest guys on the bench while we field rural bankers who should be playing golf with clients?

Inflation hawks at the Fed

The Economist reports that the FOMC hawks are pressing for the Fed to not only close the TALF (which occurred at the beginning of this month), but also to begin to unwind it by selling $15 to $25 billion per month. In other words, to begin to shrink the Fed's balance sheet and reverse the stance of monetary policy. 

This is despite the fact that bank lending and total private sector credit continue to contract. Contracting credit (deleveraging) is deflationary, which explains why core inflation remains close to zero. Any change in the Fed's stance at this time in the face of continuing credit contraction would be deflationary and would lead to a resumption in the decline in nominal GDP and a continuing decline in government tax receipts (which are declining at the rate of 10% per annum).

So long as the private securitization markets (home mortgages, commercial mortgages, auto loans, credit cards, etc.) remain closed, credit growth will depend entirely on banks, the GSEs and the Fed, and will remain weak. 

To begin to withdraw credit from the market a this time is analogous to encouraging an ICU patient to get more exercise. If and when inflation reappears (which I don't expect), the Fed has ample tools to react: it can shrink its balance sheet and/or raise interest rates. But for now, it should be worried about combating deflation, not inflation.

D-day for Greece: May 19th

Greece will most likely default on its May debt maturities because the EU/IMF rescue package won't be ready in time (if ever). 

This is because the rescue requires parliamentary approval by every EZ member state, including Germany. The NYT reports that the German opposition will block any fast-track approval of the package, and there may also be a constitutional challenge. 

D-day is May 19th, when Greece faces a EUR 8.5 billion debt maturity. It's possible that the IMF could bridge the gap, but I don't think that the IMF has ever granted a bridge loan in advance of a full "agreement". 

Will Greece shock the system like Lehman?

By this summer, Greece will have to ask its bondholders to participate in a "distressed exchange" in which bonds and short-term notes are exchanged for longer-maturity and, in some cases, lower coupon bonds. Something on the order of 10-year bonds with a 4.0 or 4.5% coupon (which, in classic Argentine style, will undoubtedly be subsequently defaulted upon). The question is not whether or even when it will happen (this year).

The question is market impact: Will this be an exogenous, asymmetric shock like Lehman, or will it be an anticipated non-event like Argentina? I have little doubt that it will be the former: another myocardial thrombosis like Lehman. This is because Greece (which is not a big deal) will reveal the spectre of something truly worrisome: countries that are not only too big to fail but also too big to rescue, like Austria and Germany in 1931. 

Since WWII we have faced the default of countries which were not TBTF such as all of Latin America. But now we have a set of countries which are TBTF but also too big to be rescued, which we haven't seen since the Great Depression. 

If the credit markets withdraw confidence from Portugal, it will also default. Default has pretty dire consequences with respect to fiscal balance and growth. Default results in an instantaneous and automatic budget balancing due to loss of external market access (and no national printing press). There is a minor benefit in the reduction of debt service, but this is a minor cushion against the massive and instantaneous fiscal consolidation required by the need to balance revenue and expenditure. Budgets have to be balanced in the face of national recession and declining tax revenue. 

Such draconian adjustments have not been witnessed in Europe in modern memory. Such adjustments can ony occur at the expense of state dependents: public sector employees and all pensioners (i.e., most Greeks). Fragile political regimes with recent legitimacy are at risk of rudderlessness or chaos. Postwar Greek and Portuguese history have not been characterized by stability or legitimacy. Once subject to these pressures, we should expect a reversion to these countries' political history of the sixties and seventies. 

To what extent can Italy and Spain escape this contagion, in the fall of 2010? Only to the extent that, by then, they will have successfully demonstrated their ability to substantially reduce their fiscal deficits in the face of Eurozone contraction, a tall order.

The Goldman "fraud" case

The SEC says that Goldman should have told the sophisticated institutional investors who bought the Abacus synthetic CDO that there was someone else on the other side of the trade. By this logic, when you buy a stock, the broker must inform you that someone else is selling the stock. The logic is so twisted that one does not know where to begin. But someone else has taken this on: Sebastian Mallaby at the Washington Post.

In SEC vs. Goldman, who's really at fault?

Let's stipulate that there's a problem with the power of Goldman Sachs. The firm takes vast risks and earns vast profits; then, when it gets into trouble, as it did after the Lehman Brothers failure, it turns to the government for a bailout. But the case the Securities and Exchange Commission has brought against Goldman also involves a problem. Unless the SEC is sitting on more evidence than it has laid out so far, the charge sheet looks flimsy. If Goldman has become a poster child for excessive power on Wall Street, the SEC might become a poster child for government power run amok.

The SEC's 22-page complaint states that Goldman sold fancy mortgage securities without disclosing that a hedge fund manager, John Paulson, was betting that those same securities would go bad. This is a non-scandal. The securities in question, so-called synthetic collateralized debt obligations, cannot exist unless somebody is betting that they will lose value. The firms that bought Goldman's securities knew perfectly well that some other investor must be taking the opposite position. It was their job to evaluate the Goldman offer and make up their own minds. One of the big losers in the deal was IKB, a German bank with a big business in mortgages. We're not talking mom and pop.

Perhaps the SEC is suggesting that Paulson's involvement changes this logic, because the hedge fund manager is famous for making billions from his mortgage bets? There's a superficial case here: Even if investors don't mind that somebody else is on the other side of the trade, maybe they wouldn't want to bet against a superstar. But at the time of the deal, Paulson was a low-profile player whose name would not have set off alarm bells. And intermediaries like Goldman are not supposed to blab about the identities of their clients.

Next, the SEC complains that Paulson had a hand in designing the securities, maximizing the chances that they would blow up. He did the equivalent of building a timber house with a large fireplace and a blocked chimney, then buying fire insurance on the structure. Shocking though this may sound, it is another non-scandal. An investor who wants to bet against a bundle of mortgages is entitled to suggest what should go into the bundle. The buyer is equally entitled to make counter-suggestions. As the SEC's complaint states clearly, the lead buyer in this deal, a boutique called ACA that specialized in mortgage securities, did precisely that.

Finally, the SEC asserts that Goldman, and specifically its young mortgage whiz, Fabrice "Fab" Tourre, tricked ACA into believing that Paulson meant to bet on the mortgages' soundness, not the other way around. This is the nub of the case, and if there's proof that Goldman or Tourre was dishonest, the SEC could yet emerge with its reputation intact. But none of the e-mail fragments quoted in the complaint comes close to being a smoking gun.

What the complaint does show is that ACA believed Paulson was a buyer, not a seller; and the really intriguing mystery is how ACA could have been so dumb. As the deal was taking shape, ACA and Paulson met repeatedly. If ACA had any doubt as to Paulson's intentions, surely it could have asked him a straight question rather than relying on alleged hints from Goldman. Throughout the negotiations, Paulson kept proposing notoriously low-quality mortgages for the bundle and vetoing high-quality ones. It should have been obvious to ACA that he meant to bet that they would go down.

The worst that can be said on the basis of the available evidence is that Goldman knew ACA was being stupid and failed to point this out. That falls far short of the offenses that the SEC alleges, which might be why two of the SEC's five commissioners refused to vote for the action against Goldman -- a rare split in an enforcement case. And yet, rather than treat the SEC's adventure with due caution, politicians and regulators are jumping on the bandwagon. British Prime Minister Gordon Brown, who just happens to be fighting an election campaign, has pushed British regulators to pile on to the SEC case. German Chancellor Angela Merkel, who could use some market scapegoats to distract from the euro zone's debt crisis, is threatening to follow suit. Congressional investigators are planning to grill Goldman officials for the umpteenth time.

Much is wrong on Wall Street, and Congress should pass some version of the regulatory package that is bottled up in the Senate. But the premise for more regulation is that the regulators will behave responsibly. Let's hope the SEC remembers that.

Questions about Europe and the outlook for global growth

The bad scenario that the EZ is trying to avoid is a Greek default, leading to contagion in other weak EZ members. While the EU probably has the resources to rescue both Greece and Portugal, it does not have the resources to rescue Italy or Spain. So here are some questions:

• Can Greece regain market access over a reasonable time period, such that the EU does not have to assume all of its debt?
• As Greece's bonds decline in price and its ratings continue to decline will banks have to begin to take writedowns this fiscal year?
• If Greece cannot regain market access (and most observers are skeptical), will the EU be willing or able to refinance all EUR 300 billion of Greece's sovereign debt as it matures?
• If the bailout becomes a protracted affair, what would happen if Greece failed to meet its fiscal targets (as is very likely)?
• Assuming that Greece is supported for this year, is that enough time for Portugal, Spain and Italy to show sufficient progress toward their deficit reduction targets such that they keep market access?
• If Greece ultimately defaults and contagion spreads to one or more other EZ members, what is Plan B?
• In the event of one or more EZ government defaults, what are the implications for the exposed banks in France and Germany?
• Can a firewall be drawn around the northern European banks in the event of major government defaults?
• Will the ECB be willing to engage in unorthodox manoeuvres in order to offset the deflationary impact of either (a) massive fiscal consolidation in the EZ and/or (b) sovereign defaults?
• If not, what is the outlook for nominal GDP growth in Europe over the medium term?
• And what are the implications for global growth given this situation?
• Can the US grow while Europe shrinks?

The future of an illusion

Right now, we have a national consensus that bank bailouts are a "waste of taxpayers' money". 

It seems that the only public voice of reason on this issue is Paul Krugman who understands that (1) bailouts are necessary, and (2) that the Senate Republicans are demagoging this issue in order to prevent stricter regulation.   

Wall Street is willing to take the risk that bailouts will be prohibited in order to avoid the regulation that would make them less likely in the future. 

We need much better regulation, and we need the government to be able to intervene to prevent a 1930-33 catastrophic meltdown of the financial system. 


The TARP was the best investment this country has ever made. Basically, we paid a few billion dollars in order to prevent a massive contraction in GDP, incomes and tax revenue. Without the TARP, the deficit and the national debt would be much larger, and growth prospects much worse.

The way to deal with moral hazard is prudential supervision, not a laissez-faire attitude toward financial stability.

Below, verbatim, is Krugman's column from today's NYT:

On Tuesday, Mitch McConnell, the Senate minority leader, called for the abolition of municipal fire departments.

Firefighters, he declared, “won’t solve the problems that led to recent fires. They will make them worse.” The existence of fire departments, he went on, “not only allows for taxpayer-funded bailouts of burning buildings; it institutionalizes them.” He concluded, “The way to solve this problem is to let the people who make the mistakes that lead to fires pay for them. We won’t solve this problem until the biggest buildings are allowed to burn.”

O.K., I fibbed a bit. Mr. McConnell said almost everything I attributed to him, but he was talking about financial reform, not fire reform. In particular, he was objecting not to the existence of fire departments, but to legislation that would give the government the power to seize and restructure failing financial institutions.

But it amounts to the same thing.

Now, Mr. McConnell surely isn’t sincere; while pretending to oppose bank bailouts, he’s actually doing the bankers’ bidding. But before I get to that, let’s talk about why he’s wrong on substance.

In his speech, Mr. McConnell seemed to be saying that in the future, the U.S. government should just let banks fail. We “must put an end to taxpayer funded bailouts for Wall Street banks.” What’s wrong with that?

The answer is that letting banks fail — as opposed to seizing and restructuring them — is a bad idea for the same reason that it’s a bad idea to stand aside while an urban office building burns. In both cases, the damage has a tendency to spread. 

In 1930, U.S. officials stood aside as banks failed; the result was the Great Depression. In 2008, they stood aside as Lehman Brothers imploded; within days, credit markets had frozen and we were staring into the economic abyss.

So it’s crucial to avoid disorderly bank collapses, just as it’s crucial to avoid out-of-control urban fires.

Since the 1930s, we’ve had a standard procedure for dealing with failing banks: the Federal Deposit Insurance Corporation has the right to seize a bank that’s on the brink, protecting its depositors while cleaning out the stockholders. In the crisis of 2008, however, it became clear that this procedure wasn’t up to dealing with complex modern financial institutions like Lehman or Citigroup.

So proposed reform legislation gives regulators “resolution authority,” which basically means giving them the ability to deal with the likes of Lehman in much the same way that the F.D.I.C. deals with conventional banks. Who could object to that?

Well, Mr. McConnell is trying. His talking points come straight out of a memo Frank Luntz, the Republican political consultant, circulated in January on how to oppose financial reform. “Frankly,” wrote Mr. Luntz, “the single best way to kill any legislation is to link it to the Big Bank Bailout.” And Mr. McConnell is following those stage directions.

It’s a truly shameless performance: Mr. McConnell is pretending to stand up for taxpayers against Wall Street while in fact doing just the opposite. In recent weeks, he and other Republican leaders have held meetings with Wall Street executives and lobbyists, in which the G.O.P. and the financial industry have sought to coordinate their political strategy.

And let me assure you, Wall Street isn’t lobbying to prevent future bank bailouts. If anything, it’s trying to ensure that there will be more bailouts. By depriving regulators of the tools they need to seize failing financial firms, financial lobbyists increase the chances that when the next crisis strikes, taxpayers will end up paying a ransom to stockholders and executives as the price of avoiding collapse.

Even more important, however, the financial industry wants to avoid serious regulation; it wants to be left free to engage in the same behavior that created this crisis. It’s worth remembering that between the 1930s and the 1980s, there weren’t any really big financial bailouts, because strong regulation kept most banks out of trouble. It was only with Reagan-era deregulation that big bank disasters re-emerged. In fact, relative to the size of the economy, the taxpayer costs of the savings and loan disaster, which unfolded in the Reagan years, were much higher than anything likely to happen under President Obama.

To understand what’s really at stake right now, watch the looming fight over derivatives, the complex financial instruments Warren Buffett famously described as “financial weapons of mass destruction.” The Obama administration wants tighter regulation of derivatives, while Republicans are opposed. And that tells you everything you need to know.

So don’t be fooled. When Mitch McConnell denounces big bank bailouts, what he’s really trying to do is give the bankers everything they want.

European dominoes

After Greece goes, the bond-market will round on another wounded eurozone sovereign, undoubtedly Portugal.

Mohamed El-Arian in the FT:

Buoyed by a cyclical recovery, markets around the world have yet to recognise the complexity of this situation. When they do, it will also become apparent that Greece is part of a wider, and historically unfamiliar phenomenon – that of a simultaneous and large disruption to the balance sheet of many industrial countries. Tighten your seat belts.

One way or another, this spiralling crisis will force weak countries to balance their budgets, either in response to the risk of loss of market access or default. That means that much of Europe will face a Great Depression scenario: deflationary fiscal policy in the face of economic recession. 

As Krugman pointed out in today's NYT, fiscal contraction in the face of deflationary monetary policy can only lead to disaster. Will the ECB cushion this blow, or will it do what the Fed did in the early thirties? And if it does pursue deflation, can it survive as an independent institution?