Central Banks Are Too Busy To Buy Bonds

September must be Diversity Training Month at the world’s central banks because they seem to have taken the month off.

This month the ECB, the BoJ and the Fed all announced big splashy bond-buying programs.. The ECB announced “unlimited” Outright Monetary Transactions to buy the bonds of compliant governments. The BoJ announced a Y10 trillion increase in its JGB Asset Purchase Program. The Fed announced its open-ended QE3+, wherein it would buy mortgage and agency bonds until its full employment mandate was fulfilled.

These announcements, coming at the same time, pushed equity markets up around the world. Now the markets are falling back, and some pundits are already calling the exercises a failure. Let's look at the facts..

We start with the inscrutable Japanese. On the 19th the BoJ announced that it would add another Y10 trillion ($100B) to its existing Y70 ($700B) trillion APP. Two observations: (1) twenty years of BoJ failure have shown that incremental purchases accomplish nothing; and (2) the BoJ’s recent announcement is meaningless. It merely continues the bank’s existing QE program, which is tiny compared to other countries and which has--surprise!--not worked.

The BoJ currently shares the title for World’s Worst Central Bank with the Reserve Bank of Zimbabwe. Under the BoJ’s care, Japan has experienced over twenty years of negative nominal growth and an increase in government debt from 70% of GDP in 1992 to 220% today. What should have been paid for in rising nominal tax revenue over those years was instead purchased with IOUs. Frankly, it is now too late for Japan: the inflation that it will take to dissolve the debt mountain will bankrupt the banks many times over. The endgame will be either default or high inflation. Bottom line: No good news.

Next, let’s look at the hapless Europeans. Draghi made his big announcement on the 6th. Activity to date: nothing. Even though both Ireland and Portugal are fully qualified for the ECB’s bond buying program, they have yet to receive the slightest benefit. Perhaps OMT wasn’t meant for puny countries but rather as a firewall around Spain. At some point in the future, Spain may see fit to beg for help and become a beneficiary. But so far, the ECB hasn’t bought a single bond under OMT. And, although OMT is not a QE program (unfortunately), it is noteworthy that the ECB’s balance sheet is contracting. That makes sense, since higher unemployment will help to underpin price stability.

Now for the Americans: more nothing. Instead of expanding its balance sheet as promised, the Fed’s balance sheet has actually shrunk since the big announcement. In its statement, the FOMC said that “The purchases of additional agency MBS will begin tomorrow (9/14), and are expected to total approximately $23 billion over the remainder of September.” Well, as of yesterday the Fed’s MBS is down by $9 billion, and September is now over. I don’t mean to be churlish, but is it really that difficult to print money and buy bonds?

So I have two points to make: (1) these banks should start putting their money where their mouth is and get on with it; and (2) in the case of QE3, don’t say that it isn’t working, because it hasn’t started yet. If Bernanke actually does what he said he’ll do, the stock market will take notice.

Europe Is Holding A Bake Sale For Greece

A month ago I posed the question “Will Greece blow up before election day?”, and answered no. I said no because the consequences of Grexit are unknown, and the cost of endless bailouts is cheaper than default, repudiation and general chaos. No one wants Greece to blow up, not now.

I said that the facts would be fudged and the bailout would be provided on the basis of meaningless Greek promises (redundancy). I also said that the IMF will be harder to “fix” than the ECB or the EU, since the IMF is not controlled by the EU, notwithstanding the woman who heads it.

That remains my prediction. However, pulling off this trick won’t be easy. Everyone agrees that Greece must be bailed out, but that is where the agreement ends. It appears that there are at least three flies in the ointment: the IMF team, which has not been co-opted by Lagarde;  the Bundestag, that won’t give Greece any more money; and the Greek people, who are going on strike tomorrow to demand free money from the sky.

A Grexit can only be prevented by forgiving Greece its sins, “extending” all of its deadlines, and throwing in another EUR 20 billion to keep it afloat until the next bailout. It is easy to forgive sins and extend deadlines; it is not so easy to come up with another twenty billion in bailout money. The IMF has said no to any more money. The EFSF/ESM can’t provide it unless the IMF is on board (so they say), and unless the Bundestag authorizes it. The ECB can’t provide it, because Greece is noncompliant with the Troika. And the Greek government will not agree to the latest austerity plan unless they are paid twenty billion to do so.

What’s a mother to do? Merkel will have to figure out a way to get her coalition to approve the new money, which it is loathe to do. We are witnessing the consequences of the constitutional court’s decision to give a veto to the Bundestag. All additional EU bailouts must be approved by the Bundestag, which is not made up of Brussels bureaucrats or French socialists. The elected German politicians must either approve all future bailouts, or must be responsible for the “End of Europe”.

This would all be easier to handle if Greece were located on the southern border of the US, because then it would have full American support, as Mexico did in 1994. Without American leadership and support, the financial geniuses on the Continent must solve this crisis on their own. They will solve it, but they haven’t yet figured out how.

In any case, Europe is doing its small part to re-elect the president by ensuring that this crisis will drag on past the November election. The Dow must not be allowed to crash for the next six weeks!

Spain Remains A Basket Case

Aside from the Greek circus, Spain is now the cockpit of the eurozone government debt crisis. How does Spain look as she confronts the need for a big bailout?

For the sake of this discussion, let’s agree that the ratio of government debt to GDP is a good measure of sovereign risk. Both government debt and GDP are nominal figures; no complicated constant dollar calculations are required. Government debt grows at the rate of beginning period debt plus the current year’s fiscal deficit in current dollars. For the D/GDP ratio to stabilize, nominal GDP must grow at the same rate as the deficit as a percent of GDP. Not rocket science.

Let’s take a look at Spain’s numbers.

Spain’s nominal GDP (EUR B), as calculated by the OECD, has been pretty flat:
2006: 986
2007: 1,053  (+7%)
2008: 1,088  (+3%)
2009: 1,048  (-4%)
2010: 1,048  (+0%)
2011: 1,063   (+1%)

Spain’s general government fiscal deficit as a % of GDP as calculated by Moody’s has been high:
2007 (+1.9%)
2008 (-4.5%)
2009 (-11.2%)
2010 (-9.3%)
2011 (-8.9%)
2012 (-6.6%) est.

Spain’s central government debt (EUR B), as reported by the Tesoro Publico, has grown rapidly:
2007 307B
2008 358 (+17%)
2009 475 (+33%)
2010 540 (+14%)
2011 592 (+10%)
2012 605 (July) (+2%)

Spain’s general government debt to GDP ratio (%) as calculated by the Fed has risen by 250%:
2007 36%
2008 40% (+4%)
2009 54% (+14%)
2010 61%  (+7%)
2011 69%  (+8%)
2012 91% (proj.) (+22%)

That is what the ECB is facing, as it seeks to facilitate Spain’s effort to become a creditworthy sovereign issuer. Spain’s numbers are all going in the wrong direction. The ECB can help to refinance Spain’s maturing debt at affordable rates (if it tries hard enough). But it can do nothing about Spain’s large fiscal deficit, which only the government (with the Troika’s help) can fix. And the ECB has announced no plans to raise the eurozone’s rate of inflation or the rate of nominal GDP growth. The outlook is grim.

Looking forward, Spain’s nominal GDP growth outlook is at best modest (zero?), while its fiscal deficit is unlikely to get much below 5-6% of GDP, despite whatever cuts Spain eventually agrees to. Thus, the medium-term outlook for Spain’s debt ratio is a steady annual increase, in the direction of higher credit risk, lower credit ratings, and higher bond spreads. Spain will remain a deteriorating credit until its budget comes into a sustainable balance and its GDP starts to grow in a sustainable way. Neither are likely without much higher inflation in the eurozone (which had been experiencing deflation until recently).

Moody’s currently rates Spain at the bottom of investment grade (Baa3), with the rating under review for possible further downgrade (to junk). In a recent comment on the continuing review for downgrade (expected to end soon), Moody’s sounded pessimistic in observing that:
“official support beyond banking recapitalisation but short of a full package may also pressure the rating below investment-grade if (1) the combined measures were unlikely to succeed in maintaining ample market access; or (2) if these measures were effectively providing the bulk of the Spanish government's funding needs through crisis-management tools such as the European Financial Stability Facility and ESM, and European Central Bank actions that provide liquidity to government debt markets. Short of the accompanying fiscal and structural reforms being successful, full return to market access at the end of these initiatives may prove very difficult, raising the risk of private sector participation in a debt relief effort before more official support is provided.”

That sounds to me that Moody’s will either downgrade Spain or extend further its review (begun three months ago). Most likely they will take the rating to Ba2/negative outlook (which won't lower bond yields).

My overall conclusion is that while the OMT can help to overcome the market’s reluctance to buy Spanish debt, it can’t fix Spain debt trajectory. That can only be done by politically unpalatable austerity combined with massive unsterilized QE by the ECB. By sterilizing the OMT program, the ECB has condemned Spain to a future of zero growth, weak government revenue, and rising debt ratios. Let us hope that Bernanke’s QE3+ will succeed, and provide a model for the ECB before it is too late.

There Is No Such Thing As Conservative Monetary Policy

“Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.”
--J.M. Keynes, General Theory

"Gold was an objective value, an equivalent of wealth produced. Paper is a mortgage on wealth that does not exist, backed by a gun aimed at those who are expected to produce it.”
--Ayn Rand, Atlas Shrugged

I am a proud member of the party of free enterprise, individual liberty, and sound economic policy. The GOP stands against all of the little tendrils of neomarxism that have found their way into the Party of the People. We stand for a balanced budget, limited government, and thrift. We want America to prosper, and for a prosperity shared by all, as opposed to the growth-destroying redistributionism of the Left. We have smart economists who can patiently explain what is necessary create the conditions for growth. We believe that we are the party of growth.

However, my party also has a dark side (yes, imperialism, but in addition to that): a sound dollar. Who could be opposed to that? We don’t want the US to become Argentina or Zimbabwe do we? We don’t want to live in a country which periodically slices the zeros off of its currency, and where you to carry a calculator to figure out what things cost in “real money”, do we? No, we don’t. We want a “sound currency”.

And so, the House GOP deputy whip, Kevin Brady, has introduced the “Sound Dollar Act of 2012”. Boy, who could be against that besides Barney Frank?

The bill begins with the “finding” that:
“Monetary policy can only affect the level of employment in the short term because nonmonetary factors determine the level of employment in the long term...Therefore, to maximize long-term economic growth and achieve the highest sustainable level of real output and employment, price stability should be the objective of monetary policy.”

The bill then proceeds to eliminate full employment from the Fed’s mandate: “Section 2A of the Federal Reserve Act is amended(1) by striking ‘‘goals of maximum employment, stable prices, and moderate long-term interest rates’ and inserting ‘‘goal of long-term price stability’’.”

To be honest, as a conservative/libertarian, I don’t fully understand why the right of my party is opposed to the full employment mandate. Those of us in the “market monetarist” camp tend to be pretty conservative. We believe that prosperity leads to sound policy, while depression leads to leftist nostrums like  green jobs and ObamaCare. But the “hard money” guys somehow see the Fed as an ally of the Left. Romney and Ryan are criticizing QE3 as “another bailout” and a short-term “sugar rush” to re-elect Obama.

Another Republican statement (Rep. Raul Labrador) on this subject: “It is going to sow some growth in the economy, and the Obama administration is going to claim credit.” Labrador is objecting to QE3 because it might help the economy.

Right now, the small but influential “market monetarist” community is happily celebrating last week’s victory, when Bernanke finally agreed to acknowledge the Fed's full employment mandate and--hold your hat--to target employment as an explicit objective of Fed policy. The market monetarist community feels that there has been a major intellectual breakthrough in D.C., and they (see: Wolfgang Munchau at the FT) are seeking to export this breakthrough to the eurozone, where it is so desperately needed.

These celebrations may prove premature. I recently received an email from the Romney-Ryan team, which said:
“This past week, the Federal Reserve announced it would print $40 billion every month to prop up this administration's jobless recovery -- that's money we can't afford for jobs we will never see.”
Those words are not music to the ears of market monetarists. The GOP seems to be doubling down on sound money.

The market monetarist school may have a short life in power if it is unable to convince the Congress and the next president that full employment is not a left/right issue, and that good growth policies have no ideology. Appropriate monetary policies are not only a moral imperative (if one sees unemployment as a bad thing), but also a fiscal imperative if we are ever to stabilize our debt-to-GDP ratio. It is the only way that we can have GDP outrun our debt mountain.

The House GOP are currently slaves not to a defunct economist, but to a defunct philosopher and novelist, Ms. Alisa Rosenbaum (Ayn Rand). It is unfortunate that Ms. Rand harbored opinions concerning monetary policy. I am sure that Ms. Rand’s experiences in the early days of the Soviet Union were enlightening, but they gave her the wrong idea about inflation.

A Brief Introduction To German Constitutional Law

Excerpts from the Sept. 12th decision of the Federal Constitutional Court:
“The ESM Treaty may only be ratified if, at the same time, it is ensured under international law that the limitation of liability limits the amount of all payment obligations arising to the Federal Republic of Germany from this Treaty to its share [EUR 190 billion] in the authorised capital stock of the ESM and that no provision of this Treaty may be interpreted in a way that establishes higher payment obligations for the Federal Republic of Germany without the agreement of the German representative.
“The German Bundestag is prohibited from establishing mechanisms of considerable financial importance which may result in incalculable burdens with budget significance being incurred without the mandatory approval of the Bundestag.
“To what extent the decision taken by the Governing Council of the European Central Bank on 6 September 2012 on a programme concerning the purchase of government bonds of financially weak Member States whose currency is the euro complies with these legal requirements was not a matter for decision in the present proceedings.”

For my sins, I actually read the Constitutional Court’s entire decision (in translation). I have excerpted what I think are the crucial parts. The court permitted the government  to sign the ESM treaty on the proviso that it does not bind Germany to future expenditures beyond its initial capital contribution of  EUR 190 billion. The Court did not express an opinion concerning Draghi’s OMT, although plaintiffs had asked it to do so.

The court’s decision has been widely interpreted as a green light for greater fiscal integration. Indeed, Jose Manuel Barroso, the president of the European commission, called for a federal European state in his annual “state of the union” address: "I call for a democratic federation of nation states that can tackle our common problems, through the sharing of sovereignty." Barroso said that a federation of Europe is "unavoidable" if Europe's embattled common currency is to survive the financial crisis. His aides said that he plans to recommend a plan for common eurozone bonds.

Somehow I fear that the president of the European Commission may not yet have read the Constitutional Court’s decision. It is as if the Court said the opposite of what it said, or that what it said doesn’t matter. The Court specifically prohibited the ratification of any treaty that bound Germany to pay or owe any more money than EUR 190 billion, which absolutely excludes the possibility of a eurobonds or a fiscal union. As best as I can tell, it also ruled out the idea of the ESM’s leveraging itself by borrowing from the ECB or the capital market.

In my view, this means that the ESM will be quite limited in scale, and will not be big enough to be helpful to either Spain or Italy. It will merely serve as the gateway to the ECB’s bond buying program--which will be challenged before this court.

If Barroso is correct that only a federation can save the eurozone, Germany’s constitution will need to start “evolving” very quickly.

Bernanke Hits It Out Of The Park

FOMC Statement, Sept. 13th, 2012:
“If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.”


It may be safe to fight the Fed when it is floundering around ignoring its employment mandate. It isn't safe to fight the Fed when it decides to achieve its mandate.


I had predicted that the FOMC would announce another round of QE, in the amount of $500B. I criticized the decision in advance by saying that the Fed should target outcomes rather than endless incremental inputs.

I was wrong; I underestimated Bernanke’s powers of persuasion with the hawks.
It looks like he has finally used his considerable authority to begin to practice what he used to preach as a professor.

He has announced that the Fed will continue to buy securities (QE3+) until the outlook for the labor market improves substantially. While it is true that he will do this in increments of $85 billion per month, he made an open-ended promise to keep buying bonds until his target is achieved. This is a major intellectual breakthough for the Fed.

The Fed has begun to do what the ultra-doves (the “market monetarists”) have been begging for since 2007: use its unlimited resources to fulfill its full employment mandate.

I wonder if the hawks fully understand what they have just signed up for or, if they do understand it, whether they really mean it. That is because, I think it will cost at least another one trillion for the Fed to achieve its new target, and maybe two trillion. 

That means that the Fed will have to buy bonds at $85 billion per month for one to two years. That is probably beyond Bernanke’s tenure in the job. Who knows what the next chairman will think of this policy? And if ever inflation dares to rise one iota over 2%, the Fed will have an excuse to stop the whole exercise.

Unlike the Supreme Court, the Fed is not bound by its own precedents, and can change its mind at any time (as it just did). Nonetheless, this is the first time in history that the Fed has targeted employment growth by any means necessary.

In the past, the Fed's weapons were conventional (interest rates) and unconventional (incremental QE), but never open-ended QE. The last time something like this happened was when FDR horrified economists by raising the price of gold until commodity prices recovered (which was 100% successful).
In my view, it is no longer safe to fight the Fed. The Fed has gone nuclear, and it can't lose at least as long as Bernanke is chairman. The era of weak recovery and high unemployment is over, if Ben follows through. The risk of an inflationary shock is low. Therefore, the Equity Risk Premium is high at the same time that the earnings outlook is good. Also, no matter what happens in Europe, the Fed can overcome it as long as it pursues its new policy. I find it hard not to be bullish. I am buying SPY.

Looking For Black Swans In The Eurozone's Infirmary

I thought that this might be a good time to take a quick look into the eurozone’s ICU to see how the PIIGS are doing. My particular interest is in identifying any countries that look likely to blow up this fall. I will review the PIIGS in the order of their current Moody’s bond rating, from highest to lowest.

Italy
(Baa2/Negative Outlook. Barely eligible for investment grade portfolios. Bonds at 5.1% trade as a Baa3.)

Italy is the Big Enchilada of the PIIGS.  As a major economy with EUR 2 trillion of debt, it is way too big to be allowed to default. However, refinancing a debt burden on that scale cannot be handled by the EFSF/ESM. It would require the full resources of the ECB, and then some.

Italy’s bond yield has been quite volatile. It was as high as 7.2% last fall. Since the OMT was announced, it has fallen to 5.1%, which is still too high.

Moody’s downgraded Italy from A3 to Baa2 in July, providing the following rationale:
“A key factor underlying Moody's two-notch downgrade was the assessment that the risk of a further sharp increase in Italy's funding costs or the loss of market access has increased due to fragile market confidence, contagion risk emanating from Greece and Spain and signs of an eroding non-domestic investor base. The risk of a Greek exit from the euro has risen, the Spanish banking system will experience greater credit losses than anticipated, and Spain's own funding challenges are greater than previously recognized. In this environment, Italy's high debt levels and significant annual funding needs of EUR 415 billion (25% of GDP) in 2012-13, as well as its diminished overseas investor base, generate an increasing liquidity risk. The second driver of the rating action was the deterioration of Italy's near-term economic outlook, as manifest in both weaker growth and higher unemployment, which creates risk of failure to meet fiscal consolidation targets. Failure to meet fiscal targets in turn could weaken market confidence further, raising the risk of a sudden stop in market funding”.

So far, Monti seems to be hoping that the ECB’s OMT announcement plus further reform  at home will bring Italy’s bond yields down further, which I doubt. His fiscal situation will worsen, and his government’s domestic power position will continue to decline. In the end, Monti will have to apply to the troika for assistance, and the ECB will have to move heaven and earth to establish an informal yield ceiling.

Spain
(Rated Baa3, on review for downgrade. Moody’s says that its review will continue through the end of September. Spain is already ineligible for most investment grade portfolios. Trading as a Ba1 at a yield of 5.6%.)

Spain, with EUR 750 billion of debt, is Europe's other big problem. Although Spain’s bond yield has come down since the OMT announcement, it is still high at 5.6%. The Spanish banking system has been steadily losing deposits due to convertibility risk (which is, of course, “unthinkable”).  Spain requires help from Europe to pay its maturing debt, recapitalize its banks, and bail out its regions. Rajoy has been slowly going through the stages of grief and is currently moving from denial to bargaining.

Because Spain is too big for the EFSF/ESM to rescue, it ultimately will be up to the ECB to bring Spain’s yields down to a financeable level. The immediate question is the size of the capital hole in the banking system. The longer that Rajoy waits to apply to the Troika for assistance, the more likely Moody’s is to downgrade Spain to below investment grade, which will add to the pressure.

Ireland
(Rated Ba1/Negative Outlook. Ineligible for investment grade portfolios. Bonds at 8.2% yield trade at their rating level.)

Ireland is the Troika’s poster boy for compliance and success. Ireland has executed its austerity program and is on track for continued fiscal consolidation.

Moody’s says that it  “sees a possibility that the end of the current support programme at year-end 2013 will not only prompt a need for further rounds of official financing, but that private sector creditor participation is also to be required as a precondition for such additional official support.”

One can only hope that Moody’s is mistaken in suggesting that the Troika will require a bond default as a precondition for additional assistance, since this would make Ireland a credit like Greece. Europe can’t be that stupid.

As a fully-compliant government, Ireland should be the first in line for bond purchases under the OMT. They don’t even have to apply. It will be interesting to see if the ECB steps up. I can see no reason why they shouldn’t, if they want the program to have any credibility. Let’s see how fast Draghi can bring down Ireland’s yields. What is he waiting for?

Portugal
(Rated Ba3/Negative Outlook. Ineligible for investment grade portfolios. Bonds yielding 8.1% trade at their rating level.)

Portugal remains in austerity hell. It has no market access, is in permanent depression, and still faces major additional cuts. It is on track but has a long way to go, with no light at the end of the tunnel.

Moody’s assessment is quite pessimistic: “considerable uncertainty over the prospects for institutional reform in the euro area and the increasingly poor macroeconomic outlook across the region will continue to weigh on already fragile market confidence and make it difficult to reverse Portugal's adverse government debt trajectory”. Moody’s adds that a Greek exit would not be helpful for Portugal.

Greece
(Rated C, in default; remaining bonds yield 22% in anticipation of a second default.)

Greece, on permanent life support from Europe, is way off track in the implementation of its Troika-designed program. It has done almost nothing to comply, and prefers rioting to reform. Greece is the proof that there is almost nothing that a eurozone government can do to get kicked out of the eurozone. Europe knows that a Greek exit would be another Lehman event and would put intolerable pressures on the other PIIGS. The Greek negotiators know that. I expect that Greece will get its money by once again agreeing to a plan it has no intention of implementing. Greece is impossible to reform and too big to fail.

Conclusion
If you want to gauge these five credits as potential black swans, you’d have to start with Greece, although I am confident that Greece will get bailed out no matter what. Next would be Spain which is playing chicken with Europe on the terms of its bailout, but this is political theater. Spain will have to apply, so the risk of an unanticipated explosion is low. Italy may be the sleeper of the bunch, because most of her plausible scenarios are on the downside, as Moody’s stated. Time is not on Monti’s side, and his credit is likely to worsen.

Because neither Italy nor Spain can be rescued by the ESM, they will ultimately have to be rescued by a display of shock-and-awe by the ECB. By shock-and-awe, I mean massive unsterilized bond buying. That can only occur when Draghi has enough votes. Let’s hope that, when one of these behemoths starts to keel over, Draghi will have the votes to do something.

Pathology Of The Eurozone Crisis

I have been asked a number of times “How did the eurozone crisis happen, and how did it grow so big before it was discovered?”

The crisis happened because European Monetary Union was poorly conceived, badly designed, and poorly executed. It grew so big because, like other such bubbles, it worked beautifully so long as it expanded.

EMU was conceived mainly for political reasons, namely to further cement “Europe”, and to further Europe’s desire for a restoration of its “world power” status. Instead of first creating a functioning political union with a government, a legislature and fiscal revenue, Europe put the cart before the horse and created a currency union without a nation, without centralized government, and without fiscal revenue or fiscal sharing.

The "Two Europes"
There is a lot of literature about the ideal conditions for a monetary union, and suffice it to say that the eurozone meets none of them. Europe is a geography, not a nation and not a culture. To be more specific about the differences, the northern part of Europe is more developed than the southern part. The north has stronger political institutions, greater national cohesion, disciplined labor markets, and a competitive private sector. Specifically, the northern European countries have been successful at maintaining international competitiveness despite having hard currencies. Unit labor costs are controlled in such a way that currency devaluation is not necessary.

By contrast, southern Europe is less developed than the north; it is more “Latin,” in the negative sense of the word. Political institutions are weaker, national cohesion is less evident, regionalism is more pronounced, and labor markets are inflexible. Southern Europe has never been successful at maintaining competitiveness with a hard currency. Southern Europe has historically dealt with poorly controlled labor costs by devaluation. Devaluation permits countries to avoid having to control labor costs.

This is why I say that EMU was poorly conceived: it was unsuitable for the heterogenous mix of countries involved.

Furthermore, the eurozone was badly designed. If, ex ante, one had wanted to create a European monetary union, one might have taken a close look at one of the world’s most successful monetary unions, the dollar zone. The dollar zone has three features that have been crucial to its success: (1) a national banking system which is nationally regulated and nationally guaranteed; (2) complete insulation of banks from the creditworthiness of their respective state governments; and (3) the absence of state-level convertibility risk.

The eurozone has none of these crucial features. It lacks a national banking system, national deposit insurance, and national bank regulation. Its banks are highly exposed to their respective governments, and they depend on these governments to guarantee their deposits. And depositors in eurozone banks are exposed to the risk that their deposits could be frozen or redenominated by their respective governments.

The Wrong Central Bank
The eurozone has another design flaw, an almost fatal one. That is that it chose the wrong model for its central bank. A monetary union which contains countries that rely upon a weak currency to remain competitive should not have chosen the Deutsche Bundesbank as its model. The eurozone’s central bank should have included Latin design elements, such as a higher inflation tolerance and a full-employment mandate. In other words, the ECB should have been modeled on the Banca d’Italia, a more forgiving institution.

By choosing the Bundesbank model, the solons had decided that it would be easier to change the nature of southern European society than for the Germans to accept the lira as their currency. That was a mistake: thirteen years of monetary union have not changed southern Europe. Unit labor costs are still uncontrolled, and the tolerance for deflationary policies remains low. Indeed, instead of the south changing, it is the ECB that will now have to change if EMU is to succeed.

The Bubble Economy
Now, given the foregoing flaws, how was the eurozone bubble able to grow so big for so long?  The answer is because it acted as a Ponzi-scheme. When EMU was embarked upon in the mid-nineties, a euphoric mania began in which, as if by magic, southern European countries lost their historic country risk. The magical word on everyone’s lips was “convergence”, the idea that somehow the creditworthiness of the southern countries would converge with the AAAs of the north.

The “convergence trade” meant that one could stop obsessing over southern budget deficits, secure in the knowledge that they were all on an inevitable path toward compliance with the Maastricht fiscal criteria (<3% deficit, <60% D/GDP). The thinking was, ignore the inevitable bumps, and ride the credit spreads down to zero. Overnight, these countries became magnets for capital inflows: their returns were high while their risks were low. A virtuous cycle began in which success fueled success and all the metrics pointed in the right direction. (All the metrics except the current account, but that was now “irrelevant”.)

This bubble started growing in 2002, and it was still growing when the great recession hit in 2008. In such a steep recession, it was natural for countries to run temporary budget deficits, so there was little concern over red ink in 2008 and into 2009.

Greek Perfidy
However, what ultimately poked a hole in the euro bubble was the discovery in late 2009 that Greece had been cooking its books for years, and had never been in compliance with the Maastricht criteria. (Imagine, a country knowingly publishing false statistics! Who had ever heard of such a thing?)

All of a sudden, Greece got hit with a big bucket of cold water. A country which had enjoyed much higher concentration limits than it deserved now began to discover what happens when your limits are reduced. Greece quickly lost market access and required a bailout.
   
At first it appeared that Greece would only need temporary liquidity support to tide it over until it could get its budget back in balance. Then it appeared that Greece would be unable to repair itself quickly and would be out of the market for a long time, requiring Europe to refinance its maturing debt. When it became evident that not only could Greece not balance its budget, but also that its debt levels were unsustainable, Europe began to realize that fixing Greece was going to be time-consuming and costly.

It was at this point that Europe made its next major mistake. This was to announce that, if Europe were to continue funding Greece, its debts would have to be reduced to a manageable level. And, if the European taxpayer were to have to rescue Greece, its bondholders would have to contribute (what is known in credit circles as "default").

Contagion
That might sound perfectly reasonable to a politician, but it sounds perfectly unreasonable to a bondholder who has been repeatedly told that default by a eurozone government was “unthinkable”. Overnight, the unthinkable became not only thinkable but a fait accompli. Greece was rescued at the expense of its bondholders and, more importantly, at the expense of the eurozone’s credibility in the bond market. The eurozone minus credibility equals the end of euro mania.

Had Greece been quietly cleaned up, it would have been a manageable problem. But when the doctrine of  “bondholder bail-in” was proclaimed, that meant that every eurozone government instantly became a “credit” once again, to be evaluated on a stand-alone basis.

When the world’s credit analysts turned their microscopes onto the eurozone, they discovered a lot of ugly credits squirming around which were quickly named the “PIIGS”, for Portugal, Ireland, Italy, Greece and Spain. These countries then got hit with their own buckets of cold water, were declared personas non grata, and lost market access. This probably would not have happened if Greek bondholders had been protected (which would have cost very little in the scheme of things).

Epilogue
Ultimately, of the five PIIGS, two have been bailed out once (Portugal and Ireland), one has been bailed out twice (Greece), Spain is in the process of receiving multiple bailouts, and only Italy has survived on its own. And now Cyprus has been added to the list, even though it doesn’t fit into the acronym.

We have just now entered the next phase of the EMU crisis, in which the central bank has begun to develop Latin characteristics. But even now, it isn’t yet Latin, and it will need to be before this is over.

The Differences Between the Eurozone and the Dollarzone

How the US succeeds as a monetary union while Europe doesn’t, and why Greece is in a debt crisis while California isn’t:

1. The California banking system’s creditworthiness is not linked to the state’s.
>California’s banks are not heavily exposed to the California government’s credit risk because they are not the government’s principal source of funding, due to the tax-exempt nature of California’s debt.
>California has no responsibility for the solvency of the California banking system; instead the federal government is responsible for the solvency of all banks in the dollar zone.
>Bank deposits in the dollar zone are guaranteed by the US government.
>Because of the excellence of US bank accounting and regulation, dollar zone bank financial statements are credible.
>The American states have no control over their banks, and can’t order them to buy state debt.
>The Federal Reserve does not condition the provision of  bank liquidity on the fiscal performance of the California government.
>The federal government does not condition state-level funding on state government fiscal performance.
>The Federal Reserve does not buy state government debt.
2. California’s market access is unrelated to its credit rating
>Because of the Constitutional accident of tax-exempt state debt, most of California’s debt is held by California residents and not by foreigners.
>Because California has a monopoly on the issuance of debt that is tax exempt in California, her access to the bond market is unimpaired despite her volatile credit risk.
>The California bond market is entirely domestic. It is neither national nor international.

3. The government of California is a small part of California’s economy
>Most government spending in California is federal, not state.
>The California economy would survive the bankruptcy of the state, because it would not bring down the banking system, and federal spending would continue.
>The US government does not condition its California spending on the state’s fiscal performance.
>Most California residents are not employees of the state, and the California public sector is small compared to that of Greece.

4. California bank deposits have no convertibility risk
>There is no risk of a California currency redenomination because, pursuant to the US Constitution and the outcome of the Civil War, California cannot exit the dollar zone, nor can she be expelled from it.
>California cannot impose currency or capital controls.

What the eurozone would have to do to separate bank and state solvency and to eliminate convertibility risk:

1. The ECB guarantees bank deposits.
2. The ECB is responsible for bank solvency and regulation.
3. The ECB imposes strict, uniform and transparent solvency and liquidity standards on all eurozone banks.
4. The ECB’s bank regulatory regime is comprehensive, intrusive, incorruptible and independent of government interference and political pressure.
5. National central banks are abolished and removed from the ECB governing council.
6. ECB does not condition the fulfillment of its statutory responsibilities on the fiscal behavior of member governments.

7. The EU does not condition its spending policies on the fiscal behavior of member governments.

8. Governments can default on their debt but cannot redenominate.
9. Interest on government debt is tax-deductible for households but not for banks.
10. Government debt is marked to market, forcing timely recapitalization.
11. Concentration limits are imposed on bank exposure to government risk.