Capitalism and Freedom

Germany plays with Greece

2012-02-09T20:19:00.001-08:00

If you believe what you read in the paper, Europe is on the verge of yet another Greek rescue package intended to prevent default next month when EUR ~14 billion in Greek government bonds become due.

The deal has the following elements:

1. Greece (all parties) agrees to an austerity diktat issued by the Eurogroup (formerly known as the Troika). The parties must sign and parliament must pass enabling legislation this weekend. No dawdling this time.

2. Private-sector bondholders agree to a debt swap in which they receive worthless paper in exchange for worthless paper with a higher fictitious face value. All bondolders must agree or else holdouts will be forced to exchange, resulting in an involuntary default. This deal has been “almost done” for weeks. The deadline is Monday.

3. The Eurogroup will lend Greece either EUR 130 or 145 billion in order to keep it afloat for the rest of 2012 (if you believe in the Easter Bunny).

The psychology here is interesting. The Germans are in an emotionally conflicted position. Bailing out Greece is a small price to pay for European financial stability. But the whole exercise sticks in the German craw, especially since the Greeks will sign anything and do nothing. One part of the German mind wants to get the bailout over with and move on, while the other part wants to push the Greeks over the cliff and watch their well-deserved demise.

This conflict is visible in the prescriptive language of the diktat. The exasperated tone is reminiscent of Austria’s ultimatum to Serbia in 1914 (another case of German frustration with the crafty Balkan mentality). It is a kind of Prussian wishlist of Greek good government reforms, with a utopian flavor:

* A reduction of 22 percent to the minimum wage, currently at 751 euros per month gross, with an additional 10 percent reduction to the basic salary for young people aged under 25.
* A freeze on the minimum wage of three years.
* A freeze on all salary raises until the unemployment level is reduced from its current 19 percent to under 10 percent.
* A reduction in the pensions of employees of state companies OTE telecoms and Public Power Corporation by 15 percent, as well as of seamen by 7 percent.
* Placing in the labor reserve scheme 15,000 state employees by the end of 2012, with the target of reducing general government employment by 150,000 by the end of 2015.
* The reduction from six months to three of the period over which collective sectoral labor agreements continue to be in effect after their expiration. If a new labor agreement is not drawn up in this period, the sector in question will be bound by the basic national standard, without, however, forfeiting benefits for years of service, job hazard, children and education.
* Collective sectoral agreements will have a limited duration of three years, while existing contracts with a 24-month duration will expire in one year from now.
* A reduction in contributions to the IKA Social Security Foundation of 2 percent effective immediately, and an additional 3 percent in 2013.
* A review by end-June of the special salary status of judicial employees, state doctors, diplomats, and police and military personnel.
* The sale by end-June of scheduled share packages in the following state-owned companies: Public Gas Corporation (DEPA), gas distributor DESFA, Hellenic Petroleum (ELPE), betting agency OPAP, the Attica and Thessaloniki water and sewerage companies (EYDAP and EYATH), and the International Broadcasting Center.
* The abolition of permanency for employees at state-owned companies and banks.
* The restriction of tax exemptions, simplification of the value added tax and property tax structure.
* The closure of 200 tax offices across the country by the end of the year.
* The hiring of 1,000 more tax auditors, to bring their total number by the end of April to 2,000.
* Eliminating the extension of payment terms for overdue taxes and social security contributions.
* A further reduction in military spending by 0.15 percent of GDP.
* The recapitalization of Greek banks through common shares with limited voting rights and through contingent convertible bonds.

Quite a list, no? All that’s missing are German gendarmes stationed at Greek customs posts. Does the list bear any relation to Greece’s future budgetary policy? No.

None of this will happen. The Greeks know this and the Germans know this. But it is intended to provide sufficient political cover for the Bundestag to pass the bailout legislation, which Merkel's coalition will ensure.

The bailout will go through and the Greek saga will last a bit longer. To the extent that any aspects of the diktat are implemented in fact, we will have more ITV footage of the usual riots, etc. I would not expect the Papademos government to fall, because the parties and the army want to have nothing to do with these measures. The parties want to return after the explosion, not before.

Clowns at play

2012-01-17T10:34:00.001-08:00

Is there anything that the EU could have done or could yet do to make the euro crisis worse?

Begin by stating that an obviously insolvent Greece is actually just fine and those who disagree don’t understand Europe;
When Greece can no longer borrow in the market, admit that it has a temporary problem that can be fixed by a touch of austerity plus a generous portion of Brussels happy talk;
Concede that, in addition to pinch of austerity, Greece may need substantial official loans to finance its huge deficits “until it regains market credibility”;
Make sure that such loans are small, late, and contingent on ever-tighter austerity targets;
“Restore” market confidence by asserting that default by a eurozone member is unthinkable and that such bonds are risk-free;
Announce that any further bailouts must include partial bond default (“private sector involvement”) and that no one should have ever seen them as risk-free;
When Italian and Spanish yields rise to junk-bond levels, announce that future bailouts will not require public sector involvement, adding that neither Italy nor Spain actually require bailouts;
As eurozone government bond pricing becomes increasingly affected by market-access and credit-risk concerns, denounce market participants who raise these issues;
As eurozone government bond prices steadily fall, invent accounting schemes that prevent eurozone banks from having to show mark-to-market losses

Which brings us to the latest, and most humorous development: the assault upon the rating agencies for beginning to reflect in their ratings the scale of the stresses facing eurozone governments and banks.

There are three prongs to this assault:
1. Accusations of incompetence, irresponsibility, and “foreign influence”;
2. Another attempt to create a “European” rating agency to counter the malign anglosaxonism of the Big Three; and
3. The push for regulations to prohibit the publication of irresponsible and/or disruptive ratings.

The first prong (jawboning) is the usual Brussels Orewellianism, which market participants ignore. The second (a European rating agency) is a 25-year old chestnut that has reared its head many times. The idea is that a tame house-agency would produce different market outcomes than the current system. A good analogy is that by controlling the weather bureau one can control the weather. It also ignores the continued existence of the Big Three and their uncontrolled opinions.

The third prong, ratings blackouts, would reduce market disruption during periods of sovereign stress:

“Some members of the [European] parliament are in favour of banning publication of negative ratings," Wolf Klinz, a German Liberal member of the European Parliament said. "Some of the socialists and conservatives say it's a good thing to have the option to ban the publishing of ratings if they do come at the wrong moment," Klinz told Reuters.
The original blackout proposal was intended to cover only publication of negative ratings of countries receiving bailouts. But some politicians could now go further and ask for publication to be banned if it comes at an 'awkward' moment for the country concerned. (Reuters, 2/17/12)

This is the option that I find most humorous. I very much doubt that this proposal will ever actually be implemented, but I wish that it would be, as an object lesson in market behavior.

The idea is that, when a country is in negotiations for a bailout or is otherwise under stress, the EU would promulgate a decree temporarily banning the publication of any rating opinion on the country. Thus, the agencies would issue press releases stating:

The government bond rating of France has been temporarily suspended in accordance with the EU’s blackout order. Until such time as the blackout period is lifted, we will have no rating opinion with respect to France’s government bonds.

During the blackout, French bonds would, by law, be unrated by any recognized agency. Since many institutional investors are not permitted by their clients’ guidelines to hold unrated bonds, the blackout directive would cause market chaos.

I do not mean to imply that the EU has exhausted its options with respect to further exacerbating the euro crisis. Within the next month, as the Greek bond default negotiations proceed and as Italy seeks to issue billions in bonds, we will entertained with many more such gaffes, blunders and magic tricks.

The EU summit will fail

2011-12-07T20:39:00.001-08:00

This week’s EU summit meeting will fail. The purpose of the meeting is to agree to a fiscal stability plan that will persuade the ECB to rescue Italy and Spain. This will fail for two reasons.

First, there is considerable daylight between what Germany wants and what the EU or the eurozone can agree to. Germany wants a new treaty with binding constraints. A new treaty requires all 27 countries to sign on because every country has a veto. A number of EU countries that are not in the eurozone lack enthusiasm for this idea. It is unclear if European law contemplates a treaty that leaves out a number of members. There could be a eurozne-only agreement, but not a treaty. It is hard to see how the leaders can emerge on Saturday with anything like what Merkel wants.

Second, there is little reason to believe that there is anything that can persuade the Bundesbank to reverse its position on rescuing Italy and Spain. While Draghi has made hopeful noises, the president of the Bundesbank, Jens Weidmann, has not. His position is that this is a matter for the EU to solve via eurobonds, which Merkel has ruled out. Draghi cannot rescue Italy and Spain without the Bundesbank’s consent.

It will be interesting to see how the leaders, who are staring into the abyss, can construct a communique that will obscure the summit’s failure.
Many European leaders have said that a failure to rescue Italy and Spain will lead to catastrophe. But standing in their way is Germany, which won’t agree to guarantee other countries’ debt, and the Bundesbank, which will not allow the Bundesbank to become the eurozone’s bond buyer of last resort.
Without either eurobonds or an ECB rescue, Italy and Spain are doomed.

In the event of their default and/or redenomination, the rest of Europe will have to recapitalize their banks. This will place strains on everyone, especially France and Germany. In the end, I would expect the ECB to capitulate and embark upon an unprecedented campaign of quantitative easing.

Should it fail to capitulate (soon), the outlook for the eurozone is dire. Those of us outside the eurozone (UK, Canada, US, Australia, Japan) will be able to lean against the deflationary forces blowing over from Europe.

The major economy most at risk now, besides Italy and Spain, is France. France may lose its AAA, will have to bailout its banks, and will have to remain credible in the bond market. This will force a level of austerity that could lead to civil unrest.

Draghi's speech to the European Parliament: a breakthrough?

2011-12-01T19:21:00.001-08:00

Mario Draghi, head of the ECB, gave a somewhat dovish speech today to the European parliament. As the NYT reports:

He seemed to be saying that the bank would use its virtually unlimited resources to keep financial markets at bay, if government leaders in the euro region agreed to do their part by addressing the structural flaws that had allowed the debt problems of Greece to mutate into a threat to the global economy.

“What I believe our economic and monetary union needs is a new fiscal compact,” Mr. Draghi said. “It is time to adapt the euro area design with a set of institutions, rules and processes that is commensurate with the requirements of monetary union.” After government leaders take steps to improve the way the euro area is managed, “other elements might follow,” Mr. Draghi said.

I can’t imagine Draghi would make such a statement without the consent of the ECB’s governing board, including the Bundesbankers. He seemed to be saying that if the “Merkel Plan” is adopted, the ECB would intervene more forcefully in the government bond market.

The Merkel Plan would change the eurozone from a monetary union into a fiscal union, with Brussels in charge of national fiscal policy. It has not yet been fully embraced by Sarkozy, and it leaves unanswered what would happen to the 10 EU members who are not part of the eurozone.

I won’t say that the ECB’s independence has been compromised de jure, because it certainly hasn’t. But the ECB has found itself in the awkward position of either leaving its “price stability” comfort zone, or else standing by while the eurozone (its raisson d’etre) goes away. It would be understandable if certain board members did not wish to preside over the dissolution of the eurozone.

“Who will rescue the eurozone?” is a hot potato that has been tossed back and forth between the ECB and the eurozone governments for a number of weeks. It would seem that they have begun to inch toward a joint plan:
the eurozone will impose a fiscal strait-jacket upon itself, in return for which the ECB will intervene forcefully in the bond market, thus rescuing Italy and Spain.

There are two big ifs here: (1) Will all 17 members agree to the Merkel Plan; and (2) if they do, can Draghi really deliver the ECB in force? Previously, the ECB had demanded that the eurozone issue guaranteed eurobonds. Now it would appear that it is prepared to buy national bonds without any guarantees on the basis of the “fiscal pact”. As always, I am skeptical. But this latest news suggests that all is not yet lost, and there may indeed be light at the end of the tunnel.

If so, this is very bullish news, the best news in months if not years.

France should ring-fence its banks now

2011-12-01T10:32:00.001-08:00

There are two ways that Italy and Spain can be rescued from collapse: either the eurozone agrees to issue eurobonds which are guaranteed on a joint-and-several basis by all 17 members, which would be used to refinance maturing debt; or the ECB agrees to act as bond buyer of last resort and establishes a standing bid for Italian and Spanish bonds at an agreed yield.

If either of these events occur, Italy and Spain will be able to continue to repay maturing debt. If neither of these events occur, then at some point the bond market will close to Italy and Spain, as it did to Greece. (The bond market may have already closed, since the ECB does not disclose its purchases by individual country.)

Under the bad scenario, Italy and Spain will have to restructure their debt and/or leave the euro. Either way, banks will be faced with substantial writedowns.

Which brings us to France. France is a strong credit (somewhere in the AA category) despite its banking system’s exposures to Italy and Spain. Its banks, however, are not strong credits on a standalone basis, because of their eurozone exposures as well as general unprofitability.

The weakness of France’s banks (especially BNP) is contaminating France’s own credit, such that France is having to pay yields as much as 2% above Germany. It is time for France to bailout its banks, and thus demonstrate its ability to withstand defaults by Italy and Spain.

There are a number of ways for France to bailout its banks, but here is a pretty common method: Establish a state owned entity (or use an existing state institution such as CDC) to buy marketable assets (i.e., sovereign bonds) at current market prices (below their current accounting value) and make up the losses with new equity. That way, the banks would no longer be at risk of further writedowns on this paper, and should thus regain their credibility in the debt market. There is much less of a problem with exposures to Italian and Spanish banks; these are manageable and declining, with the ECB taking up the slack.

For reasons that I can’t fully understand, the rating agencies have said that if France incurs additional indebtedness in order to bailout its banks, it is likely to lose its AAA rating. Since these costs are known contingent liabilities, this threat suggests that the agencies are using mechanical debt ratios, as opposed to taking into account contingent liabilities. This is particularly peculiar for S&P, which has been saying for over a decade that it takes into account the contingent liability posed by the banking system when analyzing sovereigns.

In any case, France has already lost its AAA in the bond market, partly in anticipation of a downgrade, and partly due to the weakness of its banks. In my opinion, France should bite the bullet now, take the downgrade, and move on. This would give the bond market one less thing to worry about.

Today's announcements mean nothing

2011-11-30T08:50:00.000-08:00

So, the Dow index is up by over 700 points this week. This is certainly a market that has been impatient for good news. What was the good news?
1. Reports of a Paris/Berlin plan to organize a fiscal stability pact for the eurozone without the need for a treaty.
2. Reports of an $800 billion IMF bailout plan for Italy, since denied.
3. Establishment of large dollar swap lines between the Fed and the ECB.
4. Lower collateral haircuts at the ECB.

The Paris/Berlin plan is intended to lure the ECB into bailing out Italy; that won’t happen. The IMF bailout of Italy was a false rumor. The Fed/ECB moves announced today are plumbing adjustments which mirror their actions after the Lehman bankruptcy. They are routine and easily predicted.

The dollar run on the eurozone has squeezed the banks; these steps should make it easier for eurozone banks to meet their creditors’ demands. It won’t stop the run. There is nothing in this package for Italy itself, only its banks. So, as the police like to say, nothing to see here folks.

I would venture to say that, later this week, the harsh reality will sink in, and the markets will lose their euphoria and give up their gains. At present, there is nothing standing in the way of a major Italian funding crisis.

Thoughts about Greek redenomination

2011-11-29T14:38:00.000-08:00

Let’s assume that Greece manages to run out of money in the next few months (which is up to the EU/ECB/IMF troika). Assume that the troika says no to the next tranche or the one after that, and Greece can’t pay its bills. (Note that its bills don’t include maturing bonds because it is in the process of repudiating them). Then what?

Greece will have two choices: stay on the euro and default domestically (stop paying government wages), or redenominate into drachma. They will opt for the latter, redenomination.

How would this work? I can't think of any exact precedents, but the closest I can come up with would be Argentina’s 2001 move from the dollar currency board into the New Peso or whatever they called it. Here is my scenario for Greece:

1. By presidential decree, freeze all deposits, debts and financial contracts, foreign and domestic.
2. Impose currency and capital controls prohibiting any movement of financial assets out of the country.
3. Temporarily close all land, sea and air borders to prevent the smuggling of euro notes.
4. Announce the redenomination of all deposits, debts, contracts, and currency notes into drachma on a one-to-one basis. This would include all foreign debts, claims and contracts with the possible exception of the ECB.
5. Require that all euronotes be exchanged for drachma.
5. Allow the drachma’s external value to float (since the Bank of Greece will have no international reserves and no international credit, assuming that the ECB does not make credit available).
6. Sell drachma bonds to the Bank of Greece in order to pay the state’s bills.
7. Nationalize and recapitalize the banking system with government bonds.
8. Impose permanent capital and exchange controls to prevent capital flight and speculative attacks on the drachma.

Debts incurred under foreign (i.e., English) law will have to be litigated. There is ample legal precedent for successful repudiation of such debts and contracts (Peru, Ecuador, Argentina, Russia, China, Cuba, etc.).

Once this exercise has been completed, Greece will be effectively debt free, will be able to pay its bills, will have a solvent and liquid banking system, and will have a very competitive currency. However, its international trade lines will be temporarily eliminated, until it is able to accumulate enough foreign currency to finance its imports on a cash basis.

The terms of trade will shift dramatically in favor of Greek exports and against imports. The importation of oil (which requires dollars) will be a particular problem, unless exporters are willing to extend credit. This could prove to be a big problem, although Greece would not be the first country in such a fix. Over time, as Greek exports grow, foreign currency receipts would be able to finance imports. (Currency controls will allow the Bank of Greece to prioritize imports.)

The standard of living in real terms would decline as inflation would exceed nominal wage growth. The real price of domestic tradeable goods will rise with the real cost of imports. The need for fiscal austerity will be a function of the regime’s willingness to tolerate inflation. Given the Greek social model, the government will choose inflation over the alternative, and there will be no external pressure to do otherwise. We have already seen this in Russia, Yugoslavia, Ukraine and elsewhere. While it is true that the middle class’s domestic savings will be wiped out, most Greeks have their savings elsewhere, so the social impact may be muted.

The foregoing is my best estimate of what we are likely to see next year. Because Greece is small, the international impact would be negligible, as would be the case with Portugal. The same would not be true for Spain or Italy.

Europe retries the "Mellon Experiment"

2011-11-29T10:48:00.001-08:00

What happened to Italy and Spain in the past year? How did they go from being respectable AA sovereigns able to issue debt at low yields to international basket cases having to pay Latin American rates? Did their credit ratios change? Did they lurch to the left?

Well, no. Nothing happened. They have the same credit metrics today that they have had for years. But something happened. What was it?

What happened was PSI, German for “private sector involvement”.

Until last summer, it was eurozone doctrine that “default by a eurozone sovereign is unthinkable.” Which meant that the eurozone was a collective credit, in which the weak were supported by the strong to everyone’s mutual benefit. This was a great policy so long as it existed only in theory and not in practice. Then the high-living Greeks came along and demanded a bailout.

Faced with bailing out a hopeless quasi-marxist charity case, German voters balked. Germany decided that it wouldn’t support a bailout of Greece unless there was PSI, meaning that bondholders must “participate” in the “burden sharing”.

The theory was that by injecting risk into eurozone bonds, the market would encourage fiscal discipline in a way that the original eurozone treaty had failed to do.

The German desire for market discipline in the eurozone worked as well as anyone could have hoped. The market realized that the bonds of eurozone sovereigns and banks were risky, and began to price in this risk.

The credit risk premium demanded by the bond market is a function of expected loss. If default is impossible, expected loss is zero. If a default is a given, expected loss is the “loss given default”, the difference between the present value of the promised and expected cashflows.

Greece has announced that it will provide its bondholders with a deal worth 25% of the promised value. Therefore the “official” expected loss on Greece’s bonds is now roughly 75% (but actually more, since the deal involves new paper of questionable value). So, not only is there now risk in the eurozone bond market, there is a lot of risk.

Once the bond market understood that eurozone sovereigns were standalone credits, it began to look at them as such. Not only did investors have to analyze each of these credits (using, God forbid, financial ratios!), it had to anticipate how other creditors would act, since not only were these countries exposed to insolvency risk, they also faced liquidity risk.

Using the “liquidity risk screen”, out popped two names: Spain and Italy. They popped out because their market takings are so large and everyone’s exposures are so large. Reductions in investor and counterparty concentration limits would push these names out of the bond market (since everyone was at their limits already).

So now Italy and Spain no longer trade as double-A western Europeans; instead they trade as BB “special situations”. Investment grade portfolio managers are selling them in anticipation of the inevitable downgrades into junkland.

So, thanks to the miracle of market discipline, we are now looking at defaults by Greece, Italy, Spain and Portugal. Isn’t market discipline a wonderful thing?

During the the Depression, the secretary of the Treasury, Andrew Mellon, advised the president, Herbert Hoover:
Liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate. It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people. (Herbert Hoover, Memoirs)

The Mellon Experiment lasted four long years (1930-33), and was an economic disaster on a scale that beggars the imagination. We are about to watch as Mr. Mellon’s experiment is tested once again, this time in Europe. Will it be more successful there? Will it help people to work harder and live more moral lives? Will the fragile political institutions of southern survive what they were unable to survive the last time?

The deus ex machina for the US in the Depression was the replacement in 1933 of the deflationist Hoover team with the inflationist Roosevelt team, which took the US off gold and flooded the economy with dollars. Europe has no Roosevelt in the wings, only Mario Draghi.

$800 billion IMF bailout for Italy?

2011-11-27T18:40:00.000-08:00

The financial media are moving a story out of Italy (La Stampa) that the IMF will launch an $800 billion rescue of Italy and Spain:

The International Monetary Fund is being lined up potentially to help Italy and Spain amid growing fears that a European rescue scheme will not be able to prop up the countries, it emerged last night. Reports in Italy suggested that the IMF is drawing up plans for a €600 billion (£517 billion) assistance package for the country. Spain may be offered access to IMF credit, rather than a rescue package, to avoid it being “picked off” by the markets in the coming weeks. (Telegraph)

What is even more incredible is that Bloomberg reports that this story is moving markets.

Now for a dose of reality. The IMF has never and will never engage in a major operation without the active consent of the US for obvious reasons. Therefore, a rescue of the eurozone on any scale (let alone $800 billion!) requires US consent which, in practice, includes the House of Representatives, which holds the purse-strings. This would require Treasury (Geithner) to consult with the House (Boehner). Boehner would have to consult with his caucus, who would be outraged at being even asked. (Some perspective: Two presidential candidates are members of the IMF subcommittee: Ron Paul and Michelle Bachmann.)

Secondly, the IMF’s balance sheet is currently around $360 billion. It would be a bit of a stretch for a $360 billion institution to launch an $800 billion rescue of a single member, even if the US was on board.

So this market-moving story is untrue. Once the market figures that out, it will begin to sink in that there is no deus ex machina in the wings for the Italians and the Spanish. And once the market has finished grasping at straws, it will have to begin to process what is really going to happen: the unthinkable.

Dateline: Athens. This is not a joke.

2011-11-27T13:42:00.000-08:00

Hot off the wire from Athens:
The head of Elstat, Greece’s new independent statistics agency, faces an official criminal investigation for allegedly inflating the scale of the country’s fiscal crisis and acting against the Greek national interest.

Andreas Georgiou, who worked at the International Monetary Fund for 20 years, was appointed in 2010 by agreement with the fund and the European Commission to clean up Greek statistics after years of official fudging by the finance ministry.

“I am being prosecuted for not cooking the books,” Mr Georgiou told the Financial Times. “We would like to be a good, boring institution doing its job. Unfortunately, in Greece statistics is a combat sport.”

The accusations against him, which are likely to shock European Union officials, come as eurozone finance ministers prepare to decide on Tuesday whether to release a delayed €8bn ($10.6bn) loan tranche to Athens, needed to pay public sector salaries and pensions next month. Over the past 18 months rows about the size of the Greek deficit have strained relations between Greece’s finance ministry and its international creditors.

Mr Georgiou is due to appear before Greece’s prosecutor for financial crime on December 12 to answer the charges. If convicted of “betraying the country’s interests”, he could face life imprisonment.

Here is some background on this story from September:

Greece revamps statistics service board after row

Fri, Sep 16 2011

ATHENS, Sept 16 (Reuters) - Greece said on Friday it would replace the board of its independent statistics service (ELSTAT) after two members resigned and another was quoted as alleging that 2009 deficit data had been artificially inflated.

It said ELSTAT chief Andreas Georgiou would keep his post.

The upward revision of Greece's budget deficit in 2009 to 15.4 percent of gross domestic product exposed the scale of the country's fiscal derailment and sped up the debt crisis which is still rocking the euro zone.

"The 2009 deficit was artificially inflated to show that the country had the biggest fiscal shortfall in all of Europe, even higher than Ireland's which was 14 percent," ELSTAT board member Zoe Georganta was quoted as saying by the Eleftherotypia newspaper.

Georganta said the inclusion of a number of utilities under the general government inflated the deficit. She said this had not been handled according to Eurostat guidelines and that the chairman rejected the board's objections.

"We have a new kind of occupation in Europe by the Germans," Georganta told Real FM radio, adding that German officials at Eurostat put pressure on the government to inflate the 2009 deficit to justify harsh austerity measures.

Greece in 2010 unveiled legislation to make its discredited statistics service fully independent after the European Union demanded that it puts an end to the release of flawed economic data.

Frequent revisions of national account data since the country joined the euro zone in 2001 had infuriated its partners in the bloc who demanded an overhaul of the service.

The overhaul took place under former finance minister George Papaconstantinou. It included regulations to stop political meddling by giving parliament, rather than the government, the task of appointing its chief.

Papaconstantinou was quick to dismiss the allegations on Friday, saying the deficit revision was fully in line with Eurostat's methodological guidelines.

He said the revision of Greek fiscal data in 2010 was the result of close cooperation with Eurostat and the same methodology as the rest of Europe was applied.

"Unfortunately for all of us, Greece's deficit in 2009 was 15.4 percent of GDP as was officially announced by Eurostat and ELSTAT," Papaconstantinou said in a statement.

"Let's understand the dire situation the country faced instead of fabricating cheap and easy conspiracy-type excuses for the absolute fiscal derailment we experienced," Papaconstantinou added.

Finance Minister Evangelos Venizelos on Friday introduced an amendment to a draft bill on bank supervision which stipulates that ELSTAT's current board will be replaced, with the exception of its chief.

Parliament has to approve the new board at ELSTAT.

Venizelos told lawmakers on Thursday that the resignations did not affect data collection and processing and put his support behind ELSTAT chief Andrea Georgiou.

"Unfortunately, at a level of interpersonal relations and functions, a problem has emerged," Venizelos said without elaborating.

"The president of ELSTAT is considered by all our institutional partners, and mainly by Eurostat, a person of experience and someone who can guarantee that the sad chapter of 'Greek statistics' is closed," Venizelos said.

ELSTAT President Andreas Georgiou said in a statement: "The compilation of these statistics was done in full compliance with the rules and standards of the European System of Accounts and European Union Regulations."

Paris and Berlin try again

2011-11-27T11:44:00.000-08:00

The latest front in the European civil war over the fate of the eurozone is no longer Athens or Rome or even Berlin. It is Frankfurt, headquarters of both the Deutsche Bundesbank and its “subsidiary”, the ECB.

To the west is Paris, which is desperately seeking to find a way to make the ECB rescue Italy before it's too late. To the east is Berlin, which is desperately seeking to find a way to make Italy creditworthy enough for the ECB to rescue. In the middle is the Bundesbank, which is the ultimate arbiter in this matter.

Last week, Paris, Berlin and Rome agreed to stop hectoring the ECB to act as Italy's lender of last resort. Next week, they plan to move to Phase II, in which they will replace demands with inducements. The plan, as reported, is for the eurozone to announce a new “stability pact” to enforce budget discipline, but without the insuperable hurdle of another EU treaty.

Reuters reports:
"Based upon these measures, there should be a majority within the ECB for a stronger intervention in capital markets," Welt am Sonntag said. It quotes a central banker as saying: "If the politicians can agree to a comprehensive step, the ECB will jump in and help."

There is no mention of the Bundesbank, but presumably it is included in this optimistic prediction.

I am skeptical. Rome can sign a hundred new stability pacts (Rome will sign anything), but pacts do not bind the Italian political process. Italian politics is about only one thing: how to slice the pie. There is no room in such a system for a smaller pie, only a larger one.

Italian politics developed over half a century of inflation and devaluation. When the pie got too big, the currency did the adjustment. Under the euro, it’s the pie itself which must do the adjusting: mission impossible.

Foreign observers labor under the illusion that replacing Berlusconi with Monti makes the slightest difference. It doesn’t. Monti and his technocratic cabinet are irrelevant in Italian party politics: they have no party. Their “base” is foreign: Brussels, Paris, Berlin. Only Italians get to vote in Italian elections.

So therefore, the key question is not whether a new stability pact will make Italy creditworthy; it can’t. The question, instead, is whether such a scheme could be used to induce the ECB to pretend that Italy is creditworthy. Or in even more crucial terms, whether Berlin has any leverage over the Bundesbank.

I don’t know the answer to this. I have no idea what levers Berlin might have to get the Bundesbank on board. Going by history, however, it does not have sufficient leverage. We should find out pretty quickly, because time is of the essence.

For argument’s sake, let’s assume that the Bundesbank and the ECB relent, and announce that the ECB will begin to bid directly at Italian bond auctions, with the goal of keeping yields below X%.

What would be the consequence? Clearly, there would be a major global rally across all asset classes, even euphoria. But we’ve been to euphoria before.

Once the shouting died down, would anyone trust the ECB enough to buy Italian bonds at the targetted yield, or would investors take advantage of the subsidized bid to unload? They would unload! Italy’s government debt exceeds EUR 1.5 trillion, which is a pill that the ECB would find hard to swallow, since its total assets are EUR 2.5 trillion.

So, over time, the ECB would be confronted with the choice of having to to sell every other asset it owned, giving up on Italy, or losing control of the monetary base. These are the considerations that have led the ECB to take the hard line that it has so far.

Political Addendum
It should go without saying that this latest scheme was cooked up by Sarkozy. It represents his latest effort to find a way out of the fix that the eurozone is in. Merkel has gone along because (a) she doesn't want to seem indifferent to the Italian crisis; and (b) it takes the ball out of her hands and drops it into the ECB's court. The Bundesbank has been saying that this is a problem for the eurozone governments to solve, while the eurozone governments have been saying that it is the ECB's problem.

Here comes the run

2011-11-24T12:34:00.001-08:00

That sucking sound you hear is the Big European Bank Run.

Right now there are four bank runs occurring in the eurozone: (1) the bond market has closed to many eurozone banks, and their maturing bonds cannot be refinanced; (2) as bank risk committees lower their eurozone concentration limits, interbank and counterparty exposures are being cut or eliminated; (3) wholesale depositors (money funds, investors and corporations) are prudentially reducing their eurozone limits; and (4) retail depositors in Greece, Italy, Portugal and Spain are either cashing out their deposits into euro notes, or transferring them outside of the eurozone, to Switzerland or beyond.

At the acute level, all (retail and wholesale) depositors fear a deposit freeze in the critical countries, which is by now inevitable for Greece, and very likely for Italy, Spain and Portugal. Greece will need to freeze deposits soon, because Greek depositors aren’t stupid. They know that, once your euro deposit has been frozen, it will emerge on the other side as drachma-denominated wallpaper. Once Greece announces its freeze, the heat will be on for the rest. Those who freeze will, of course, have to leave the zone. You can’t unfreeze back into a currency that you don't print.
At the subacute level, creditors are wary of all European banks with exposure to the critical countries. Despite the fact that most such banks are too big to fail, credit committees are loathe to rely exclusively upon such contingent promises.

Although so far all of my forecasts have been directionally correct, my accuracy as to timing has been poor; I expect things to happen faster than they do. This has been because I overestimate the market’s speed of reaction, and I underestimate Europe’s ability to come up with endless fudges (such as eliminating collateral standards at the ECB). Nonetheless, I predict that Greece will have to freeze by year end, which should prompt the cascade of events resulting in the breakup of the eurozone.

As we know from similar such situations in the past, the authorities in the frozen countries may seek to force the repatriation of offshore deposits. For this reason, prudent eurozoners will follow long-established tradition by moving their funds far away, using dummy corporations as well as cash in numbered boxes. And the truly prudent will want these caches denominated in anything but euros, which may explain why 10-year Treasuries now yield a whopping 1.9%.

Are German bunds now a risk asset?

2011-11-23T13:51:00.003-08:00

This morning, the German finance ministry’s auction of 10-year notes was substantially undersubscribed, forcing the Bundesbank to buy 35% of the sale, and resulting in a 15 bp rise in yield to 2.06% (compared with 1.90% for comparable-maturity Treasuries).

Until now, German bunds have been the risk-free benchmark for the eurozone, against which other issuers’ credit spreads are calculated. It would now appear that if the Treasury were to offer benchmark maturities in euros, they would trade through bunds. In other words, there now appears to be some sort of risk premium being added to bund yields.

Markets don’t give reasons for their decisions, and therefore there is no way of knowing why this happened. It certainly hadn’t been predicted. I can come up with a few possible reasons:
1. Bond investors performing top-down sector analysis have decided to reduce their exposure to Europe in general and the eurozone in particular*.
2. Investors recognize that there is a risk that the ECB will start printing money (for various reasons) producing a change in inflationary expectations.
3. There is a risk that Germany will be forced to backstop other eurozone sovereign credits, thus threatening Germany’s AAA rating.
4. A collapse of the eurozone could plunge Germany into a recession which would create fiscal pressures.
5. Speculators who have been long bunds and short peripherals may have decided to close out, thus increasing the supply of bunds on offer (although this seems pretty far fetched).

Whatever the reasons, the signal that it sends is a very bearish one. If the markets start demanding a risk premium for bunds, then premia across the board must rise further. Also, this event may strengthen the hand of those arguing against Germany risking its AAA to help the eurozone.

My conclusion would be that the eurozone is now in extremis barring something major coming out of the ECB or Berlin.
*In this evening's FT: A senior trader at a US bank said: “We are now seeing funds and clients wanting to get out of anything that is denominated in euros and that includes Bunds because they don’t know what will happen to monetary union."

How much time does Europe have left?

2011-11-22T20:27:00.000-08:00

Let us begin by taking the following as given: there will be no deus ex machina for the eurozone. Neither Germany nor the ECB will have a change of heart about bailing out the eurozone. The EFSF will remain the chimera that it has been since its inception.

Given the foregoing, how much time does Europe have left?

Right now, all that stands between the eurozone and Armageddon is the ECB. The ECB has been buying peripheral sovereign bonds, and it has been providing eurozone banks with unlimited liquidity (EUR 247 billion at today’s auction). Buying peripheral bonds has blunted spread-widening, and the liquidity spigot has prevented a liquidity crisis.

In theory, the ECB may provide unlimited liquidity to solvent member banks. Eurozone banks are technically solvent because they have not marked their sovereign bonds to market, nor are they likely to do so anytime soon. However, the ECB cannot refinance the entire eurozone banking system; it is too big. To do so would expand the euro's monetary base and severely complicate the conduct of monetary policy. (Wise observers would be happy to see the ECB forced to create a little inflation, but that is not in the cards.)

The Bundesbank has made clear that the ECB cannot, under its governing statutes, provide “monetary financing” to eurozone member states. The ECB is by no means independent of the Bundesbank. Therefore, unless the Bundesbank relents (which we have already ruled out), the ECB cannot buy the bonds of the peripheral sovereigns in the quantities they will require if the debt markets remain closed.

So how much time is there left before this crisis comes to a head? My guess is that the ECB will have exhausted its appetite for peripheral debt by the end of January. If, as and when the ECB stops buying, the prices of Italian and Spanish bonds will plummet, which will place great pressures on the “economic solvency” of the eurozone banks.

I cannot predict whether at some point these pressures force revaluations and consequent recapitalization, but this will occur next year.

It wasn't supposed to be this way: Socialism without money

2011-11-16T12:30:00.000-08:00

A lot has been written about the pitfalls of allowing people to govern themselves. One of the best such analyses, if not the most recent, was written by Plato 2,500 years ago, in the parable of the “ship of state”. His criticism was that the skills of the politician are not the same as those of the statesman. The statesman (philosopher/king) must understand not only how to get power, but how to exercise it, and that those who rise to command are more likely to be skilled in the former than in the latter:

The sailors are quarrelling with one another about the steering. Every one is of opinion that he has a right to steer, though he has never learned the art of navigation and cannot tell who taught him or when he learned, and will further assert that it cannot be taught, and they are ready to cut in pieces any one who says the contrary.
They throng about the captain, begging him to commit the helm to them; and if at any time they do not prevail, but others are preferred to them, they kill them or throw them overboard.
Having first chained up the captain's senses with drink, they mutiny and take possession of the ship and make free with the stores. Thus, eating and drinking, they proceed on their voyage in such a manner as might be expected of them.
The man who leads the crew in their plot for getting the ship out of the captain's hands and into their own they compliment with the name of sailor, pilot, able seaman. But that the true pilot must pay attention to the year, seasons, sky, stars, winds, and whatever else belongs to his art, if he intends to be really qualified for the command of a ship, has never seriously entered into their thoughts or been made part of their calling. (Republic, Book VI)

This is precisely where we stand today (or at least, stood last week) with respect to the governance of the postwar Western democracies. The crew has been in command of the ship for some time (about forty years), and has been making free with the stores, eating and drinking in such a manner as might be expected of them.

They have been enabled in this debauchery because they inherited a ship of state with stored wealth in the form of unused debt capacity. They have been using this debt capacity to bribe each other for the temporary right to steer the ship. The four decades of eating and drinking the ship’s stores have been pleasant.

But now there is a problem on the horizon, to which Plato only alluded: what happens when the ship’s stores run out or, in the modern case, when the ship reaches its debt capacity?

We have the great (but temporary) luxury in the US of being able to watch as other counties around us run out of stores. In the past we have seen this happen to countries run by “other kinds of people”, such as communists and banana republicans. But now we are seeing it happen to countries not too different from our own: countries crewed by western Europeans, until recently regarded as “well run”. Indeed, the lifestyles on board some of these countries have been even more civilized than our own.

The people running these countries have never known any statescraft besides mortgaging the future in order to live beyond their means. This is all they know how to do: how to slice up this year’s piece of their children’s inheritance.

They don’t know it, but these politicians have left this world and have entered a completely new one: a world of not only finite financial resources, but a world in which the supply of resources is completely exogenous. They are learning that their long-honed skills of compromise, negotiation, bribery and flattery have no more value than necromancy, alchemy or phrenology. In a world of finite financial resources, the only valuable skills are economy and decisiveness, skills that not only do they not possess, but which they deride as inappropriate (see: all the printer's ink now being spilled about the “fetish of austerity”).

As Myron Minsky pointed out, the inflection point in the debt supercycle does not manifest itself gradually, such that it can be planned for and ameliorated. It happens when it happens (a black swan), and then it follows its course as the cycle changes decisively from leveraging to deleveraging, as lenders go on strike. (N.B.: Once the cycle turns, it is not merely a matter of not being able to borrow more, but rather the much more serious matter of having to repay what you have already borrowed.)

In the case of the current crisis, the black swan was the Greek government’s announcement in the fall of 2009 that Greece had been cooking its books for at least a decade. This caused a loss of confidence in Greece and unleashed the bond market jackals to begin to hunt down other other weak members of the herd.

This problem could have been contained if such a thing as “Europe” had existed in a corporate, as opposed to geographical, sense. But Greece soon revealed that Europe is not a country but rather a club, with no governance other than the membership committee.

The Eurocrats first said that the Greek problem was transitory and irrelevant because default by a eurozone sovereign was unthinkable and, in Trichet’s words, “not under discussion”. This was a somewhat persuasive argument until, last summer, Germany insisted that a precondition of any sovereign bailout would be a bond default. In other words, bond default went from being unthinkable to being a precondition of a bailout. That was the moment when the gas began leaking badly from the eurozone bubble. Things got dramaticaaly worse this week when the president of the Bundesbank stated decisively that the ECB would not act as a lender of last resort to eurozone sovereigns.

With this statement putting the nail in Italy’s coffin, the markets began to attack not only the non-AAA weakings but also the “strong”, AAA sovereigns such as France and Austria. Insted of trusting and waiting for long-promised “fiscal and structural adjustment”, the eurozone bond market is saying: “Show me, show me now, not tomorrow.” Overnight, the bar for market credibility has been raised ten notches higher.

As I said earlier, the political leadership of Europe is skilled at compromise and negotiation, skills which are completely lost on the capital market. You can’t negotiate with Bill Gross, or take Barclay's country risk committee out to dinner. These people owe you nothing, and they have nothing to gain by “working with you” or “being reasonable”.

I can see this epiphany already dawning on the Continent's leadership. You can hear it in the recent public statements of Papademos, Monti, Zapatero and Sarkozy. Their mouths are all saying the same thing: “We have no alternative to austerity. This is no longer a policy debate. There is no other path. It’s getting late.”

They are saying this because overnight they have become statesmen instead of politicians (and Monti never was a politician).

Unlike everyone else in their political systems, they have responsibility for financing the state. That responsibility concentrates the mind when the first thing you do each morning is to check Bloomberg to see how your bonds are doing. Each of these guys is doing that now, and what they are seeing is reflected in the frightened things they are saying.

Right now, diminishing credit market access is happening to Greece, Italy, Spain, Portugal, Ireland, France and Austria. Of these, France, Spain and Italy fall into the category of “too big to wargame”. Which means that they need to be wargamed now.

Europe: The panic has spread to the core

2011-11-15T17:36:00.000-08:00

The eurosystem is a lender of last resort – for solvent but illiquid banks. It must not be a lender of last resort for sovereigns because this would violate Article 123 of the EU treaty [prohibiting monetary financing – or central bank funding of governments]. I cannot see how you can ensure the stability of a monetary union by violating its legal provisions. I think the prohibition of monetary financing is very important in ensuring the credibility and independence of the central bank, which allow us to deliver on our primary objective of price stability. This is a very fundamental issue. If we now overstep that mandate, we call into question our own independence. (Jens Weidmann, president of the Bundesbank, Nov. 10th, FT interview)

I haven’t been blogging lately because I’ve been waiting for something to happen. Well, it just did.

Apparently, the bad thing has finally started. The eurozone bond market has lost hope, and Europe’s credit system has begun to shut down. Today, the market panic spread to the core AAA nations of France and Austria. Credit spreads for both countries are now approaching 2% over Bunds. A complete loss of market confidence and a closing of the debt capital markets to all but a handful of eurozone sovereigns now appears inevitable.

The scramble to make the EFSF into a credible “bazooka” has failed, and the ECB has made clear (see above) that, aside from its traditional role as liquidity provider to banks, it will do nothing to prevent a market collapse.

In credit analysis, a standard question to pose to any debt issuer is: “How long can you avoid default in the event of a loss of market access?” The usual answer to this question was usually “But that could never happen!” Well, now it might. Not just for the hangers on that should have never been in the eurozone, but perhaps even for foundational countries such as France and Austria.

At some point, France may have to answer this question: Should France lose market access, what is her debt maturity calendar and what are her available resources? This is a question no finance minister ever wants to have to answer. (Latin American finance ministers know the answer to this question off the top of their heads. European ones, less so.)

France’s first line of defense is what the peripherals have been doing, which is having its banks borrow against its bonds at the ECB. Ratings on collateral no longer matter at the ECB, so presumably this game could go on for some time. But it will be highly visible, and it will not make the Bundesbank happy to see the ECB become France’s only lender.

In theory, there is a way out: restore confidence by establishing a path to fiscal balance. But it is too late for that. The markets are no longer interested in what Sarkozy, Zapatero, Monti, or Papademos may be able to do to cut expense or raise revenue. What is happening in these parliaments is now a sideshow.

Until now, market panics have been offset by ECB bond purchases (most lately, Italy). But the ECB doesn’t have the resources to take on the combined Italian, French and Spanish bond markets without a major impact on the size of its balance sheet and thus, on monetary policy. This the Bundesbank will not tolerate, as Weidmann indicated above.

Thus, market panic will no longer be intermediated by the ECB, and will be visible to all. The rest of this week will be interesting.

Europe: No one left to lie to

2011-09-23T19:47:00.000-07:00

“Europe” has exhausted its credibility with the credit markets. The corrosion began in the Anglosphere, where there is very little investment in the “European idea” (see: euroscepticism). Over time disbelief has slowly spread not only around the world, but more recently into the heart of Europe itself.

Why is this? I would advance three reasons: (1) Europe has no leadership. (2) Credit market participants can do arithmetic. (3) Every statement issued by the European authorities has been not only a lie, but a conscious lie, and has been proven to be such.

Who runs Europe? The Council? The Commission? France? Germany? The ECB? It’s like asking who runs MLB, or FIFA. Nobody. How can a political entity with no authoritative spokesman have any credibility?

When Greece, Portugal and Ireland lose capital market access, and when Spain and Italy appear in danger of losing access, it is difficult to say with any credibility “Nothing to see here folks; move along”. Anyone with calculator can plot how long it will take for these countries to run out of euros, given the scale of their maturing debt and their ongoing budget deficits. (Yes, countries with balanced budgets can still go bankrupt if they can’t refinance their maturing debt.)

The European party line for the last two years has been: “We have everything under control. This is Europe. Default by a eurozone member is unthinkable, so don’t think about it or, God forbid, talk about it.” OK, so that means that in the end, Europe will bail out the South, right?
Except that (1) this doesn’t apply to Southern banks; and (2) further sovereign bailouts will include “private sector participation”.

This means that “Europe” does not guarantee the PIIGS’s banks, and that there is no risk of a sovereign default, aside from “private sector participation”.

If “Europe” had the courage to tell the truth, they would say that “We will help the PIIGS and their banks, but we expect you (the bondholder) to help out too.” In other words, there is considerable credit risk with respect to the PIIGS and their banks. Which is why credit is being withdrawn and why credit spreads are rising to the point that Italy and Spain are steadily losing market access.

Europe must choose now, not next month, whether they will protect the bondholder in PIIGS sovereign and bank debt or whether they won’t. If they will, they need to publish a credible plan, such as a massively expanded EFSM with joint and several guarantees and a AAA rating from Moody’s and S&P. Or, if not, they must publish a credible scheme to recapitalize the Northern banks in the event of massive Southern defaults.

In the absence of a credible bailout plan, and in the absence of emergency recaps of BNP, SoGen, Credit Agricole, and the Landesbanken, why would any Credit Committee refrain from ordering a steady reduction in concentration limits for every bank in the eurozone?

The PIIGS problem is no longer central. What is happening now is systemic: a run on the eurozone’s banking system that could make Lehman look like a slip-and-fall. This run must be met with two tools at once: (1) unlimited euro and dollar liquidity from the ECB so that liquidity is not an issue; and (2) a massive shock-and-awe recapitalization in order to facilitate an eventual return to the credit markets.

There are two ways to achieve this. The easiest is to simultaneously recapitalize the banks while stating that, if further capital is needed, it will be forthcoming (i.e., an implicit state guarantee). The other (currently popular) way is to contribute enough capital to allow re-entry while piously stating that this is the “last bailout”. This approach requires an enormous amount of capital in order to be remotely credible. From the FT:

The EU internal markets commissioner, Michel Barnier, said the 16 banks that nearly failed the stress tests “are judged to be fragile and must also be strengthened further. We want the recapitalisation for these banks to be by private means. The era of bailing out banks must end.”

Very helpful, M. Barnier.

Now that “Europe” has lost all credibility in the credit markets, further Wizard of Oz-like statements will prove not merely useless, but frightening. ("They have no clue!")

The time for soothing statements has passed, and the time for decisive and credible action is rapidly running out.
My prediction? Catastrophe, of course. My best analogy to what is going on in Brussels today is the Imperial Cabinet in the summer of 1945. Denying the obvious, awaiting the inevitable.

Greece's bluff is about to be called

2011-09-20T09:05:00.001-07:00

Here is the immediate state of play for Greece. Greece runs out of money next month, and lacks capital market access. The only way to avoid default is a further EUR 8 billion tranche from the Troika (IMF, EFSM, and the ECB).

In the past, Greece has played chicken with the Troika, by failing to comply with its agreements and saying “if you don’t give us the money, we’ll default and you’ll regret it”. (As Donald Trump used to say to his bankers, “I’ve got a guy at the court house ready to file at any time.”

The “northern league” (Germany, Netherlands, Austria, Finland) have wearied of this game. They have decided to use this tranche to force Greece to comply 100% with their diktat, which includes a reduction in nominal wages, public sector layoffs, pension reform, privatizations, and tax compliance enforcement. And they want these demands to be certified by “inspectors” from the Troika.

These demands are perfectly reasonable and in fact inevitable. But they are politically impossible for both the ruling socialist and the opposition populist party because they represent political suicide. This is a pill that Greece cannot swallow. They can pretend; they can sign all sorts of agreements; but they can't actually do it.

One of two things will happen over the next two weeks: (1) Papandreou will force his cabinet and party to swallow the pill and, much more critically, convince the inspectors that this is not another scam; or (2) the northern league will say no, and Greece will default.

The northern league wants Greece to default, but it doesn’t want to be seen as wanting it, so they have disguised this desire behind a list of demands that Greece can’t meet. (Shades of Austria’s 1914 ultimatum to Serbia.) No matter what Papandreou does, it will never be enough.

I am confident that Greece has a Plan B to default and redenominate quickly (over a long weekend). Somewhere deep in the vaults under the Bank of Greece is an old drachma printing press that they can fire up. The New Drachma will float--downward.

The challenge is what to do about all that defaulted debt denominated in euro. There are two choice: unilaterally redenominate all debts foreign and domestic into drachma, or else redeem all foreign debts with long-term, low interest euro bonds.

This situation will crystallize quickly, because there is a deadline looming. As I said, I expect that Greece will be denied the next tranche and will then default by the end of October.

Greece will restructure next month

2011-09-18T13:04:00.000-07:00

The Easter Bunny and Europe were locked in a room until one emerged victorious. Who won? The Easter Bunny, of course, since there is no such thing as Europe.

"Europe" has about as much political meaning as the Western Hemishphere, Southeast Asia or the Arab League.

The American republics belong to the OAS; Southeast Asian countries belong to ASEAN; Arab states belong to the Arab League; European states belong to the EU.

None of these organizations has sovereignty or control over its members. Lenin described sovereignty as “ the monopoly of violence”. There is no doubt that the United States has the monopoly of violence over its members, as was demonstrated by Lincoln.

Imagine if the US federal government lacked taxing power and relied on voluntary "contributions" from the member states? That's how it operated from 1777 until 1789 and it didn't work, just as Europe isn't working. Voluntary contributions don't work. Taxes do.

Brussels has no such control over its members. (Who’s going to invade Germany if they don't sign up for the bailout?)

Every communique coming out of Brussels demonstrates that no one is in charge. Not the European Commission, not the Council, not the ECB and not the rotating "president". The EU is a club, not a state. The member states are democracies, subject to the will of their peoples, not the EU.

Greece is the current case in point. Greece will run out of money next month. Either Greece is allowed to default, triggering a larger eurozone crisis, or else the “rejectionist front” consisting of Germany, Netherlands, Austria and Finland (all AAA by the way) will have to cave and sign on for donating their taxpayer's wealth to Greece for the indefinite future. No one can force the rejectionists to do this, and I think they won’t. (And if they do ultimately do donate money, it won’t be to Greece.)

The reason is this: whether it is via the EFSM bonds or via a eurobond, in either case a AAA rating is required. The EU has no balance sheet and can’t issue debt.

The AAA bond rating can only be achieved by a joint and several guarantee by the eurozone’s member states. If such guarantees were issued, each member country would now have a large but unquantifiable contingent liability that in all likelihood will called upon in the end. And when the bill comes due, will Portugal pay it's prorata amount? What if they can't--or won't? And who will make them?

As the guarantee is several, that means Germany is potentially on the hook for the whole tab. Germany is not going to buy this plan, and has already said so, more than once. Merkel has had it with Sarkozy and his endless schemes (all intended to pin the tail on Germany). France is terrified of a eurozone breakup; Germany is not.

As commentators have been noting, Germany’s and France’s AAA ratings are not ironclad. If they staple on a few hundred more billion euros, there would be downward pressure. Personally, I expect France to lose its AAA in any case, based on its fiscal trajectory. But Germany will never give up its AAA, no matter how much it despises the ratings agencies.

Therefore, I expect a Greek “restructuring” next month, followed by eurozonal bank guarantees and/or nationalisations. Either way, the problems will be fiscalised at the national level. (Forget an ECB bailout; the ECB won't budge.)

What is driving the US equity market?

2011-09-10T16:38:00.000-07:00

The stock market did not tank on Friday because of Obama’s “jobs” speech. That’s because his speech provided the stock market with no new information (other than that he will never pivot to the center, but that’s actually good news for capitalism). Obama himself is now irrelevant to the stock market, aside from his poll ratings (capitalists want him to lose).

At present, there are only two people in the world to whom equity investors are paying attention: the German Chancellor and the Chairman of the Board of Governors.

Greece needs to be on an eternal and unlimited IV drip from “Europe” which means Germany. The chancellor is under enormous pressure from Sarkozy and Trichet for Germany to become Europe’s unending sugar-daddy. But Europe’s problem is German demography: the WW2 generation is dead, and their descendents see the Federal Republic not only as a normal country, but also as a very responsible country, with nothing to apologize for. “We are Europeans in good standing, and we are no longer suckers for guilt-games.”

The German taxpayer is unwilling to take his credit card and hand it to Greek cigarette-smoking marxists lounging at their grandfather’s ouzo cafe. Greece represents everything that Germans hate about Europe and the eurozone. The eurozone was the price that Germany had to pay for reunification, a bad bargain. (And one they can now revoke.)

So, if the CDU/CSU/FDP coalition is to survive, at some point Merkel will have to pull the plug on Greece, or on the euro. Sarko won’t like it, but it isn’t his money. And if Germany becomes the guarantor of the eurozone’s debt, it won’t keep its AAA, which is something that no German could ever accept. So whatever happens to be going on in Berlin at the moment (i.e., Juergen Stark resigning from the ECB), is market information, as opposed to Obama's daily speech.

Why does the S&P 500 care about Greece? Because an unravelling of the eurozone would be (a) uncontrolled; (b) deflationary; (c) bad for global growth and trade; and (d) calling into question European financial and political stability. In other words, a reduction in global demand.

The other focus of the stock market’s attention is the FOMC, chaired by Ben Bernanke. Will there or won’t there be QE3? If the answer is no, very bad for stocks (and Obama). If the answer is yes, the reverse. Hence Rick Perry’s schoolyard threats to Bernanke about "playing politics" with monetary policy. Gov Perry thinks that Bernanke should continue to keep 15 million people out of work, in order to help the GOP. Their wives and kids? Who cares?

The GOP opposes QE3, because (a) it is as economically ignorant as Obama/Pelosi; and (b) it would help Obama by reducing unemployment and causing more of the horrendous “hyperinflation” we have recently been experiencing. (Can anyone remember 1980?). This kind of politics is cheap, cruel, and unpatriotic, and bad politics in the long-run. The GOP should want the economy to prosper no matter who is president. A nation of state dependents is a nation of Democrats. Hello Belarus.

Here is my prediction: Greece can’t comply with the austerity package, Germany and the ECB pull the plug, game over for Greece. Greece will have to go cold turkey and implode upon itself. That means redrachmaization, hunger and social unrest. (Greece has no exports, bulk shipping rates are in the tank, and strikes and riots don’t help tourism.)

After Greek default, contagion spreads ( it’s spreading now), but Greece is arguably a special case, and Europe may (may) be able to erect a firewall around it. Ireland, Spain and Portugal are not basket cases. Italy still has a short window in which to demonstrate that it is not the rich man’s Greece. Mario Draghi should be PM instead of the unserious Berlusconi. It will come to that, and hopefully soon. If Italy defaults, Houston we have a problem.

Any such dire European scenario would inevitably mean that the US will need to have as many QEs as we need to prevent deflation and to sustain nominal demand. If Perry is elected, intimidates the Fed, and causes deflation and negative nominal growth, he will be a one-term president, and maybe our last president.
But isn’t it curious how, when hard money guys (e.g.,Nixon) become president, they become inflationists overnight. I promise you that President Perry will have a revelation from God that nominal growth is holy and sacred, and will play golf weekly with Bernanke.

Brief political note: American governance today

2011-08-16T22:34:00.001-07:00

Right now Americans are watching a three ring political circus.

In one ring we have Congress, now taking a well-deserved vacation after playing around with the debt ceiling, triggering an unprecedented downgrade, and causing global turmoil. Great work, guys. Enjoy the beach.

In the next ring, we have the Commander-in-Chief and Leader of the Free World taking a field trip with his extensive entourage through the underpopulated parts of the Midwest, doing photo-ops with ethanol farmers. He may visit a windmill or lithium diode factory, if David Plouffe can find any out there among the silos and Dairy Queens.

Our president is using his ethanol tour (hopefully his bus runs on clean Iowa corn) to push a number of his “jobs” initiatives, the centerpiece of which is extending unemployment benefits into eternity. Why do unemployment checks create jobs? Because they’re spent. By this logic, the more people out of jobs, the more jobs will created (food stamp printing plants, community organizers, jobs counselors, social workers, retraining consultants and sociologists who will explain that government annuities don’t reduce the incentive to work)*.

But wait, the president says that “when he goes back to Washington” (after spending two weeks at Martha’s Vineyard dodging the Clintons), he will unveil a “detailed” jobs plan. He’s been keeping it secret for all these years; thank goodness he’s finally decided to allow us to see it. I can’t wait.

And in the third ring we have the 2012 GOP “hopefuls”. I will spare you the Snow White and the Seven Dwarfs witticisms that we always hear at this time of the cycle (they were probably wittily saying something similar in 1804).

But seriously, the Tea Party has screwed everything up. The party of Robert A. Taft has become the party of Sarah Palin, Michelle Bachmann and Rick Perry. The whole point of elections is to (1) win them; and (2) and then make America a better place for its citizens to prosper.

The Democrats have their own albatrosses to bear: the ever-expanding list of tribal caucuses, and plenty of left-wing nut jobs. (Good news, Congressman: Guam has not yet capsized).

But the Tea Party is screwing up the GOP nominating process by demanding that candidates sign up to a right-wing laundry list that will render them unelectable in November. Romney has been right to ignore the Tea Party; he wants to win, not to lose heroically.

And now let’s take a look at the Tea Party’s “substance”. Hmm. Allow the US to default. Abolish the central bank. Abolish paper money and put the US back on gold (at $1700 an ounce, that would be quite expensive, but a windfall for for Russia). Drag Ben Bernanke down to Texas in order to lynch him as a traitor (that would be the Texas governor in dressed up in cowboy boots, a tuxedo and a large toupee).

It is that last item, this irruption from the tobacco-stained gums of the toupeed Texas governor that motivated me to write this post. Here is bit of the governor’s down home Texas wisdom concerning the Governor of the Federal Reserve Board:

“If this guy prints more money between now and the election, I don’t know what y’all would do to him in Iowa, but we would treat him pretty ugly down in Texas. Printing more money to play politics at this particular time in American history is almost treacherous -- or treasonous in my opinion.”

I am speechless. What can you say to that mixture of bullying arrogance and cretinous stupidity? He is like W without the class. "This guy"? That would be Chairman Bernanke to you, Rick.

I think the only way to maintain calm at a time like this is to pull Mencken off the shelf and get some perspective: it’s supposed to be a circus. I just wish foreigners didn’t have to watch it. They may not get the joke.

Now look. No one should be an academic snob. Lincoln did not graduate from Harvard. But educational achievement is a relevant datapoint, nonetheless. Here is Governor Rick’s academic resume:
“Perry attended Texas A&M University, where he was a member of the Corps of Cadets, a member of the Alpha Gamma Rho fraternity and was elected senior class social secretary and was also elected as one of A&M's five yell leaders (a popular Texas A&M tradition analogous to male cheerleaders). Perry graduated in 1972 with a 2.22 GPA, earning a bachelor's degree in animal science.”

If the best you can do at A&M is a 2.2 in animal science, you really should not be seeking to lead the Free world. You should be judging Longhorns at the State Fair.
*Food stamp czar Tom Vilsac:
I should point out, when you talk about the SNAP program or the food stamp program, you have to recognize that it's also an economic stimulus. Every dollar of SNAP benefits generates $1.84 in the economy in terms of economic activity. If people are able to buy a little more in the grocery store, someone has to stock it, package it, shelve it, process it, ship it. All of those are jobs. It's the most direct stimulus you can get in the economy during these tough times."

What a nominal world!

2011-08-15T09:31:00.001-07:00

No one who is not living in Zimbabwe, North Korea or Ukraine thinks in real terms. So long as inflation is moderate, we think in nominal terms. We say “Hey, honey, I got a raise today!”, not “Hey honey, on real terms, I'm barely treading water!” This is called the “money illusion”, except that, as long as inflationary expectations are in check, it is not an illusion; it is an economic law.

I will now advance the Mahoney Theorem which is appropriated from Scott Sumner, who hasn't yet trademarked it:
When an economy with sticky wages (aka, the West) is mired in a low-growth, low-inflation situation (i.e., low nominal growth), real growth and employment are functions of nominal growth. Nominal growth is therefore a precondition for real growth and employment growth. And the monetary authority is therefore responsible for employment growth.

Why is this? Well, obviously the money illusion, which works so long as inflation is moderate. But, just as importantly, moderate inflation allows nominal wages to rise while real wages fall, in order to regain competitiveness. In the modern economy (other than Hong Kong, where wages are uniquely flexible) nominal wages never fall and normally rise (see: minimum wage laws). The only way that labor can be made competitive in an adverse trading environment is real wage decreases. (And currency depreciation, another topic.) When nominal business revenues rise, nominal payrolls rise. When nominal revenues stagnate, nominal payrolls (at best) stagnate.

Right now, the whole world (besides witch-doctor economies such as Zimbabwe, North Korea and Ukraine) is in the grip of that seventies religion: price stability. We are fighting the last war. Yes, double-digit inflation is bad, a given, no argument, why are we still talking about it! But do we really want price stability, 0% inflation? No. We want moderate inflation in order to provide the correct incentive structure for investment and employment. My desired formula is 3% inflation and 3% real growth, for nominal growth at a healthy 6% (which, BTW, would allow us a 6% deficit and stable debt ratios).

There may be an island-living, survivalist tribe of neo-Keynesians who would still argue that “money doesn’t matter”. In other words, that contractions and expansions of the money supply are irrelevant in the determination of real growth. To which some monetarist once replied, “Well, if that’s true, then why couldn’t all the world’s trade could be conducted using a single penny?” QED. Money matters.

Bernanke grabs the steering wheel

2011-08-14T13:16:00.001-07:00

Excerpted from the FOMC’s August 9th statement:

The Committee currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman (New York); Elizabeth A. Duke (BOG); Charles L. Evans (Chicago); Sarah Bloom Raskin (BOG); Daniel K. Tarullo (BOG); and Janet L. Yellen (BOG).
Voting against the action were: Richard W. Fisher (Dallas), Narayana Kocherlakota (Minneapolis), and Charles I. Plosser (Philadelphia), who would have preferred to continue to describe economic conditions as likely to warrant exceptionally low levels for the federal funds rate for an extended period [without specifying duration].

This is big news. In the Greenspan era, the FOMC voted unanimously for whatever the chairman wanted. In the Bernanke era, the FOMC has had at most two dissenters (Warsh or Hoenig, both now thankfully gone). It was pretty clear that, in order to maintain “institutional credibility”, Bernanke wanted to minimize public dissent. (So as not to give the Ron Pauls of the world any more meat to chew on.)

What this has meant in practice, is that the hawkish minority have had leverage over the expansionary majority, thus interfering with Bernanke’s desire to grow M2 until he saw growth and inflation moving up and unemployment moving down. He wanted the Fed to do what he had wanted the BoJ to do ten years ago: target outcomes, not inputs.

I see last Tuesday as a breakthrough because it signals that Bernanke has given up on consensus-building, and is prepared to move ahead with continued unconventional policies on the basis of a working majority in the committee.

Under QE1, after the Lehman crisis, the Fed was growing M2 at over 10%. After QE1 ended in 2009, M2 growth slowed to an anemic and deflationary 1%. That is why 2010 was such a disappointment: the Fed was prematurely “conservative”. The Ben launched QE2 (which ended in June) and got M2 growth back up to over 9%.
I can’t imagine that he intends to keep the monetary aggregates stable going forward, especially with the recent market turmoil, disappointing employment numbers, and fiscal tightening. I expect him to turn the pumps back on this fall.

I would also hope that he would wake up and stop paying interest on free reserves, which seriously impedes the Money x Velocity = Price x Transactions policy mechanism, by depressing Velocity. If he really wants to get things moving, he should charge the banks a fee (negative interest rate) for parking their money at the Fed.

If he can grow M while stabilizing V, we will get the nominal GDP growth that we need to put people back to work and to stabilize the debt/GDP ratio.

Understanding sovereign credit ratings

2011-08-09T14:58:00.003-07:00

John Moody invented bond ratings in 1909, focusing initially on railroad bonds (which were the bread and butter of the US capital market at the time). As time passed, he expanded his coverage to include corporates and, in 1918, munis and foreign governments. He did not rate foreign governments out of personal interest, but because his US subscribers were being sold new or seasoned dollar-denominated sovereign debt. (The London capital market was closed due to the war; New York remained open, without exchange controls.)

Moody's rating scale was originally based on railroads and industrials. He intended for the rating scale to have room for large railroads and corporations in the Aaa category. When munis and governments were added, they were slotted into the same scale but with different definitions (some of which were very politically incorrect!).

Sadly, his track record with “government” ratings wasn’t so good. The Great Depression was very bad for munis, Latin America and central Europe. World War II was not good for defeated powers which hadn’t already defaulted.

I might add that the Depression wasn’t good for the US either. When the banking system collapsed in 1931-33, the bond market dried up, and the Fed was too busy trying to stem the gold drain to worry about the Treasury. Treasury almost defaulted in 1933 between the election and the inauguration. It had run out of money due to a huge deficit and lack of market access.

What’s interesting is that I know all this arcana because I have read John Moody’s investor newsletters during the Depression. He was all over this near-default, but maintained the Aaa throughout. I have to assume that this was for ordinal, rather than cardinal reasons. In a rank ordering of bonds in 1933, Treasuries were still on top and “money good”. Even when the US repudiated (3/33) the promise to redeem its bonds in gold, it remained Aaa.

The USA, on a cardinal basis, was not a great credit in 1945 with an enormous war debt, but, on an ordinal scale, it was the best in the world if you don’t count Sweden or Switzerland which saved themselves billions by staying out of the action. The UK looked even worse than the US, but was still Aaa and has always been, if my memory is correct. (I don't think the UK should have kept its Aaa in the postwar period, nor when it was begging from the IMF in the seventies.)

The global capital market closed in 1930, and did not reopen until over fifty years later. When it did, and American investors were once again being sold soveriegn bonds, the agencies began to assign ratings to foreign governments selling dollar bonds in the Yankee market and the eurobond market. In the 1980s, sovereign credit methodologies were primitive and not very good. Mistakes (in retrospect) were made.

Over the next thirty years, the quality of sovereign credit analysis steadily improved, as did the quality of the analysts and their methodologies (and their data). In the 1990s, the agencies dramatically expanded their coverage from a dozen countries to over 100, in order to establish "sovereign ceilings" for bank ratings.

To oversimplify, there are essentially three sovereign methodologies at the agencies: one for developing economies, one for high-income economies, and one for economies which either borrow in foreign currency (eurozone), are dollarized, or are hard-pegged to the dollar (or any other foreign currency). All of the methodologies are tied to ratios and other data. As of 2007 (when I retired), Moody’s published the most comprehensive and uniform data, in its Country Credit Statistical Handbook. It is possible that S&P and Fitch now offer similar products but I doubt it; these things are very labor-intensive.

So, why does S&P think that the USA is a worse credit than it was in 1945, and a worse credit than Johnson & Johnson? I would advance two reasons.

One is that the (salutary) development of prescriptive sovereign methodologies has resulted in an ontology which is unintentionally separate from the corporate scale in terms of expected loss. Can I prove it? No. But I feel it. And I’ll take a Treasury any day over J&J.

Another is that the cardinal aspect has gotten a lot stricter since 1933 and 1945. The ratios are the ratios, the CBO projection is awful, and that’s that. You’ve got to do what your methodology says to do.

But I will conclude with this observation: I don’t think that the UK, France or Switzerland are better credits than the US. The UK and Switzerland have large contingent liabilities (banks), and France has a socialist mindset. Our banking system is manageable, and few of our politicians (outside of Vermont) are avowed socialists.

S&P out on a limb

2011-08-07T10:59:00.000-07:00

Last week, I confidently predicted that S&P would not downgrade the US. I reasoned that to take what many will see as an extreme position would erode S&P’s credibility, especially when the other two agencies disagree. (Which, by the way, is an inadmissable reason to maintain a rating, but everyone has a subconscious).

The United States is a very complex sovereign credit, because it prints the global reserve currency, which creates artificial central bank demand for its bonds. Also, as Gavyn Davies points out in today’s FT:

The US cannot be forced to default on debt which is denominated in its own currency while it has huge untapped taxable capacity and a sovereign central bank to boot. It would only default because of the existence of a debt ceiling voluntarily imposed by Congress.

Aside from the optics, was S&P’s decision correct? That depends in part whether one believes that S&P rates sovereigns on the corporate scale. They say they do, but do they really? If one takes their stated methodologies at face value, the downgrade was warranted. They had laid out clear criteria in advance and the criteria were not met (a bipartisan deal to reduce the deficit by an amount sufficient to stabilize the country’s key debt ratios at a level consistent with AAA).

Did S&P do the responsible thing? Yes. Rating agencies are not allowed to have a published opinion that differs from the rating committee’s own internal opinion. When a rating agency downgrades a credit, the issuer suffers (see Enron, AIG, Greece). Rating agencies do not and may not consider the possible impact on the issuer or on the capital markets. Otherwise no one would ever be downgraded. All issuers are not created equal.

What is the political backwash for the agencies? The usual nonsensical ideas: (1) regulate them more; (2) create more of them (with government money); and (3) reduce their “power”. This kind of talk has been going on since the agencies started downgrading NYC in the 1960s. It erupted after Enron/WorldCom, and again after the CDO mess. Always stymied by that obscure 1789 Constitutional amendment which says something about the press.

I do not see how a government can regulate an opinion provider (aside from fraudulent activities that would apply to all opinion providers). Right now the Italians are “investigating” the rating agencies for publishing opinions with which Sr. Berlusconi disagrees, or finds inconvenient.

I expect the political upshot to be basically nothing, other than the fact that this has embroiled the agencies in domestic politics in the middle of a national political campaign, which is not good.

The one upside is that this event bolsters the agencies’ argument that they are publishers and deserve First Amendment protection (which has been upheld in federal court on multiple occasions).

It is my hope that, down the road, if the SEC does go after the agencies, the agencies will challenge the constitutionality of the rating agency section of Dodd-Frank (which is unconstitutional).

Dodd-Frank is such a mess: (1) it seeks to remove rating agencies from regulations, which is good and returns them to being private sector opinion providers, like Morningstar; and (2) it directs the SEC to regulate the agencies, with all that implies about winks and nudges (not always subtle).
The Europeans have not been subtle about “incorrect” rating opinions. I have always wondered how many NSA-equivalents wiretap and intercept rating agency communications. Not whether, that’s not an issue, but how many.

I expect S&P to confirm the USA's AAA, with a negative outlook

2011-08-03T15:18:00.001-07:00

Now that both Moody’s and Fitch have affirmed the AAA, I consider it quite unlikely that S&P will go out on a limb and unilaterally rate Treasuries at AA+. I remember when Moody’s took Japan to A2, it made the rating irrelevant in both domestic and foreign currency. Maverick positions hurt credibility (see: Central Banks, the IMF).

The US remains a benchmark standard for “risk free”. The ceiling deal should result in a less frightening fiscal trajectory over the medium term. Therefore, it would be premature to downgrade before the process plays out in December.

I expect more threatening language, a negative outlook, but no downgrade.

Eurozone defaults: From unthinkable to mandatory

2011-08-03T13:27:00.001-07:00

“I expect that [in addition to Greece] other euro area sovereigns, most likely Portugal and Ireland, will experience ratings defaults. The new European Stability Mechanism (ESM) that will replace the European Financial Stability Facility will have a sovereign default resolution mechanism. For sovereigns deemed insolvent, debt restructuring will be a pre-condition for access to ESM funds.
Private sector creditors share the burden of sovereign debt restructuring. Private sector involvement, so far on a supposedly voluntary basis, is on the map. I expect that before the end of the Greek programme, there will be deep coercive debt restructurings for Greece and other periphery sovereigns – without that it seems inconceivable their debt burdens can be lowered to solvency-consistent levels.”
--Wiliam Buiter, Citigroup Chief Economist, in the FT

There is a lot of really disturbing information in that paragraph. One year ago, we were told (condescendingly) by the EU and the ECB that defaults by eurozone members were unthinkable, and that any (Anglo-Saxon) discussion of the possibility was ill-informed and irresponsible. Everything was under control; it was just that foreign economists “don’t understand Europe”.

Well, it turns out that the foreign economists did understand Europe, because they knew that even the EU cannot suspend the laws of gravity and simple arithmetic. They did not drink the “Europe” Kool-Aid. Europe thought that if everyone would just shut up, the “market” would miraculously “believe in Europe” and credit spreads would retreat as fiscal austerity took hold.

Now we learn that eurozone default is no longer unthinkable: it is now a mandatory precondition of further bailouts. But the “market” is still expected to remain open to these issuers out of a sense “responsibility” or “solidarity”.

Well, the “market” consists of fiduciaries investing or lending other people’s money: their clients and depositors. It would be the height of irresponsibilty for an institutional investor to lend his clients’ money to risky countries which are expected to default. Which means that there is going to be only one source of bids for these countries’ debt: the EU and its various organs.

This means that the public debt markets will remain closed for Greece, Portugal and Ireland, and that they are rapidly closing for Spain and Italy. Either the ESM (Germany) will have to become their sole source of funding, or as Buiter implies, they get the ESM funding on the condition that they default and partially repudiate.

Once a country has defaulted (and partially repudiated), the capital markets will remain closed for a long time. Is the ESM going to be willing to fund the peripherals’ fiscal deficits (as well as their maturing bonds)? It might try to impose harsher austerity to force budgets into balance, but the political consequences would be dire. If they remain in deficit and the ESM says “no mas”, then the peripherals will have no choice but to balance their budgets (and their external accounts) while still defaulting on their maturing debt.

Developing countries have done this before, and developed countries did it in 1931-33. But the political consequences were in every case, a shift to the left or to the right. The political center did not hold because it had lost legitimacy.

I would hold out a little bit more hope for Ireland making it through because it is a Northern European country, it is competitive and has an educated and industrious workforce. Finland did it in the early nineties, they did not default and they are AAA.
And Eire is very small, so a bailout won’t break the bank, the way it would for Spain or Italy.

Can the US remain immune? Perhaps, especially if the economy grows and the fiscal trajectory becomes sustainable. Despite all the hoopla about the US having lost "global credibility", it remains the ultra blue chip in the debt market. Throught the latest crisis, Treasury prices have continued to be bid up. An S&P downgrade to AA+ may cause a blip, but I think it can be accommodated, just as it was in Japan, Canada, the UK and New Zealand.

But the outlook for the PIIGS is about as bad as it could be. The eurozone is not only a failure, but also a catastrophe which will play out over the next five years.

The USA's rating outlook

2011-07-15T15:44:00.001-07:00

If the debt limit is raised again and a default avoided, the Aaa rating would likely be confirmed. However, the outlook assigned at that time to the government bond rating would very likely be changed to negative at the conclusion of the review unless substantial and credible agreement is achieved on a budget that includes long-term deficit reduction. To retain a stable outlook, such an agreement should include a deficit trajectory that leads to stabilization and then decline in the ratios of federal government debt to GDP and debt to revenue beginning within the next few years. Moody's does not take a position on what measures should be included in any deficit reduction package. Instead, it is the resultant deficit and debt trajectories that are relevant to the rating and its outlook.
--Moody’s press release on the US rating review (7/13/11)

It would appear that what is most likely to happen is that a ceiling deal will be agreed, the ceiling will be raised and default will be avoided, thus allowing the agencies )or at least Moody's) to retain the AAA on the US, which would be good. However, it is pretty clear that while Moody’s rating will be confirmed at Aaa, the rating outlook will be negative. This because the two other conditions (deficit trajectory and a debt-ceiling permanent fix) are highly unlikely by August 2nd.

However, there is the possibility of an eventual bipartisan deal on the budget. Fixing the debt ceiling permanently will be harder. One idea would be to abolish the debt ceiling in exchange for a balanced budget amendment. This is a very bad idea, because it would create a big crisis the next time the economy has a heart attack. But it doesn’t matter because I don’t think there are the votes.

Another idea (mine), is both easier and better: index the debt ceiling to a fixed percentage of nominal GDP (e.g., the current ratio). This doesn’t require adding a bad and unenforceable amendment to the Constitution, and it should prevent further unending ceiling crises. It’s not perfect (the recession problem), but it can be adjusted at any time by legislation. Or, simply restore Gramm-Rudman-Hollings that required a balanced budget (which means it can be suspended when necessary by legislation). Under GRH the budget was not only balanced, it went into surplus. Remember the looming “Treasury shortage”? Bush and Obama solved that problem.

I certainly hope that both issues can be addressed to Moody’s satisfaction, because they are necessary, and because the US does not need the overhang of a negative rating outlook. The world will be a better place if the US can change its fiscal trajectory and stop having these artificial ceiling crises, and if the Aaa can move back onto more solid ground. The US should be Aaa1 (AAA+), not Aaa3 (AAA-). (When Moody’s started publishing sovereign ratings in 1918, the US bond rating was Aaa*, denoting an even higher category not bestowed on any other country’s.)

I think Ron Paul (who is chair of the House Subcommittee on Domestic Monetary Policy) has now shown himself to be utterly unserious and a truly dangerous person. He wants to abolish the Fed, return to gold AND cause a US default. This would all be fine if he was still publishing his loony newsletter. Just imagine how his plan would play out: no fiat currency, no lender of last resort, and no bond market.

In fact, we’ve already been there in 1932-33, when the US was on gold, there was no fiat currency, Treasury was running out of cash, the Treasury bond bond market was closed (because the banking system was contracting), and Hoover was forced to cut the budget in the middle of a financial panic. That was not an experiment to be repeated outside of a laboratory.

The Crime of '11

2011-07-14T17:16:00.001-07:00

When the US became a federal republic in 1789, it found itself in a bad spot financially. The Continental Congress had financed the war with paper money, which caused Weimar-style inflation. The paper (“Continental dollars”) was bought up by speculators hoping for redemption in coin. From our nation’s founding until 1933 (Civil War aside), the dollar was pegged to gold at $20 an ounce. Continentals traded for pennies.

Most officials thought that sticking it to the speculators would be necessary and prudent. Hamilton, the Treasury Secretary, was an Anglophile who understood that England had defeated France because it was a good credit and France was not. The Rothschilds bought British bonds; they shuddered at France’s paper (and they made a nice profits whenever the UK won).

Hamilton believed that the US would be like Britain and not like the rest of the world: we would be a sound credit. No defaults. He redeemed all of the Continentals in gold.

The US has had many credit events since “redemption”: States have defaulted and repudiated their debts; the entire South defaulted and the US repudiated the Confederacy's debts; we issued paper currency during the Civil War (but redeemed it all in gold); we broke the gold clauses in our bonds in 1933 when FDR temporarily took us off gold; and we went off gold entirely in 1971; dollar “Silver Certificates” were with drawn form circulation unredeemed. But the US never ever failed to repay its Treasury bonds on time and in full, if you define “in full” as legal tender and not gold.

So, what was the result? The result was that by mid-20th cenury, the dollar and the Treasury bond became the dominant instruments in the world, the reference for value, the world’s reserve currency (you sell us Toyotas, we give you low-yield paper), and the image of stability and safety. Switzerland with liquid markets.

This is ultimately about brand management (and trust). Warren Buffett said that it takes years to build a reputation and seconds to destroy it. Would Coke put polluted water in its sodas? Would Toyota remove the brake pads from its cars? Would Boeing disable the control surfaces on the Dreamliner? No. But the US, which has built the most important financial brand in world history, the Treasury bond, is about to default. This really takes the cake for stupidity.

We are witnessing is the result of the ideological sorting out of the political parties. In the 1950s, this issue would have been resolved with phone calls from Ike to Speaker Sam Rayburn and Majority Leader LBJ. Rayburn and Johnson were both conservative Texas Democrats, now a forgotten species. The divide between Pelosi and Cantor appears simply unbridgeable. The last time we were in this position was 1861. That didn’t play out well either.
And by the way, default is unconstitutional. If I were the President I would pay my debts no matter what Congress does. Congress can impeach him, but the Senate won't convict. Frankly, I'd impeach him if he didn't override Congress.

The creditworthiness of the United States

2011-07-14T11:48:00.000-07:00

Credit belongs only to the most enlightened and best governed nations.
--Daniel Webster

There are a four considerations: (1) will the USA keep its AAA, (2) will it default, (3) what are the possible consequences, and (4) what is the longer-term outlook.

The AAA rating is now on a very short leash: the agencies are saying that the US must agree a deal NOW, and agree a credible debt/GDP trajectory that is consistent with the highest sovereign rating. (These parameters have been published.)

While I could argue that the agencies should leave the AAA alone (because the US is still a very high grade credit), they have no big incentive to treat the USA any different from any other OECD sovereign. So I would expect them to downgrade the US next week or the week after, if no deal is reached. It’s silly to downgrade a bond issuer after it has defaulted. Not much predictive power there!

Additionally, given the CBO’s adjusted medium-term debt trajectory forecast, legislative gridlock (with or without a default) suggests that the US is moving from what I would call Aaa1 to Aaa2, in the direction of Aa1. It’s just simple arithmetic.

However it is important to observe that there are two kinds of countries: those that borrow in their own currency, and those that don't; the latter would be the entire eurozone. Every other OECD country finances itself in the same currency that it prints. (And please don't tell me that euros are domestic currency, except for perhaps Germany).

Printing presses are useful in debt crises. The Fed is the US’s lender of last resort, it has unlimited resources, and a big incentive to help. US default is much less likely than it is for countries that commit the original sin of funding themselves in foreign currency (the eurozone).

Given the digging of trenches on Capitol Hill, the US is at real risk of a technical default which, while it would make the US look like a banana republic run by clowns, would not fundamentally change the country’s underlying credit parameters. Treasuries would still be the best and most liquid bonds in the world. (When Moody’s took Japan to A2 in 1998, it had no impact on JGB yields.)

While a default would be a major dislocation, I don't expect Treasury yields to move dramatically in the event of a temporary default. Institutional investors, banks and central banks will have to scramble to change their investment guidelines. The longer this standoff lasts, the worse it gets (it becomes less technical and more real). It will be a big blow to confidence, upon which rests the $50 trillion of debt outstanding globally.

The impending Eurozone crisis makes global investors want dollars (and gold, yen and Swiss francs), so I just don't see huge currency/bond dislocations because the temporary default would be technical and not not real. The expected loss of a defaulted US Treasury bond comes very close to zero.

What matters most is not a temporary default, but rather a failure to address the CBO's (adjusted) medium term debt trajectory forecasts. If the Democrats insist on no entitlement reform, and the Republicans insist on no revenue enhancement, the CBO forecasts will materialize, and the the US will face a major crisis in the next decade.

Additionally, as Moody’s points out, when a country defaults and does not adopt reforms to prevent such an event from ever happening again, it doesn’t smell like a AAA, even if the expected loss remains miniscule. Household FICO scores reflect not only repayment but punctuality.

What is happening in Washington today is unworthy of the issuer of the world’s reserve currency. It is deeply irresponsible. As J.P.Morgan observed, “Collateral is no substitute for character”. Serious countries do not default on their debt due to partisan budget battles. Alexander Hamilton would move to Canada if he were alive today.

Parliamentary democracies do not face this problem. It is a major constitutional problem for the US. (And it is absurd for Congress to appropriate trillions in spending and then deny the Treasury the ability to finance it.)

We don't need anymore shocks. Lehman and the PIIGS are enough. Modern finance is founded on leverage and confidence, and I do not wish to live through a rapid deleveraging of the global economy (1930-34). There is a growing view that modern finance (1980-2011) is a huge Ponzi scheme funded by debt that cannot be repaid without big inflation. I don't subscribe to this view, so long as central banks are prepared to manage the deleveraging without catastrophic deflation (1930-1933).

It is particularly unfortunate that this rodeo in D.C. is occurring at a time when confidence in the eurozone it at an all-time low. National problems can become global problems when they are coincident.

Europe faces its Minsky Moment

2011-06-26T13:52:00.000-07:00

In 1933, Irving Fisher published his seminal “Debt-Deflation Theory of Great Depressions”. His theory was that over-indebtedness will ultimately lead to liquidation. Debt liquidation leads to distress selling and to a contraction of deposit currency as bank balance sheets shrink, leading to falling prices. As prices fall, the vicious cycle continues because even though prices are falling, indebtedness does not. Deflation makes debt bigger. (That’s Greece we’re talking about.)

Milton Friedman, Ben Bernanke and Barry Eichengreen (along with most other students of monetary policy) agree with Fisher’s theory. In fact, it’s so difficult to refute that it’s become an axiom.

Which brings us to 2011. What is the economic phenomenon that has characterized the past 29 years (i.e., since the crash of ‘82)? One word: leverage, ever growing leverage. Leverage at banks, shadow banks, mortgages, mortgage-backed securities and their derivatives and, of course, governments of all shapes and sizes.

Leverage is inherently evil because it increases financial fragility. If a financial institution has 4% equity and its assets decline in value by 4.1%, it is insolvent. Leverage exposes debtors to creditor confidence. Borrowers default when and only when no one will lend to them anymore.

Creditor confidence is not modelable. It is purely a matter of group psychology: “I’d better get out now because I see people heading for the exits”. It is unpredictable. Who could have imagined that Goldman Sachs, AIG and GE would lose creditor confidence in 2008?

There are only three ways out of over-indebtedness and a loss of creditor confidence: bailout, default or (in the case of governments) inflation.

As we speak, private sector creditors have lost confidence in Greece, Portugal and Ireland (governments and banks). They are living on life support from the troika (EU/IMF/ECB). They are small and manageable. But the loss of confidence is now spreading to Spain (government and banks) and to eurozone banks exposed to the diseased sovereigns and their banks.

In 2008, the contagion was confined to major banks active in the mortgage, RMBS and CDO markets, which the central banks funded and the governments recapitalized. Today, the contagion appears to be spreading to the entire eurozone banking system. The eurozone banking system is too big to fail and too big to bailout, unless the ECB has the guts to step up to the plate (which is, by the way, its job).

The Germans have talked tough about the need to liquidate failing non-German banks. Let’s see how they feel about liquidating the Landesbanken or Deutsche Bank.

Europe is facing its greatest challenge since 1939. Will it take extraordinary measures to maintain financial stability, or will it be sauve qui peut?

The eurozone is shuddering

2011-06-25T12:40:00.001-07:00

The risk of a catastrophic financial accident is as high as it was in 2008. Eurozone bank risk spreads are rising as investors take flight, while the yield on one month Treasury bills is now below zero. Even though the troika (EU/IMF/ECB) is moving forward with Greece’s bailout, investors are seeking cover anyway. Thus Greece doesn’t have to default for there to be a eurozone financial crisis.

If Spain, Portugal and Eire (governments and banks) lose market access, they will have to reschedule (default) because the troika doesn’t have enough money to rescue them all, along with Greece.

This scenario would be more like the cascading worldwide defaults of 1931 than 2008. One would have to imagine that the wealth destruction in such a scenario would be unprecedented.

Can such a scenario be contained to the Eurozone, or could contagion spread to other developed markets? I can’t see how other European banks won’t be affected to some extent, but they benefit from borrowing in domestic currency, which their central banks can print. I would not expect that non-European banks and governments would be affected, because they all borrow in their own domestic currencies.

Such a scenario would pose an unprecedented challenge to the ECB, which would have to make some very hard choices in order to maintain financial stability (i.e., taking on trilllons of exposure to eurozone banks, presumably with government guarantees of questionable value).

None of this would be happening were it not for the incredibly stupid idea of a monetary union of a hodgepodge of economies based on a geographic concept. The lesson learned during 1931-33 will now have to be relearned: only domestically issued fiat money can prevent deflation and defaults. No country should ever adopt a foreign currency as its own: If you can’t print it, don’t borrow in it. (And no central bank in the world can print gold, so forget about that “solution”.)

The breakup of the eurozone is such a black swan that its ultimate ramifications fall into the Rumsfeldian “unknown unknowns”. I’d have to say long-term bullish, but short term frightening.

Greek default looms

2011-06-16T14:06:00.000-07:00

Previously I had predicted that Greece would default within six months. It is now evident that I was a tad over-optimistic. Default will occur considerably sooner than that.

First of all, Germany won’t mount another bailout unless Greece embraces reform and unless bondholders take some pain. Far from embracing reform, the Greeks are rioting and the government is falling. (Video footage of violent riots has become one of Greece’s fastest growing exports.)

It will be difficult to form a unity government committed to reform, because the opposition would rather renegotiate the bailout that Greece got a year ago, which will not be music to German ears. The Greek plan is to demand a new bailout while defaulting on the prior one. Angela will not be amused.

Greece cannot commit to reform because the people won’t accept it. Germany can’t agree to a bailout unless Greece commits to reform. The ECB, Greece’s largest creditor, refuses to participate in any debt reprofiling, which Merkel demands.

Therefore, Greece will soon run out of money to pay its maturing liabilities and will therefore default, along with its banking system which will collapse.

In my opinion, Greece has no choice but to default, exit the eurozone and redenominate its currency and its debt.

The consequent losses to European banks will be large. This would set up another Lehman event, in which the interbank markets freeze. The ECB will be the provider of liquidity, until the losses are sorted out and the banks are recapitalized.

The Fed will have to step up liquidity operations as well, as in 2008. This will be a deflationary event and may require QE3. Real possibility of a double dip in the 3rd quarter.

Greek default this summer: implications

2011-06-01T19:38:00.001-07:00

Greece is within six months of utter and irreversible collapse. Her electorate will not accept the German castor oil plan. She has the choice of balancing her budget under a German rifle corps, or defaulting and balancing her budget anyway (deadbeats can’t borrow).

By September, she will be in default in the worst possible way. Greece is not Argentina, she is Egypt, or Congo. There will be nothing orderly or lawful about her default. Her banks will succumb, her creditors will be left penniless, the ECB will no longer remember her name, and her tax revenues will drift towards zero. She will be a humanitarian basket case, except for the fact that Europe will be unsympathetic to Marxist defaulters. Maybe UNICEF will step in.

Once Greece sinks beneath the waves, Europe will have to come up with a jerry-rigged central funding scheme to keep the fires of hell away from Ireland, Portugal, and the other dodgy credits. Good luck on that. I would expect the worst for Eire and Lisbon.

How many times does the world have to learn that ungovernable Third World countries should not peg their currencies to anything of real external value? Isn’t that the lesson of Latin America, East Asia and, now, the golden Teutonic paradise of euroland?

The Anglosphere is lucky that (aside from Eire) neither UK, US, CAN, AU or NZ have chained ourselves to this catastrophe. We’ll get the blowback, but not another Depression.

Investment implications? No idea, aside from bullish for $ and gold.

Europe must plan for a Greek defult now

2011-05-04T14:26:00.000-07:00

Greece has not been compliant with the terms of its rescue loan. The Germans are balking at a second rescue. I really don’t see what will prevent an attempted restructuring. Credit spreads are in the stratosphere.

Greece’s debt lacks a collective action clause, so that it cannot negotiate with its creditors the way a company can. However, because Greece is not subject to a court, it can restructure unilaterally. However, I would expect that it would seek to negotiate the terms of the restructure with the ECB, the IMF and the EFSF.

Greece has lost access to the capital market. Restructuring will be another nail in that coffin. A negotiated restructure will mean that Greece will be saddled with a mountain of debt and no hope for market access. This means that Europe (the EFSF) will have to finance Greece’s budget deficit. The terms for such loans will be draconian because Europe will want the budget balanced rapidly. Thus, failure to comply with the first rescue’s conditions will only result in worse conditions.

Greece also has the nuclear option: default and repudiation. Since the capital markets will remain closed, and the European spigot rapidly turned off, Greece would have to balance its budget while still owing an amount in excess of its GDP. What is the incentive to honor its debts if there is no reward? Germany is not going to invade if Greece defaults. We have already seen repudiation in Latin America (about 100 times over two centuries).

In the end, either France and Germany cough up a lot of money, or else Greece defaults and repudiates some or all of its debt. They can’t pay it and they won’t pay it. The Greek electorate will not willingly put itself through what Romania went through in the 1980s.

In my opinion, now is the time for Europe to forget its “stability” delusions and start thinking about how to manage a Greek default. This will require another bank recapitalization and, in order to keep the interbank market open, another bank guarantee scheme. The ECB will have to put aside its dreams of a rate hike, and instead launch a massive liquidity infusion.

Europe must also decide what to do about Ireland. Ireland’s debt exceeds its debt capacity.

A German official said that a Greek default will have a market impact an order of magnitude greater than Lehman in 2008. That depends entirely on how well the authorities handle it. If it is bigger than Lehman, the ECB and the EU will have to up their game considerably. Right now they are in denial and unprepared.

Will Portugal be the first domino?

2011-03-23T15:02:00.000-07:00

At present there are three eurozone members who have lost the ability to access the private capital market: Greece, Ireland and Portugal. Greece and Ireland have agreed to drastic austerity in exchange for access to the European Financial Stability Facility (and the IMF and ECB).

The Portuguese government has been attempting to perform fiscal surgery on itself without a bailout. Today the Portuguese parliament rejected the government’s austerity plan; the government has resigned; and there will be an election.

A bailout appears to be inevitable. But the EFSF/IMF scheme requires drastic austerity along the lines that have just been rejected. The new government and parliament will be faced with a choice between drastic austerity or default (resulting in even more drastic austerity). There is no “Get Out of Jail” option.

I would expect the ECB to keep Portugal on life-support while a new government is elected and formed. But unless Portugal requests a bailout on Draconian terms, there will be no bailout and Portugal will descent into the abyss.

It is possible that the Europeans will blink and keep shovelling euros into the Portuguese treasury despite uncontrolled budget deficits, but I can’t see Angela Merkel keeping her government together under such circumstances; the German people are already very angry about the EFSF.

Also, the EFSF may demand that bondholders agree to rescheduling and/or take a haircut. This would foreclose market access for a long time, forcing the eurozone to refinance all of Portugal’s maturing debt, a political impossibility.

The only way that Portugal can prevent economic collpase while remaining in the eurozone is to swallow the austerity pill and become a ward of the eurozone for the foreseeable future. Can any free people vote for drastic long-term austerity? The Baltics did, but for the euro peripherals, I am skeptical.

It is unclear how long the Greek and Irish peoples can tolerate a repeat of the Great Depression.

The threat of inflation

2011-02-16T12:34:00.000-08:00

Headline news today: “Core producer prices rise at fastest rate in two years”.

Market reaction: “This may force the Fed to reconsider its position that inflation is not a serious threat this year,” said Michael Woolfolk, analyst at BNY Mellon Global Markets. “While the Fed can brush aside upside surprises to headline inflation, it cannot as easily brush aside upside surprises to core inflation.” (FT)

Now, some perspective. Core PPI grew at an annual rate of 1.6% in January. During the recession the PPI was in deep deflationary territory, falling from 205 to 170 (17%). Since the Fed began to the money supply, PPI has “recovered” into very low single-digit growth.

However, all measures of inflation are currently under 2%: CPI, core CPI, PPI, and core PPI. Core CPI has not been this low since the New Frontier. There is no reason for the Fed to reconsider its position that inflation is not a serious threat this year. The Fed continues to undershoot its inflation and employment targets.

The good news is that, due to quantitative easing, the money supply (M2) has begun to grow again at a comfortable (and non-inflationary) annual rate of 5%. We are in recovery, and monetary velocity has begun to rise modestly (1%). The combination of 3% real growth (let’s hope) and 2% inflation would get nominal GDP growth up to 5% (from minus territory in 2009). 6% would be better, but I will settle for 5%.

The impending departure of the hawkish Kevin Warsh from the Board of Governors and the FOMC is a good thing, in the sense that hopefully the president will nominate a more dovish governor who would be more supportive of Bernanke’s efforts to grow nominal GDP. Hopefully, Warsh won’t start testifying before Ron’s Paul’s committee about the danger of inflation.

Please note that, in all the debate about the US’s growing debt/GDP ratio, a missing fact is that one of the best ways to stabilize this number while the US is still in AAA territory is to grow nominal GDP. Growing our way out of debt is much less frightening than defaulting our way out of it. That was one thing that both Ronald Reagan and Bill Clinton understood.

ECB halts bond purchases: Why?

2011-02-01T11:06:00.001-08:00

Reuters:
The European Central Bank bought no government bonds for the first time since October last week, reflecting growing market confidence that policymakers are
getting on top of the euro zone debt crisis.

Analysts said the ECB's move was a reflection of the better
debt market conditions and its hopes that Europe's rescue fund,
the European Financial Stability Fund, would take over its
uneasy role of debt buyer of last resort.

"It further reinforces Trichet statements that the ECB is
present in the market commensurate to the strains they see. The
ECB has clearly looked at the situation and decided that the
situation is not as pronounced as it was last month," said RBS
economist Nick Matthews.

"It is also occurring against a backdrop where the ECB
appears to be supporting an enhanced role for the EFSF which
could see the EFSF becoming the vehicle to buy bonds rather than
the ECB."

Here is my take on what may actually be happening. There has been a tug-of-war between the ECB and Germany over the size and scope of the EFSF. The ECB does not want to become the de facto bailout fund for the peripheral eurozone members.

It may be that this decision to stop buying government bonds is political and not financial. This is the best way for the ECB to pressure the European Commission to make the EFSF more credible, in that hope that markets will calm down, or in the hope that the bonds that the ECB has bought don’t go bad.

We will see if I am correct pretty quickly.

Sovereign credit risk: Eurozone, Japan, US, UK

2011-01-31T17:10:00.000-08:00

There is a lot of confusion in the financial media (aside from Martin Wolf at the FT) about sovereign credit dynamics. Below is my short precis of sovereign credit risk factors:

1. Fiscal trajectory
This involves forecasting three variables: government revenue, government expense, and nominal GDP. GR - GE = fiscal deficit. Add forecast annual deficits to outstanding debt, and measure against both revenue and GDP. (The debt to revenue ratio is the more critical.) Another useful ratio is interest/revenue.

There are some scary fiscal trajectories out there, especially Japan, Greece and Ireland, which appear to be unsustainable without massive fiscal consolidation coupled with rapid GDP growth: an unlikely scenario. The US has a bad trajectory as well.

2. Debt capacity
Debt capacity is a country’s maximum sustainable debt level in relation to GDP or government revenue. Sustainable means without “debt restructuring”. There are many factors which influence this measure, such as the depth of the domestic capital market, whether the country has a fiat (printable) currency or, much worse, a currency (e.g., the euro) which it cannot print. Also important is social cohesion, the perceived legitimacy of the government (compare Finland with Egypt), and the overall level of development. Examples of high debt capacity are the UK after WW2, and Japan today. By this measure, Ireland is in much better shape than Greece. The Irish pay taxes, have a small public sector, and don’t riot much (the riots were in the North).

3. Market access
Market access is the ability of the country to refinance in the debt markets, as well as the ability of the banking system to remain funded and liquid. Here again, it helps to have a deep capital market and a fiat currency (under a fiat currency, the banks are always liquid). In the eurozone, only Germany, France and perhaps Italy have deep domestic capital markets, but they do not have a fiat currency. Japan, with the worst debt ratios in world history, has excellent market access due to its huge domestic savings glut. It can issue bonds at amazingly low yields. The banks buy the bonds and the population funds the banks.

4. External support
Greece and Ireland have lost market access. They are being kept afloat by the ECB (which discretely buys governmnt bonds and lends to banks) and by the EFSF which acts as a lender of last resort to member states. Therefore, in these two cases, the central issue is no longer the underlying fundamentals (fiscal trajectory and debt capacity) but rather the political decision-making concerning external support.

This is why the ECB is at war with the European Commission. The ECB does not see itself as the eurozone’s bailout fund (just as the Fed has little interest in buying California bonds). But the Commission has so far refused to establish a large, credible bailout mechanism for the peripherals, because Germany doesn’t want to be the eurozone’s de facto bailout fund either.

UK
How does the UK look in this prism? It has an unsustainable fiscal trajectory as the PM and the Chancellor will happily inform you. It appears to have more runway on debt capacity, so long as the Coalition is seen to have a credible deficit reduction plan (the plan is credible, but will the Coalition hold together?). It is extremely lucky (i.e., smart, thanks to the unsung Gordon Brown) that it did not adopt the euro. Britain can grow its money supply with complete autonomy, and can let the pound depreciate to regain competitiveness. The UK’s big problem is that it has a services economy, not an export economy, and devaluation does not really make the City of London more competitive.

Market access is good unless there is a breakdown of the Coalition, which is unlikely. Should the Coalition lose its majority due to fiscal disagreements, confidence in sterling and gilts could hit a wall, and bond yields would add a default risk premium.

US
Here again, the fiscal trajectory is unsustainable over the next decade (according to the Congressional Budget Office). The US is entering a potentially catastrophic demographic shift, not with a surplus, but with a very high deficit. As the boomers retire, the costs of MediCare and SocSec will create a major structural imbalance. It’s actually quite frightening, considering the difficulties of a meaningful budget compromise. Can Harry Reid and John Boehner agree on anything? (The UK has a significant constitutional advantage in that the Government always commands a majority in the House.)

US debt capacity? Quite a bit of runway left, judging by the the Japan-like Treasury yields demanded by investors. Ditto for market access; Treasury auctions are going very smoothly, and the Fed is doing its part with $600B of QE2.

External support? That would be Asia (Japan and China), which buy Treasuries with their current account surpluses. No evidence of a problem there.

Conclusion
So, my judgement would be that Greece and Ireland must default, the UK is at risk unless the Government keeps its majority, and the US is also at long-term risk if the GOP and the Democrats cannot agree this year on a plan for fiscal consolidation.

The China-US summit

2011-01-17T12:15:00.000-08:00

The People’s Bank is in a real bind. Central banks have mandates. The PBC’s dual mandates are difficult to achieve: parity with the dollar and growth without high inflation. Maintaining dollar parity requires the PBC to invest China’s enormous current account surplus in dollars (otherwise, the yuan would rise in dollar terms). The PBC requires exporters to sell their dollars to the bank in exchange for yuan.

As the PBC’s balance sheet expands, so does the money supply and thus inflationary pressures. The PBC is seeking to dampen inflation by curbing bank lending and raising interest rates. The PBC could also fight inflation by allowing the yuan to appreciate, but that it out of the question. Export growth trumps inflation. The PBC’s policies have been very successful. China’s growth and prosperity since 1979 have been remarkable.

But now the PBC and the government have two problems (besides inflation). One is that China is under increasing pressure from the G-20 to allow the yuan to rise. The other is that China is concerned that the value of it’s ~$3 trillion dollar nest egg is threatened by the US’s massive deficits and by QE2, which China believes represents a stealth devaluation.

Yesterday, President Hu made two somewhat contradictory statements (in a written Q&A with the Journal) which highlight his dilemma. First, he said the the dollar’s hegemonic status is obsolete. Then, in the same statement, he said that US monetary policy “has a major impact on global liquidity and capital flows and therefore, the liquidity of the U.S. dollar should be kept at a reasonable and stable level”.

In 2009, the PBC called for a new synthetic reserve currency regime. France has made similar statements. But there is nothing stopping the PBC or the ECB from buying SDRs or diversifying their reserve portfolios.

As I pointed out in my most recent post, I expected the PBC to buy euro-denominated government bonds, and indeed it did so last week in the Spanish and Portuguese auctions. But it is one thing to buy euros and another to stop buying dollars.

The ECB could diversify away from dollars and buy yen, won, sterling, the A$, the C$, etc. But that would be symbolic. Monetary policy on the ECB’s scale cannot be conducted with illiquid, boutique currencies. Buying yuan bonds is out of the question due to China’s exchange controls.

So the PBC and the ECB are exposed to both the US credit risk (still AAA!), and devaluation. And I don’t see that there is much to do about it, other than jawboning the Fed and the Treasury, which hasn’t worked.

President Hu’s summit with President Obama will be highly scripted, and I don’t expect anything major to come out of it.

Can China peg the euro to the dollar?

2010-12-24T13:54:00.000-08:00

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

2010-12-21T10:50:00.000-08:00

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?

2010-12-18T13:44:00.001-08:00

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?

2010-11-26T15:21:00.001-08:00

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?

2010-11-16T11:46:00.000-08:00

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

2010-11-15T14:57:00.001-08:00

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

2010-11-15T11:05:00.001-08:00

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?

2010-11-14T16:34:00.000-08:00

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

2010-11-14T14:50:00.001-08:00

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?

2010-11-13T14:20:00.001-08:00

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?

2010-11-10T16:25:00.000-08:00

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.”