Will Greece default?

Remember the East Asian crisis of 1997-8? The crisis was sparked by the famous "fall of the baht", when Thailand was unable to maintain the peg to the dollar, causing a run on the country's short-term debt. This in turn sparked scrutiny of nearby counties with similarly mismatched external positions (too much short-term dollar debt, too little dollar reserves). 

Creditors turned on Korea, Indonesia and even Malaysia (which wasn't mismatched, but was in the wrong neighborhood). Ultimately, the Clinton administration and the IMF organized rescue packages that ended the runs, but not before the virus infected Russia, which did default. 

One of the many lessons of the crisis was "put out the fire before it spreads to the rest of the neighborhood". 

We may now be witnessing the beginning of another financial crisis in what had been one of the most stable parts of the world: the eurozone. 

I think that it is only a matter of time before Greece loses the confidence of the international capital markets and is unable to refinance. This would force the EU to confront an almost impossible situation: either let Greece go, sparking contagion to other weak eurozoners (Italy, Portugal, Spain, Ireland); or, cobble together a rescue mechanism that might need to be extended to others. This is clearly causing huge angst in Brussels.

The Times (UK) reports today that:

Leaked documents have revealed Brussels will publish a plan for Greece this week, under the headline “Urgent measures to be taken by May 15, 2010”.The package includes demands to “cut average nominal wages, including in central government, local governments, state agencies and other public institutions”. 

This isn't going to work. The Greek (socialist, union-dominated) government is in no position politically to implement such a scheme. Most indebted governments have three choices: default, devalue or deflate. Greece can't devalue because it (like Michigan) has no national currency, and it can't deflate by raising interest rates over which it has no control (also like Michigan). The only way it can restore competitiveness is to use fiscal policy to force a deflationary recession, which is politically impossible. 

This leaves Brussels two unpalatable options: default or bailout. If they are smart, they will choose bailout (with strict conditionality). But right now it appears that there is no EU consensus on this question. It should also be noted that the EU has very limited federal revenue and a tiny balance sheet. Any rescue will have to be funded by Germany and France, so this will ultimately be up to Nicholas and Angela. Gordon (not in the zone) has signaled that he will sit this one out.

The senators who voted no on Bernanke

Below is the dishonor roll of senators who voted against Ben Bernke's confirmation as Fed chairman:

Democrats:

Begich, Alaska; Boxer, Calif.; Cantwell, Wash.; Dorgan, N.D.; Feingold, Wis.; Franken, Minn.; Harkin, Iowa; Kaufman, Del.; Merkley, Ore.; Specter, Pa.; Whitehouse, R.I.;  Sanders, Vt.

Republicans:

Brownback, Kan.; Bunning, Ky.; Cornyn, Texas; Crapo, Idaho; DeMint, S.C.; Ensign, Nev.; Grassley, Iowa; Hutchison, Texas; Inhofe, Okla.; LeMieux, Fla.; McCain, Ariz.; Risch, Idaho; Roberts, Kan.; Sessions, Ala.; Shelby, Ala.; Thune, S.D.; Vitter, La.; Wicker, Miss.

Sarkozy accuses the US of "monetary dumping"

From today's FT:

President Nicolas Sarkozy on Wednesday stepped up his calls for a new Bretton Woods system to stabilise global exchange rates, promising proposals for reform of the international monetary system when France takes over the presidency of the G8 and G20 next year. 

“The prosperity of the postwar era owned much to Bretton Woods … we need a new Bretton Woods,” he told the World Economic Forum in Davos. “We cannot preach free trade and tolerate monetary dumping. France, which will chair G20 in 2011, will place reform of the monetary system on the agenda.”

Translation: The US, as the global monetary hegemon, should not be allowed to debase its currency ("monetary dumping"). From a moral perspective, he is right. But from a practical perspective, he is heading out to sea. 

This sterile debate is now almost 40 years old. The Europeans criticize the US, which does nothing because the Europeans have no leverage in this arena. The dollar is the reserve currency of choice because of its liquidity, not because the US forced foreign central banks to buy it. 

Sarkozy is essentially calling on the Fed to peg to the euro, thus surrendering US monetary sovereignty to Trichet and his deflationist accomplices at the ECB. US monetary policy would thus shift from targeting price stability to targeting the value of the dollar in euros. This is never going to happen. 

However, there is nothing to prevent the ECB from pegging the euro to the dollar, which is what in my opinion they should do. But this would mean that the eurozone would surrender its monetary sovereignty to the Fed, which would be anathema to the Germans. 

So this whole discussion is a complete waste of everyone's time, which is entirely appropriate for the G-8 and G-20 gabfests. "It's our currency, but it's your problem."

Throwing Bernanke and Geithner over the side

There is growing opposition in the Senate to Ben Bernanke's reconfirmation on both sides of the aisle, and there is increasing pressure on Tim Geithner as well. 

I can certainly think of a few reasons why they might be thrown overboard:

• They let Lehman go, an event from which we have by no means recovered;
• They have signally failed to make a persuasive case for TBTF and the so-called bailouts;
• Bernanke has failed to persuade the FOMC to adopt inflation-targeting as Fed policy;
• Bernanke has presided over the first annual decline in nominal GDP in 60 years;
• Geithner has insufficient clout in the White House to stand up to the Emmanuel bank-bashing populists.

But none of the above are among the crimes for which these men are being pilloried. Instead, they are accused of "bailing having out Wall Street while doing nothing for Main Street". This criticism reveals either willful ignorance or disingenuous populism. 

Let's do a thought experiment. Let's imagine that, instead of rescuing the financial system, they had simply allowed events to take their course. The financial system and the money supply collapse. Debts become due as they mature with no hope of refinance. Nominal GDP declines by 25%. 


Haven't we been here before? Doesn't this sound a lot like the Hoover administration in general and Andrew Mellon in particular? Is this the history we want to repeat?

Bernanke and Geithner took enormous personal risks to rescue the financial system, employing their authorities and powers to their utmost, and beyond. Did they do this for personal gain? Did they benefit in any way, other than to be subjected to show trials on Capitol Hill? How much do Barbara Boxer or John McCain know about the conduct of monetary policy during a financial crisis?

Personally, I don't think that Bernanke has done enough with respect to fighting deflation and growing nominal GDP. I think the reason for this is not that he doesn't get it--considering the fact that he wrote the book on the subject. 

Instead I think that his failure to do more is due to his desire to maintain a degree of consensus on the FOMC, bringing the inflation hawks along with him as the data unfolds. He lacks Greenspan's clout and is uncomfortable with close votes on huge decisions. This is extremely unfortunate, but I do not see how someone else could possibly do a better job. (...Although, if Bernanke goes, Chairman Summers might be willing to grab the hawks by the throat.)

How to make the credit contraction worse

I believe that it is fair to say that sustained economic growth cannot resume in the US until the credit contraction ends and banks begin lending again. The continuing decline in the credit aggregates is short-circuiting the Fed's efforts to stimulate growth. (Shades of Japan.) 

Despite quantitative easing resulting in an increase in the monetary base from $800 billion to $2 trillion, the real economy remains stalled and prices are flat. This is because, despite massive increases in free reserves, bank loan portfolios continue to contract, and also because the private sector securitization engine remains broken. 

C&I loans are declining at a rate of almost 20% (by far the steepest rate of decline since the Depression), and household indebtedness is also contracting. 

The hole left by the private sector is currently being made up by the government:

• The federal government is growing its debt at an average annual rate in excess of 20%;
• The federal government and the Fed are keeping Fannie and Freddie on life support with capital and unlimited credit;
• The Fed is supporting the ABS markets via the TALF.

Essentially, the economy is in the ICU on oxygen and glucose. The patient is still alive, but is not showing signs of sustainable recovery. 


However, the outlook for a recovery in credit growth is very bleak. It appears that it is the policy of the government to take measures intended to further contract the credit available to businesses and households. 

Consider:

• Capital and loss-reserve standards are being raised, not lowered, forcing banks to shrink their balance sheets.
• The Obama administration has proposed limiting bank size, forcing a reduction in loan portfolios.
• The administration has proposed a tax on uninsured bank liabilities.
• The IASB and the FASB want to consolidate off-balance sheet vehicles and to require additional capital against derivative exposures, both of which would put renewed pressure on bank capital ratios.
• The TALF is inexplicably scheduled to end at the end of March.
• Populist attacks on bankers, the banking system and bank compensation are not helping to retore animal spirits in the financial system.

These factors suggest that credit will continue to contract, cancelling out the effects of monetary and fiscal stimulus. Contracting credit will pull nominal and real growth downward, reducing federal and state revenue, and increasing the deficit.

Some questions for the Crisis Commission to ask Wall Street CEOs

1. How much were your total writedowns on securities and how much by type of security?

2. Why was your bank holding such a large amount of unsold securities?

3. Were your huge RMBS and CDO exposures flagged by your risk management system and your risk management professionals?

4. If so, why didn't you seek to hedge or reduce these exposures?

5. If not, please explain your understanding of the words "robust risk management".

6. Is it the policy of your firm to "originate to sell" or to "originate to hold"?

7. What did your firm's internal capital models indicate with respect to capital adequacy at the end of 2007?

8. How did your capital models perform in 2008?

9. What did your firm's internal liquidity models indicate at the end of 2007?

10. How did those models perform in 2008?

11. How don you explain the utter failure of your firm's risk management, capital adequacy and liquidity models and policies in 2008?

12. How would you define "competent management" in the context of your industry?

13. In view of your industry's near collapse and rescue by the government, do you support strict regulation of risk management, capital adequacy and liquidity?

How long will the ECB remain independent?

During the run-up to monetary union, the Germans would only agree to exchange the DM for the euro if they were assured that member states would not be able to pressure the ECB to inflate. They got what they wanted: Europe is now governed by an apolitical, unelected, "independent" central bank that is hawkish on inflation, dovish on deflation and oblivious to growth or employment: a blue-eyed BoJ. 


Clearly this arrangement has been a bad thing for peripheral Europe, where low interest rates fueled a debt-financed boom/bust and which today has no ability to devalue or fight deflation. 


But today's paper reports that Germany's GDP shrank by 5% in 2009, which raises the question as to whether the ECB isn't bad for core Europe as well. Certainly this has been the French view for some time. 


By its own admission the ECB is undershooting its inflation target, and it is certainly not delivering economic growth or full employment. How would it rate its performance against any set of objective criteria? Are deflation, stagnation and high unemployment exogenous phenomena, like bad weather or bad luck? 


I predict that before this cycle is over, there will be a major debate over the ECB's governance and the political relationship between the ECB and the Commission. With growth of negative 5%, maybe even the Germans will come around.

Another brilliant idea from the D.C. pitchfork brigade

The Nobel Prize-winning geniuses on Capitol Hill have come up with another bi-partisan scheme to improve our financial system. They--Sens. John McCain (R) and Maria Cantwell (D)-- want to restore Glass-Steagall and prohibit banks from being in the securities industry and vice versa. 


Please recall that the standalone investment bank was invented by Senator Carter Glass(D-Va) in 1934. Thus the US became unique in the world by placing its capital market into the hands of Wall Street broker/dealers who were supposed to intermediate billions in capital flows with no core funding, minimal capital and no lender of last resort. This prescription for disaster finally bore fruit  in the fall of 2008, when the standalone investment bank model finally died a well-deserved death


When Lehman failed, there was a funding run on the remaining investment banks (Goldman, Morgan Stanley, Merrill). Although they had plenty of good collateral, the money markets were closed tight. No one wanted their name. This impelled them to merge with or convert to bank holding companies in order to come under the Fed's umbrella (and, ultimately, to develop sources of bank-like core funding, God willing).


If we are lucky, a silver stake has been driven for good into the heart of the wholesale-funded investment banking model.  If, by some horrifying circumstance,  the Glass-Steagall Act were to be  restored by the Senate's  Know-Nothing caucus, the government will mandate the resurrection of these misshapen creatures (a financial version of The Night of the Living Dead), and the US will inevitably face another wave of failures and bailouts. 


Citi will disgorge Salomon/SmithBarney, BofA will  gift us with Merrill, and JPM will rebirth Bear Stearns. And what, dare one ask, will happen to Goldman and Morgan Stanley when they are pushed out of the Fed's nest to fend for themselves? Are they expected to self-liquidate before or after they pay their penalty taxes?


This whole idea would fall under the "unthinkable" category if we didn't have the pitchfork crowd in Washington today. Are we truly condemned to relive bad history every 75 years? 

The problem with the BoJ

The new Japanese finance minister, Naoto Kan, has called on the Bank of Japan to support the government's efforts to weaken the yen. His remarks have been criticized for weakening the independence of the BoJ. 


It completely eludes me how the shibboleth of central bank independence can be viewed as more important than ending deflation and growing the real economy. The BoJ's record as an independent central bank has been one of utter failure, with flat nominal GDP growth for two decades, compensated for by massive fiscal deficits. 


An erosion of the BoJ's independence would be a very good thing.

China and the dollar

China has called upon the US to redress "global imbalances" by spending less and saving more. This is part economics and part politics. The Asians want to put the US on the defensive because of our twin deficits, both of which they are financing involuntarily. They want to be able to lecture us, after all of the unwanted "advice" coming out of Washington over the years.

But their arguments are entirely one-sided. The deficit countries (us) have to make all the adjustment. The surplus countries don't have to do anything because "exchange rate appreciation of surplus country currencies has not proven to be effective in adjusting current account imbalances" which is true only at the margin. Freely floating exchange rates will over time result in balanced trade. But the RMB doesn't float; it is pegged to the dollar--by them, not by us.

The Chinese want us to pursue sound policies that will support a strong dollar in relation to other currencies: in other words, we should peg to the world instead of vice-versa. All the adjustment should occur in the US. The exchange-rate value of the dollar should be an objective of US monetary policy. 

The Chinese are right that we need to spend less and save more. But the way to get there is not an exchange-rate anchor. Such an anchor requires extraordinary national discipline and consensus that the external value is more important than growth or inflation/deflation. Hong Kong has been able to do it because it is not a democracy, and the dollar peg is supported by consensus.

If China is so unhappy about US economic policies, all they have to do is to unpeg the RMB from the dollar and peg to something else (the SDR, the euro, the yen, a basket) or float, which is what both Japan and Korea have done. But they havn't done this. Why? Because the US is the Importer of First and Last Resort, and they want their products to be cheap in US$. They want us to run a big trade deficit so they can fill it with their goods. They are classic mercantilists, except the mercantilists accumulated gold while the Chinese collect (depreciating) paper dollars.

There is no such thing as virtue in international financial relations, only self-interest. The Chinese aren't bad nor are we. We are all acting in our own self-interest. The G-20 will call on the US to balance its budget (which we should) and on the Chinese to appreciate the RMB (which they should). China and the US will do as they please. China will threaten to sell dollars, which they won't. The US will put tarriffs on Chinese products, but not enough to deprive us of what we want to buy. Nothing will change. Ten years from now the Asians will own a mountain of Treasuries, but that won't force a change.