"What's the phone number for Europe?"

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

Barroso versus Van Rompuy

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

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

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

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

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

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

When will Germany leave the euro?

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

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

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

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

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

Is the ECB broke?

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


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

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

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

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

Should Greece repudiate its external debt?

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

 

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

 

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

 

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

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

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

The guns of May

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


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

Thinking through a Greek debt restructuring

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


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

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

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

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

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

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

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

"Where do they find these people?"

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

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

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

Can you imagine a British economist on the FOMC? 

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

Inflation hawks at the Fed

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

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

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

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

D-day for Greece: May 19th

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

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

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

Will Greece shock the system like Lehman?

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

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

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

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

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

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