The Making of a New Monetary System and Economic Model?!

Without any commentary. A collection of accounts and descriptions of the situation WE are in.

The debt ceiling crisis – Running out of money

Jul 29th 2011, 8:45 by Buttonwood

PERHAPS the oddest thing about the debt ceiling debate to an observer from the east side of the Atlantic is the process itself. In Britain (and in the rest of Europe, as far as I am aware), the government proposes a Budget, the opposition votes against it and that is it. If the government is defeated on a key issue of financing (which the debt ceiling surely represents), then the administration resigns, an election is held and a new government comes to power. Finance is so essential to the nature of government that the idea of separating the budgeting power from the executive branch seems no way to run a country. Yesterday’s shenanigans, where the House spent all day trying and failing to pass a bill that faced automatic rejection in the Senate, resemble a Dickensian satire featuring the Circumlocution Office, a body designed to ensure that nothing gets done.

Anyway, it seems that US may soon have a problem that featured in a column a few weeks ago, running out of money. In the modern world, debt is money and money is debt; the ability to issue debt is essential to the state.

[...]

From a historian’s point of view, what is fascinating is that these problems are re-emerging after 40 years of a shift to fiat money, a change that seemed to remove all constraints on money creation. I have argued before that this shift drove most of the developments of the last 40 years from the rise of the finance sector to asset bubbles, and that the 2007/2008 crisis was a watershed moment (like the 1930s and 1970s) from which a new system will emerge. I assumed it would take a decade or so for the ramifications to work through, but the US Congress seems determined to accelerate the process.

 

Finance and Economics. Jul 30th 2011 | from the print edition

Buttonwood – Running out of options

Governments in the rich world have painted themselves into a corner

 

ECONOMIC policy in the developed world over the past 25 years has followed one overriding principle: the avoidance of recession at all costs. For much of this period monetary policy was the weapon of choice. When markets wobbled, central banks slashed interest rates. A by-product of this policy was a series of debt-financed asset bubbles. When the last of those bubbles burst in 2007 and 2008, the authorities had to add fiscal stimulus and quantitative easing (QE) to the policy mix.

The subsequent huge rise in budget deficits was largely the result of a collapse in tax revenues that had been artificially inflated by the debt-financed boom. Britain and America ended up with deficits of more than 10% of GDP, shortfalls that were unprecedented in peacetime.

Those deficits may have been necessary to avoid a repeat of the Depression. Economists will probably still be debating this issue in 75 years’ time, just as they still discuss whether Franklin Roosevelt’s New Deal programme was effective in the 1930s. But the “shock and awe” approach to Keynesian stimulus has an unfortunate consequence. Any decline in the deficit, even to a still whopping 8% of GDP, acts as a contractionary force on the economy: either the government is spending less or taxing more.

As a result governments are reluctant to cut the deficit too quickly for fear of sending their economies back into recession. But unless there is a rapid recovery, the debt will keep piling on, making the ultimate problem harder to solve.

Turning to monetary policy, interest rates are 1.5% or below in most of the developed world and are negative in real terms (the Bank of England kept rates at 2% or more for the first 300 years of its existence). In a normal recovery central banks would be looking to increase rates from crisis levels by now. But high debt ratios (particularly in the household sector) make central banks very uneasy about raising interest rates for fear of ushering in another round of the credit crunch. With the big exception of the European Central Bank, most have repeatedly postponed the moment at which monetary policy is tightened. The parallels with Japan, where interest rates have been at rock-bottom for a decade, are striking.

As for QE, it is hard to tell how successful it has been as a strategy in reviving the economy although it certainly seems to have helped to prop up equity markets. Central banks seem reluctant to push it much further at the moment. But there is no suggestion that the economy is strong enough for them actively to unwind the policy by selling assets back to the markets.

In all three cases the story is the same. Governments and central banks have thrown a lot of stimulus at the economy and the result has been a fairly sluggish recovery. They have painted themselves into a corner. They cannot go forward, in the sense that there is little political or market appetite for more stimulus. But it is also hard for them to go back.

Withdrawing stimulus is not just risky economically, but hard politically, too. In Britain a sluggish second-quarter growth rate of 0.2% has led to talk that the coalition government needs to slow the pace of its austerity programme. But if you actually look at the data, the government has barely begun its deficit-cutting work. In the first three months of the fiscal year public spending is £5.2 billion ($8.5 billion) higher than in the same period of 2010-11, or £3.6 billion higher if interest payments are excluded. An increase in joblessness, leading to higher benefit payments, is not the cause: the unemployment rate is lower than it was a year ago. A rise in value-added tax may have eaten into consumer demand (tax revenues are £5.3 billion higher than in the same period of 2010-11) but VAT also rose in January 2010 and GDP jumped by 1.1% in the second quarter of that year.

The danger for Britain is not just that its deficit-cutting strategy may have an adverse effect on growth. It is also that sluggish growth may prevent it from cutting its deficit significantly. Tim Morgan of Tullett Prebon, a broker, calculates that if the British economy grows at 1.4% annually, half the expected rate, the budget deficit will still be more than 8% of GDP in 2015.

In a sense, the bill has come due for the past 25 years. A policy of avoiding small recessions has resulted in the biggest downturn since the 1930s. Public finances turned out to be weaker than politicians thought. As a result, they have used up all their ammunition tackling the current crisis. Governments in the rich world will have very few options left if the economy weakens again.

 

Non-independent investment research (Saxo Bank)

STEEN’S CHRONICLE – Another step towards Crisis 2.0? by Steen Jakobsen

[...]

The Keynesian endpoint
Since the crisis hit in 2008, world policy makers have basically operated on the idea that creating more debt could create more growth – the basic tenet of classic Keynesian policy. I am increasingly convinced that we are reaching what some have dubbed the “Keynesian endpoint”, where the failure of this Keynesian approach to turn the economic ship yields to a more balanced approach to monetary- and fiscal policies (rather than bail everything out all the time). This turn will occur not because it makes sense, but because circumstances simply leave no alternative.

Time is up
The second point is the increased likelihood that “time is up”. This idea came from my friend and hedge fund manager Dan Arbess of Xerion Capital : “Here’s the thing. Every politician likes to spend, that’s how they get elected. Republicans don’t like taxes, but boy can they borrow. That game is ending so now, there are no more options for spending without taxing. It’s going to get interesting with two totally different worldviews: Democrats tax and spend, Republicans cut taxes and spend…Democrats tend to think government is the solution, Republicans think it’s the problem”. Well put and time is up for the US spending juggernaut, regardless of how it will be stopped.

If we look at key indicators for the EU and the US there is increasingly clear evidence, to which the market has been paying insufficient attention , that time is indeed up and the alarm bells are ringing:

[...]

The real risk to Italy, Belgium, Spain, Denmark and other countries remains their internal domestic economic- and political agenda: zero growth means by definition that the debt burden will increase when you are running a budget deficit. This you can live with in transition periods, but we are well into the 10th year of below long-term trend growth and in many countries barely even making it to positive growth. There is a price for this: downgrades, increased yields to finance the debt and a desperate need to keep a primary balance at zero or positive (the budget deficit before interest expenses = primary deficit).

[...]

The next few days are important as political events, but the most likely long-term impact is…surprise, surprise: more of the same:

The US dollar will continue to weaken 3-5% per year, the politicians will buy some time into the next election cycle, yields will creep higher and higher for non-core countries, equities will be over-bid relative to bonds as investors are losing faith in governments, and the disparity between the rich and poor will only yawn wider as the latter suffer on the inevitable standard of living declines that are forced upon them by wages that fail to keep pace with cost of living increases.

We have dealt with bigger crises than this before – you only need to go back to your own grandparents – they lived through wars, booms and a depression, and still created wealth beyond anyone’s dream. The big difference? They grew up respecting and expecting hard times, hard work and each other. Today we all want to believe that the last thirty years will be extended by another five to ten years before we start the rebuilding. We are now definitely in Crisis 2.0 early stages, I constantly meet clients and investors who keep complaining I’m too negative – but am I really negative, or am I merely trying to make you aware that the light at the end of the tunnel is not the exit but an approaching freight train? I hope I am wrong. I really do (and I often am) but a touch more reality would help us all.

 

currencythoughts.com – by Larry Greenberg

Debt Problems and the Currencies July 29, 2011

[...]

The U.S. debt crisis has been framed by analysts and investors around the political stalemate that is real and in everyone’s face day after day. The markets wonder how close to the August 2 deadline will officials delay making a deal, and the possibility of no deal until closer to mid-August emerged this week. Expectations have been lowered regarding the composition of an agreement and how much time it will buy before the next fabricated crisis surfaces as has occurred time and again in the euro area.

But a less discussed dimension of the problem is now pushing its way into the spotlight, and this concerns the tolerance of the advanced economies against fiscal and monetary restraint. Sufficient deficit reduction might not be possible under either an all-partisan Democrat plan or an all-partisan Tea Party plan. These strategies need adequate economic growth to succeed, but the U.S. economy is more crippled than generally realized.

• Real GDP expanded just 0.8% annualized in the first half of 2011 when the bulk of QE2 was provided. A year ago, the FOMC was forecasting a real GDP growth range in 2011 of 3.5-4.2%, and private-sector projections were centered somewhat above 3.0%. The optimism of these estimates highlights that the economy’s usual resilience isn’t as strong as such was.
• U.S. real GDP expanded only 1.6% in the year between 2Q10 and 2Q11 and managed only a 0.2% annualized pace during the four years between the second quarter of 2007 (just before the financial crisis began) and the second quarter of this year.
• Anemic U.S. growth is part of a fairly universal phenomenon among advanced economies. Japan’s “lost decade” between 1Q91 and 1Q01 saw real GDP there climb at a 1.1% annualized rate. In the ensuing decade between 1Q01 and 1Q11, real GDP rose even more slowly, 0.5% per annum. The 20-year growth rate between 1Q91 and 1Q11 was 0.8% per annum. In Britain where a Conservative-led government has begun massive fiscal restraint, real GDP rose less than 1.5% annualized in the first half of 2011 and 0.7% over the four quarters between 2Q10 and 2Q11. Growth since the onset of the global financial crisis four years ago has averaged negative 0.4% per year in Britain. Euroland GDP rose by a decent 2.5% over the latest four reported quarters to 1Q11, but the distribution of results among members was highly diverse and included a drop in Greek output of 4.8%. Moreover, euro area GDP during the past four years averaged just 0.1% per year.

I take away three lessons from Japan’s experience. First, the hangover from a financial system can endure more than a generation. Second, the bigger one is, the harder one can fall, and third, reining in public debt requires more than a will to act. One needs an economy that is sufficiently repaired to tolerate austerity. Otherwise, macroeconomic restraint just digs a deeper hole. The Bank of Japan has wanted to normalize rates for fifteen years but is still stymied against doing so, and Finance Ministry officials were looking for an exit strategy when debt was approaching 100% of GDP and are still waiting for the right opportunity as debt hovers near 200% of GDP now.

The U.K. experience offers more warnings to be heeded. British July purchasing manager survey results will be published next week, but recent trends through June portray a difficult time coping with fiscal austerity. The manufacturing PMI fell from 61.5 in January to 51.3 in May, while the service-sector reading declined from 57.1 at the end of the first quarter to 53.9 in June. Slow growth hampers public-sector revenues, and Britain’s budget deficit was no smaller in the first quarter of the current fiscal year than it had been in the first quarter of the previous financial year.

Economic circumstances in the euro area’s peripheral nations have been very difficult as well. Market players love to mock the “clowns” who decide policy in Europe and America but fail to fully comprehend that in representative democracies, policymakers tend to be sounding boards of viewpoints found in the rank and file citizenry, only they hold such positions more extremely. Excessive household and corporate debt tend to be a pre-existing condition for excessive government debt, and Keynesian economic theory suggests that it’s best that balance sheet reductions not be undertaken on a massive scale simultaneously in all three areas.

Another lesson for the United States from Europe is that whatever is done to cauterize the debt problem proves insufficient in the eyes of market players, who pass judgement with their money. To be sure, euro zone leaders have offered up a series of packages that treat symptoms rather than causes of the region’s fiscal mess. It has been said that if half of the concessions made eventually had been taken early in the crisis, market order would have been restored, meaning reduced peripheral bond yield spreads. I suspect not and believe also that nothing the Congress and Obama Administration undertake in the next week or two will manage to correct America’s structural problems or satisfy investors for more than a transitory while.

 

Lessons from past Sovereign Debt Crisis

• Time works against you in environments of crisis, fear, uncertainty and contagion effects.
• Public bickering about possible solutions is not helping, is unproductive.
• Solution needs to be European for a European problem through and through. They have to take ownership. All have to be in the same boat.

What is the difference between Ireland and Iceland?

1 Letter and the Euro!

*Patiently waiting for the first details on the deal they struck … it is now 6:15pm BST*

… and a comprehensive bailout package and the loss of sovereignty.

Update Monday 1:30pm BST (Statement from Sunday evening below)

Kicking the can down the road.

—————————————————————–

“Ministers unanimously agreed today to grant financial assistance in response to the Irish authorities’ request on 22 November 2010. Ministers concur with the Commission and the ECB that providing a loan to Ireland is warranted to safeguard financial stability in the euro area and the EU as a whole.

Euro-area and EU financial support will be provided on the basis of a programme which has been negotiated with the Irish authorities by the Commission and the IMF, in liaison with the ECB.

Ministers welcome the staff-level agreement on a three year joint EU/IMF financial assistance programme for Ireland. The Irish Government approved the programme on 28 November. Ministers unanimously endorse the measures announced today.

Building on the strong fundamentals of the Irish economy, the programme rests on three pillars [conditions of the bailout]:

• An immediate strengthening and comprehensive overhaul of the banking system
• An ambitious fiscal adjustment to restore fiscal sustainability, including through the correction of the excessive deficit by 2015
• Growth enhancing reforms, in particular on the labour market, to allow a return to a robust and sustainable growth, safeguarding the economic and social position of its citizens.

The financial package of the programme will cover financing needs up to 85 billion euros, including 10 billion euros for immediate recapitalisation measures, 25 billion euros on a contingency basis for banking system supports and 50 billion euros covering budget financing needs. Half of the banking support measures (17.5 billion euros) will be financed by an Irish contribution through the Treasury cash buffer and investments of the National Pension Reserve Fund.

The remainder of the overall package should be shared equally amongst:

• (i) the European Financial Stabilisation Mechanism (EFSM),
• (ii) the European Financial Stability Facility (EFSF) together with bilateral loans from the UK, Denmark and Sweden, and
• (iii) the IMF (22.5 billion euros each).

The main elements of policy conditionality, as endorsed today, will be enshrined in Eurogroup and Council Decisions to be formally adopted on 6 and 7 December. The Eurogroup will rapidly examine the necessity of aligning the maturities of the financing for Greece to that of Ireland. [meaning Greece got an extra four-and-a-half years to repay the emergency loans totaling 110 billion euros to match the seven-year term under Ireland’s deal.]”

Annex : Distribution of the Loan to Ireland
Total Programme Volume        (Billions of euro)
Contribution by Ireland            17.5
External support                   67.5
Total                              85.0

External Support Breakdown
IMF (One-Third)*                   22.5
Europe (Two-Thirds)                45.0
Total                              67.5

European Breakdown
EFSM                               22.5
EFSF (Plus Bilaterals)             22.5
Total                              45.0

EFSF (Plus Bilaterals) Breakdown
EFSF (Effective) euro area         17.7
United Kingdom                      3.8
Sweden                              0.6
Denmark                             0.4
Total                              22.5

—————————————————————–

And while Irish finance minister bargained on the conditions of the bailout (12.5% corporate tax rate will be untouched), Germany and France pressed further ahead to ‘introduce “collective action clauses” for debt issued after a temporary crisis facility (EFSF) expires in 2013′. So that investors share rescue costs with taxpayers for future bailouts.

Talking heads (Bloomberg)

Bloomberg’s Elliott Gotkine reports on Ireland’s 85 billion-euro ($113 billion) bailout package
4 years of Austerity to repay bailout package, principal plus interest (5.8%).

Ireland’s government plans to cut spending by about 20 percent and raise taxes over the next four years to reduce its budget deficit to 3 percent of gross domestic product by 2014, from 32 percent this year, [...]

FT’s Wolf Interview on Ireland’s Aid Package, Euro Outlook
Bailout = 50% of GDP. Bank problem is now fiscal problem. This will come to haunt them. EFSF probaply have to be increased, and PIIGS nightmare is still unravelling. “It can spread to everybody except Germany.” EURO will exits for much longer but not in current form and with its current member states.

Callow on Irish Bailout (Chief European economist at Barclays Capital)
Bailout package might be able to defuse the situation in Ireland, takes out some degree of uncertainty. But Portugal and Spain are still up for debate. Portugal got difficult task at hand. Fiscal tightening might push Portugal back into recession. Spain very different. Large challenges ahead, not dissipating very soon.

Nomura’s Maloney on Irish Bailout (Sean Maloney, an interest rate analyst at Nomura)
Bailout for banks mean better than last week, calming down the situation in the short-term (2013). Politicians/Officials buying time, liquidity and solvency. Portugal will not challenge EFSF, but Spain could.

Other good commentary and analysis via Zero-Hedge

• The move [Ireland using pension fund assets to foot the bill] reflects a willingness by governments to use long-term assets to fill short-term deficits,
• Ireland would save the world from much misery by defaulting now and driving the vampire banks into liquidation,
• policy announcements made today testify the Eurozone’s authorities’ ongoing resolve to address the repercussions of the credit crisis. As we wrote last week, however, investors are likely to continue to focus on the Iberian peninsula, namely Portugal’s chronic twin deficits, and the potential unrecorded losses in the non-listed Spanish banks.

At the cost of future generations!

And A Fistful of Euros blog asserts correctly that “the EFSF’s powder has been kept dry in case it’s needed elsewhere”, and that “[m]ost of the Irish contribution to the package comes from the [Ireland's] National Pension Reserve Fund (NPRF), which was sold at inception as pre-funding public sector pensions from 2025 onwards.  In truth, the NPRF had already become a banking sector intervention vehicle since 2008. [...] So the pension money goes to the banks, and it’s left to a future Irish government to sort it out with Ireland’s 2nd most effective lobby group (the public sector unions, after the banks) how this gets paid for. The current government, its time horizon limited by an inevitable 2011 election loss, was happy enough to oblige.  The current opposition, and likely future government, wasn’t at the table.  That’s another EU democracy deficit.” Short-term thinking at it’s best because of the lack of accountability.

Means that after many years of austerity, taxes have to be increased considerably to cover the gaping hole in the public pension fund. The future lack of growth in OECD countries is a self-fulfilling prophecy. Oh joy.

GDP growth in Europe likely to be uninspiring

GDP will be hit by fiscal squeeze. Low Euro will off-set some pain due to exports.

Growth in the eurozone will be hit by government belt tightening, says the EIU in its latest forecast adding that euro will also hover at a lower level against the US dollar in to 2011. (via Economist Intelligence Unit)

Your Place and Success is Guaranteed

Dear Institutionalised-Money-Laundering-Mafia aka HedgeFunds/PE/Banks/InvestmentBanks/Moneymanagers,

your place and success in the past was and in the future is guranteed. No need to worry. Central Banks and the political hemisphere will do the right thing to save us all — me too. Nobody gets harmed. It’s a win-win game.

USA, China, Europe, UK. Japan cancelled. Australia can't pronounce properly.

As I wrote before, the 750bn Euro TARP Fund for PIIGS is an umbrella for the skinned (interconnected) banking sector in Europe. Meredith Whitney already mentioned back in March, that many are trying hand over fist to find assets to sell to finance Basel II (higher capital requirements to address risk). Made even harder by the current sell-off in assets and equities. Double-dip?

Now I have to read this;

Because the trouble in Europe is rooted in government debt problems, there is good reason to think events “will probably fall short of becoming a worldwide recessionary shock,” Federal Reserve Bank of St. Louis President James Bullard said. The official noted the world has seen these types of events before, and “there is nothing intrinsic about such crises that they need to become important shocks to the broader, global macroeconomy.”

“It is always possible that “this time will be different” and maybe it will be, but that would be unusual given the historical evidence,” the central banker said.

Bullard downplayed the likelihood these events will spread “contagion” throughout the global financial system. He noted that the pricing levels for default insurance on major U.S. and European banks may have moved “sharply higher,” but it’s not at “the extreme levels seen during parts of late 2008 and the first half of 2009.”

The central banker said the key reason why he’s not particularly worried the global economic recovery will be undone is the stance that’s been taken by governments. Major nations “have made it very clear over the course of the last two years that they will not allow major financial institutions to fail outright at this juncture.” Since these “too-big-to-fail guarantees are in place, the contagion effects are much less likely to occur,” Bullard said.

Market notes

• EMU banks don’t take yet advantage of new $ swaplines opened by Fed/Centralbanks because they a tick more pricey
• LIBOR shot up over the .5%, SNB funnelling money into the FX market via UBS to protect CHF, “doing everything … to protect”.
• Spain banking system is falling apart due to its collapsed housing market (non performing loans), can’t hold it together anymore. Plus the over leveraged private sector. Spain has its very own Balance Sheet Recession due to the cheap inflows of the past. Unemployment won’t come down from its 20%-25% (especially the young) in the next 12 months. Link1, Link2.

By and large, Fed officials have been fairly confident that European trouble would not kill off the U.S. recovery. The most ominous warning has come from Fed Governor Daniel Tarullo, who said last week “the European sovereign debt problems are a potentially serious setback” for the U.S., with the potential to strike at both the tender state of the banking sector, and on growth.

• US has its very own problems, the $ may go higher (thus crude lower), screwing exports and Obama’s plan to fight unemployment with more export jobs.
• As the credit market situation darkens on global markets for sovereigns (and corporations), higher rates are demanded due to higher risk. Not only Bonds and Gilts will feel that, but Treasuries too.
• And what’s with the sale of 6/12 month to 2 year treasuries only in the last quarters? Could haunt them.

It is contained, that’s what she said.

Dear Eurocrats, Please “Let Me Down Easy”

Chris Isaak performing “Let Me Down Easy”

At first you smile, then turn away
I’ve been thinking of what I should say
All last night I stayed up dreaming,
I’m still dreaming
I look at you, I’m just a guy
I know my place but still I’ll try
You must be tired of people asking,
But I’m still asking
Please. Oh, please let me down easy
Please, just let me down easy

[...]

If you told me to follow you know I’d fly to you,
Here I go, I may fall but I will try
So please, let me down easy
Please, just let me down easy
Please, just let me down easy
If you want me to follow, you know I’ll fly

For Your Interpretation only.

• BaFin banned naked short sales on financial stocks and unsecured CDS on government bonds in the euro zone (via) (reaction from yesterday evening)
• Central Banks are in the FX markets apparently, big moves
• PIMCO reduced its EU positions in its portfolio – from 18% to 13% – over last couple of months.
• US landscape not better, sort of, Volcker-Rule could upset market
• Everything is planned according to insiders. Laws for Greece default/restructuring are currently being drafted. (via)
• Filed under humor, or controlled demolition: Greece Banks shorted its own country. And weeks before that we found out that Greece did not accept a 20 billion Euro loan from Hayman Private Equity in Feb 2010 at favourable conditions for Greece.

Common Sense

You can’t help an alcoholic to overcome his addiction by giving him rationed eggnog. And past IMF interventions always led to default/restructuring¹ — the only exception is Japan, but who knows how long that exception will hold.

Please. Oh, please let Greeks down easy

1.) Have not looked that up, I am just recalling my EconHistory101

Planning for the worst. Eurozone bond market.

The following are excerpts from Peter Boone and Simon Johnson with general commentary of mine.

Peter Boone is chairman of the charity Effective Intervention and a research associate at the Center for Economic Performance at the London School of Economics. He is also a principal in Salute Capital Management Ltd.  Simon Johnson, the former chief economist at the International Monetary Fund, is the co-author of “13 Bankers.”

When Mr. Trichet (head of the European Central Bank, ECB) and Mr.  Strauss-Kahn (head of the International Monetary Fund, IMF) rushed to Berlin this week to meet Prime Minister Angela Merkel and the German parliament, the moment was eerily reminiscent of September 2008 – when Hank Paulson [and Ben Bernanke] stormed up to the US Congress, demanding for $700bn in relief for the largest US banks.  Remember the aftermath of that debacle: despite the Treasury argument that this would be enough, much more money was eventually needed, and Mr. Paulson left office a few months later under a cloud.

I hoped for Europes’ own Hank and Ben couple weeks ago, as the condition worsened. Like in my post from yesterday – it’s nice to see that others see the resemblance in the same light, while monetary and fiscal policy come together.

There are three possible scenarios.  First, the ECB may be allowed to really let loose with “liquidity” – and somehow buy up all the bonds of troubled eurozone nations.  But this is exactly the process that always and everywhere brings about high inflation.  The Germans would fight hard against such a policy, although it would prevent default.

Possible, but with a strong stance against it from other EMU (European Monetary Union) member states. What speaks against this is; (i) the problem of not being able to control where inflation spreads; (ii) the limited number of instruments to stop the program and collect excess liquidity afterwards; (iii) the outflow/flight of capital; (iv) the forming of local bubbles; (v) that PIIGS (Portugal, Italy, Ireland, Greece, Spain) governments not undertaking fiscal tightening (austerity measures) as stringent as necessary - prolonging the program of ‘creating liquidity’ and thus increasing the risk of running into unintended consequences.

Second, officials still hope that bond yields for weaker governments widen but then stabilize.  This is bad news for troubled eurozone countries, but they manage to avoid default.  The rest of the world grows by enough to pull up even the European “Club Med + Ireland”.  Call this the trickle down scenario or just a miracle.

Impossible. Spreads from UK, Portugal and Spain are already rising every trading day.

Most likely, the situation is about to turn much worse and a third scenario unfolds.  The nightmare for Europe is not at this point about Greece or Portugal – it is all about Italian and Spanish bond yields.  This week those yields are rising quickly from low levels, while German yields are falling – so this spread is widening sharply.  The yields for Spain – for example – are rising because hitherto inattentive investors, who always thought these bonds were nearly as safe as cash, suddenly realize there are reasonable scenarios where those bonds could fall sharply in value or even possibly default.  Given that Spain has 20% unemployment, an uncompetitive exchange rate, a great deal of public debt, and a reported government deficit of 11.2 percent (compared with headline numbers for Greece at 13.6 percent and Portugal at 9.4 percent), everyone now asks:  Does a 5% yield on Spain’s ten year bonds justify the risk?  The market is increasingly taking the view that the answer is no, at least for now.  So, we can anticipate Spanish (and Italian) yields will keep rising.  In turn, this causes other asset prices to fall in those nations, thus worsening their banking systems, and hence leading to credit contraction and capital flight.  It is a dismal prognosis.

Then it gets worse.  As rates rise, traditional investors in euro zone bonds, which are pension funds and commercial banks, will refuse to take more.  There will be no buyers in the market and governments will not be able to roll over debts.  We saw the first glimpse of this on Tuesday, when both Spanish and Irish short term debt auctions virtually failed.  Once this happens more broadly, the problem will be too big for even Mr. Trichet or Ms. Merkel to solve.  The euro zone will be at risk of massive collapse.

We had that already on some occasions (April 21ss):

The move in Greek bonds comes as Germany failed to sell as many bonds as it planned in an auction on Wednesday. Earlier this month, the Bundesbank said it expected to sell €3bn of 30-year Bunds on Wednesday.

It received bids totalling €2.752bn but sold only €2.458bn. German bond auction failures were rare until the credit crisis. There have been several Bund auction failures since the start of the crisis in 2007, as governments faced expected record amounts of debt to pay for fiscal stimulus packages and bank bail-outs. Before the crisis, the last German bond auction not to reach its target was in July 2000, after the dotcom crash. (via FT)

Peter Boone and Simon Johnson continue with …

If this awful but unfortunately plausible scenario comes about, there is a clear solution – unfortunately, it is also anathema to Mr. Trichet and Ms. Merkel, and thus unlikely to be discussed seriously until it is too late.  This is the standard package that comes to all emerging markets in crisis: a very sharp fall in the euro, restructuring of euro zone fiscal/monetary rules to make them compatible with financial stability, and massive external liquidity support – not because Europe has an external payments problem, but because this is the only way to provide credible budget support that softens the blow of the needed austerity programs.

The liquidity support involved would be large:  if we assume that roughly three years of sovereign debt repayments should be fully backed – and it takes that kind of commitment to break such negative sentiment – then approximately $1 trillion would be needed to backstop Greece, Portugal, Spain and Italy.  It may be that more funds are eventually needed – but in any case, the amounts would be less than the total reserves of China.  These amounts would also be reduced as the euro falls; it could be heading back to well under $1 per euro, which is where it stood one decade ago.

External financial support would only make sense if combined with key structural reforms, including an end to the repo window at the ECB.  As former UBS banker Al Breach recently argued, the ECB could instead issue bonds to all nations which would then be used subsequently for monetary operations – every central needs a way to add or subtract liquidity from the financial system.  These bonds would need to be backed by a small “euro zone” tax, thus making the ECB more like other central banks around the world.  It would no longer accept bonds of “regional governments” in the union as collateral, and instead would buy and sell “eurozone” bonds.  These new eurozone bonds would also offer a way for governments to roll over some of their existing debts.

Eurozone bond market

Sane reasoning (and lessons of 2007/2008) rules out a case by case action plan. That is what Hank and Ben will tell us. That is what they realised after Bear Stearns got picked up by JP Morgan Chase, Fannie Mae and Freddie Mac put in receivership under the helm of Hank, a shotgun marriage between Merrill Lynch and Bank of America was arranged, Lehman filed for Chapter 11 as no one wanted to pick them up from the tarmac, AIG received its first bailout billions and Washington Mutual was sold to JP Morgan Chase. Financial institutions were deeply connected to each other. As Henry Paulson famously said, “as the situation changes, you have to change too.” The PIIGS situation is not different, they are deeply intertwined with one common denominator — mounting problems, critical events, will accelerate in its occurrence until bold and unilateral action is taken.

In my post from February, titled “Europe caught the flu“, I pitched the idea of creating a TARP like program for the European Monetary Union, before the problem gets worse and spreads.

The unique situation of Europe can not be contained, in a fashionable way, when borrowing gets even more expensive in 2010 for all other European countries (whether or not part of the EMU). Or when the problems are addressed on a case by case basis. Because of that, the Commissioners in Brussel have to do everything possible (bending the legal clauses of the treaty), to stabilize Greece and the Euro. The consequences not to find a workable and pragmatic solution ahead of the problems, will be much more costly for the European Monetary Union (EMU) when the IMF is asked by EMU states to give ‘technical assistance’.

Spain reached new unemployment level highs and raised its budget-deficit forecast for 2010 this week, markets have already an eye on them for a long time as well on Portugal. Out of sight (or not in the news currently) are the East-European states which received, in parts, IMF emergency loans. But the counting of fiscal and human casualty costs the credit explosion and implosion of the West created, is not yet over.

So, how to treat these patients and possible future patients, equally well? The only thing what comes to my mind now is ‘TARP for EMU’.

I proposed that “[e]very EMU country pays an amount in the billion Euro fund, set in a formula of GDP, debt and growth forecast as variables.” Some of the bullet points for my idea back than in February are very similar to the formulation of an Eurozone bond market, Boone and Johonson outlined in their post.

Where my idea is based on creating an instrument for PIIGS and other weak peripheral countries to service their debt — Boone and Johonson remodel the whole monetary system of the EMU because there is need for structural reforms. But what is not clear is whether or not EMU member states can only draw liquidity through the Eurozone bond market (at rates the same for all EMU countries, a shared burden) or countries like Germany and France are still able to issue their own bonds.

I prefer the ‘shared burden’ scenario, although an unlikely scenario with hindsight of the history of European parliamentary unity. As Boone and Johonson imply, ”decisions over fiscal and monetary policy need to be handled in a fair and reasonable manner.” History was in parts unreasonable. Thus, pundits are right to call it the ‘make or break of Europe’ time, because the outlook is dire and doesn’t offer any other options with limited downside.

Markets do not spare cowards. They take advantage of them.

Fresh from the wire. Mohamed El-Erian CEO and co-CIO of Pimco writes (emphasis mine):

[L]ate-moving sellers have been looking over the past few days to reduce their holdings of Greek bonds. This has accentuated market volatility and illiquidity. Combined with this week’s downgrades in the credit ratings of peripheral European countries, the result has been a dramatic sell-off in European equities, a further disorderly widening in sovereign risk spreads and pressure on the euro.

Meanwhile, the disorderly market moves of recent days will place even greater pressure on the balance sheets of Greek banks and their counterparties in Europe and elsewhere. The already material risks of disorderly bank deposit outflows and capital flights are increasing. The bottom line is simple yet consequential: The Greek debt crisis has morphed into something that is potentially more sinister for Europe and the global economy. What started out as a public finance issue is quickly turning into a banking problem too; and what started out as a Greek issue has become a full-blown crisis for Europe.

[...]

The numbers involved are large and getting larger; the socio-political stakes are high and getting higher; and the official sector has yet to prove itself effective at crisis management.

The Greek debt crisis is now morphing into something much broader. No wonder the European Union and the International Monetary Fund are scrambling to regain control of the rapidly deteriorating situation. There is talk of a bigger bailout package for Greece. The heads of the European Central Bank and IMF have made the trip to Germany that is reminiscent of the Ben Bernanke–Hank Paulson trip to Congress in the midst of the U.S. financial crisis.

“It has become a full-blown crisis.” They could not contain it.

On April the 8th I wrote on my tumblr – Does Europe need his own Ben & Hank duo?! It “Could Turn Into The Endgame.”

I see it.

We’ve found the Apple cart. I wrote on the 13th of April after looking at the US stockmarket on the 9th of April;

[I]t is always impossible to know what developments will surface to upset the applecart. It could be Greece (PIIGS) or even UK. It could be China. It could be a trade war or a currency depreciation cycle. Or rising prices (inflation in general) of resources like oil, copper, steel which take a break on the recovery.

And as early as February, I compared the situation already with the Asia 1997 and hoped for an contingency plan.

The FinancialTimes and WSJ reports that “its 10-year borrowing costs, are now more than twice as high as those of the German government.” Thus, it is a reasonable argument to have a Plan B C after the Lehman and Northern Rock debacle. Because this problem of out-of-whack government debt, in the EU zone, feels like history but with other features (as always).

Why could they not contain it?

I will be very brief;

• Europes’ political landscape scrambled to get its treaties ratified, could not find a common denominator in a reasonable time-frame, and most of them are career politicians primarily reporting back to their constituency at home – not Europe.
• Coordination within the political landscape, regional central banks and ECB is during these times is dysfunctional. The feedback-loop is too slow, too slow in general.
• Day-to-day politics and home-turf politics still shape the discussion.
• The problems of independent fiscal responsibility, same monetary policy and currency, vastly different societal and cultural background and differences between member states.
• Greece cheated too often.
• ‘Frau Nein’ aka Angela Merkel. Instead of showing leadership capabilities, she and her party (coalition, current and past) tends to sit things out. This one was one too much. Instead of taking care of ‘contagion risk’, she cared more about regional politics (NRW) and polls. Her career and the future of the defunct coalition with the FDP. But I guess it is too much to ask for, that politicians learn fast from the events not older than two years ago.
  • On the same account you can blame France President Sarkozy and Finance Minister, Trichet & Crew, and Spains’ Finance Minister who told the IMF some weeks ago they know how to handle the problem.

Looking back, in February 2009 – it all seemed so clear what to do. But this week, Europe got its own Dump Japan (97/98) moment. Dumb junk, dump Europe. Jürgen Stark, who is a member of the board of the European Central Bank, stated, “We may already have entered into the next phase of the crisis: a sovereign debt crisis following on the financial and economic crisis.”

I posted lots about Greece in the last months leading up to this moment on my Tumblr (search Greece).

Update 1st of May 12:31pm:

Via Scott Mather (Managing Director, Portfolio Manager). Global Disparity Presents Post-Crisis Risks, Opportunities (emphasis mine):

In the wake of the recent economic crisis, new risks and opportunities lie ahead as countries are forced to grapple with a changed economic environment. Important fundamental differences will increasingly drive economic and financial markets in disparate ways across countries. Historically, debt growth has been used as an economic stabilizer in times of need and helped to level economic activity among countries. But going forward, the unprecedented accumulation of sovereign debt will increasingly limit policy flexibility and further push countries apart in terms of economic performance. Many countries are already very near a tipping point, having exhausted maneuvering room during the recent economic crisis.

Much of the last few decades can be characterized as a period of increasing “sameness”: Economic and market correlations rose between countries even as the overall volatility of growth and inflation fell. This development masked growing imbalances and future sources of instability. Some of these imbalances were exposed in the economic crisis. But owing to differences in initial conditions and policy choices made throughout the economic crisis, the decades of growing sameness to which we have been accustomed have likely ended. Many old vulnerabilities remain unaddressed and many new sources of instability are surfacing. Differences between countries will grow much larger in the years ahead.