AMERICAN FUTURE

When central banks act together, you know things are really bad. They were certainly bad in October 2008, when central banks acted together to reduce short-term interest rates. Here’s how the October 9 issue of the Wall Street Journal reported the story:

The world’s central banks launched a large coordinated attack against the widening global financial crisis, lowering short-term interest rates in unison.

The emergency action, which involved the Fed, the European Central Bank, the Bank of England and others, is a sign that fears that the financial crisis could cripple the global economy are spreading rapidly.

Central banks in the U.S., the euro zone, the U.K., Canada, Sweden and Switzerland each cut short-term interest rates on Wednesday by a half percentage point, noting that “the recent intensification of the financial crisis has augmented the downside risks to growth.” Acting on its own, the People’s Bank of China also cut rates, as did Australia’s central bank, a day earlier.

Three years later, coordinated action is again deemed necessary. According to the Fed, the purpose of today’s coordinated action is to “ease strains in financial markets and thereby mitigate the effects of such strains on the supply of credit to households and businesses and so help foster economic activity.”

As in 2008, the Chinese eased monetary policy simultaneously with the coordinated action of other central banks:

China’s central bank will cut the portion of deposits that banks must hold in reserve for the first time in three years, in a sign of Beijing’s concern over slowing growth in the country and in key export markets like Europe.

On Wednesday evening, the People’s Bank of China said it would reduce the required reserve ratio for all banks by 0.5 percentage points, starting from December 5.

Central bank statements:

• U.S. Federal Reserve
• Bank of Canada
• Bank of England
• Bank of Japan
• European Central Bank
• Swiss National Bank

As this post is being written, equity markets are up sharply. It should be kept in mind that, subsequent to the October 2008 central bank action, stocks plunged for another six months before bottoming on March 9, 2009.

As I summarized in a recent post, Juergan Stark (the German representative on the European Central Bank’s Executive Board) argued, in response to a growing clamor for the ECB to function as a lender of last resort, that the eurozone debt crisis can only be solved by member states getting their budgets under control, not by relying on the European Central Bank’s extra liquidity measures or bigger bailout packages.

Three days ago, the Financial Times interviewed Jens Weidmann, the president of Germany’s central bank (the Bundesbank) and a member of the ECB’s governing council. Not a sliver of light separates Stark’s and Weidmann’s views. From the FT article summarizing the interview:

The president of Germany’s powerful Bundesbank has firmly rebuffed international demands for decisive intervention in the bond markets by the European Central Bank to combat the eurozone debt crisis, warning that such steps would add to instability by violating European law.

Bundesbank president Jens Weidmann told the Financial Times that only politicians could resolve the crisis, and he rejected the idea of using the ECB as “lender of last resort” to governments.

He also criticised actions taken by eurozone governments as “inconsistent”, and warned that their plans to involve private sector banks in rescue plans for Greece could add to the eurozone’s woes. Such private sector involvement, he said, could undermine market confidence in the eurozone’s crisis-fighting tools such as the rescue fund, the European financial stability facility.

In a separate article analyzing Mr. Weidmann’s words, the FT makes reference to the Weimar hyperinflation — a topic I’ve emphasized on more than one occasion.

Mr Weidmann’s opposition to the European Central Bank stepping up its purchases of Italian government bonds and acting as “lender of last resort” to eurozone governments – a position widely supported by Germans – is often put down to the country’s collective memory of 1920s hyperinflation.

Here’s the complete transcript of the interview:

Financial Times: We are at a dangerous point for the eurozone. People are now talking openly about the eurozone breaking up. Is that possible?

Jens Weidmann: For me, the eurozone as a whole is not at stake. What we face is a sovereign debt crisis that now shows contagion effects on other eurozone countries. The seriousness of that crisis is apparent, but it’s not a crisis of the euro. The point I’m making these days is that the current approach to tackling the crisis shows inconsistencies that have repercussions on the credibility of this approach. These inconsistencies relate to the fact that we are pooling risks more and more in a framework that relies on fiscal policies decided at the national level. We need a debate now about the future architecture of the monetary union – that is, whether one wants to move back to the Maastricht framework, which needs to be improved, or whether there is a willingness and political support to move towards a more integrated union where you delegate national sovereignty on fiscal issues to a European level.

FT: So what is the correct response to Greece?

JW: Greece has agreed on an adjustment path. We finally need to implement what has been decided. Market turmoil comes from the fact that this implementation has been questioned – and not because the plan is not credible.

FT: Was it a mistake to change the terms of the Greek private sector involvement [PSI] in October?

JW: The Bundesbank has pointed out from the start, that one of the dangers of these PSI negotiations is that PSI might appear an easy way out of self-inflicted problems. If this is the case, you achieve the opposite of what you wanted to achieve. You will have more contagion instead of containment of the crisis because it’s seen as a potential model for other countries. Once decided, reliability and trust in agreements is very important, especially in a crisis like this one – which is basically a confidence crisis. One of the effects of the renegotiation of the PSI is that the perception of sovereign risk in the market has further changed. There is now substantial private sector involvement that will apparently not trigger the credit insurance of the Greek exposure. So at least for some countries, the risk profile of their sovereign bond markets has deteriorated.

FT: But what about an involuntary writedown? If you have rules, there have to be consequences when the rules are not obeyed.

JW: All the financing that was given to Greece and was necessary to buy time for structural reform, relies on Greece sticking to the adjustment programme. If it doesn’t, the basis for this help would no longer be there – with all the consequences that entails.

FT: You talked about consequences if Greece doesn’t stick to the adjustment plan. Should that include an exit from the eurozone?

JW: That’s not a discussion that I want to join.

FT: If funding to Greece did stop, the ECB would have to decide how to deal with the Greek banking system. How should the ECB should act in that kind of case?

JW: I don’t want to speculate what would happen if somebody decided this way or another way. Regarding the role of the eurosystem [of eurozone central banks], I will just confirm to you that we will act according to our mandate and provide liquidity to solvent banks and ensure price stability – this is our task. It’s the task of governments to ensure that banks in Greece are solvent. We provide liquidity to solvent banks against adequate collateral.

FT: What’s the way out now for Italy? Yields have risen to unsustainable levels. Does Italy need a bail-out?

JW: You are rushing to conclusions in saying that the interest rate levels are unsustainable. Of course this level may not be sustainable in the long run if there is a lack of fiscal discipline and economic growth remains low. But in the short run I do not think it is such a big an issue. What we are facing in Italy is an acute confidence crisis, and only the Italian government can resolve that crisis by implementing what has been announced. Italy is very different from Greece in a lot of respects. I’m confident that Italy will be able to deliver.

FT: With its bond buying, is the ECB trying to help Rome, or put pressure on Rome?

JW: It’s not about helping Italy or penalising Italy. The ECB Governing Council has always stressed that the Securities Markets Programme is about ensuring the monetary policy transmission process., But it comes with risks. The risks are reflected in our balance sheet. There’s also a risk that you mute the incentives that come from the market. Recent experience has shown that market interest rates do play a role in pushing governments towards reforms. You have seen that in the case of Italy quite clearly.

FT: In principle, the ECB could buy up a lot more bonds and keep the yields where it wanted …

JW: We have a mandate and we have to stick to our mandate. Fixing an interest rate for a country is certainly not compatible with our mandate. You would guarantee a certain refinancing cost for a government and you could not argue that this was not monetary financing. The stated purpose of the SMP is to cope with dysfunctional markets and it’s not to ensure a specific spread for a specific country.

FT: Is the Italian bond market dysfunctional at the moment?

JW: What we see is a reaction to the political problems in Italy and the lack of implementation and I wouldn’t consider that as dysfunctional. You can argue whether there’s an overreaction or not, but the main reason is the political situation and the lack of implementation in Italy – and that we can’t fix.

FT: What, then, is the role of a central bank in a crisis like this?

JW: The role of the central bank is clearly defined. It is to ensure price stability and to support the competent authorities in ensuring financial stability. With this formulation, it is clear that the responsibility for financial stability lies with governments. The EFSF [the European financial stability facility] or the ESM [its successor, the European stability mechanism] are ways to buy time and, in that sense, are sensible instruments.

FT: But isn’t the problem with the eurozone that there is no stabilising anchor and only the European Central Bank can perform that function?

JW: There was such an anchor, the stability and growth pact. It was just that this pact was not respected, it was softened.

FT: Can you explain why the ECB cannot be lender of last resort?

JW: 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.

FT: The impression is that the Bundesbank will stick by principles until the whole house burns down …

JW: Right now we’re talking about the EU treaty and I don’t see how you can build trust in a system that violates laws.

FT: Are you a pragmatist?

JW: I am president of an institution which is bound by a legal framework. We should respect the division of labour in a democracy. This has nothing to do with pragmatism or dogmatism.

FT: What if there is a conflict between Article 123 and the risk of a refinancing crisis for Italian debt?

JW: That assumes that you can address the issues in Italy with liquidity and that’s not the case. This whole debate completely blurs responsibilities. Furthermore, monetary financing will set the wrong incentives, neglect the root causes of the problem, violate the legal foundations on which we work, and destroy the credibility and trust in institutions. You won’t solve the crisis by reducing incentives for the Italian government to act. It’s really an absurd debate in which we are telling institutions: don’t care about the law.

FT: How should the EFSF be financed? Should European countries pool their special drawing rights at the IMF?

JW: EU governments have decided how to finance the EFSF. They agreed on guarantees for the EFSF and, in their last meeting, on two options on how to leverage the EFSF – by an insurance model or a special purpose vehicle. Instead of working on implementing these approaches, we now have the next idea that is completely out of the realm of what has been discussed previously. I don’t think it builds confidence in crisis resolution capabilities if from week to week, from one meeting to the next, you are questioning your last decision. SDRs are a part of our foreign exchange reserves. Using foreign reserves as capital of an SPV whose only purpose of is to fund governments is just a thinly-veiled form of monetary financing. For exactly that reason, the IMF itself is not allowed to do this operation.

FT: Some in Washington have suggested the ECB could lend, directly or indirectly, to the IMF, which could then help Italy. Would you rule that out as a possibility?

JW: Again, the crucial point is that the eurosystem is not permitted to lend to eurozone member states – no matter whether this is done directly or indirectly by using the IMF as an intermediary. In contrast, if you talk about regular IMF instruments the existing financing structure is preserved. The Bundesbank has always lived up to it’s responsibilities in adequately funding the IMF.

FT: How big do you think the EFSF’s lending capacity has to be to be effective?

JW: I think the EFSF has the resources to deal with the problems in the eurozone. I don’t want to say that leverage is not useful, but you just have to be aware that this is not a magic wand. Markets will look through financial engineering and it is clear that all the leverage will in the end increase the expected loss on the guarantees. What matters is whether there is political will in the countries standing behind the EFSF to honour the guarantees.

FT: Do you think the insurance model of leverage is credible to the markets?

JW: My main concern is the credibility of the construction and the assessment of whether the guarantees are honoured. I think the insurance model has been put into question by the recent decisions on the PSI.

FT: You referred to two paths for the future of the eurozone: the return to Maastricht, or the move to fiscal union. Do you have a preference between the two?

JW: This is a genuinely political decision. The duty of the central bank is to illustrate ways that would ensure a stability-orientated basis of the monetary union. It’s up to policymakers then to make a choice between these models.

FT: Does your idea of fiscal union involve eurobonds?

JW: It does not necessarily involve eurobonds. If there was a political decision in favour of fiscal union, you could of course issue eurobonds at the end of the integration process. But this is not something I’m asking for. In both models, you would penalise rule violations. In the Maastricht model, the rules would be the stability and growth pact, with automatic sanctions for violations and the no bail-out clause. In the fiscal union model you also need strict rules for deficit and debt. If you breached those rules you would need to delegate your national sovereignty on fiscal policy to a supranational level. I think the true question at the heart of this is: are governments, parliaments, and people ready to accept a supranational level, a European level that assumes the ultimate responsibility for fiscal policy, at least in case of a breach of the rules? In my view, the declaration from leaders at the last EU summit was not clear enough. They talked about minor treaty changes. But this is not a minor change – this is a major change with follow-up changes in national constitutions. Without clear answers, you might not have the basis for a stability-orientated monetary union.

FT: And do you need an orderly sovereign default mechanism in either model?

JW: In the “Maastricht-plus” model, if you wanted to enforce the no bail-out clause, then of course an orderly restructuring mechanism is an important element.

FT: When you talk about a stability-orientated monetary union, is it the same as saying that other countries have to be more like Germany?

JW: No, it’s not about being more German or not being German. Fiscal solidity is not only a German issue, and the crisis has clearly revealed its importance as the basis of financial stability and political stability.

FT: With its large export surpluses, some see Germany as part of the problem for other eurozone countries …

JW: What you have to see is that we have already had our reform process. Remember what Germany has done in reforming its labour market. What we are seeing are partly the fruits of those reforms. We all have to become more competitive. Of course we have to recognise that imbalances are an issue. At the same time, I think this debate sometimes lacks analysis in that a surplus or deficit is, per se, not something that is always good or always bad. If you have an ageing population then a trade surplus makes sense to provision for that by accumulating capital outside your own country.

FT: Why shouldn’t Germany, which has total credibility in financial markets, loosen its fiscal stance?

JW: Germany has that credibility because it followed a specific fiscal path in the past, and it should not lose that track record and credibility by abandoning that path. It’s very important that Germany remains the stability anchor within the monetary union.

Besides, I think that the effects on the euro area of a shortlived fiscal impulse from Germany are largely overestimated.

FT: Will we see a recession in Germany?

JW: Because of reforms in the past, Germany is in a better position if you look at the growth figures. The labour market is also in a more robust position than in many other euro area countries and this is again the effect of those past reforms. The third quarter of German growth is still quite robust, but we will experience a moderation of growth in the fourth quarter of this year and the first quarter of next year. However, downside risks have clearly increased.

FT: Given the forecast for a sharp fall in inflation next year, do you see scope for further ECB interest rate cuts? Your predecessor saw 1 per cent as a floor for the main ECB interest rate. Do you see that also as a floor?

JW: I won’t speculate about the future actions by the eurosystem and limits to future action. We decreased rates because of expectations that growth forecasts would be revised downwards and inflationary pressure will recede. So currently the policy stance is appropriate.

FT: If the economy turns a lot worse and deflationary risks seem much bigger than inflationary risks, are people not going to worry that there is nothing left in the ECB toolbox?

JW: Our baseline scenario is not the one you described, but rather a deceleration in growth rates and I think our toolbox will be appropriate to cope with this. To come back to the starting point of our debate: the risk scenarios you’re talking about have a lot to do with the current sovereign debt crisis. In my view this underlines the importance of governments acting decisively.

Over the past three days, Spiegel Online has posted an English translation of the German newsmagazine Der Spiegel’s recent cover story on the history of the euro. “The best laid plans of mice and men” would be an apt subtitle. So would “the road to hell is paved with the best of intentions.”

I’ve combined the three installments, which are dated October 5, 6, and 7.

Financial Times

• Alan Greenspan, “Europe’s crisis is all about the north-south split“

The ranking of credit risk spreads by size across the eurozone in 2010 was almost identical to the ranking of the level of unit labour costs (relative to that of Germany), suggesting that the higher labour costs and prices have rendered “euro-south” less competitive and so more subject to credit risk. The more competitively priced net exports of the northern eurozone participants, in effect, more than covered the rising level of net imports of the south. In short, between 1999 and the first quarter of 2011, there has been a continuous net transfer of goods and services shipped from the north to the south. Northern Europe in effect has been subsidising southern European consumption from the onset of the euro on January 1 1999. It is not a recent phenomenon.

• Howard Davies, “It’s time for plain-speaking to Europe’s electorates“

No one knows today which euro-denominated contracts, which are found all over the world, should be redenominated into one or more new currencies. Would it be on the basis of nationality, or residence, or intended place of settlement of the contract, or law of jurisdiction over the contract? Who would decide? Which courts could enforce whatever was decided? In every case of redenomination there would be a winner and a loser, so every attempt to enforce a change would be disputed. Then arrangements for the new currency(ies) would be needed. Intricate preparations were made over many years to introduce the euro – we were involved.

• Gillian Tett, “America’s six key lessons for a ‘euro Tarp‘”

Firstly, size matters. When Hank Paulson, then Treasury secretary, unveiled Tarp back in 2008, he told colleagues he was looking for a “bazooka” to stun the markets and turn sentiment around. At the time, $700bn seemed big enough to work, since this number – crucially – outpaced market expectations. And while those expectations subsequently got inflated – and analysts started calling for, say, $1,000bn – these doubts did not set in until later; and, crucially, after sentiment had turned.

Secondly, co-ordination is crucial. One reason why Mr Paulson’s bazooka “stunned” the markets was that it was wielded by a single team – policy was being set by a close-knit group of Treasury and Fed officials. This mattered because in late 2008, investors had no stomach for delay or conflicting policy signals.

Thirdly, excessive democracy does not always help. In the first stage of Tarp, politicians were involved; Congress, after all, initially vetoed Mr Paulson’s plan before approving it after a market crash. But later a tight team of bureaucrats took control and were able to fire the Tarp bazooka with speed, in a straight(ish) line. Remember how Mr Paulson yanked the bank chief executives into the Treasury on a Sunday afternoon and ordered them to accept capital injections – and sign? That could never have occurred if Congress had been involved.

Fourth, plans need to be flexible. When Mr Paulson initially created Tarp, his team thought that the $700bn would be used to buy bad assets from banks. However, they later decided to recapitalise the banks instead. Future financial historians will argue endlessly about whether this was the “right” decision but if nothing else, this showed that the Treasury had great freedom to act.

Fifth, stress tests only work if they address the visible points of stress that the public and markets care about. The US stress tests of early 2009 were far from perfect; some experts thought, for example, that reserves for commercial real estate were too small, and there were no reserves for impairment of sovereign debt. But while that worried geeks, the stress tests did address the issue that was really bothering markets: namely whether there were enough reserves for residential mortgages. And that, coupled with their comprehensive nature, made them seem “credible” enough to turn sentiment.

. . . there is a sixth key point to remember. Back in 2008, it was widely assumed – at least among the US public – that most of the $700bn used in Tarp was permanently “spent”. But these days, Treasury officials reckon that less than $50bn has really been lost. For once Tarp was deployed, and sentiment stabilised, then asset values rose, along with bank earnings, enabling much of that money to be repaid.

• Philip Stephens, “Save the euro — let Greece default“

The pressing decision is about the timing and terms of Greek default. It is possible that the politicians still have a choice between orderly restructuring and a chaotic collapse that quickly engulfs everyone else. Possible, but not certain. The more governments argue about how to build firewalls around the other peripheral economies and about how to insulate the banking system, the more likely the flames will spread uncontrolled across the continent.

• Lex, “European stress tests: a grim backdrop“

Which part of “stress test” do the eurozone’s policymakers not understand? That so many European banks passed the annual exams in July yet still had their shares trashed by investors says it all: the pass mark was too low and the questions were too narrow. That banks have since struggled with funding and come under the microscope of US regulators rightly concerned at the risk to US banks shows the consequences of eurozone policymakers’ state of denial. Their failure to allow for eurozone defaults doomed the tests of the European Banking Authority. Its retests must take account of the grim backdrop.

• John Kay, “What Europe can learn from Kissinger-style ambiguity“

Ambiguity has been central to the European project. The European Union is built on what Cass Sunstein, the US legal scholar, describes as incompletely theorised agreements: it is often possible to reach consensus on a course of action even if there are different reasons for and objectives behind such action. The evolution of monetary union in Europe was an incompletely theorised agreement. For Germany, it was a means of extending the economic discipline of the Bundesbank to more profligate trading partners. For France, it was a way of putting European monetary policy under greater political, and particularly French, control.

• Patrick Jenkins, “UK government fears new RBS bail-out“

Nervousness is growing in Whitehall that the government might have to inject further capital into Royal Bank of Scotland as part of an effort to recapitalise Europe’s banks.

Moody’s added to that unease on Friday by downgrading RBS amid a re-rating of the UK banking sector after a review of the systemic support offered by the British government.

• Peter Spiegel, “Barroso enters fray over bank support“

José Manuel Barroso, president of the European Commission, will soon present his own plan for Europe-wide bank recapitalisations, the clearest sign yet that the region’s leaders could come up with a strategy to shore up its financial sector as soon as a summit later this month.

Although the Commission does not have the power to impose capital injections by national governments, Mr Barroso’s comments on Thursday echoed those by Angela Merkel, the German chancellor, who this week said her government was prepared to prop up German banks and urged a co-ordinated European effort.

• Hugh Carnegy, “France fights pressure to recapitalise banks“

Nicolas Sarkozy, who will be in Berlin on Sunday for euro crisis talks, must have winced when he heard Angela Merkel, the German chancellor, say on Wednesday that her government was prepared, if necessary, to recapitalise the country’s banks.

The French president, his ministers and officials have stuck rigidly to the exact opposite line through the past few torrid months of crisis – that France’s banks do not need recapitalisation, despite being under constant attack in the financial markets for their heavy exposure to risky eurozone sovereign debt.

The centre-right government insists the banks are stable, based on plans set out by the big three – BNP Paribas, Société Générale and Crédit Agricole – to meet minimum capital requirements under Basel III regulations by 2013, six years ahead of deadline.

And the banks themselves are keen to avoid state equity injections, which would likely be dilutive to shareholders.

Wall Street Journal (no links)

• Brian Blackstone, “Central Banks Step Up Battle to Contain Crisis“

The Bank of England made a surprise decision to buy government bonds to try to bring down interest rates and spark growth, while the European Central Bank revived measures from last year to try to keep capital flowing to Europe’s ailing banks.

“This is the most serious financial crisis at least since the 1930s, if not ever,” U.K. bank chief Mervyn King said, explaining the decision to add money into the strained financial system. “We’re creating money because there’s not enough money in the economy.”

A flurry of meetings by global policy makers in recent weeks has done little to inspire confidence that a permanent fix is in store for Europe’s beleaguered periphery, and economic indicators in recent days have offered fresh signs that Europe risks sliding into another recession. France’s statistics agency Thursday predicted recession for Spain and Italy by year’s end, saying that would help drag France’s growth to zero.

• William Horobin, “France Lowers Outlook, Sees Italy, Spain, Slump“

France’s growth outlook has deteriorated sharply over the summer and the country is headed for a second quarter of stagnation as the shock of the euro-zone debt crisis manifests itself in the real economy, national statistics agency Insee said Thursday.

Insee slashed its gross domestic product growth forecasts for the remainder of the year to 0.3% in the third quarter and zero growth in the fourth quarter, bringing 2011 GDP growth to 1.7%.

The statistics agency had previously forecast 0.5% quarter-on-quarter growth in the final two quarters of this year and 2.1% for the full year. However, “events over the summer have wrecked this scenario,” Insee said in its outlook.

“The lesson of the summer is that while we had been saying for a year and a half that the Greek crisis was a risk, now we are seeing this risk has materialized in figures,” said the head of Insee’s forecast department, Sandrine Duchêne.

Insee expects Italy and Spain to go into recession in the second half of 2011, with contractions of 0.1% in the third and fourth quarters for Italy and a contraction of 0.2% in Spain. Economic surveys in the two countries have deteriorated significantly over the last few months, with industrial production in Spain particularly weak, Ms. Duchêne said.

The weakness of other European countries will contribute to a stagnation of world trade in the third quarter. In the fourth quarter trade is expected to decline, and as demand from businesses shrinks, consumption will be the sole supporter of growth in France to the end of the year, Ms. Duchêne said.

• Geoffrey T. Smith, “European Banking Body May Consider New Stress Tests“

The European Banking Authority said Thursday it can’t rule out launching a new round of stress tests on Europe’s banks, but denied having already done so.

Separately, European Commission President José Manuel Barroso said Europe’s banks may need recapitalization and work is already underway on some aspects of this.

An EBA spokeswoman said “the situation has evolved rapidly and dramatically” since the EBA published the results of its stress tests in July, adding that the body, “as a technical authority, will of course assess all the alternatives.”

• Brussels Beat, “Plan to Recapitalize Banks Remains Thin on Details“

Stock markets around Europe have rallied this week on the apparent expectation, fostered by such comments, that the failure of Franco-Belgian bank Dexia SA has galvanized the euro zone into recognition that it has a major problem and plans to do something about it. To convince the markets, it would have to be quite a plan: The International Monetary Fund has estimated that the currency bloc needs €200 billion to €300 billion ($267 billion to $400 billion) to cope with the crisis and its knock-on effects.

There’s no detail, though, of any proposal, except one that Germany has been pushing. Under it, governments would pledge to launch or relaunch backstop funds like the one Germany created after the 2008 financial crisis. If the private market won’t provide the money, then national governments will act. If they are financially stretched, then the expanded European Financial Stability Facility, soon to get authority to supply banks with capital, will step in. Berlin appears to be hoping EU leaders will back the idea at a summit on Oct. 17-18.

Critics say that wouldn’t be so much a plan as an announcement, and are skeptical that anything more significant is in the works.

New York Times

• Editorial, “The Trouble with Greece“

Europe has been right to demand that, in exchange for bailout financing, Greece carry out painful structural reforms to make its economy more competitive and able to generate more revenue to pay down the country’s huge debts. Without that pressure, Athens would likely never be able to overcome fierce resistance from public-sector unions, professionals, the wealthy and all of the special interests determined to keep doing business as usual.

But Europe has been dead wrong to simultaneously demand that Greece impose steep new taxes and deep social spending cuts guaranteed to prolong and worsen an already severe recession. That will make it impossible for the country to earn its way out of debt.

“At today’s meeting, which was held in Berlin, the Governing Council of the ECB decided that the interest rate on the main refinancing operations and the interest rates on the marginal lending facility and the deposit facility will remain unchanged at 1.50%, 2.25% and 0.75% respectively.“

At his press conference, Jean-Claude Trichet explained the decision:

Based on its regular economic and monetary analyses, the Governing Council decided to keep the key ECB interest rates unchanged. Inflation has remained elevated and incoming information has confirmed our view that inflation is likely to stay above 2% over the months ahead but to decline thereafter. At the same time, the underlying pace of monetary expansion continues to be moderate. Ongoing tensions in financial markets and unfavourable effects on financing conditions are likely to dampen the pace of economic growth in the euro area in the second half of this year. The economic outlook remains subject to particularly high uncertainty and intensified downside risks. [My emphasis] At the same time, short-term interest rates remain low. It remains essential for monetary policy to maintain price stability over the medium term, thereby ensuring a firm anchoring of inflation expectations in the euro area in line with our aim of maintaining inflation rates below, but close to, 2% over the medium term. Such anchoring is a prerequisite for monetary policy to make its contribution towards supporting economic growth and job creation in the euro area. A very thorough analysis of all incoming data and developments over the period ahead is warranted.

You don’t have to be a Nobel Prize winner to draw the following inference from Trichet’s words: If the eurozone’s inflation rate is greater than 2 percent, the ECB will not lower interest rates, irrespective of the rate of growth or contraction of the eurozone’s economy. This is an iron-clad rule admitting of no exceptions. It will be adhered to even if economic weakness should result in social unrest.

Financial Times

• Peter Spiegel, “Europe thinks the unthinkable to solve crisis“

The window for resolving the eurozone’s sovereign debt crisis is closing more quickly than policymakers anticipated . . . Eurozone governments, many facing growing public disquiet, must now address three overlapping policy discussions for stepping up their response to the crisis. Once-unthinkable proposals for fiscal union and shared responsibility for sovereign debt are now being hurriedly readied for ministerial discussion . . . Senior European officials hope that by the time of a summit of European Union leaders in October, they will have: put in place powers for the eurozone’s €440bn rescue fund; agreed on the need to expand the fund’s firepower; and presented plans for further economic integration. But policymakers still have to work out countless disagreements that could doom the process . . .Mujtaba Rahman, Europe analyst for the Eurasia Group, said the biggest risk now was that EFSF powers would be diluted in the national parliaments in legislative horse-trading, drastically reducing their effectiveness . . .Many contributing countries [to the EFSF] are now unable to increase their commitments for political reasons or because they could jeopardise their own credit ratings.

NEXT STEPS

Sept 27 Greek parliament votes on unpopular new property tax
Sept 28 Finnish parliament votes on new powers for the European financial stability facility, the eurozone bail-out fund
Sept 29 German parliament due to ratify the EFSF, but will Chancellor Angel Merkel win over her coalition partners?
Oct 3 Eurozone finance ministers meet in Luxembourg
Oct 11 Slovak parliament votes on the EFSF, the last eurozone member to do so
Oct 13 Eurozone ministers could meet again to sign off on a Greek aid tranche
Oct 14 G20 finance ministers meet in Paris
Mid-Oct Greece starts to run out of money
Oct 17-18 Herman Van Rompuy, European Council, president, will make proposals on fiscal union at an EU summit
Nov 3-4 G20 summit in Cannes
Dec Talks begin on next aide tranche for Athens
Dec 9 EU summit at which leaders to discuss increasing EFSF at summit and fiscal union
Early 2012 German parliament votes on a permanent bail-out fund to replace the EFSF

• Quentin Peel, “Germany and the eurozone: Besieged in Berlin“

When the Bundestag votes on Thursday on increasing guarantees underpinning the European financial stability facility – the €440bn eurozone rescue fund – there is overwhelmingly likely to be a big majority in favour. If so, it will not reflect popular opinion. Polls suggest that 75 per cent of voters are against the move, which would raise Germany’s part of the EFSF guarantees from €123bn to €211bn . . . Germans are worried about government borrowing and inflation, with the experience of hyperinflation in the 1920s and 1940s still colouring all their economic debates. The eurozone debt crisis has replaced unemployment at the top of the list of domestic concerns.

• Raghuram Rajan, “The IMF must stop playing second fiddle in Europe“

The only glimmer of hope during the meetings in Washington came with Europe’s willingness to use the European financial stability facility more imaginatively – as equity, for example, or as first-loss insurance for investors . . . There is, however, no consensus on how to do this. Some propose bringing the EFSF and the European Central Bank together, to leverage the EFSF’s funds. This is a recipe for trouble. Giving the ECB a quasi-fiscal role, even one where it is somewhat insulated from losses, risks undermining its credibility . . .Put simply, the world has to recognise that the eurozone’s problems are now too big for the eurozone alone to deal with. The world has a stake in their resolution. And it has an institution that can channel help: the IMF.

Wall Street Journal

• Editorial, “A Fannie Mae for Europe’s Bonds?“

. . . the alternative being suggested is to turn the EFSF into a kind of leveraged buy-up fund for government bonds. This is supposed to achieve two things: First, it could take euro-zone members out of the clutches of those fickle and rapacious private investors. And, second, it would allow the ECB to maintain a sheen of respectability, as it would merely be lending to this bank against collateral, just as it does with other banks.Here is where the Fannie Mae likeness begins to emerge—as a government-guaranteed leverage machine for lowering the cost of a certain kind of debt. The difference with Fannie is that this proposal involves sovereign debt instead of mortgages, and the borrowing is being done directly from the central bank. Fannie at least had to market its debt to private investors . . . Now imagine a scenario in which this new super-bank borrows a few trillion from the ECB to buy up government bonds—and then the bond prices go down. Given the leverage built into this euro-zone Fannie bank, it wouldn’t take much in the way of interest-rate normalization to wipe out the capital underlying all the capital that this euro-Fannie would start with.

New York Times

• Jack Ewing, “Mixed reaction to Europe’s talk of bolstering a bailout fund“

. . . leaders tried to quash rumors that Greece and its creditors had discussed the possibility of banks’ taking a larger cut in the value of their Greek bond holdings — perhaps as much as 50 percent — to reduce the government’s debt burden to a more manageable level. Such a move remained highly controversial and was opposed by the large banks as well as the European Central Bank, which owns Greek bonds with a value of as much as 60 billion euros, or $80.8 billion.

Now that’s a presumptuous title if I ever saw one. Well, maybe not. The policies being followed by the governments and central banks of the U.S. and Europe clearly aren’t solving the economic crisis. The anemic economic recoveries on both sides of the Atlantic have run out of steam and the world’s stock, credit and commodity markets have plunged in anticipation of worse to come. The markets are telling us that time may be running out to preempt another Lehman moment and a further slump in economic activity that would turn recession into depression. Despite rising investor angst and an ever-growing avalanche of weakening economic indicators, there’s no evidence that the individuals in positions to alter the course of economic events are starting to have second thoughts about current fiscal and monetary policies.

How have the advanced industrial countries of the West arrived at what increasingly appears to be a tipping point?

Immediately after Lehman’s failure, fiscal and monetary policies were loosened in true Keynesian fashion. The West didn’t fall into the financial abyss and the recession didn’t turn into a depression.  Asset values recovered and the recession officially ended in June 2009. The economy ended its 18-month stay in intensive care. As it became evident that the world economy would soon be discharged from the hospital, governments, central bankers, economists and the public refocused their attention to the aftereffect of its stay in intensive care:  ballooning public debt. Preventing financial and economic collapse resulted in the shifting of trillions of dollars of debt from the private sector’s to the public sector’s balance sheet. Rapidly rising unemployment reduced government tax revenue and increased government spending. Government debt-to-GDP ratios rose to unprecedented peacetime levels. With economic recovery underway, concern about the future solvency of government rose to the top of the worry list.

Fiscal Policy: Tightened

With fear of public sector insolvency having overtaken fear of depression, economic policy was ripe for change. The change has taken the form of calls for and the implementation of increasingly austere fiscal policies. Austerity, its advocates argue, is the path to economic salvation. In every country, those who would rely primarily on reduced spending and those who would rely primarily on higher taxes on the wealthy have something in common: both assume that heightened fiscal rectitude will reduce their government’s debt-to-GDP ratio. By lowering the perceived risk of future insolvency, they aver, the private sector’s confidence will improve. Facing the future more confidently, consumers will buy more and business will invest more. This positive feedback loop involving consumers and business will create a self-sustaining, accelerating economic recovery. That recovery will create more jobs, leading to reduced government spending on unemployment insurance and related items and increased government tax revenues. The budget deficit will contract, borrowing requirements will diminish, the debt-to-GDP ratio will fall, and the real –as well as the perceived — risk of insolvency will vanish.

The ramifications of faith in fiscal austerity as the exit strategy from hard times extend beyond the economic to include the political sphere. Intrinsic to this exit strategy are political disagreements over the mix of spending reductions and tax increases. The issue of the distribution of austerity’s pain came to the fore during this summer’s debate — I use the word advisedly — in the U.S., which heavily contributed to the downgrading of the credit rating of America’s sovereign debt. More significant than that downgrade was the public’s disgust with the spectacle in the House of Representatives. It can’t be doubted that the extreme partisanship so vividly on display further undermined consumer and business confidence in the ability of the government to come to grips with a sputtering economy. This feedback from the political to the economic realm revealed itself in the aforementioned steep market declines, which can best be interpreted as a discounting of further economic weakness.

It’s as simple as that, or is it? Spending decreases and tax increases have something in common: if everything else remains constant, they both drain purchasing power from the private sector.  The “everything else” is the effect of fiscal austerity on confidence. For austerity to boost consumption, the positive impact on the propensity to consume of a reduction in the perceived risk of insolvency in the long-term must exceed the negative impact of the reduction of purchasing power in the short-term. Said another way, for austerity to have its intended effect, it must result in a decline in the propensity to save. Only if this requirement is met will business have an incentive to accelerate hiring and capital investment.

If, as I anticipate, fiscal austerity has the opposite of its intended effect, the circle will be vicious rather than virtuous. Budget deficits, borrowing requirements, debt-to-capital ratios and insolvency risks (both perceived and real) will increase. Confidence will erode. The evidence, as highlighted by the unfolding Greek tragedy, indicates that the adverse outcome is the likely outcome.  But this conclusion doesn’t rest upon Greece, which might be considered an exceptional case. More significantly, as fiscal impetus has turned into fiscal drag, the economies of both the U.S. and Europe have slowed and are now either on the verge of, or already in, a contraction phase.  If governments react to this development by further tightening fiscal policies, they will assuredly produce a second worldwide recession. Should this occur, the 2010s will be remembered by future generations as the decade of the Second Great Depression. As noted earlier, there is at present no reason for optimism that governments and a broad swath of the public understand the predicament we now face. Absent such an understanding, the likelihood of further contractionary fiscal actions is disturbingly high.

Monetary Policy: Loosened

Three weeks after Lehman’s bankruptcy, the Fed lowered the Fed funds rate (the interest rate banks charge each other for overnight loans) to 1.5 percent from 2 percent. Two more reductions were announced by the end of 2008. At year’s end, the rate had been reduced to zero percent (more accurately, for technical reasons, the rate was 0.00 to 0.25 percent). For the first time ever, banks in the U.S. with insufficient liquidity could borrow from banks having more liquidity than they needed without incurring interest expense. One need not look further than this to appreciate the seriousness of the financial situation as seen by those closest to it. The Fed funds rate is still zero percent.

The European Central Bank (ECB) is the equivalent of the Federal Reserve for the 17 countries that employ the euro as their currency. In the eurozone, the “deposit facility” interest rate has the same role as the Fed funds rate. As shown in the following table, the ECB’s monetary policy has been somewhat less accomodative. Most importantly, it has twice raised the deposit facility rate during 2011. Inflation fears were the stated reason for the interest rate increases. Still, at 0.75 percent, the interest rate is far below the inflation rate.

Overnight Interest Rates, 2008-2011

During the 12 months following the end of the recession, real (inflation-adjusted) U.S. GDP grew at a disappointingly slow 3.3 percent — far below the norm for the first year of a recovery. What made this sub-par performance  particularly worrisome was that it happened while short-term borrowing costs in the private sector, reflecting the zero percent Fed funds rate, were at historically low levels. During the summer of 2010, Fed Chairman Bernanke telegraphed the Fed’s intention to implement a policy — subsequently dubbed “quantitative easing” — aimed at stimulating the economy by driving down long-term interest rates. In a speech delivered on August 26, 2010, he said that one of the options for providing additional monetary accommodation was “to expand the Federal Reserve’s holdings of longer-term securities,” and added that he believed “that additional purchases of longer-term securities . . . would be effective in further easing financial conditions.” By the time this policy was implemented in late 2010, market participants had fully discounted its intended effect by driving down yields on longer-term fixed-income securities.

Chart 1.

Chart 2.

Still, the economy refused to cooperate. Real GDP growth fell to 3.1 percent during calendar 2010, two-tenths of a percentage point lower than it had been during the 12 months ending in June, 2010. Growth continued to decelerate during the first half of 2011. The Fed’s reaction to the persistent and growing weakness in the economy was to announce “operation twist” on September 21. In a press release titled “What is the Federal Reserve’s maturity extension program (referred to by some as “operation twist”) and what is its purpose?,” the Fed explained:

Under the maturity extension program, the Federal Reserve intends to sell $400 billion of shorter-term Treasury securities by the end of June 2012 and use the proceeds to buy longer-term Treasury securities. This will extend the average maturity of the securities in the Federal Reserve’s portfolio.

By reducing the supply of longer-term Treasury securities in the market, this action should put downward pressure on longer-term interest rates, including rates on financial assets that investors consider to be close substitutes for longer-term Treasury securities. The reduction in longer-term interest rates, in turn, will contribute to a broad easing in financial market conditions that will provide additional stimulus to support the economic recovery.

For three years, the Fed’s policy has been to deflate interest rates. What began as the deflation of short-term rates has been extended all the way out the maturity spectrum to include 30-year Treasury bonds. This latest interest rate deflation, while helping borrowers — in particular, home owners with variable rate mortgages and first-time home buyers — entails noteworthy risks. The most significant of these risks is its impact on bank profitability. Banks, of course, borrow short and lend long. Accordingly, the outlook for bank profits is at its best when the yield differential between short- and long-term fixed-income securities is large. Operation twist narrows the differential; it “flattens” the yield curve. This new headwind facing the banks comes at a time when another headwind — the eurozone’s sovereign debt crisis — is intensifying, with no end in sight. U.S. banks have an exposure of $650 billion to the debt of Greek, Irish, Italian, Portuguese, and Spanish governments. With the housing market still in the doldrums and the mounting possibility of having to write-down the value of their holdings of eurozone public debt, the flattening of the yield curve could not have come at a less propitious moment. The Fed is betting that operation twist won’t increase systemic risk in the U.S. financial system. It’s a bet that the Fed had better win.

The Problem — And the Solution

The U.S. and Europe are suffering from the same underlying disease: economies that never really recovered from the financial crisis and which will continue to stumble along or soon experience the long-feared double-dip. The European situation is worse, and far more complex. The American states are married; they have one monetary policy and one fiscal policy. The eurozone countries are engaged; they have one monetary policy and 17 fiscal policies. Adding to their problems is the fact that their engagement documents don’t allow them to voluntarily break their engagement or to have other members of their extended family force them to call off their engagement. This is reason enough to conclude that, if a way out of the worldwide economic crisis is to be found, it will start in the U.S.

By now, it should be obvious that credit cost deflation — reducing interest rates — isn’t going to revive the American economy. It should be equally obvious that budget deflation — reducing government spending and/or increasing taxes — isn’t going to revive the American economy, either. If the U.S. is going to lead the industrialized West out of the economic wilderness, it must fundamentally change its fiscal and monetary policies.

We should reverse both of these policies. Fiscal policy should become expansionary. Monetary policy should become restrictive. The eurozone’s sovereign debt crisis provides us with a window of opportunity to do both.

The arguments against fiscal stimulus and my counter-arguments are as follows:

• Fiscal stimulus doesn’t work — Those who support this argument point to the anemic economic recovery that began four months after the February, 2009, passage of the Obama administration’s $787 billion stimulus package.  Top advisers within the administration wanted a larger stimulus, but political realities prevailed. In particular, Christine Romer, who was then the chairperson of the Council of Economic Advisers argued for a stimulus package of at least $1.2 trillion. As reported in the New Yorker,

The most important question facing Obama that day [in December 2008] was how large the stimulus should be. Since the election, as the economy continued to worsen, the consensus among economists kept rising. A hundred-billion-dollar stimulus had seemed prudent earlier in the year. Congress now appeared receptive to something on the order of five hundred billion. Joseph Stiglitz, the Nobel laureate, was calling for a trillion. Romer had run simulations of the effects of stimulus packages of varying sizes: six hundred billion dollars, eight hundred billion dollars, and $1.2 trillion. The best estimate for the output gap was some two trillion dollars over 2009 and 2010. Because of the multiplier effect, filling that gap didn’t require two trillion dollars of government spending, but Romer’s analysis, deeply informed by her work on the Depression, suggested that the package should probably be more than $1.2 trillion.

Would a $1.2 trillion plus stimulus have launched the economy onto a faster growth trajectory? There’s no way to know for sure; the best I can do is to provide an analogy. The economy is frequently referred to as an engine. An immobilized car needs to be jump-started. If the external power source that’s connected to the car’s battery isn’t powerful enough, the engine won’t start. A more powerful external source will succeed where the less powerful one failed. Returning to the economy, it’s a fallacy to assert that, because a stimulus program of a certain size produced a disappointing result, any stimulus package, regardless of its size, will be unsuccessful.

• Fiscal stimulus is inflationary — In some circumstances, this is true. But not in the current circumstances. Chart 3 shows that the velocity of money — the rate at which money changes hands in the economy — is now falling after a brief, mild acceleration following the implementation of the stimulus program. With a stagnant or contracting economy ahead, it’s more likely that money velocity will decline further than to reverse direction. Another analogy will drive home this point. The Fed has been pouring billions of gallons of gasoline (money) into the gas tank (the economy), but fewer miles (purchases) are being driven (made).

Chart 3.

• The dollar will weaken — Perhaps, but that’s not necessarily a bad thing, as it would improve our export competitiveness. In fact, as shown in Chart 4, the dollar has significantly strengthened against the euro in recent days. Since the last day depicted in the chart, the value of the dollar has climbed further.

Chart 4.

At the beginning of this section, I said that the eurozone’s sovereign debt crisis provides us with a window of opportunity to reverse the directions of our fiscal and monetary policies. Now it’s time to explain why.

To safeguard their wealth from the effects of the crisis, Europeans are selling euros, buying dollars, and using their dollars to buy U.S. sovereign debt — Treasury notes and bonds. Notwithstanding occasional glimmers of hope, the eurozone’s crisis admits to no simple solution and will continue for an extended period of time. Accordingly, our interest rates will remain at or near their current historical lows. This means that federal government interest expense as a percent of GDP will not become a budget-buster. Simply stated, for as long as the eurozone’s sovereign debt crisis continues, the U.S. will not have a sovereign debt crisis. This provides us with an opportunity to implement a very sizable fiscal stimulus program without risking the deleterious side-effects that such a program would normally entail.

Changing our fiscal policy is only a part of the solution. A sizable stimulus program will put more money into more people’s pockets, but will they, in this age of deleveraging, spend it or save it (paying down credit card debt counts as saving)?

Chart 5.

This is where reversing our monetary policy enters the picture. The price of credit has been declining for three years. Consciously or not, this trend has undoubtedly seeped into the minds of American consumers. This credit price deflation provides an incentive to defer major purchases. The best example, of course, is housing. If, in addition to expecting a further erosion of home prices, a family also anticipates that mortgage rates will continue to decline, it has an added incentive to wait.

With the stimulus program boosting economic activity, the Fed should announce that, starting on a certain date and every three or six months thereafter, it will increase the Fed funds rate by a quarter percentage point and reduce its holdings of long-term government securities by a specified amount. Replacing credit price deflation with credit price inflation will provide the incentive to purchase now rather than in the future.

There you have it. My solution to the economic crisis is to implement policies that are the exact opposite of those currently in place. Replacing one without replacing the other won’t suffice. Fiscal stimulus without credit price inflation would put more money into more pockets without providing an incentive to spend. Credit price inflation without fiscal stimulus would further weaken the economy.

Political Realities

I haven’t been looking forward to writing these final words. Setting forth a solution to the economic crisis is one thing; expecting that for now and the foreseeable future it has a snowball’s chance in hell of being enacted is another.  The current momentum favoring fiscal rectitude is irresistible. Public opinion being what it is, opposing it amounts to political suicide. We will continue down the current path until it has been completely discredited. What will it take for public opinion to reverse direction? One way or another and by the end of this year, we will have started to walk down the path, instead of just talking about it. If my analysis is on the money, it won’t be a pleasant walk. Stagflation without the “flation” is the most optimistic scenario I’m willing to countenance. If, as seems more likely, the unemployment rate rises into the double digits as the effects of fiscal stringency accumulate, it will be interesting to see whether either of our political parties changes its mind as election day approaches. The ideological rigidity of the Republicans makes it next to impossible for them to undertake an about-face. So, if either of the parties is to change its mind, it will be the Democrats. For now, all we can do is to wait and see.

Board of Governors of the Federal Reserve System

• FOMC Statement

. . . there are significant downside risks to the economic outlook, including strains in global financial markets.

Financial Times

• Roger Altman, “America and Europe are on the verge of disastrous recession“

Overall, we could be in for a repeat of the experience of 1937, when America fell back into recession after three years of recovery from the Great Depression.

• Charles Dumas, “Spain, not Greece, may be the biggest eurozone threat“

The chances are high of a Spanish asset price slide and banking crisis, with stagnation (at best) or depression, if it sticks in the euro. For Portugal they are close to 100 per cent.

New York Times

• Floyd Norris, “Constraints on central banks leave markets adrift“

. . . the slogan for markets as the International Monetary Fund and World Bank meet this week in Washington could well be, “You’re on your own. Don’t count on anybody to bail you out.”

Spiegel Online

• Romain Leick, “The weakness behind Sarkozy’s European vision“

Thinking about Germany has become a French obsession, because France is worried. It is wondering whether Germany will remain true to the European Union and the euro . Will Germany choose solidarity over discipline? Will Germany ultimately accept the measure that prevailing Parisian opinion considers inevitable and agree to collectivize national debt within the euro zone?

• David Böcking, “Belligerent Berlusconi Toys With Europe“

Italian Prime Minister Silvio Berlusconi refuses to recognize that his country is in trouble. Vast debt, sluggish growth and rising borrowing rates indicate that Rome too may be infected by the euro-zone debt crisis. But the EU has few tools at its disposal to get Italy to take action.

• The World from Berlin, “Italy’s chief problem is its own government“

Prime Minister Silvio Berlusconi blasted Standard and Poor’s on Tuesday, saying its downgrade of Italian debt was politically motivated. German commentators tend to agree, but they say the real problem is Berlusconi himself.

VoxEU

• Michael Bordo, “A fiscal union for the euro: some lessons from history“

The single European currency is the first of its kind – a union where monetary policy is decided centrally and fiscal policy decided nationally – something that many argue is the root cause of its troubles. This column looks to history to find examples of federal states with a common currency but without the frailties currently being exposed in the Eurozone. The main lesson: No bailouts.

In the same Wall Street Journal article (no link) that says “Greece is in a bind. Its official creditors say it is not following through on promised steps to reduce its deficit—but austerity measures so far have pushed the economy into deeper recession, squeezing tax revenues and increasing spending on social safety nets,” members of the “troika”( the International Monetary Fund, European Commission and European Central Bank) are reported as threatening not to release €8 billion in bailout funds — without which Greece will likely run out of money next month — unless further spending cuts are made.

Greek Finance Minister Evangelos Venizelos said his country would announce the closure of several state-linked organizations this week and make further spending cuts in its 2012 budget. Greece is due to submit its 2012 draft budget to parliament on the first Monday in October, as foreseen by the Greek constitution. The plan will be voted on by the end of October.

According to Greek government officials, the troika is pressing Greece to cut 100,000 public jobs by 2015, either through outright layoffs or by placing some of those workers in a special labor reserve. Workers on reserve would be retained on 60% salary for up to a year, but would face dismissal after that if no new jobs were found for them. Greece might also have to consider retroactively–and with immediate effect–rescinding all public-sector hiring that took place in 2010 and 2011, Greek officials said. That could affect 25,000 or more workers, one official said.

Let me get this straight. The austerity measures thus far implemented have worsened the Greek recession. The troika now demands that additional austerity measures be taken. Has it not occurred to the IMF, EC, and ECB that experience indicates that more austerity will result in a further deepening of the recession, making it impossible for Greece to reduce its debt-to-GDP ratio? If continued — and there’s no reason to believe it won’t be — the troika’s prescription will result in bankruptcy, not recovery. This is a recipe for an accelerating downward spiral that will produce collateral damage outside of Greece, and not just in the eurozone.

Is it worth pointing the world towards a second great depression so that Greece can be punished for its past misdeeds?

Below the fold is the statement of Greek Finance Minister Venizelos. Continue reading ‘This Is Insanity’ »

If you’re still unsure as to the German position on the eurozone, this Spiegel Online interview — actually, it’s more like an interrogation — of Bundesbank President Jens Weidmann should make it clear. The complete interview follows this brief excerpt.

SPIEGEL: What exactly would happen if Greece were not to fulfill the conditions for the next tranche of aid payment? Would Greece no longer receive any money at all?

Weidmann: Part of the regulatory framework of the monetary union is to uphold agreements. This means that Greece must live up to its commitments, and that there will be no aid payments if these promises aren’t kept. Otherwise we would be setting false incentives.

SPIEGEL: The consequence of such behavior, a Greek bankruptcy, doesn’t scare you?

Weidmann: The goal should be to prevent this from happening, in that Greece implements the agreed reform program. It isn’t helpful to speculate openly about what scenarios would ensue if the Greek government decides differently. But how credible can stricter rules be for the future, and that’s the whole point of strengthening the Stability and Growth Pact, if a repeated violation of the rules results in aid coming from the community — and under conditions that are relatively attractive? This sort of a system destroys the incentives for sound fiscal policy in the long term.

SPIEGEL: In the short term, however, there is the risk that a Greek bankruptcy will trigger another banking crisis.

Weidmann: All conceivable scenarios will have serious effects on the affected country itself, and on all countries. However, one has to consider which overall costs are higher in the long run. And in that sense, I believe that it’s very important which incentives are set to promote sound government finances, and how one secures the acceptance of the monetary union in the countries providing the aid.

Related articles from today’s Spiegel Online:

• Merkel’s Euro Strategy at Risk from Partner in Freefall

• Merkel’s Authority Is on the Wane