AMERICAN FUTURE

. . . a default by a major government, a break-up of the eurozone or both are now conceivable. The consequent flight to safety, which must include attempts to hedge cross-border exposures in a supposedly integrated currency area, threatens a meltdown. We are witnessing a lethal interplay between fears of sovereign insolvency, emerging sovereign illiquidity and financial stress.

These are the words of Martin Wolf in his weekly column in the Financial Times.

Mr. Wolf doesn’t spare words in his criticism of Germany:

German policymakers persist in viewing the world through the lens of a relatively small, open and highly competitive economy. But the eurozone is not a small open economy; it is a large and relatively closed one. The core country of such a union must either provide a buoyant market for less creditworthy countries when the latter can no longer finance their deficits, or it has to finance them. If the private sector will not provide the needed finance, the public sector must do so. If the latter fails to act, a wave of private and public sector defaults will occur. These are sure to damage the financial sector and exports of the core country itself, as well.

The failure of Germany’s leaders to explain these facts at home makes it impossible to solve the current crisis. Instead, they indulge in the fantasy that everybody can be a lender, simultaneously. For small open economies such as Latvia and Ireland, regaining competitiveness and growth through deflation might work. For a big country such as Italy, it is too painful to be credible. Wolfgang Schäuble, Germany’s finance minister, may call for such austerity. It will not happen.

Today, raging fire must be put out. Only then can attempts at building a more fireproof eurozone begin. The least bad option would be for the ECB to ensure liquidity for solvent governments and financial institutions, without limit. It should not, in fact, be intellectually difficult to argue that buying bonds is compatible with continued monetary stability, since broad money has been growing at a mere 2 per cent a year. It is sure to be politically hard, however, particularly for Mario Draghi, the incoming Italian ECB president. Yet it is what has to be done given the inadequate size of the European financial stability facility if called on to help larger beleaguered euro-member countries. Politicians must then dare to support such action.

What should happen if the German government decided that it could not support such a bold step? The ECB should go ahead anyway rather than let a cascading collapse unfold. It would then be up to Germany to decide whether to leave, perhaps with Austria, the Netherlands and Finland. The German people should be made aware that the results would include a soaring exchange rate, a massive decline in the profitability of Germany’s exports, a huge financial shock and a sharp fall in gross domestic product. All this would be apart from the failure of two generations of efforts to build a strong European framework around Germany itself.

Germany possesses a binding veto over efforts to expand official fiscal support. But it is losing control over its central bank. In a crisis so menacing to Europe and the world, the one European institution with the capacity to act on the requisite scale should dare to do so, since the costs of not doing so are bound to prove devastating. That will surely create a political crisis, but this would be better than the financial crisis unleashed by a failure to try.

In the end Germany must choose between a eurozone disturbingly different from the larger Germany it expected or no eurozone at all. I recognise how much its leaders and people must hate having been forced into a position in which they have to make this choice. But it is the one they confront. Chancellor Angela Merkel must now dare to make that choice, clearly and openly.

The highlighting is mine.

“No matter how you organise a future fiscal space in the eurozone, it will either be meaningless, or infringe the German constitution.”

It’s a big help to have some one on your staff who understands economics and finance and the German language. The Financial Times — and, apparently, only the FT — has such a person in Wolfgang Munchau. He’s read the 29-page ruling by the German Constitutional Court (has anyone run across an English translation of this very significant document?). Munchau doesn’t like what’s in it. He doubts that the eurozone will survive.

This is an important article, worthy of being posted in its entirety. All highlighting is mine.

The two real options for a resolution of the eurozone crisis came into full conflict last week. The first is a common eurozone bond. The second is a monetisation of national debt through the European Central Bank. Angela Merkel rejects the former. Europe’s central bankers reject the latter. Jürgen Stark, a member of the European Central Bank’s executive board, rejects both, and last week resigned in protest. Along with other conservative economists, he is advocating a third way, adjustment through depression – the simultaneous deleveraging of the private and public sector debt.

As an advocate of eurozone bonds, I have to admit their prospect looks grim after last week’s ruling of the German constitutional court. The court upheld the European financial adjustment facility, the crisis mechanism. This was, undoutedly, good news. But after I read the whole ruling, which ran to 29 tightly written pages, I realised that this judgement was not a victory for the eurozone at all. On the contrary, it categorically rules out any policy option beyond what has been agreed so far. I cannot see how it can be consistent with the survival of the eurozone, given the policies of member states and the ECB.

Much of the language in this document is opaque constitutional jargon. But on the issues that matter, the ruling is surprisingly, and depressingly, clear. It says the German government must not accept permanent mechanisms – as opposed to the EFSF, which is temporary – with the following criteria: if they involve a permanent liability to other countries; if these liabilities are very large or incalculable; and if foreign governments, through their actions, can trigger the payment of the guarantees. If I were a plaintiff in this case, I would regard that statement as an open invitation by the court to bring a new case against the European stability mechanism.

The ESM will be the permanent successor to the EFSF from 2013. It fulfils a good subset of those conditions. The justices ruled with a seven to one majority in this case, but later said it was a close decision. If the plaintiffs were to bring a much more focused case against a more ambitious mechanism, they might stand a better chance.

If the ESM is a borderline case under German constitutional law, there can be no such doubt about a eurobond. The court’s verdict leaves me no alternative but to conclude they are indeed unconstitutional.

Moreover, you cannot get around this unfortunate fact with an ingenious combination of eurocratic trickery and financial engineering. The court, quite cleverly, did not mention eurobonds. It talked about liabilities. The Bundestag is not precluded from giving money to Greece, but it cannot empower a third party, such as the EFSF or ESM, let alone a hypothetical European Debt Agency, from usurping sovereign power. Sovereignty can be delegated in small slices, but not permanently.

A eurobond is, of course, a permanent mechanism. It also involves a permanent loss of control. Its size is very likely to be substantial. There would not be any point in issuing a small eurobond – it would not resolve the crisis. And unless member states were to transfer some of their sovereignty to Brussels, all the inherent risks in the structure would come from non-compliance by national governments or parliaments. In other words, a eurobond perfectly matches the conditions set by the constitutional court for an arrangement that violates the German constitution.

What if the EU decided to create a fiscal union after all? The constitutional court already decided in its ruling on the Lisbon Treaty that this is not possible either. A fiscal union would require a referendum, in which the German electorate would decide to abolish the sovereign German state, and transfer sovereignty from Berlin to Brussels. Suffice to say, that this is not very likely to happen. So we have an impasse. No matter how you organise a future fiscal space in the eurozone, it will either be meaningless, or infringe the German constitution.

Moreover, the political hurdles have also gone up recently. Angela Merkel has ruled it out so forcefully that she cannot turn her back on this promise. Even the leaders of the opposition, who are more sympathetic to the idea, would find themselves constrained by the ruling.

What does this mean? First, the ruling significantly increases the probability of default by one or several member states. This is a simple consequence of the Law of Large Numbers. There are now so many hurdles in place that a systemic accident is very likely to happen at some point. Do we really think the Bundestag, after having reluctantly accepted the need for a second Greek loan programme, will vote for a third? Or a second Portuguese or second Irish programme? Will they vote Yes once the EFSF starts buying bonds, or recapitalising banks? It takes a single No vote to trigger a default. When that happens, there will be no time left for diplomacy.

The ruling leaves a post-Stark ECB as the sole backstop that could prevent a break-up of the eurozone. Next week I will explain why this option is not going to work either.

For lack of better words, I’m looking forward to Munchau’s next column.

As we await with less than baited breath President Obama’s jobs speech, we’ve been on the receiving end of downbeat, downward-revised economic forecasts from the ECB and the OECD.

ECB

Following the ECB’s announcement that, as expected, it had decided against a further increase in eurozone interest rates, bank President Jean-Claude Trichet held a press conference. Among his words were the following:

Looking ahead, a number of developments seem to be dampening the underlying momentum in the euro area, including a moderation in the pace of global growth, related declines in equity prices and in business confidence, and unfavourable effects resulting from ongoing tensions in a number of euro area sovereign debt markets. As a consequence, real GDP growth is expected to increase very moderately in the second half of this year.This assessment is also reflected in the September 2011 ECB staff macroeconomic projections for the euro area, which foresee annual real GDP growth in a range between 1.4% and 1.8% in 2011 and between 0.4% and 2.2% in 2012. Compared with the June 2011 Eurosystem staff macroeconomic projections, the ranges for real GDP growth in 2011 and 2012 have been revised downwards.

In the Governing Council’s assessment, the risks to the economic outlook for the euro area are on the downside, in an environment of particularly high uncertainty. Downside risks mainly relate to the ongoing tensions in some segments of the financial markets in the euro area and at the global level, as well as to the potential for these pressures to spill over into the euro area real economy. They also relate to further increases in energy prices, protectionist pressures and the possibility of a disorderly correction of global imbalances.

Notwithstanding these numerous downside risks, Trichet continues to favor front-loaded fiscal retrenchment, especially if these risks materialize:

Turning to fiscal policies, a number of governments have announced additional measures to ensure the achievement of their consolidation targets and to strengthen the legal basis for national fiscal rules. To ensure credibility, it is now crucial that the announced measures be frontloaded and implemented in full. Governments need to stand ready to implement further consolidation measures, notably on the expenditure side, if risks regarding the attainment of the current fiscal targets materialise. Countries that enjoy better than expected economic and fiscal developments should make full use of this room for manoeuvre for faster deficit and debt reduction. All euro area governments need to demonstrate their inflexible determination to fully honour their own individual sovereign signature, which is a decisive element in ensuring financial stability in the euro area as a whole.

In my humble opinion, Trichet’s prescription is a recipe for a downward spiral.

OECD

During a presentation of its latest Interim Economic Assessment, the OECD’s Chief Economist, Pier Carlo Padoan, said that “Growth is turning out to be much slower than we thought three months ago, and the risk of hitting patches of negative growth going forward has gone up.” In its press release, the OECD offered these thoughts:

The debate over fiscal policy in the United States, the sovereign debt crisis in some countries  of the euro area and the fact that governments have fewer options to boost growth are driving both business and consumer confidence downward. The extent of bank deleveraging, due to the impact of regulatory changes, may also have been underestimated.

Earlier improvements in the labour market are now fading, hiring intentions are softening and there are greater risks that high unemployment could become entrenched.

In a reversal of its previous stance, the OECD has adopted a dovish view on interest rates:

The OECD recommends that central banks keep policy rates at present levels, and barring signs of recovery, consider lowering rates when there is scope.

Other monetary policy responses to the crisis could include further central bank interventions in securities markets, strong commitments to keeping interest rates low over an extended period and the withdrawal of monetary tightening in emerging economies.

Clearly, the OECD and the ECB aren’t on the same page.

Click below for the OECD’s Interim Economic Assessment.

POWERPOINT PRESENTATION

You — and, much more importantly, governments and monetary authorities — think you have it all figured out. The measure of your country’s fiscal health is its debt-to-GDP ratio. Reducing that ratio is the holy grail. The reward for achieving this is a lower interest rate on your sovereign debt. If your country is part of the eurozone and has a poor debt-to-GDP ratio, you’ll be a recipient of European Central Bank and International Monetary Fund rescue packages, but only if you implement fiscal austerity programs. Acting together, the rescue packages and austerity programs will result in a sustained decline in your country’s debt-to-capital ratio which, in turn, will lead to a downward trend in the interest rate on your sovereign debt. All’s well that ends well.

Alas, there’s a serious gap between theory and practice. Theory says that there should be a high degree of correlation between the yields on a country’s bonds and one or more measures of a country’s fiscal health. The following table is a compilation of three different bond yields (at the market close on September 7, from the Wall Street Journal) and five different fiscal health metrics (taken from the IMF’s April 2011 Fiscal Monitor). It shows, for instance, that while Spain’s gross debt and net debt to GDP ratios are better than Germany’s, its interest costs are hugely higher than Germany’s. There are numerous other inconsistencies with theory that can be gleaned from a close study of this table.

Are markets rational? Pardon me for not inserting myself into that debate. I will say this, though: if the market is rational, it’s taking into account considerations other than what is supposed to be the most important one. And, if that’s true, the validity of the austerity-will-make-you-healthy policy prescription is open to serious question.

(1) The general government sector consists of all government units and all nonmarket, nonprofit institutions that are controlled and mainly financed by government units comprising the central, state, and local governments. The overall balance is net lending/borrowing, defined as the difference between revenue and total expenditure.

(2) The primary balance is the overall balance excluding net interest payments.

(3) Gross debt is all liabilities that require future payment of interest and/or principal by the debtor to the creditor.

(4) Net debt is gross debt minus financial assets, including those held by the broader public sector.

(5) Gross funding need is overall new borrowing requirement plus debt maturing during the year.

Unfortunately, the world is moving in the general direction I’ve discussed in previous posts. In a nutshell, markets are crashing because fiscal austerity programs are being implemented at the very moment that economic growth has disappeared, and the effect of fiscal rectitude will be to worsen both budget deficits and debt-to-GDP ratios. My view continues to be that this disastrous sequence of events will eventually terminate with a bang: the breakup of the eurozone.

Morgan Stanley has taken another baby-step in the direction of reality recognition. Here’s the full text of its revised but still overly optimistic economic forecast:

Ever more BBB: We are cutting our global GDP growth forecasts by a combined full percentage point in 2011-12, to 3.9% from 4.2% in 2011, and to 3.8% from 4.5% in 2012. We now see growth in the developed market economies averaging only 1.5% this year and next (down from 1.9% and 2.4% previously) – markedly more sluggish than the 20-year trend growth rate in DM of 2.3%, and more than a full percentage point below the 2.6% rate in 2010 as the world rebounded from the Great Recession. While we had been calling for a BBB recovery in DM all along, the path now looks even more bumpy, below-par and brittle.

EM isn’t immune, but generating 80% of global growth: The great EM-DM growth divide continues, but EM economies won’t be immune to the DM slowdown, in our view. We now see EM growth decelerating from 7.8% in 2010 to 6.4% this year (6.6% previously), and further to 6.1% (6.7%) in 2012. While this keeps EM GDP cruising above its 20-year trend rate of 5%, it implies significant further cooling of growth compared to last year’s bonanza. Remarkably, despite slowing growth, EM economies – which now account for half of global GDP (using PPP weights) – will generate fully 80% of global GDP growth we are forecasting for 2011-12.

A policy-induced slowdown: There are three main reasons for our downgrade. First, the recent incoming data, especially in the US and the euro area, have been disappointing, suggesting less momentum into 2H11 and pushing down full-year 2011 estimates. Second, recent policy errors – especially Europe’s slow and insufficient response to the sovereign crisis and the drama around lifting the US debt ceiling – have weighed down on financial markets and eroded business and consumer confidence. A negative feedback loop between weak growth and soggy asset markets now appears to be in the making in Europe and the US. This should be aggravated by the prospect of fiscal tightening in the US and Europe.

US and Europe dangerously close to recession: Our revised forecasts show the US and the euro area hovering dangerously close to a recession – defined as two consecutive quarters of contraction – over the next 6-12 months. The US growth disappointment in 1H11, when GDP advanced by an annual average rate of less than 1%, illustrates the brittleness of the US recovery in the face of external shocks (oil, Japan earthquake), despite ongoing QE2 and fiscal stimulus at the time. While the current quarter should still show some rebound in growth to around 3% from the very low bar in 1H, much of this rebound is likely due to temporary factors such as the ramping up of auto production as supply disruptions ease. The most critical period for the US economy will likely be 4Q11, when we may see some fallout from the heightened volatility of risk markets, and 1Q12, when we get an automatic tightening of fiscal policy if, as our US team currently assumes, this year’s fiscal stimulus measures expire.

Europe’s woes to continue: The ECB’s past rate hikes and, more so, the sovereign crisis and the additional fiscal policy tightening as well as the banking sector funding stress it produces, will take an additional toll on growth, in our view. Our European team now sees euro area GDP broadly stagnating later this year and in early 2012. Thus, it won’t take much to tip the balance towards recession, especially as a final resolution of the debt crisis (in the form of fiscal transfers or common bond issuance) is likely to be very slow in coming. Our European team has slashed its already below-consensus 2012 euro area GDP forecast from 1.2% to a mere 0.5%. In our view, despite the problems in the US, the euro area is clearly the weakest link in the global chain.

Dangerously close to recession, but not our base case: While we think that the US and the euro area will be dangerously close to recession over the next several quarters, we are not making recession our base case, for three reasons. First, companies are sitting on a pile of cash and display healthy profit margins. Second, the decline in oil prices from the peaks earlier this year should act as a partial stabiliser, lowering headline inflation over the next 6-12 months and supporting household real disposable incomes. Third, we expect the major central banks to lend additional support, with both the ECB and the Fed cutting interest rates and possibly implementing additional non-standard easing measures.

Why this is not 2008: Initial conditions are better now. Back then, household, corporate and bank balance sheets were much weaker, employment in the US was already falling and unemployment rising, monetary policy was tight, and the Lehman collapse meant that the financial system, including trade finance, totally seized up. Against this, fiscal and monetary policy have less (though not zero) room for manoeuvre now. So, while a freefall of the economy similar to 2008 looks very unlikely, policy also has less potential for a shock-and-awe response, if needed. Surely, we should not take too much comfort from saying that this is not 2008 – after all, the recession that followed was the deepest since the Great Depression. However, a plausible recession scenario in 2011-12 would be much shallower than the 2008-09 experience. To get a 2008-type recession, one would have to assume a major Lehman-type policy error, such as the default of a European sovereign, which could bring the whole financial system down. While not impossible, we currently attach a very low probability to such an outcome. We will elaborate more on bear and bull scenarios in the coming weeks.

EM policy-makers to cushion the blow: The current slowdown in EM growth now looks set to be prolonged into 2012 by the weaker DM outlook. But with inflation at or close to a temporary peak, some policy easing in EM looks likely to provide a cushion for growth. EM policy-makers should be able and willing to help their own economies avoid a hard landing, but they won’t be able to bail out the world, in our view. Absent the kind of tail risks that were present in the world in 2008, and having barely emerged from a battle with inflation and overheating, EM policy-makers at this point will likely signal that they want to use just enough policy stimulus to help their own economies. In fact, given the constraints on DM policy-makers, EM policy-makers should really be ready to act relatively more aggressively, but this is unlikely given lingering inflation risks. If neither aggressive nor pre-emptive action is forthcoming, then a DM shock to growth could slow down EM economies significantly. Any policy action would then have to be aggressive. The good news? We believe weaker DM growth will reinforce many EM policy-makers’ resolve to support the rebalancing towards domestically led EM growth and allow more rapid exchange rate appreciation.

The early signs are encouraging if the recent moves in the renminbi are anything to go by, and they will be welcome relief for a slowing EM economy. Our AXJ team now expects further downside, particularly in 2012, to its below-consensus growth forecast. Latin America and CEEMEA growth is now forecast to be 1% and 0.6% lower than previously expected. Regional giants China, India and Russia all show better resilience than their respective regions, with growth now lower by 0.3%, 0.4% and 0.3%, respectively, than previously expected. Growth in Brazil, however, has been marked down from 4.6% to 3.5% in 2012, a little lower than the downgrade for the region as a whole.

Inflation, not deflation: While near-term inflation expectationshave eased, reflecting weaker growth and lower commodity prices, longer-dated forward measures of inflation expectations (such as five-year five-year-forward breakevens) have remained elevated during the recent turmoil. This suggests that a Japan-type negative feedback loop between weaker growth and deflation expectations can most likely be avoided. The difference to Japan, despite other similarities, is that monetary policy has acted much more aggressively much earlier in this crisis, thus nurturing expectations of positive inflation and pushing real interest rates into negative territory.

After increasing steadily for several years, the price of gold has risen at a much faster rate in recent days. Not coincidentally, the transition from slow and steady to rapid and volatile has taken place as it has become glaringly apparent that, in the U.S. and in Europe, governments lack the will and monetary authorities the ability to deal effectively with the sovereign debt crisis.

Everybody agrees that confidence is eroding rapidly and that the surge in gold’s price reflects that erosion. Gold is a hedge against an increasingly obscure future. It is a beneficiary of a flight to safety.

Safety from what?

There are two diametrically opposed answers to this most fundamental of all questions: inflation and deflation.

Inflation

Those for whom inflation is the risk point to the exceedingly accommodative monetary policies of central banks in the mature industrialized world and, especially, in the United States. A case in point is the Fed’s recent decision, based on its current economic forecast, to keep short-term rates near zero percent for at least the next two years. While inflation is not now a serious problem, there is a body of opinion that  holds that excessive liquidity resulting from central bank actions such as the one just taken by the Fed must inevitably lead to high and accelerating inflation. The adherents to this view accept the monetarist view, as set forth by Murray Rothbard and Milton Friedman, that the rate of inflation, with a lag, is determined by the rate of growth of the monetary base. Their concern is the “debasement” of currencies.

The way to end debasement, some of them argue, is to return to the gold standard; in particular, the “classical” gold standard, which was the international monetary arrangement that existed for many decades prior to the outbreak of World War I.

That standard was conceptually beautiful in its simplicity and automaticity. In each country that adhered to it, the amount of paper currency in circulation was limited by the amount of gold held in reserve by its central bank. “Gold cover” was the phrase used to describe this relationship. If the value of a country’s imported products was greater than the value of its exported products, it would make up the difference by reducing its savings; that is, its central bank would balance the books by shipping some of its gold reserves to other countries.

A reduction in the country’s gold reserves necessitated a reduction in the amount of circulating paper currency; otherwise, the gold cover would be violated. With less currency in circulation, prices and wages would decline. The decline in prices would make the country’s exported products more competitive. The prices of imported products would climb. Exports would increase, imports would decrease, gold would flow back to its central  bank, and a new equilibrium would be established. All of this happened without direct human intervention.

The gold standard operated in a world radically different from ours. As already noted, its world was one in which wages were flexible in both directions. More important, it existed at a time when governments did not take any responsibility for the economic well-being of their citizens and citizens did not believe that such a responsibility existed. The mandate of central banks was to keep their currencies stable, no matter the domestic consequences of doing so.

The downside of the gold standard became apparent during the Great Depression. As production and employment plummeted across the world, governments faced a choice. They could persist in adhering to the gold standard. If they did, they could not devalue their currencies in order to increase their exports. Or they could attempt to boost their exports by abandoning the gold standard and devaluing their currencies. By the mid-1930s, all major industrialized countries had left the gold standard and moved to “fiat” currencies — currencies whose values could be manipulated by monetary authorities. Academic studies have shown that those countries that were early departures from the gold standard suffered less from the Depression than those that departed later.

Deflation

As country after country turns to fiscal austerity in their efforts to reduce their budget deficits and debt-to-GDP ratios, the specter of deflation is raising its ugly head. There is no guarantee that reducing government spending and increasing taxes — whatever their mix — will solve the problems addressed by these actions. Less spending and more taxes will drain purchasing power from the economy. Tax collections and GDP growth will both be negatively impacted. The resulting debt-to-GDP ratios may worsen, not improve.

This has already happened in Greece, whose debt-to-GDP ratio has worsened since the implementation of its austerity measures. That country’s fundamental problem is its lack of international competitiveness. If it were able to devalue its currency, its competitiveness would improve. Because of its membership in the eurozone, it cannot devalue. Thus, it faces exactly the same choice as did the gold standard adherents during the Great Depression. It can remain on the eurozone standard and suffer years of economic privation, or it can leave the eurozone and enter an uncharted but possibly more hopeful future.

Greece’s problem is that the agreements that established the eurozone do not allow countries to leave it: once in, always in. It is for this reason that European governments and the European Central Bank are trying — and, thus far, failing — to find a solution to the Greek problem. These unsuccessful efforts are responsible for the continuously expanding European financial contagion. As we learned during the contagion of 2008-2009, dysfunction in the financial markets can spillover into the real economy with astounding speed and severity. It could easily happen again.

The eurozone standard is the modern day equivalent of the gold standard. Countries that are in economic trouble are forced to implement austerity measures that have ramifications outside their borders. In the 1930s, a crisis in little Austria spread like wildfire to Germany, Great Britain and, finally, to the United States. In our time, a crisis that began in little Greece has spread like wildfire to Portugal, Spain, Italy, and, perhaps France.

Returning to the gold standard would amount to an enlargement of the eurozone. All available evidence indicates this would be an unmitigated disaster.

“If the euro zone does fall apart, a fitting epitaph [Grabinschrift] might read, „The ECB feared 3% inflation“.”

The above is a quote from the latest post in the German blog Kantoos Economics, which I have just discovered and will now visit regularly.

The European Central Bank (ECB) is the reincarnation of the German central bank, notwithstanding the fact that it’s currently led by Jean Claude Trichet, a Frenchman. Memories of the Weimar hyperinflation and its aftermath are embedded in the German DNA. This explains why the ECB has price stability as its only mandate. Our central bank, the Fed, has a dual mandate — controlling both inflation and unemployment.

It’s highly revealing that it is now considered to be within the realm of possibility that the eurozone will fall apart. I’ll go a step further by predicting that it will fall apart and that its dissolution will represent the climax of the financial panic that is now enveloping the world.

What a time to be on vacation! In a future post, I’ll set forth the reasoning behind my gloomy forecast.

Otmar Issing, the author of this column, is president of the Centre for Financial Studies and a former member of the European Central Bank’s executive board.

The crisis of European economic and monetary union seems to confirm a long-standing belief that monetary union cannot survive without political union. I belonged to a group that argued that the euro should have been preceded – or at least accompanied – by political union. Many observers are now interpreting the European Union’s manifold financial rescue measures to support Greece as a step in the direction of political union. Therefore, should people like me not be happy with this development?

In fact, the opposite is true. Connecting the initial idea of a political union with developments currently under way is both logically flawed and politically dangerous. In short: a consistent concept of a political union should be based on a constitution, and imply a European government controlled by a European Parliament, elected according to democratic principles.

What we see happening now is something quite different. More and more national taxpayers’ money is now at risk to “save” the euro. Yet the conclusion that this process is leading in the direction of political union is derived from the strict conditions imposed upon member states that broke the rules, in exchange for help – conditions which imply a kind of European control over elements of member state governments.

If these conditions do trigger reforms – which in many countries is long overdue – that would be welcome. However, the fact that a member country can be assured that its membership of the euro – even in the case of permanent violations of the rules – will be saved at any price causes moral hazard and creates an obvious potential for blackmail.

The decisions taken at the last European crisis summit on July 21 greatly extended the powers of the European Financial Stability Facility and brought new help for Greece. This increase European involvement in domestic policymaking. But this is not a move in the direction of a true political union. It is a dangerous step, and one which will end up dividing Europe.

Most observers rightly interpret this increasing shared fiscal liability as a step in the direction of a European common bond. The idea of issuing bonds which all member states of the eurozone guarantee insofar seems sensible, as it would immediately lower interest rates for the highly indebted countries. However, there is a problem too, given it would also lead to higher interest rates for those countries that enjoyed credibility with financial markets in the past. Those who claim that this effect would be small succumb either to an illusion or deliberately underestimate this risk. Considering the amount of debt which over time would become “common” for each country, it is hard to overestimate the interest risk for the hitherto responsible debtors.

A common bond would also immediately relieve some countries of their burden of a record of fiscal irresponsibility. A stronger case of free riding can hardly be imagined. Lack of fiscal discipline is rewarded, while fiscal solidity is punished. The implied transfer of taxpayers’ money would also take place without the involvement of national parliaments – a clear violation of the fundamental democratic principle of “no taxation without representation”.

Suggestions as to how one might control and limit the issuance of such bonds are unconvincing. Almost all treaties promising European fiscal discipline have been broken time and again. The worst example was delivered by France and Germany in 2002-03, when they violated the Stability and Growth Pact, and even organised a political majority against the application of its rules.

All efforts to strengthen the pact are of course highly welcome. However, the bad experience since the start of Emu, but also any analysis of the implied incentives in the political process, deliver a clear message: political control of national fiscal policies from the European level will always be compromised by different interests. The idea that a new European process to transfer taxpayers’ money that is neither democratic nor governed by principles that support fiscal solidity would move in the direction of political union is totally misleading.

Emu is based on rules enshrined in international treaties. The euro was created as a “depoliticised currency” – its stability entrusted to an independent central bank with a clear mandate to maintain price stability. Any attempt to “save” monetary union via agreements which transfer sovereignty to a European level, where violations of fundamental treaties have become a regular event, lacks any logic. In the end it will only further alienate the people from Europe itself.

A monetary union with a stable euro can only survive if central bank independence is fully respected. This implies that the European Central Bank abstains from fiscal policy actions. Yet to change the “no bail-out” clause ever more in the direction of a bail-out regime is not a step towards a democratically-legitimised political union. It is a move on a slippery road to a regime of fiscal indiscipline drowning hitherto solid countries in the morass of over-indebtedness.

This type of political union would not survive. Its collapse would be brought by resistance from the people. In the past cries of “no taxation without representation” have brought war. This time the consequence would be to threaten the collapse of the most successful project of economic integration in the history of mankind.

Good luck to Europe. Economic nationalism in the most powerful economy in Europe, as understandable as it may be, is an ill omen.

Nouriel Roubini was right. Nouriel Roubini was wrong. You read that correctly. In the business of market forecasting, being right but being early is to be wrong. Years in advance, Roubini argued that the housing boom was a house of cards and that when the inevitable bust came all the cards would be flat on their backs. But if you exited the stock market when he started to broadcast his views, you left a lot of money on the table. Such is life in financial circles.

Now, Roubini is hardly alone is predicting hard times. He goes somewhat further than most, however. In his Financial Times column, he says that avoiding another severe recession may be mission impossible:

All advanced nations need a weaker currency, but they cannot all have it together – if one is weaker another has to be stronger. This is a zero sum game which risks only the resumption of currency wars. Early skirmishes are beginning as Japan and Switzerland try to weaken their exchange rates. Others will soon follow.So can we avoid another severe recession? It might simply be mission impossible. The best bet is for those countries that have not lost market access – the US, UK, Japan, and Germany – to introduce new short-term fiscal stimulus while committing to medium-term fiscal austerity. The US downgrade will hasten demands for fiscal reduction, but America in particular should commit to look for significant cuts in the medium term, not an immediate fiscal drag that will worsen growth and deficits.

Most western central banks should also introduce further QE, even though its effect will be limited. The European Central Bank should not just stop rate hiking: it should cut rates to zero and make big purchases of government bonds to prevent Italy or Spain losing market access – the outcome of which would be a truly major crisis, requiring doubling (or tripling) of bail-out resources, or debt workouts and a eurozone break-up.

Finally, since this is a crisis of solvency as well as liquidity, orderly debt restructuring must begin. This means across the board reduction on the mortgage debt for the roughly half of America’s households that are underwater, and bail-ins for creditors of banks in distress. Greek-style coercive maturity extensions, at risk free rates, must also come for Portugal and Ireland, with Italy and Spain to follow if they lose market access. Another recession may not be preventable. But policy can stop a second depression. That is reason enough for swift and targeted action.

Tomorrow looks to be the day that the credit rating downgrade inspired intensification of the U.S. credit crisis and the Italy inspired intensification of the eurozone credit crisis meet head-on. I have nothing further to add on our crisis, but, thanks to Zero Hedge (ZH), there is more to be said about the eurozone crisis.

Goldman Sachs is an adviser to the Italian government, among many others. Zero Hedge (ZH) has obtained the full text of a Goldman client note that, says ZH, is “a prompt” to European Central Bank President Jean Claude Trichet.

Here’s the client note, with my highlighting and my interspersed explanations and comments:

“Europe Should Say That BTPs Are ‘Cheap’”

1. Overview

Italy is now squarely at the centre of Euro-zone sovereign market pressures. The yield on two-year Italian government bonds (BTPs), which ended last week at around 4.4%, is trading at its highest relative to corresponding maturity LIBOR [The London Inter-Bank Overnight Rate, which can be thought of as the international equivalent of the Fed Funds Rate] in a number of decades. Similarly, the yield spread to German bonds across the yield curve has reached higher levels than in the early 1990s, when controlling for the FX regime. In some maturities, Italian government bonds now yield more than Spain’s.

Italy represents the second-largest EMU government bond market after Germany, and accounts for around a quarter of the Euro area’s sovereign debt stock, held mostly by resident financial institutions. A further escalation of the crisis would result in considerable capital shifts and welfare losses across the entire single currency area, and beyond. ["Beyond" must mean the U.S.]

In this note, we look at what could have triggered such acute tensions, and comment on their possible resolution. In our view, Italian government bonds are fundamentally attractive, but we have reached a point where only the European authorities can credibly signal this is the case. In the near term, secondary bond market purchases by the ECB would represent a much needed ‘circuit-breaker’.

2. In the Area of Self-Fulfilling Prophecies

Italy’s woes are partly the result of shifts in the outlook for the sovereign’s credit fundamentals. Darker clouds have gathered over the trajectory for global growth, as reflected in our downwardly revised forecasts on Friday August 5. This comes at a time when investors’ focus is shifting from the increase in public-sector liabilities—and the cost of bailing out the private sector—to how sovereigns will be able to grow out of indebtedness. [Austerity doesn't breed growth; it dampens it]

In this respect, Italy does not have a strong track-record (real GDP growth averaged around 1.5% in the period 1999-2007). And after a sizeable contraction during the crisis, real GDP growth has lagged that in the other large Euro-zone economies. Moreover, political risks and uncertainty have increased, and several observers have questioned the government’s resolve to push through structural reforms in key areas such as labour markets and the welfare state.[Sounds like S&P's rationale for downgrading our debt, doesn't it?]

But there are positive aspects too, which should not be forgotten. Italy already runs a non-interest budgetary surplus of close to 1% of GDP—the only country in the G-7 group to do so—and has maintained a prudent fiscal stance for years. And its debt stock, while high, is at the lowest level relative to Germany’s and France’s in several decades. In the period 1999-2007, its debt-to-GDP ratio fell by around ten percentage points to 103.6%, as even the modest growth it achieved outpaced the increase in liabilities.

As described in the Box on page 4, we look at Italian bond spreads over the past 20 years, comparing Italy’s fundamental performance with Germany’s both in isolation, and controlling for what has happened in other EMU countries. Our findings suggest that the yield spread between 10-yr Italian BTPs and German Bunds should be around 170-210bp based on current and prospective relative fundamentals. The current level of close to 400bp represents a multiple standard deviation event. [Or a "tail" event, to use the current financial parlance]

This can mean one of two things. Either we are experiencing an extreme situation, which enables investors to buy BTPs at severely distressed prices. Or the distribution of possible outcomes has changed substantially, as higher yield spreads negatively interact with fundamentals (think of the impact on commercial banks, for example), limiting the supply of credit and affecting spreads in a circular reference. There is an element of truth in both interpretations.

Upon joining the single currency, Italy lost control over monetary policy and with it the option to devalue. [As did every other member of the eurozone] As a ‘price taker’, it can pay its debt down by taxing wealth and income, grow out of it, or reduce the face value of its liabilities. To be sure, this has been true since EMU [European Monetary Union] inception and the logic could be extended to other sovereigns of the single currency area.

But Italy’s policy constraints have been brought to prominence lately by references to continued ‘market access’, cited by Moody’s as a justification for downgrading Italy’s rating outlook in the aftermath of Private Sector Involvement (PSI) for Greece. Investors have ‘discovered’ that debt restructurings [Reductions in principal values; in the vernacular, "haircuts"] are an option even in a highly advanced and financially integrated area such as the Euro-zone. And in a world of imperfect information, dominated by a great focus on capital preservation, they have started rationing credit to sovereign borrowers based on their cost of funds.

3. Maintaining Market Access

A forward-looking analysis would indicate that Italy’s funding terms are still within the limits of affordability.

We projected Italy’s gross government debt-to-GDP-ratio from 2011 to 2030, under a set of different working assumptions. The primary surplus increases from around 0.1% of GDP in 2010 to 2.9% in 2013, as targeted in the old Italian Stability Program (this is roughly 1ppt below what was announced by the Italian government this past Friday). We also use the Stability Program’s assumption for nominal GDP growth over 2011-2014 (around 3.0%-3.5%). As the interest rate on the public debt, we use the current effective servicing costs and simulate the implied increase from any given market rate using the current debt maturity profile.

The two tables to the right [not shown here] show the level of Italian debt in 2030, assuming various combinations of nominal growth and roll-over cost from 2015 onwards, as well as a fixed primary balance of 3.5% or 1.5ppt below the current projections in the Stability Program. As can be seen, Italy’s debt-to-GDP-ratio decreases for a wide combination of nominal growth and interest rate assumptions.

All else equal, this indicates that Italy’s debt dynamics are fairly sustainable—even when subjecting them to relatively large increases in debt servicing costs, as well as decreases in trend nominal growth. Increasing the primary balance [by excluding interest payments] to 5%, as currently projected by the government, would lead to decreases in Italy’s debt-to-GDP-ratio even with permanent debt servicing costs as high as 7%-8% and trend nominal growth at 3.5%.

The limitations of this analysis are twofold. Firstly, the interplay between the three control variables—nominal growth, the primary balance and funding costs—is much more complex than illustrated here, and expectations play a large role. Secondly, it assumes investors will be willing to extend credit to the sovereign smoothly and continuously as yields increase. The risk is that, if tensions escalate, Italy could instead find itself credit constrained.

4. Greater Risk-Sharing Needed

There is growing evidence to suggest that the price action is becoming self-reinforcing, and is disregarding economic fundamentals. [This is the feedback loop to doomsday] Italy has tried to signal that the current borrowing prices are unattractive by cancelling scheduled issuance. But debt amortization requirements are large, and this cannot last for long: the Italian Treasury needs to roll over around EUR400bn of maturing debt over the coming 16 months.

As we noted in European Weekly Analyst 11/25, in a situation where a ‘good’ and a ‘bad’ equilibrium (high yields become self-fulfilling) co-exist, the official sector can play a role. We see three interconnected stages of policy:

In the short term: As Dirk Schumacher and others have commented this past week, the ECB should act as a circuit-breaker at this juncture, interrupting the unfolding speculative dynamic in order to safeguard the transmission of monetary policy. [Short-circuit the feedback loop] The central bank is the only institution that can act quickly, and without a budget constraint. As in the case of FX [foreign exchange] interventions, in order to be fully effective, ECB purchases in the secondary bond market should be coordinated, i.e., involve all Euro-zone central banks, or at a minimum receive the endorsement (even tacit) of all countries. Ideally, greater coordination with the fiscal authorities could be sought, whereby the EFSF [European Financial Stability Fund] makes use of its newly extended powers and pledges to swap back part of the bonds that the ECB has bought. If the Euro-zone governments want to credibly convince private lenders that Italian bond yields have overshot their fundamentals, they should be prepared to take that risk themselves. [Put up or shut up!]

Over the medium term, Italy’s credit fundamentals need to be further reinforced. As our empirical analysis implies, fitted bond spreads have moved up lately and, based on IMF forecasts for GDP growth, the deficit and debt, they are forecast to move broadly sideways at around 150-200bp. On Friday, the Italian government made a commitment to bring the non-interest balance to a surplus of 5% already by 2013, from 1% now, and to ‘tie its hands’ through a German-style ‘balanced budget rule’ requiring a modification of Art.81 of the Italian Constitution. The government also promised more on the liberalization front (starting with changing Art.41 of the Constitution to say that all economic activities that are not explicitly prohibited are allowed), and on labour market reforms. More information on both fronts should transpire this coming week.

And, in the medium to long term, a deeper discussion should take place on Euro-zone trend growth dynamics and policy management. The Pact for the Euro—underwritten last March—envisages that all countries should reach a balanced budget over the next couple of years, and should continue to reduce public debt as a percentage to GDP under a formulaic rule. Structural reforms should help raise the growth potential, but are unlikely to boost economic activity while they are carried out (Germany’s adjustments over the past year weighed on domestic demand). [Structural reforms is a euphemism for austerity]  Against this backdrop, running countercyclical policy at this juncture will fall more heavily on the ECB, as our new forecasts indicate. going ahead, a gradual pooling of at least some Euro area wide fiscal policies (and funding) may be required.