AMERICAN FUTURE

“I fear that austerity without end will bring about a return to the unstable populist politics the European Union was designed to prevent. That could shatter the eurozone and, with it, the EU, thereby ending the most successful attempt to build peace and prosperity in Europe since the fall of the Roman Empire. Moreover, it is clear – and has long been so – that the responsibility for preventing that outcome rests on Germany, Europe’s central power, in every sense. As Charles Kindleberger argued, in a panic, the creditworthy country has to lend freely if a fixed exchange rate system (or in this case a currency union) is to survive.

It is often forgotten, not least in Germany, that the rise of Adolf Hitler to power was preceded not by the great inflation, which occurred a decade before, but by the great depression and the austerity of Heinrich Brüning, in response. Thus, votes for the Nazi party jumped from a relatively insignificant 810,000 in 1928, to 6.4m in 1930, and 13.7m in July 1932. Deep economic collapses are dangerous.

Deep economic collapses are very dangerous. Mr Schuknecht, with his emphasis on the long term, completely ignores these dangers.  If trying to avoid such a dire outcome is “short-termism”, so be it. I think of it as trying to find a practical exit from the current trap. Without it, the eurozone may never reach the long term.

Fiat justitia, et pereat mundus (let justice be done, even if the world perishes) is a dangerous motto.”

The above quote is from Martin Wolf’s reply to Ludger Schuknecht, the Director General of the German Ministry of Finance. Herr Schuknecht took strong exception to a recent column (“The riddle of German self-interest“) by Mr. Wolf.

Regarding populist politics — of the right-wing variety, this article in the FT is a warning of what may become a more commonplace occurrence.

“Those who don’t know history are destined to repeat it.”

– Edmund Burke (1729-1797)

“Those who cannot remember the past are condemned to repeat it.”

–George Santayana (1863-1952)

In addition to illustrating the financial version of the Golden Rule — that those with the gold make the rules — the German government’s insistence that austerity is the only way that the health of the Eurozone’s economically-troubled members can be restored shows that knowledge of the past doesn’t prevent it from being repeated.

When World War I ended, the victorious Allies imposed a Carthaginian peace on Germany. The Versailles Treaty milked Germany dry. Unable to make its reparation payments, the government of the Weimar Republic resorted to the printing press. The hyperinflation of 1923 destroyed the savings of the middle class. Loans from American banks — a stop-gap measure analogous to credits now being issued through the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM) — restored economic and political stability for five years. In 1928, the Germany economy started to contract. Soon after the 1929 Wall Street crash, risk-averse American bankers stopped bankrolling Germany. The German economy crumbled, accelerating the worldwide economic crisis. And setting the stage for Hitler.

The lesson from this admittedly sketchy depiction of a tragic episode in world history is that victors (militarily or economically) that impose harsh austerity on losers ultimately pay a heavy price. Unfortunately, this isn’t the lesson that the Merkel Government and the majority of the German people have taken to heart. Instead, fear of inflation has been embedded in the German DNA. They know their history, but they’ve drawn the wrong lesson from it.

The export-heavy German economy is outperforming other mature economies, but for how long? If the German belief in and enforcement of austerity persists, the economies of its Eurozone trading partners — led by Greece — will fall deeper and deeper into an economic quagmire. As this happens — and whether or not the currency union survives — exports will plunge, resulting in a German economic contraction. Carthaginian austerity will undermine its author.

by Tony Barber

Papandreou (waking up): Great gods! Will these nights never end? Will daylight never come? I heard the cock crow hours ago, but my indolent and totally corrupt people are still snoring away! Curses on this debt crisis! Curses on Pasok! I can’t even sack my own public servants.

The spotlight switches to the top floor of Papandreou’s home and reveals the Troika of Creditors, who are armed with iPads and studying a pile of dusty Greek ledgers.

First Creditor: It really is quite remarkable. Until last month more than 1,000 dead pensioners were receiving payments from Greece’s biggest pension fund.

Second Creditor: And what about this? The Greek state considers 637 types of job to be so arduous that the people doing them get early retirement.

First Creditor: What sort of people?

Second Creditor: Steam bath attendants. Radio technicians. Hairdressers.

First Creditor (thoughtfully): One could look at things another way. International civil servants such as us get generous pensions and early retirement, too.

Second Creditor (stiffly): We’re not in Athens to look at things another way.

Third Creditor: Absolutely right. We’re here to look into the questions that really matter. For example, the difference between who owns swimming pools and who declares ownership of swimming pools in their tax returns. (He displays a Google Map.) The two categories do not exactly overlap – at least, not in the suburb of Ekali.

Second Creditor: Let me guess. Ten thousand swimming pools and only 1,000 owners.

Third Creditor: You underestimate the addiction to fiction of the pool-loving Greek. Ekali has 16,974 pools. But according to the tax returns there are only 324 owners.

The spotlight switches to Papandreou.

Papandreou (despairingly): Who do we owe all this money to? How much do we owe? Let me add up the interest … It’s a nightmare, these debts are deeper than the Bay of Salamis! Sometimes I wish I were back at Amherst, playing Bob Dylan songs on my guitar. But I mustn’t give up! It was Andreas, that father of mine, who got my country into this mess. I’m not like him. I’m not really a socialist at all. But it’s my duty to save Greece. I know! I’ll call a referendum!

The spotlight switches back to the Troika of Creditors.

First Creditor: Did someone say the word “referendum”?

Second Creditor: No, we’re not in Ireland.

Leader of the Chorus: Oh, mortal central bankers, you who wish to instruct yourselves in our great wisdom, take heed that you must know how to hold your own, how to withstand extreme market pressures, and how to press on without admitting to fatigue. Then you will enjoy the greatest of blessings, to live and think more clearly than the common herd and to shine in the contests of words.

Trichet (briskly, to Draghi): So, we’re clear about the first rule of central banking.

Draghi: Buy Greek bonds and call it the removal of impediments to the transition mechanism of a price stability-oriented monetary policy.

Trichet (stares at Draghi): All right, then, the second rule. It is, mon cher Mario, that one should never speak ill of one’s colleagues, especially at the European Central Bank. Here in Frankfurt we have done more than any institution in Europe, or in the entire world, to keep the euro alive. Every single one of us deserves credit.

Draghi: With that sentiment I am in complete, utter and total agreement.

(A pause.)

Trichet: All the same, I have my doubts about old Axel.

Draghi: Me, too. What on earth is he playing at?

Trichet: I don’t mind him opposing the bond purchase programme. You expect nothing less from a Bundesbank president.

Draghi: It’s natural.

Trichet: But he shouldn’t express his opposition in public.

Draghi: It’s unnatural.

Trichet: He’s having a terrible effect on German opinion. He’s making our job twice as difficult.

Enter a slave bearing a tray.

Slave: A letter from Axel Weber, master.

Trichet (opens letter and reads): Well, he has solved our problem. He’s resigning.

Draghi: Not before time.

Trichet: He’ll be lecturing in America before you can say Schuldenbremse. (Thinks.) Of course, this will clear the way for someone else to step into my shoes here.

Draghi (innocently): What’s your size?

Leader of the Chorus (to Draghi): Tell us boldly what you want of us. Then you cannot fail to succeed. When we have finished teaching you, your glory among mortals will reach even to the skies.

Draghi: Well, there is a rather delicate business in Rome …

Slave: The nurses’ uniforms are ready, master.

Berlusconi: Grazie. Here, Vlada, you’re good with figures. Answer me a question.

Vlada the Heart-Stealer: What is it, Papi?

Berlusconi: Why is the number eight so significant in my life?

Vlada the Heart-Stealer: Well, you once said you did eight of us in one night.

Berlusconi: Brava! But tonight that’s not what I have in mind. The reason is that there were eight traitors in my party who deserted me in parliament. My enemies are like bedbugs, advancing on me from all corners. They are biting me, they are gnawing at my sides, they are drinking my blood, they are yanking at my coglioni, they are digging into my backside! Now I must make the supreme sacrifice for the good of my nation. Now I must fulfil my destiny as the Jesus Christ of politics. Now the curtain will fall on the greatest premiership that Italy has known.

Vlada the Heart-Stealer: Come, come, Papi, no giving up! The thing to do is to find an ingenious way through.

Berlusconi: A way through? I only wish one would come to me.

Vlada the Heart-Stealer: Are you holding something?

Berlusconi: No, nothing whatever.

Vlada the Heart-Stealer: Nothing at all?

Berlusconi: Nothing except … The Italian people know what I have done for my country. The restaurants, the beauty salons and the private jets are all full. I’m not finished yet. Mark my words, if my enemies think they can destroy my entire career, they will be sorely disappointed. I am the most persecuted man in the history of the world, but they will never get me.

Enter the Chorus of the Clouds.

Leader of the Chorus: Old man, we counsel you, if you have a successor, send him to us to learn in your stead.

Berlusconi: He’s called Mario Monti.

Leader of the Chorus: Can you make him obey you?

Berlusconi: If he refuses, I’ll turn him out. I’ve got the numbers in the Senate.

Vlada the Heart-Stealer: Eight?

Berlusconi (wearily): Not tonight, Vlada.

Merkel: What delicious cheese!

Sarkozy (to himself): That’s her second helping.

Merkel: You really should try some, David, it will calm you down.

Cameron: I tell you, I will not hold a referendum, I will not agree to a new treaty, I will not support a financial transactions tax, and I will not listen to lectures from that ventriloquist’s dummy of yours!

Merkel (producing dummy from her handbag): Oh, I think Herman’s rather sweet. (To dummy). Give us one of your haiku.

Herman Van Rompuy (speaking through Merkel):

The fiscal compact

Is agreed. But Belgium still

Lacks a government.

Merkel (puts dummy back in bag): We’ve been practising all week.

Sarkozy (fawningly): He has a most accommodating nature, Angela.

Merkel (pleased): Even when he was quite little, he amused himself at home with making horses, carving boats and constructing small chariots of leather. He had a wonderful understanding of how to make frogs out of pomegranate rinds.

Cameron: I tell you, I will not hold a referendum, I will not join the eurozone and I will not give money to the European rescue fund! (Sighs.) It was a lot more fun with Boris in the Bullingdon Club. Killing foxes with chilled bottles of Taittinger Brut …

Merkel (to Sarkozy): You and I need to get down to business. So tell me the truth, Nicolas, was DSK set up?

Sarkozy (sweetly): As you have put it so eloquently, Angela, there is no Europe without the euro. (To himself.) Merde, she must have been gossiping with Carla.

Merkel: Well, that’s that, then, I’m glad to say we have an agreement. Europe will have a fiscal union in 250 years’ time, and I’ll have a bit more cheese.

Cameron: I tell you, I will not hold a referendum, I will not …

Merkel (turning to Cameron): What, are you still here?

Sarkozy (pausing before he deals): What about your ante, Mario?

Draghi: Oh, sorry.

Draghi places a €10 note on the table. Sarkozy inspects it.

Sarkozy: The serial number begins with a Y.

Merkel: Mein Gott, it’s Greek!

Sarkozy: Throw it away.

Draghi: How can I? They’re still in the eurozone, you know.

Merkel: Tell me about it.

Leader of the Chorus: What a thing it is to love making mistakes! For this old Europe, having loved its mistakes, now wishes to withhold the money that it borrowed.

Sarkozy continues dealing.

Merkel (to the Leader of the Chorus): Why didn’t you warn us earlier?

Leader of the Chorus: We always do this to those whom we perceive to be lovers of mistakes. We precipitate them into misfortune, so that they may learn to fear the gods.

Draghi (folds hand): I’m out.

Merkel (aghast): You can’t be!

Sarkozy: It’s you and me alone, Angela. What’s it to be? Eurobonds or the end of the euro?

Merkel (to Draghi): I sometimes think he’s worse than Chirac.

Enter Cameron, running wildly.

Cameron: Oh, Europeans, do not be angry with me! Do not destroy me! Pardon me, I’ve gone crazy through babbling. Bring me a torch, someone!

Sarkozy and Merkel: In the name of the gods, what are you doing?

Cameron: What am I doing? What does it look like? (Cameron sets the house on fire.)

Merkel: You’ll destroy us!

Sarkozy: He’ll never destroy us. I’m raising you a million euros, Angela.

Merkel (slowly folding her hand): You’ve won this round, Nicolas. But I’ll win the war.

The House of Thoughts is ablaze.

Leader of the Chorus: Lead the way out, for we have sufficiently acted as Chorus for today.

Round 2 of Reactions to the EU Summit (and some other stuff)

The consensus:

The title of the FT’s editorial — “Europe fails to reach summit” — says it all:

It should have been the climax to Europe’s thriller, a summit that would kill off the sovereign debt crisis with a salvo of confidence-restoring measures. But, apart from Britain’sdramatic exit, last week’s European summit was entirely predictable in its inconclusiveness.

To be fair, it is good news that even modest steps were taken towards closer fiscal integration. But the real, comprehensive fiscal union needed to restore faith in the euro, as opposed to a few new rules, remains elusive.

More urgently, the deal that was struck does nothing to resolve the immediate crisis. Moves to bolster the International Monetary Fund and hints of more support next year for Europe’s two bail-out vehicles are neither big enough nor fast enough to deal with the titanic task of funding peripheral countries’ debt until confidence returns.

Hopes in the existence of a big bazooka proved misplaced. Mario Draghi, European Central Bank president, on Thursday quashed hopes that he would launch an unlimited bond-buying programme to help indebted sovereigns, as European rules do not allow this.

Now there is the suggestion that the ECB has a cunning plan to give the bazooka to Europe’s banks, which will be lent bags of cheap money, with which to buy their own countries’ debt.

The argument is tempting. Friday’s summit declared that there will be no more haircuts on sovereign debt. So if banks can get three-year ECB money at 1 per cent and buy Italian bonds at 6 per cent, this could help cut debt costs while bringing seemingly risk-free returns. This is not contrary to European rules and it could be in both parties’ interests. If the sovereigns go, Europe’s banks are front line victims.

However, there are many reasons to be wary of such a solution, not least because it fools no one. The ECB would in effect be funding sovereign debt through Europe’s banks. This is hardly in the spirit of the European treaty. Second, shareholders might rightly question why banks, which have been shedding periphery bonds despite having had the arbitrage opportunity for some time now, were suddenly scooping them up. Most importantly, if the current crisis was sparked by the link between sovereign and bank risk, does it make sense to intensify that link? Right now there may be no alternative to save the euro. But it amounts to little more than sleight of hand in a crisis where clarity and resolve would do much more to restore confidence.

Unsurprisingly, the FT’s Wolfgang Munchau agrees:

. . . the decision to set up a fiscal union outside the European treaties will do nothing whatsoever to resolve the eurozone crisis . . . this is not something you would wish to do outside European treaties. The existing treaties form the legal basis for all policy co-ordination of monetary union. It gets very messy when you try to circumvent them.

[...] A fiscal union set up outside the European treaty would face severe legal and practical limitations. Unless a trick is found, it cannot make recourse to the resources and institutions of the EU. Nor can it issue eurozone bonds. The only conceivable counterparty for a eurozone bond is the EU itself.

More important even, a fiscal union created through a legal trapdoor would not help solve the crisis. The eurozone is facing a generalised loss of confidence. Investors no longer trust its crisis management, the solidarity of its citizens, even the ability to conduct sensible economic policies. The EU is not going to restore confidence through legal gimmickry that will face numerous court challenges.

Leaders should have admitted on Friday that the summit had simply failed, or perhaps have given it a few more days. Negotiations might have produced a compromise. With the fake pretence of another treaty, that is no longer possible.

Remember what everybody said a week ago? To solve the crisis, the eurozone requires, in the long run, a fiscal union with a prospect of a eurozone bond and, in the short run, unlimited sovereign bond market support by the European Central Bank. What we now have is no treaty change, no eurozone bond and no increase either in the rescue fund or in ECB support.

Policy changes the ECB announced last week will help banks directly and governments indirectly. But the EU fell short on every element of a comprehensive deal. On Friday, investors reacted positively to what was sold to them as a “fiscal compact”. But once the implications of a separate treaty are understood, I fear disillusionment will set in.

——————–

The rating agencies are equally unimpressed.

In its Weekly Credit Outlook, Moody’s says that “Pressure Remains on Euro Area Sovereigns in Absence of Decisive Initiatives” and “European Bank Recapitalization Plan Is Credit Positive, but Encourages Deleveraging”:

Pressure Remains . . .

. . . the [EU summit] communiqué reflects the continuing tension between euro area leaders’ recognition of the need to increase support for fiscally weaker countries and the significant opposition within stronger countries to doing so. Amid the increasing pressure on euro area authorities to act quickly to restore credit market confidence, the constraints they face are also rising. The longer that remains the case, the greater the risk of adverse economic conditions that would add to the already sizeable challenges facing the authorities’ coordination and debt reduction efforts.

As a result, the communiqué does not change our view that the crisis is in a critical, and volatile, stage, with sovereign and bank debt markets prone to acute dislocation which policymakers will find increasingly hard to contain. While our central scenario remains that the euro area will be preserved without further widespread defaults, shocks likely to materialise even under this ‘positive’ scenario carry negative credit and rating implications in the coming months. And the longer the incremental approach to policy persists, the greater the likelihood of more severe scenarios, including those involving multiple defaults by euro area countries and those additionally involving exits from the euro area.The credit implications of these and further measures likely to be announced in coming weeks require careful consideration against the backdrop of decelerating regional economic activity, fragile banking systems, partly dysfunctional credit markets, and the varying degree of success of country-specific measures aimed at structural change and fiscal consolidation. But in the absence of credit market conditions stabilising, the system remains prone to further shocks which would likely lead to selective rating changes. More broadly, in the absence of any decisive policy initiatives that stabilise credit market conditions effectively, our intention as announced in November is to revisit the level and dispersion of ratings during the first quarter of 2012.

European Bank Recapitalization . . .

Additional capital is credit positive as it enables banks to cope with increased stress. However, there is a risk that tighter capital requirements will encourage further deleveraging, thereby increasing the risk of a credit crunch and additional impairments.

The establishment of a sovereign exposure buffer follows criticism that the EBA’s stress test earlier this year inadequately reflected the true value of, and impairments in, banks’ sovereign exposures. Disclosures in banks’ interim statements also point to inadequate evaluation and provisioning and, in some cases, a failure to comply with international accounting standards.

[...] Supervisors are not simply seeking to achieve higher capital ratios, but also higher capital. Nevertheless, the incentive for banks to deleverage remains high and will only be exacerbated by higher capital requirements. More fundamentally, higher capital buffers cannot address the underlying cause of the disruption to the funding markets which is the sovereign debt crisis.

Fitch says that the “Summit Does Little To Ease Pressure on Eurozone Sovereign Debt”:

After the latest EU crisis meeting it is clear that politicians are responding to the eurozone sovereign debt crisis through incremental improvements. It seems that a “comprehensive solution” to the current crisis is not on offer.

This Summit demonstrated strong political support for the euro, and that its members are putting in place the institutional and policy framework for a more viable eurozone and ultimately greater fiscal union. But taking the gradualist approach imposes additional economic and financial costs compared with an immediate comprehensive solution. It means the crisis will continue at varying levels of intensity throughout 2012 and probably beyond, until the region is able to sustain broad economic recovery.

In the short term we predict a significant economic downturn across the region. The eurozone faces intense market pressure, which is triggering loss of business and consumer confidence, and weak industrial activity and retail sales. Our forecast of 0.4% eurozone GDP growth next year and 1.2% in 2013 would be significantly higher if there was a comprehensive solution to the crisis. The lack of a comprehensive solution has increased short-term pressure on eurozone sovereign credit profiles and ratings.

The latest EU Summit, like others before it, has resulted in some positive developments. There is an extra EUR200bn of funding for the IMF, the ESM has been brought forward, and there has been policy change on private-sector involvement in any future sovereign crisis. As with all Summits there is execution risk.

The extra resources for the IMF are welcome but it is not clear how and under what circumstances they would be deployed. The move away from requiring private-sector involvement (PSI) as a condition for ESM programmes is clearly positive for bondholders. The European Commission said it will “strictly adhere to the well established IMF principles and practices.” PSI has been a feature of past IMF programmes, but the Fund sets out to attract private capital to sovereigns and can be expected to use PSI as a last rather than a first resort.

Separately, the ECB also announced changes to its repo schemes that will aid bank liquidity, such as three-year liquidity lines and looser collateral requirements for structured finance. This could be positive for eurozone sovereigns if it eases pressure on them to introduce or re-activate bank debt guarantee schemes.

The Summit’s conclusions show a longer-term desire to move towards some form of fiscal integration in return for enforced fiscal prudence. We believe that most of the vulnerable eurozone countries are already implementing aggressive austerity programmes, and some are already changing their national constitutions. It is too early to judge how effective the fiscal compact will be due to the uncertainty regarding how it will be implemented.

We still believe the ECB, either directly through its sovereign bond purchase programme or indirectly by allowing the EFSF/ESM to access its balance sheet, is the only truly credible “firewall” against liquidity and even solvency crises in Europe.

Hopes that the ECB would step up its actions in support of its sovereign shareholders as a quid pro quo for institutional and legal changes that gave the ECB greater confidence in the long-run commitment of eurozone governments to fiscal discipline appear to have been misplaced.

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Lurking in the background, according to the Wall Street Journal, is an old nemesis: credit default swaps, which have been used in copious quantities by European banks:

Dozens of banks across Europe have sold large quantities of insurance to other banks and investors that protects against the risk of ailing countries defaulting on their debts, the latest illustration of the extensive financial entanglements among the continent’s banks and governments.

New data released last week by European banking regulators suggest the risks of banks suffering losses tied to European government bonds could be higher and more widespread than previously realized.

The numbers show European banks have sold a total of €178 billion ($238 billion) worth of insurance policies, in the form of financial derivatives known as credit-default swaps, on bonds issued by the financially struggling Greek, Irish, Italian, Portuguese and Spanish governments. If those bonds default, as some investors fear they might, banks could be on the hook for making large payments to the holders of the swaps.

The banks have at least partly insulated themselves from such potential losses by buying large quantities—roughly €169 billion worth—of credit-default swaps tied to the same bonds, apparently in large part from other European banks, according to European Banking Authority data.

Some analysts and investors say they had assumed that sovereign credit-default swaps, known as CDS, were primarily sold by giant global investment banks in the U.K., France and Germany, as well as in the U.S. Those banks sell the swaps to big corporate clients and other banks and institutions.

But the new EBA data show a surprising breadth of large and small European banks—at least 38 of them—have sold instruments that protect against potential losses on Greek, Irish, Italian, Portuguese and Spanish government bonds.

Of the total protection that European banks have written on government bonds in Europe’s five most-stressed countries, nearly one-third originated from German banks.

The diverse array of banks in the sovereign CDS market means that risks can spread more quickly through the financial system. It also means it is harder to predict how losses would ricochet among institutions and countries, analysts say.

The banks and some analysts argue that the industry’s actual exposure is far less than the €178 billion of swaps they have sold because the banks have purchased €169 billion in similar protection from other sources, which can offset the exposure. Many of Deutsche Bank’s purchases and sales of CDSs, for example, are with the same counterparties, with whom the German bank has legally enforceable netting agreements in place.

But some experts say it is risky to assume that all banks’ CDS transactions neatly cancel each other out.

“Netting is all very well provided that you trust your counterparty,” said Jon Peace, a Nomura Securities banking analyst. But in a crisis situation, “what you thought was net could tend toward your gross exposures” because certain sellers of the default insurance could themselves go bust.

For example, two of Italy’s biggest banks, UniCredit SpA and Banca Monte dei Paschi di Siena SpA, have sold a total of about €5.3 billion of protection against the risk of an Italian sovereign default, according to the new EBA data. The problem is that, in a default scenario, both banks likely would be in trouble themselves due to their huge holdings of Italian government bonds and the fact that their businesses are largely concentrated in Italy.

——————–

While the Organisation for Economic Co-operation and Development (OECD) hasn’t issued a statement setting forth its view of the results of the EU summit, the Financial Times reports that it “will warn in its latest borrowing outlook, due to be published this month, that financial stresses are likely to continue with the “animal spirits” of the markets – their unpredictable nature – a threat to the stability of many governments that need to refinance debt.”

For the foreseeable future it will be a “great challenge” for a wide range of OECD countries to raise large volumes in the private markets, with so-called rollover risk a big problem for the stability of many governments and economies.

Rollover risk is the threat of a country not being able to refinance or rollover its debt, forcing it either to turn to the European Central Bank in the case of eurozone countries or to seek emergency bail-outs, which happened to Greece, Ireland and Portugal. The OECD says the gross borrowing needs of OECD governments is expected to reach $10.4tr in 2011 and will increase to $10.5tr next year – a $1tr increase on 2007 and almost twice as much as in 2005. This highlights the risks for even the most advanced economies that in many cases, such as Italy and Spain, are close to being shut out of the private markets.

While borrowing was higher in 2009 and 2010, the risks are greater than ever because of rising borrowing costs in turbulent, unpredictable markets.

The OECD says that the share of short-term debt issuance in the OECD area remains at 44 per cent, much higher than before the global financial crisis in 2007. This, according to some investors, is a problem as it means governments have to refinance, sometimes as often as every month, rather than being able to lock in more debt for the longer term that helps stabilise public finances.

The OECD also warns that a big problem is the loss of the so-called risk-free status of many sovereigns, such as Italy and Spain, and possibly even France and Austria. The latter two have triple A credit ratings but investors no longer consider them risk-free.

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Contagion from the eurozone crisis appears to be spreading to emerging markets: Indian industrial production dropped by 5.1 percent in October. From the Financial Times:

“The data are way worse than we were expecting,” said A Prasanna, economist at ICICI securities in Mumbai. “Usually output is lower during the months of October and November as there are fewer working days due to the festival season but a 5.1 per cent drop is significantly more than we predicted,” he added.

Manufacturing output, which represents about 76 per cent of industrial production, dropped 6 per cent in October, compared with a year ago and capital goods production, which is considered to be a key barometer of investment sentiment in the country, fell 25.5 per cent. Meanwhile, mining production was down 7.2 per cent, as a series of scandals in the sector and continued uncertainty over the outcome of a long-awaited mining bill hurt the industry.

The full report, issued today, is available here.

Here are the first few paragraphs:

The Greek economy is going through a new, exceptionally critical phase

The decision of the 26 October Euro Summit represents a milestone on the adjustment path of the Greek economy. The main aim of the agreement reached concerning Greece was to lighten the burden of government debt and its servicing costs, while the adoption of a new multiannual EU-IMF support programme for Greece is envisaged by the end of 2011.

About a year ago, the Bank of Greece considered that the debt could be sustainable. The Bank based its assessment on (a) the full attainment of the fiscal targets that had been set — indeed, the Bank strongly encouraged the overachievement of those targets, wherever possible — and (b) a substantial improvement in competitiveness. In the event, however, the inter-related effects of an undershooting of the fiscal targets, delays in implementing structural reforms, and a sharper-than-expected decline in economic activity undercut earlier assessments about debt sustainability.

Last opportunity to reshape the economy

The new opportunity provided to Greece under the agreement of 26 October may well be the last such opportunity. Thus, the country must avoid any further delays or deviations from targets at all costs; indeed, every possible effort needs to focus on overshooting the targets. The present juncture is the most critical period in Greece’s post-war history. What is at stake is whether the country is to remain within the euro area in the future. [My emphasis] Effectively, Greece is faced with a choice between:

– an uncontrolled downward trajectory that would undermine many of the achievements that have been attained in recent decades, drive the country out of the euro area and set Greece’s economy, standard of living, society and international standing back many decades;

or

– an all-out effort within the euro area, in close cooperation with our European partners and the international community, to mitigate shocks, shorten — to the extent possible — the difficult and long adjustment period and lay solid foundations for the restructuring of the economy and reestablishment of sustainable growth.

Clearly, the latter option entails costs. However, the overall cost to society will be lower than otherwise in the medium term, and the long-run benefits will be higher than will be the case under the former option.

From the online Wall Street Journal at 11pm:

• EU Banks Struggle to Lure Deposits

Several large Italian and Spanish banks recently reported double-digit percentage declines in deposits from corporate and other institutional clients, although their overall deposit levels fell more modestly, as lenders hold a greater share of retail deposits. The deposit base at Spanish banks dropped by €48 billion ($64.8 billion), or 2%, in the third quarter, according to the Bank of Spain.

The deposit outflows come as emergency borrowings by banks from the European Central Bank soared to their highest level in more than two years Tuesday, with the ECB allotting €247.2 billion in seven-day funds to banks, a jump from the previous 2011 high of €230.3 billion.

Meanwhile, banks in countries like Spain, Portugal and Italy are scrambling to retain existing customers and attract new ones by dangling ever-higher interest rates on deposits, making it more expensive for banks to finance themselves affordably.

[...] To be sure, analysts say that overall, European banks still have hundreds of billions of euros of deposits, many of them from individual customers who tend to be reluctant to switch bank accounts. The lenders also can turn to financial lifelines from the European Central Bank, posting government bonds and other assets as collateral.

But if the drought continues, it could pose a threat. European banks face a wave of maturing debt next year—up to €800 billion, by some analyst estimates. If banks can’t replace those funds by selling bonds or gathering new deposits, they will need to compensate by cutting lending. The situation is worrying regulators, policy makers and investors. Some officials have called for European governments to band together to guarantee new long-term bank debt, but senior finance officials from European countries rejected the idea at a meeting last week, according to people familiar with the discussions.

[...] Deposit levels at five of Spain’s top six banks declined in the third quarter, while five of Italy’s largest lenders also reported declines, according to a report by analysts at Citigroup . . . Spain and Italy’s largest banks each reported declines of at least 10% in the quarter that ended Sept. 30.

With deposits simultaneously becoming scarcer and more valuable as a funding source, some banks are entering into a sort of arms race. They are jacking up the interest rates they are offering on deposits and venturing into other European countries in the hunt for new customers. Even though the ECB is keeping its key interest rate at the historically low level of 1.25%, banks in Portugal, Spain and Italy are routinely offering to pay customers more than 4% annually for deposits.

• Europe’s Smart Money Votes With Its Feet

In Italy, nonretail customers withdrew €56 billion in the three months to the end of September, a fall of 12%. Intesa Sanpaolo and UniCredit saw corporate deposits decline by 16% and 10%, respectively, according to Citigroup research. Similarly, in Spain, nonretail deposits fell by 20% in the third quarter, with Santander and BBVA losing 10% and 11%, respectively. Even the French banks weren’t immune: Société Générale and BNP Paribas saw their corporate-deposit balances fall by 7% and 6%, respectively.

[...] if the trend in deposits continues, it will add to the pressure on banks to deleverage. Euro-zone banks are likely to cut up to €2.5 trillion of assets, equivalent to 5% of their total assets, as they struggle to meet new regulatory rules, reckons Morgan Stanley. Much of this can likely be achieved by cutting international operations and investment-banking activities. But as banks try to pass on higher funding costs, lending to core domestic economies could suffer, worsening the debt crisis.

• Santander Raises Cash With  Chile Stake Sale

Banco Santander SA is preparing to sell a nearly 8% stake in its Chilean business, the latest in a string of moves in which the Spanish bank is raising concerns among investors.

The move in Chile comes as Santander, widely viewed by many investors and analysts as one of Europe’s strongest lenders, also has unveiled plans to sell 8% of its Brazilian unit; the deals could raise a total of about $3.5 billion. It also sold a slice of its U.S. auto-loan unit last month for about $1 billion and made a recent offer to exchange some of its outstanding bonds, raising about €600 million ($809 million). The goal is to strengthen the Spanish bank’s capital cushions.

The efforts highlight how Santander and other European banks are scrambling to raise capital without taking steps such as reducing dividend payments or selling new shares at distressed prices.

[...] the terms and timing of Santander’s moves are raising eyebrows in the investment community. Analysts have expressed surprise that the bank is selling chunks of two of its prized Latin American businesses. And the bank’s debt-exchange plan, intended to drum up less than €1 billion in fresh capital, is on such unfavorable terms that it prompted a group of British insurance companies that are some of the major holders of this debt to band together to complain.

• Big Selloff Hits Europe Bond Markets

The Spanish Treasury was forced to pay a euro-era record 5.11% yield on three-month Treasury bills at auction, more than double the rate paid at last month’s auction. By way of comparison, to access the short-term debt market Spain now must pay more than Greece paid at its last three-month auction a week ago.

[...] The spike in yields fanned fears that the country will find it unsustainable to raise funds in the market if the trend persists. The result underscored concerns that more financially weakened euro-zone governments may soon be priced out of the capital markets.

The cost of insuring European government debt against default using credit-default swaps shot up to record levels as concerns about the euro-zone debt crisis and U.S. deficit-reduction plans continue to spook market participants and subdue activity in the European primary bond market. Default insurance on French, Belgian and Spanish debt leapt above record closing levels Tuesday as bond yields in the region climbed.

French bond yields also spiked sharply in a sign that the debt crisis was continuing to spread to larger, top-rated countries. A continued rise in French bond yields would put the country’s coveted triple-A rating in peril and risk derailing efforts to contain tensions.

• EU Warns Greece on Bailout

The European Union has warned Greece that unless political leaders give written pledges they will back agreed reforms, an €8 billion ($10.79 billion) loan payment won’t be given and the country will run out of money in about 20 days, Greek and euro-zone officials said Tuesday.

• Pressure on Merkel Amplifies

Ms. Merkel on Tuesday stressed that joint debt issuance isn’t the right response now. “The discussion of euro bonds in the midst of the crisis is inappropriate,” she said.

Germany has never categorically ruled out the joint issuance of bonds by the euro’s 17 national governments, known as euro bonds. But Berlin insists that before euro members collectively raise financing on the open market, they must create rules that force each country to exercise fiscal discipline—or pay a heavy price.

However, many analysts say Ms. Merkel may no longer have the luxury of time to wait for euro-zone economies to heal before working on long-term changes Germany believes are needed to prevent such a crisis from recurring.

[...] Many lawmakers in Ms. Merkel’s ruling center-right coalition are deeply skeptical about joint euro-zone liability for debts, which they fear would reduce pressure for southern European countries to rein in government spending. “The moment we let up the pressure, those countries that have such problems will become complacent,” German Finance Minister Wolfgang Schäuble said Tuesday.

In addition to being a hard sell to Germany’s lawmakers and voters, euro bonds may require amending the country’s constitution, requiring a broad consensus among political parties in the euro zone’s biggest member.

This post is a veritable potpourri of worries. Be warned.

With the landslide victory of Mariano Rajoy’s center-right Popular party, the government of the Spanish Socialists has become the fifth victim (after Ireland, Portugal, Greece and Italy) of the eurozone crisis. As have the leaders of the other recently-installed governments, Mr. Rajoy has promised to enforce budgetary austerity.

No matter. Despite the Popular party’s victory, yields on Spanish sovereign debt rose today; the ten-year bond yield reached 6.6 percent. Yields on the sovereign debt of other “peripheral eurozone” countries also jumped, as did the yields on “core” countries debt.

Undoubtedly, a report from Nomura — “Currency risk in a Eurozone break-up — Legal Aspects” contributed to today’s indigestion in the eurozone bond markets. The report deals with a subject — “redomination risk” — that has evidently not previously been on market participants’ radar screens: not knowing which euros will stay euros.

It is now obvious that the widespread electoral success of parties committed to fiscal rectitude isn’t sufficient to ameliorate, much less bring to a halt, the crisis by improving investor confidence. That this has become self-evident further undermines confidence, as what was once thought to be a solution has turned out not to be. More than ever, all eyes are turned toward the European Central Bank, with the hope that the ECB will, at long last, overcome its reticence and become the eurozone’s lender of last resort. As yet, there’s no evidence whatsoever that the ECB will undertake what would be an about-face of epic proportions; last Friday, the ECB’s president said that the crisis required a political solution and that the ECB wouldn’t bailout anybody. This situation will persist unless and until Germany performs its about face. But that isn’t happening; if anything, the Germans are digging in their heels.

No wonder, then, that commentaries on the crisis are becoming increasingly strident and downright panicky.

Wolfgang Munchau, writing in the Financial Times, uses the words “insane” and “depression”:

The consensus view in Brussels and Berlin is that the crisis can be solved by technocratic governments imposing structural reform and austerity. That proposition is, in my view, insane . . . We have gone way beyond the point at which this crisis is solvable by standard instruments of economic policy. The survival of the euro will now depend on whether Ms Merkel or Mr Draghi, or both, will blink.

This may yet happen, but not right away. The ECB is facing more formidable legal constraints than those who call for an intervention acknowledge. The bank is technically allowed to engage in secondary bond market purchases, but not with the aim of helping governments incur deficits or roll over debt. Article 123 of the Treaty for the Functioning of the European Union says the ECB shall give no overdrafts to governments. Clearly, the euro was sold on the grounds that the ECB would never do what it is being asked to now. Such a law is testimony to a lack of realism, especially given what we know about the history of financial crises.

[...] The eurozone has already entered a recession, driven by three factors, each serious on its own and lethal in combination: a slowdown of the global economy; pro-cyclical fiscal austerity programmes; and a much larger than expected deleveraging of the financial sector. If present policy prevailed, the eurozone would be in danger of falling into a depression.

[...] In present market conditions, a leveraged EFSF is unrealistic. So how long can this policy vacuum be sustained? So far, the speed of the crisis has exceeded the speed of the political response. The next political turning point will come at the European Council meeting in December, which will need to decide something more substantial than previous summits.

If that does not happen, we will be getting closer to the point where member states – confronted with an unsustainable funding position – could rationally conclude that the political and financial costs of staying in the eurozone may well exceed the costs of an exit. This is not a proposition anybody would want to test. Once the eurozone goes down that road, it will not come out of this crisis in one piece.

The moment will arrive, probably sooner rather than later, when Mr Draghi and Ms Merkel will have to blink simultaneously. The odds of that happening are neither low nor high. They are indeterminate. It is the worst kind of uncertainty imaginable.

George Soros describes the current situation as “a perfect vicious circle”:

From the transcript of a press briefing by David Hawley, Deputy Director, External Relations Department:

QUESTIONER: Regarding Greece, has the IMF requested written commitments from the two leaders of the two parties in order to get Greece the six tranche?

MR. HAWLEY: As you know, we welcome the agreement on a national unity government in Greece as a step to achieving greater political certainty and stability . . . once broad political support for the measures under Greece’s economy program is assured, then we can proceed with completion of the fifth review and the release of the sixth tranche . . .

QUESTIONER: But did you put any conditions to the Greek government, the Greek parties? Did the IMF put any conditions, or you just support the Europeans?

MR. HAWLEY: You are speaking now about assurances, commitments.

QUESTIONER: Yes, written assurances.

MR. HAWLEY: Let me be clear. I’m simply saying that we are seeking assurances. I’m not going to describe specifically how those assurances will be received. It’s enough that we’re satisfied in due course that assurances are there, and I can’t go beyond that. I have nothing beyond that.

QUESTIONER: What do you mean by broad political support? Are you talking about that everybody needs to sign up on this program, including everyone from the Coalition and the opposition, number one. Number two, turn to Italy, when is the monitoring team going to Italy, and how is that going to be conducted?

MR. HAWLEY: I’ve got nothing to add on broad political support . . .

Amidst widespread calls for the European Central Bank to become the eurozone’s lender-of-last-resort, Juergen Stark (the German representative on the ECB’s Executive Board) argues 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. Stark’s views are emblematic of German financial elite opinion.

From Reuters:

The crisis of state finances can only be solved with far-reaching measures to consolidate government budgets. Permanently continuing the measures of the ECB cannot solve the crisis. For this, the trust of banks amongst themselves must be rebuilt, which can only be achieved by restructuring and recapitalizing the banking system.

The ECB may not finance states. Whoever assumes that the ECB could be pressured into this — I don’t think so. I don’t think the ECB will ever cede to such pressure.

Stark dismissed any speculation about the break-up of the euro:

Does the debt crisis endanger the stability or even the existence of the euro? This I answer with a clear no.

On Greece, Stark said:

Greece concentrated its capacities on figuring out how to make such a private sector participation work, how would a debt cut work, with what consequences. And nothing was done any more to consolidate the budget and to undertake structural reforms. And that’s why we are in this very desperate situation.

The contrast with the views of the FT’s Alexander Freeman is stark (pun intended). In “It’s time for you to fire the silver bullet, Mr Draghi,” Freeman (the chief investment officer of UBS) implores the new ECB president:

The European Central Bank, now led by Mario Draghi, must accept its role as the lender of last resort in Europe. The ECB could stop the panic engulfing Italian and Spanish government bond markets, and it is the only institution in the world with this power. To do this, it should promise an unlimited liquidity backstop to sovereign bond markets of solvent nations. As long as its support remains reluctant, “limited” and “temporary”, peripheral bond and credit default swap markets will remain vulnerable to weak demand and speculative attack.

[...] The ECB has been reluctant to act due to Europe’s own history and a fear of the political consequences for the future. The ECB remains steeped in the Bundesbank tradition of rigid inflation targeting, which has developed as a result of Germany’s own history lessons from the hyperinflation of the 1920s.[...] Ultimately, the only lasting solution is likely to involve fiscal confederation and eurobond issuance. But this will take time and only a bold stance from the ECB would calm markets for long enough for European politicians to consider and negotiate the necessary treaty changes to make this happen.

As Italian interest rates continue to soar, calls for the ECB to become a lender-of-last resort will intensify. “Investor confidence in Italy collapses” screams the FT:

Markets on Wednesday demonstrated a collapse of confidence in Italy’s ability to chart a clear course out of its political and debt crises, sending 10-year bond yields to new euro-era highs over 7.5 per cent and into territory that forced Greece, Portugal and Ireland to seek international bail-outs.

[...] LCH.Clearnet, the UK-based clearing house, added to the pressure on Rome after it raised the amount of margin, or collateral, that traders must post to insure trades of Italian government bonds against losses.

The yield on the 10-year bond soared to 7.502 per cent, a new euro-era high and nearly a full percentage point above Tuesday’s closing prices. The spread over German Bunds peaked at 575 points, before easing on heavy intervention by the ECB reported by traders.

Yields on Greek and Irish 10-year government bonds stayed above 7 per cent for 15 to 20 days before the two countries asked for a bail-out. Portugal held out for two months. Italy’s debt – more than those three countries plus Spain combined – puts it well beyond the range of current EU-IMF firepower to rescue. Italy needs to roll over some €150bn of debt in the first four months of next year alone.

PIMCO’s El-Erian maintains that “Only the ECB can save Italy now, but it can’t act alone“:

Here we go again. Europe’s debt crisis has entered a new, more dangerous phase with the yield on Italian 10-year bonds crossing the seven per cent level on Wednesday morning. This is a eurozone-era record that, if sustained, would severely destabilise the debt situation of the world’s third largest bond issuer and one of the original six founders of the modern European project.

Those who lived through the horrid days of the various emerging market debt crises will quickly recognise the four distinct factors that have come together in the last few days to form a highly destabilising cocktail. And they may well agree on what needs to be done to stop a bad situation getting worse.

Messy domestic politics have undermined the already-complicated relations between those with the potential to solve Europe’s debt crisis – the highly-indebted countries, their official creditors and private holders of their debt.

As in Greece, Italy is now going through an uncertain political transition. While the media has understandably focused on when and how Prime Minister Silvio Berlusconi will resign, what Italy urgently needs is much more complex – namely, a new government that can credibly design, implement and shepherd multiyear efforts to lower debt and deficits, while also increasing economic growth.

Secondly, it has become fashionable not only to sell Italian bonds but also to tell the world about it, as loudly as you can.

In the last few days several banks have rushed to announce that they have been actively reducing their holdings of Italian debt – as a means of reducing market concerns about their own well-being. This phenomenon is similar to the 1980s phase of “macho provisioning” that saw banks trying to outdo each other in telling the world that they were fully protected against their past loans to Latin America. The result today is to encourage and push other Italian creditors to also sell, adding to the market pressures. In too many cases, the damage to the demand for Italian bonds is much more than transitory.

Third, a series of technical changes are disrupting the Italian bond market, adding to its instability. They range from Tuesday night’s increase in margin requirements imposed by a major clearing house, to the decrease in availability of hedging instruments in the derivative markets.

Finally, the European Central Bank has appeared more hesitant in recent days to purchase Italian bonds. Whether it is an issue of willingness or ability, the result has been to add to the mounting market instabilities.

Left to their own devices, several of these factors could get even more disruptive. Italy is now in the grips of what economists call a ‘path-dependent multiple equilibria’ – where one bad outcome raises the probability of another, even worse outcome.

There is only one institution that has an immediately-available balance sheet that could stabilise the situation in the next few days and weeks – the ECB. But before we all join the chorus urging the bank to do more, we should recognise that it, alone, cannot deliver good outcomes.

To act as a durable circuit breaker, the ECB needs others to help on four critical issues: a bold and lasting separation in how we deal with Europe’s insolvent nations and its illiquid ones; a regional programme to enhance growth and employment; immediate actions to counter the fragility of the banking system; and bold political decisions to strengthen the institutional underpinning of the eurozone, either as it is configured today or via a smaller and less imperfect one.

The European summit on October 23 came close to partially addressing some of these factors but slow progress and disruptive national political developments limited its impact. As a result, Europe’s crisis has entered a new and even more worrisome phase.

With neither the region nor the global economy in a position to afford many more slippages, let us hope that this latest development will serve as a loud, urgent and effective call for proper diagnosis and comprehensive action.

The future rests in Germany’s hands. The prospects aren’t promising.