AMERICAN FUTURE

Almost a year ago — on July 11, 2011 — I put up a post titled “Is Another 1931 in the Offing?“  The probability of the answer to this question being “yes” is unfortunately higher — much higher — now than it was then. Martin Wolf’s column in today’s Financial Times is a sign of the times. The first part of his column –  “Panic has become all too rational” — deals with the present; the second with the past.

Part 1 — Today’s crisis

Suppose that in June 2007 you had been told that the UK 10-year bond would be yielding 1.54 per cent, the US Treasury 10-year 1.47 per cent and the German 10-year 1.17 per cent on June 1 2012. Suppose, too, you had been told that official short rates varied from zero in the US and Japan to 1 per cent in the eurozone. What would you think? You would think the world economy was in a depression. You would have been wrong if you had meant something like the 1930s. But you would have been right about the forces at work: the west is in a contained depression; worse, forces for another downswing are building, above all in the eurozone. Meanwhile, policy makers are making huge errors.

The most powerful indicator – and proximate cause – of economic weakness is the shift in the private sector financial balance (the difference between income and spending by households and businesses) towards surplus. Retrenchment by indebted and frightened people has caused the weakness of western economies. Even countries that are not directly affected, such as Germany, are indirectly affected by the massive retrenchment in their partners.

According to the International Monetary Fund, between 2007 and 2012 the financial balance of the US private sector will shift towards surplus by 7.1 per cent of gross domestic product. The shift will be 6.0 per cent in the UK, 5.2 per cent in Japan and just 2.9 per cent in the eurozone. But the latter contains countries with persistent private surpluses, notably Germany, ones with private sectors in rough balance (such as France and Italy) and ones that had huge swings towards surplus: in Spain, the forecast shift is 15.8 per cent of GDP. Meanwhile, emerging countries will also have a surplus of $450bn this year, according to the IMF.

One would expect feeble demand in such a world. The willingness to implement expansionary monetary policies and tolerate huge fiscal deficits has contained depression and even induced weak recoveries. Yet the fact that unprecedented monetary policies and huge fiscal deficits have not induced strong recoveries shows how powerful the forces depressing economies have been. This is the legacy of a huge financial crisis preceded by large asset price bubbles and huge expansions in debt.

Finance plays a central role in crises, generating euphoria, over-spending and excessive leverage on the way up and panic, retrenchment and deleveraging on the way down. Doubts about the stability of finance depend on the perceived solvency of debtors. Such doubts reached a peak in late 2008, when loans secured against housing were the focus of concern. What is happening inside the eurozone is now the big worry, with the twist that sovereigns, the actors upon whom investors depend for rescue during systemic crises, are among the troubled debtors. Such doubts are generating a flight to safety towards Germany and, outside the eurozone, towards countries that retain monetary sovereignty, such as the US and even the UK.

Part 2. Yesterday’s crisis

It is often forgotten that the failure of Austria’s Kreditanstalt in 1931 led to a wave of bank failures across the continent. That turned out to be the beginning of the end of the gold standard and caused a second downward leg of the Great Depression itself. The fear must now be that a wave of banking and sovereign failures might cause a similar meltdown inside the eurozone, the closest thing the world now has to the old gold standard. The failure of the eurozone would, in turn, generate further massive disruption in the European and even global financial systems, possibly even knocking over the walls now containing the depression.

How realistic is this fear? Quite realistic. One reason for this is that so many fear it. In a panic, fear has its own power. To assuage it one needs a lender of last resort willing and able to act on an unlimited scale. It is unclear whether the eurozone has such a lender. The agreed funds that might support countries in difficulty are limited in a number of ways. The European Central Bank, though able to act on an unlimited scale in theory, might be unable to do so in practice, if the runs it had to deal with were large enough. What, people must wonder, is the limit on the credit that the Bundesbank would be willing (or allowed) to offer other central banks in a massive run? In a severe crisis, could even the ECB, let alone the governments, act effectively?

Furthermore, people know that both banks and sovereigns are under severe stress in important countries that seem to lack any prospect of an early return to growth and so suffer the costs of high and rising unemployment. No better indication of this can be imagined than Spain’s final cry for help with its banks. Political systems are under stress: in Greece, a fragile democracy has imploded. Meanwhile, the German government seems to have reiterated opposition to more support.

How much pain can the countries under stress endure? Nobody knows. What would happen if a country left the eurozone? Nobody knows. Might even Germany consider exit? Nobody knows. What is the long-run strategy for exit from the crises? Nobody knows. Given such uncertainty, panic is, alas, rational. A fiat currency backed by heterogeneous sovereigns is irremediably fragile.

Before now, I had never really understood how the 1930s could happen. Now I do. All one needs are fragile economies, a rigid monetary regime, intense debate over what must be done, widespread belief that suffering is good, myopic politicians, an inability to co-operate and failure to stay ahead of events. Perhaps the panic will vanish. But investors who are buying bonds at current rates are indicating a deep aversion to the downside risks. Policy makers must eliminate this panic, not stoke it.

In the eurozone, they are failing to do so. If those with good credit refuse to support those under pressure, when the latter cannot save themselves, the system will surely perish. Nobody knows what damage this would do to the world economy. But who wants to find out?

As a long-time student of the Great Depression, I’ve often asked myself the same question that Wolf raises in his penultimate paragraph. Like him, I know now the answer.

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Being human, I take some pride in being occasionally prescient — even if, as in this instance, I wish I had not been. That’s my excuse for subjecting you to the entirety of my July 11, 2011 post:

As financial contagion spreads across Europe to include Italy, it brings to my mind 1931, when the mother of all such contagions took place. It began in Austria with the failure of the Kreditanstalt Bank. In only four months, the contagion spread to Germany, followed by England and, finally, the United States.

History need not repeat itself. However, as I argued in an earlier post, I’m concerned that the forthcoming budget deal will derail the anemic American economic recovery. Should this occur, it could have unforeseen — or, at least, unmentioned consequences — not the least of which could be an erosion of the values of the assets held by our major financial institutions. With the growing uncertainty regarding the creditworthiness of the sovereign debt of several European countries — and, hence, of the financial intermediaries holding that debt — the possibility of a financial perfect storm can’t be ruled out. Adding to that risk, in my view, is the position of the Bank for International Settlements (BIS), which in its recently-issued annual report, concluded that

Many of the challenges facing us today are a direct consequence of a third consecutive year of extremely accommodative financial conditions. Near zero interest rates in the core advanced economies increasingly risk a reprise of the distortions they were originally designed to combat. Surging growth made emerging market economies the initial focus of concern as inflation began rising nearly two years ago. But now, with the arrival of sharper price increases for food, energy and other commodities, inflation has become a global concern. The logical conclusion is that, at the global level, current monetary policy settings are inconsistent with price stability.

Even more worrisome to me is the position of the European Central Bank (ECB). While the BIS is an advisory institution, the ECB controls the monetary policy of the euro-zone, which includes all major European countries (and many minor ones, including Greece) with the exception of the United Kingdom. On July 7, the ECB raised interest rates for the second time this year.

While the U.S. Federal Reserve has a dual mandate — to keep the lids on both inflation and unemployment, the ECB’s sole objective is to contain inflation. Like the ECB, the BIS’ concern is solely with inflation; judged by the contents of its annual report, unemployment is beyond its ken. Unfortunately, in my view, the BIS’ and the ECB’s policy prescriptions — that interest rates should rise — mirror those of the many central bankers in the early 1930s who, in the midst of falling output and deflation, believed that monetary stringency was the cure for the ailing world economy. If the current slowdown in the world economy should worsen, as may happen in the aftermath of ECB’s rate hikes and the U.S. budget cuts, will these powerful institutions reverse course, or will they stay the course? I have no way of knowing. All  I can say is that, if they don’t implement policy changes under such a circumstance, the possibility of something resembling the financial crisis of 1931 unfolding within the next year or two will increase.

At the beginning of each year in the 1920s and 1930s, the New York Times published a chronological record of the financial events of the past year.  Below the fold are excerpts pertaining to the five months — from May to September of 1931 — of financial contagion that broadened, deepened and lengthened the Great Depression. For those who aren’t familiar with what transpired during those historic months, which witnessed the collapse of an international monetary system based on the gold standard, the investment of a few minutes of your time may be worthwhile.

MAY

Heavy Decline in Stocks; Bank Rates At Very Low Level

The principal event abroad, whose importance was not realized in America at the time, was the virtual failure of the great Kreditanstalt Bank in Austria, a Rothschild enterprise. Although the institution was saved by the Austrian Government, its collapse, under what proved to be discreditable circumstances, turned out later to have had an immense effect in producing the chain of circumstances which subsequently demoralized German and English finance.

JUNE

Run on Foreign Creditors on Reichsbank; Home Trade Unfavorable

The outstanding event of June was the sudden beginning of a run of foreign creditors on Germany’s gold reserve. In a very short time the recall of foreign balances and short loans from Berlin became panicky and reached almost unprecedented volume . . . The existence of a grave crisis was openly recognized by the German Government; it resulted in a precipitous fall of Germans foreign securities and in the efforts at foreign assistance to the country’s finances. The crisis was met in the middle of the month by President Hoover’s proposal of a one-year moratorium on both intergovernmental debts and German reparations [both stemming from World War I].

JULY

Critical German Situation; Run on Bank of England’s Gold

Very great uneasiness over the German situation continued during July, and in the latter part of the month financial attention was suddenly and unexpectedly converged on a run of foreign depositors on the London market and the Bank of England, similar to the “raid” on Germany and resulting in the swift development of crisis, with two advances of the Bank of England rate . . . Conferences of governments and bankers regarding the German situation were held during July at London and Paris . . .

Advances were made to the Reichsbank by foreign central banks, and emergency measures taken by the German Government regarding the situation, limiting the withdrawal of deposits and requiring that gold proceeds of foreign sales should be turned into the treasury. Early in the month the German bank and government authorities visited all important European centres in search of relief expedients . . .

In the middle of the month the strain shifted to England, in a run on the Bank of England’s gold by foreign depositors and lenders who were calling home their capital. Along with this, panic spread through European high finance . . .

Great demoralization occurred in foreign bonds on the New York market, as a result of the European troubles. At the same time domestic bonds, especially the second grade, fell to extremely low levels under forced selling of their holdings by banks which believed themselves to be in danger . . .

AUGUST

London Crisis Acute, Labor Ministry Resigns; Markets Here Uncertain

Although the German crisis was partly mitigated in August by the emergency measures taken by the government, by the assistance of other central banks, and by foreign bankers’ pledges to leave their German credits “frozen” at Berlin for six months, the strain on London increased. At the beginning of the month the Bank of England obtained a $250,000,000 foreign credit from the central banks of France and America for the support of sterling; this was virtually exhausted in three weeks . . . Pressure on the Bank of England relaxed at the end of the month, when the British government obtained a second emergency credit of $400,000,000 from French and American banks.

SEPTEMBER

England Suspends Gold Payments; Run on Our Reserves

In September the crisis in Europe’s credit situation reached a climax, and with it came outright panic in European high finance and a sudden and large-scale raid by European institutions on the American gold reserve. Simultaneously, the talk in American banking circles of impending bankruptcies of the economic world and of “breakdown of the capitalistic system” pervaded even experienced Wall Street circles.

The event which brought this mental unsettlement to a head was the suspension of gold payments by Great Britain, announced on the morning Of Sept. 21. It was followed first by similar suspension of gold payments by Norway, Sweden, Denmark, Finland and Egypt. It immediately occasioned renewed outpour of the American market of investment bonds both from home and foreign holders, along with large-scale hoarding of money on the European Continent and greatly accentuated American hoarding of cash.

“Without  the euro, the ECB ceases to exist. That is true of no other eurozone  institution. It gives it the incentive to act. It is also acting on a  large scale.”

– Martin Wolf, December 28, 2011

Regular readers of this blog are well-acquainted with the thoughts of Martin Wolf, the Financial Times’ chief economics commentator. Wolf has long been among the most vocal critics of the European Central Bank, charging that its refusal to act as the eurozone’s lender of last resort has worsened the currency union’s crisis and made it impossible to resolve that crisis.

It is therefore with considerable interest that, as suggested by the above quote, he seems to have changed his mind regarding the intentions and efficacy of the ECB’s policies and actions. Simply stated, without the euro, the ECB has no raison d’être. Like any and all institutions, it will do whatever is necessary to ensure its survival.

Wolf seems to have been greatly influenced by Mario Draghi (the ECB’s new president) who, in his interview with the FT on December 18, argued that the ECB had taken important actions during the previous week:

“We  cut the main interest rate by 25 basis points. We announced two  long-term refinancing operations, which for the first time will last  three years. We halved the minimum reserve ratio from 2 per cent to 1  per cent. We broadened collateral eligibility rules. Finally, the ECB  governing council agreed that the ECB would act as an agent for the  European Financial Stability Facility (EFSF).”

Wolf’s interpretation is as follows:

Thus the ECB is determined to fund banks freely, at low rates of interest, thereby subsidising them directly and the governments they lend to, indirectly.

Why lending to banks that use the money they borrow to lend to governments is good, while lending to governments directly is bad, is hard to understand. The only obvious difference is that in the case of lending via banks, the intermediaries may themselves go broke. That makes them unavoidably unreliable conduits. Yet if this complex procedure gets round theological objections to direct financing of governments, those who believe some financing of governments is now needed should be content.

In short, the recent decisions of the ECB look like a clever way of relieving the funding constraints suffered by banks and vulnerable sovereigns. This does not redress solvency concerns directly, though the subsidy may be large enough to make a difference even here, particularly for the banks. But it should mitigate – if not eliminate –liquidity constraints, which have proved of rising importance over the last year and half.

For those with short memories or not enough years under their belts, the title of this post is a variant of the “it’s the economy, stupid” theme that won the presidency for Bill Clinton in 1992.

From the FT’s Martin Wolf:

The summit on Friday is a huge moment. What we have heard from Mr Sarkozy and Ms Merkel does not create confidence. The problem is that Germany – the eurozone’s hegemon – has a plan, but that plan is also something of a blunder. The good news is that eurozone opposition will prevent its full application. The bad news is that nothing better seems to be on offer.

The German faith is that fiscal malfeasance is the origin of the crisis. It has good reason to believe this. If it accepted the truth, it would have to admit that it played a large part in the unhappy outcome.

It’s not fiscal deficits:

Take a look at the average fiscal deficits of 12 significant (or at least revealing) eurozone members from 1999 to 2007, inclusive. Every country, except Greece, fell below the famous 3 per cent of gross domestic product limit. Focusing on this criterion would have missed all today’s crisis-hit members, except Greece. Moreover, the four worst exemplars, after Greece, were Italy and then France, Germany and Austria. Meanwhile, Ireland, Estonia, Spain and Belgium had good performances over these years. After the crisis, the picture changed, with huge (and unexpected) deteriorations in the fiscal positions of Ireland, Portugal and Spain (though not Italy). In all, however, fiscal deficits were useless as indicators of looming crises.

It’s not public debt, Reinhart and Rogoff not withstanding:

Now consider public debt. Relying on that criterion would have picked up Greece, Italy, Belgium and Portugal. But Estonia, Ireland and Spain had vastly better public debt positions than Germany. Indeed, on the basis of its deficit and debt performance, pre-crisis Germany even looked vulnerable. Again, after the crisis, the picture transformed swiftly. Ireland’s story is amazing: in just five years it will suffer a 93 percentage point jump in the ratio of its net public debt to GDP.

It’s a balance of payments crisis:

Now consider average current account deficits over 1999-2007. On this measure, the most vulnerable countries were Estonia, Portugal, Greece, Spain, Ireland and Italy. So we have a useful indicator, at last. This, then, is a balance of payments crisis. In 2008, private financing of external imbalances suffered “sudden stops”: private credit was cut off. Ever since, official sources have been engaged as financiers. The European System of Central Banks has played a huge role as lender of last resort to the banks, as Hans-Werner Sinn of Munich’s Ifo Institute argues.

2011-11 Sinn — Target Loans, Current Accoount Balances & Capital Flows

There’s no solution unless Germany recognizes the nature of the crisis:

If the most powerful country in the eurozone refuses to recognise the nature of the crisis, the eurozone has no chance of either remedying it or preventing a recurrence. Yes, the ECB might paper over the cracks. In the short run, such intervention is even indispensable, since time is needed for external adjustments. Ultimately, however, external adjustment is crucial. That is far more important than fiscal austerity.

If Germany doesn’t, fiscal austerity (as I’ve been arguing for months) will make matters worse:

In the absence of external adjustment, the fiscal cuts imposed on fragile members will just cause prolonged and deep recessions. Once the role of external adjustment is recognised, the core issue becomes not fiscal austerity but needed shifts in competitiveness. If one rules out exits, this requires a buoyant eurozone economy, higher inflation and vigorous credit expansion in surplus countries. All of this now seems inconceivable. That is why markets are right to be so cautious.

The failure to recognise that a currency union is vulnerable to balance of payments crises, in the absence of fiscal and financial integration, makes a recurrence almost certain. Worse, focusing on fiscal austerity guarantees that the response to crises will be fiercely pro-cyclical, as we see so clearly.

In conclusion:

Maybe, the porridge agreed in Paris will allow the ECB to act. Maybe, that will also bring a period of peace, though I doubt it. Yet the eurozone is still looking for effective longer-term remedies. I am not sorry that Germany failed to obtain yet more automatic and harsher fiscal disciplines, since that demand is built on a failure to recognise what actually went wrong. This is, at its bottom, a balance of payments crisis. Resolving payments crises inside a large, closed economy requires huge adjustments, on both sides. That is truth. All else is commentary.

A few words of my own:

• Wake up, Germany. Get over your moralizing and your Weimar hyperflation complex before you destroy the European Project and, with it, the world economy.
• Will market participants be smart enough to realize that a Summit agreement that doesn’t address the balance of payments crisis isn’t a solution to the eurozone’s malaise? We’ll see in a few days.

‘TWAS THE NIGHT BEFORE . . . . . WHAT?

Financial Times

• “Fears euro summit could miss final deal“

Eurozone leaders were struggling on Tuesday to reach agreement on a much-anticipated deal to reverse their spiralling debt crisis amid mounting signals a definitive agreement would not be reached at a key summit on Wednesday night.

According to officials briefed on deliberations, talks between European government negotiators and representatives of Greek bondholders remained inconclusive, putting at risk one of the three key pillars of a deal: a final resolution on Greece’s second bail-out.

A draft of the summit communiqué circulated to national capitals late on Tuesday and described to the FT does not include any wording on a completed deal on Greek bondholder haircuts, and instead refers only to a second bail-out being concluded sometime in the future. No timetable is mentioned.

In addition, a separate “draft terms and conditions” paper on a second key pillar in the deal – beefing up the eurozone’s €440bn rescue fund – makes clear that leaders will be unable to attach a figure to how much firepower the leveraged fund will have. “A more precise number on the extent of leverage can only be determined after contacts with potential investors,” the draft states.

The draft communiqué suggests final details of the overhauled €440bn fund, formally known as the European financial stability facility, may not be concluded until eurozone finance ministers meet again. Their next scheduled meeting is not until November 7.

The political costs of falling short were made clear Tuesday in the Netherlands, where the main opposition party threatened to block any agreement to emerge from Wednesday’s summit unless it had sufficient scope to solve the eurozone crisis once and for all.

• Editorial, “Eurozone must end its miserliness“

Nearly two years after Europe’s sovereign debt crisis erupted, market and political uncertainty are worse than ever. Fear about states’ ability to service their debts is now set on a self-reinforcing course which, absent a radical shift in market psychology, could hit the very core of the eurozone. What is needed is nothing short of moving voters and markets from a mood of self-fulfilling pessimism to one of confidence in the future. So far leaders have failed at this task.

So far the signs are mixed at best. Most promising is evidence that politicians accept that the rescue plan for Athens must capture more of the market discount priced into Greek sovereign bonds. A supposed 21 per cent net present value haircut accepted by private banks was never sufficient – and did not even amount to a loss compared to the bonds’ market value. The 60 per cent cut now being mooted comes closer to realising current market discounts.

As for new bank capital, governments have settled on a reasonable enough number. But they continue to shield bank bondholders from helping to fill the capital hole caused by banks’ bad investments. Worse, governments are still dithering over how to stop the runs on sovereign debt markets that are causing banks’ woes and will not be fixed by any plausible recapitalisation exercise.

On the biggest challenge of all – preventing a refinancing crisis for a large eurozone sovereign – governments have learned little. From the start, market contagion spread in step with each declaration that obfuscated more than it clarified. Suspicion naturally grew that the eurozone was unwilling to put up money to match its rhetoric. So what is the currency bloc’s plan? A complex insurance structure designed to minimise the amount of funds put into the troubled debt markets. It is far from clear that this approach is credible enough to win over investors.

So badly have eurozone governments undermined their own credibility that it is scarcely believable that they would honour the insurance policies they want to issue. By now, the only way to shock markets back to confidence in the eurozone’s ability to stem liquidity crises is by putting money – not another promise of money – on the table. The straightforward way is to use the European financial stability facility to the hilt: the EFSF should raise money fast and on a large scale to have a war chest ready to support the prices of new bonds issued by any sovereign that is solvent, at the lowest rates the EFSF can afford to charge.

The eurozone should expand the EFSF’s firepower by agreeing to let it borrow more than the current €440bn ceiling without bigger guarantees – hence without another ratification round. This may or may not take the EFSF’s rating down a notch. So be it: that is a price worth paying for a visible, funded liquidity backstop, that will lower sovereign credit costs, restore economic confidence and mitigate bank solvency concerns.

The eurozone has the money for this: the currency bloc is in external balance. But marshalling additional resources surely does not hurt. Asian surplus states should be encouraged to help – but by buying EFSF bonds, not by joining an opaque special purpose vehicle. The European Central Bank can help. In return for being rid of its thankless bond-buying programme it can offer to repo any EFSF bond at par, securing a liquid market.

The sums needed are large. But they are dwarfed by the cost of doing too little. Eurozone leaders have vowed to safeguard their currency. They must now will the means and not only the end.

• Martin Wolf, “Be Bold, Mario, put on that fire” — An open letter to the forthcoming president of the ECB.

The economist who has best explained the role of the ECB is Paul De Grauwe of Leuven university.* Why, he has asked, do rates of interest on the debt of several big eurozone member countries exceed the UK’s, even though the latter’s fiscal position is far from superior: Spain’s deficits and net public debt are lower than the UK’s; Italy’s debt ratio is higher but its deficit far smaller; and the French deficit is smaller, though its debt is slightly larger.

It is surely surprising that markets view UK debt less sceptically than those of the others. It is not because Anglophones have devised a cunning plot to destroy the euro; they are not that clever. To put Prof De Grauwe’s alternative explanation starkly, it is the central bank, stupid.

The eurozone risks a tidal wave of fiscal and banking crises. The European financial stability facility cannot stop this. Only the ECB can. As the sole eurozone-wide institution, it has the responsibility. It also has the power. I am sorry, Mario. But you face a choice between pleasing the monetary hawks and saving the eurozone. Choose the latter.

* Only a more active ECB can solve the euro crisis, Centre for European Policy Studies, August 2011, www.ceps.be/book/only-more-active-ecb-can-solve-euro-crisis

While everyone’s attention has been focused on Slovakia, another development of potentially greater significance has taken place. The Financial Times, in an article posted after the European markets closed, reports that, according to “senior regulators,” the European Banking Authority’s board of supervisors has approved in principle the idea that banks should be made to raise their core tier one capital ratios – the key measure of financial strength – to 9 per cent, well beyond the current expections of banks and analysts, even after absorbing writedowns on the value of their sovereign debt holdings.

Officials cautioned, however, that the 9 per cent threshold – which could see dozens of banks forced to raise a combined €275bn [$375 bn], according to Morgan Stanley estimates – is still being debated in national capitals and in Brussels. Some senior officials at the European Commission, which is due to unveil its own plan for bank recapitalisations , support the higher levels and could announce their backing as early as on Wednesday. However, some members of the EBA board, notably the German contingent, are understood to have dissented, and no firm decision has yet been taken. Analysts had previously expected banks to be told to raise capital levels to 6 or 7 per cent. A final decision may not be taken until EU finance ministers meet ahead of a key October 23 European leaders’ summit. The EBA, which has given banks a deadline of Thursday to submit up-to-date sovereign exposure data, is expected to complete its assessment of the capital shortfall by next week.

It will be interesting to see how European bank stocks fare tomorrow, as the raising of the required tier one capital ratio by two to three percentage points would seemingly result in more share dilution than has thus far been discounted.

The New York Times confirms the 9 percent Tier 1 number and fills in some details:

Alain Juppé, the French foreign minister, told the National Assembly that leading French banks like BNP Paribas, Crédit Agricole and Société Générale, which are deeply exposed to the sovereign debt of Greece and other South European countries, will move to increase their capital reserves, initially by using their own revenue or through the financial markets. Money from the government would be drawn upon only as “a last resort,” he said, according to Reuters. But Mr. Juppé said that the move, which was agreed upon with Germany during talks on Sunday, means the banks’ best buffers against losses — so-called core Tier 1 capital — would increase to 9 percent or higher by 2013 from 7 percent. It remained unclear whether any of that money might be drawn from the proposed euro zone bailout fund rather than directly from French government funds.

The issue is particularly sensitive in France because of fears that the country could lose its triple-A credit rating if it had to inject billions of euros into its banks. That would be a huge political setback for President Nicolas Sarkozy of France, who faces election next year.

Meanwhile, Jean-Claude Trichet, the out-going president of the European Central Bank (ECB), told the European Parliament that the most important task was to restore the credibility of sovereign debt.

It is absolutely fundamental. If we don’t have the credibility of the sovereigns, we don’t have a backstop if we have new possible crises – new dramas of the kind that we experienced in 2008. It is something that we are observing in real time, under our eyes.

The most interesting commentary of the day is from the FT’s Martin Wolf, who maintains that the broad consensus of the world’s policymakers and commentators is that the eurozone must now do the following:

• divide countries in difficulties into the insolvent and the illiquid;
• restructure the debts of the former and provide unlimited, but temporary, support for the latter;
• and recapitalise banks, after stress tests that allow for losses on sovereign debt, either from national treasuries or from the European financial stability facility, in accordance with the flexibility given by the decisions taken in July 2011.

What most concerns Mr. Wolf is that credit default swaps on the eurozone’s most creditworthy large sovereigns, France and Germany, have begun to rise (see chart). He’s astonished that Germany’s spread is a fraction higher than the UK’s, and says that this must reflect concern that bailing out weaker eurozone members might become an excessive burden.

Hope springs eternal, as the first FT article attests.

If, like me, you’re not an expert on debt restructuring, you may find this audio guide helpful.

Financial Times

• Peter Spiegel & Alex Barker, “EU ministers look at bank aid plans” — This is the FT article than prompted a 300-point turnaround in the Dow Jones Industrial average in the last hour of trading Tuesday afternoon.

European Union finance ministers are examining ways of co-ordinating recapitalisations of financial institutions after they agreed that additional measures were urgently needed to shore up the region’s banks. Finance ministers left open the exact means of how the recapitalisation could be co-ordinated.

One option being examined is to set a new higher capital requirement for banks that went through an EU stress test last summer. The Commission and the European banking authorities working up that plan among other variants of a stress test.

Comments of Olli Rehn, European commissioner for economic affairs:

“There is an increasingly shared view that we need a concerted, co-ordinated approach in Europe while many of the elements are done in the member states. There is a sense of urgency among ministers and we need to move on. Capital positions of European banks must be reinforced to provide additional safety margins and thus reduce uncertainty. This should be regarded as an integral part of the EU’s comprehensive strategy to restore confidence and overcome the crisis.”

Comments of Wolfgang Schäuble, the German finance minister:

In a sign that European governments were preparing to act, Wolfgang Schäuble, the German finance minister, said Berlin could, if necessary, reactivate support mechanisms it put in place in 2008 to recapitalise the banks. The mechanisms had expired and the German government had until now insisted they were not needed. “Everyone said the big concern is that worrying developments on the financial markets will escalate into a banking crisis,” Mr Schäuble said at a press conference.

• Editorial, “A slippery rescue” — The determination of Greece’s official creditors – the eurozone and the IMF – to hold Athens to the commitments it has made is slipping.

The decision to “merge” the public accounts for 2011 with those for 2012, for the purpose of assessing Athens’ compliance with the conditions in the international rescue plan, is a fudge. Its only plausible function is to postpone the point at which the rescuers must decide on the consequences of Greece missing its targets. In the meantime, however, the eurozone desperately insists to be judged on what it says and not on what it does. That is no way to behave in a crisis of voter and investor confidence that threatens to rend the fabric of European integration.

The eurozone may resist saying things as they are for fear that doing so would force it to pull the plug on the rescue. But this is not so, for two reasons. The first is that slippage does not destroy the case for trusting Greece with eurozone loans. Athens is passing new measures to compensate, and some of the excessive deficit is due to the worse-than-expected state of Greece’s economy – not just the undeniable foot-dragging on tax collection and structural reform.

The second reason is that there is no hurry to make a decision. No Greek bond payments are due till December. Without new loans Athens will have to suspend salary or pension payments – a tragedy, but not one that will bring down other countries. This is an opportunity to separate Greece’s domestic challenges – largely of its own making – from the risk of contagion. For a few months, the eurozone can use the distinction to keep pressure on Athens to get its house in order.

There is a larger lesson. The more policy responses to contagion and to Greek domestic problems are distinguished, the easier it is to avoid the “moral hazard” of Greece losing its appetite for reform in the knowledge that rescue is at hand. In theory, the eurozone could stand behind outstanding Greek debt but refuse to finance ongoing deficits if Athens delays reforms of its dysfunctional state and economy.

Such tactics are risky, and may hurt or help the politics of debt control. But no safe options exist.

• Kerin Hope, “Athens able to pay public sector wages” — Not so pinched after all.

Greece’s finance minister has given assurances the government will be able to pay public sector workers and pensioners on time this month, although its next international bail-out payment has been further delayed. Evangelos Venizelos said on Tuesday that as a result of improving trends in revenue collection “we are comfortably placed until mid-November . . . there are no immediate payment problems”.

• Martin Wolf, “How to keep the euro on the road” — Almost half of the eurozone’s sovereign debt shows heightened credit risk.

The eurozone had no mechanisms for cross-border financing of borrowers who had lost access to funds. In theory, adjustment should have occurred via the classical mechanisms: a spiral of sovereign defaults, banking collapses, slumps, unemployment, falling wages, fiscal retrenchment and all round misery. Nobody forewarned the public that such brutality lay in wait. Politicians did not understand this either. When the time came, they all flinched.

Moody’s

• Moody’s downgrades Italy’s government bond ratings to A2 with a negative outlook

The main drivers that prompted the rating downgrade are:

(1) The material increase in long-term funding risks for euro area sovereigns with high levels of public debt, such as Italy, as a result of the sustained and non-cyclical erosion of confidence in the wholesale finance environment for euro sovereigns, due to the current sovereign debt crisis.

(2) The increased downside risks to economic growth due to macroeconomic structural weaknesses and a weakening global outlook.

(3) The implementation risks and time needed to achieve the government’s fiscal consolidation targets to reverse the adverse trend observed in the public debt, due to economic and political uncertainties.

Austerity? No thanks. That’s Martin Wolf’s advice to the British Government and Bank of England. The following five charts of the British economic situation, which bear a striking similarity to ours, show what’s worrying him.

Here’s what Mr. Wolf says:

It is the policy that dare not speak its name: the printing press. The time has come to employ this nuclear option on a grand scale. The alternative is likely to be a lost decade. The waste is more than unnecessary; it is cruel. Sadists seem to revel in that cruelty. Sane people should reject it. It is wrong, intellectually and morally.

A recession looms close in the UK and other high-income countries, less than four years after the start of the last one. This would be a disaster for those who would lose their jobs or the young, who would find their hopes of work further postponed.

A big danger for the UK is a sharp fall in house prices, which would threaten the finances of households and banks. A new recession would also shatter fragile business confidence, which would reduce real business investment, still 20 per cent lower in early 2011 than before the crisis. That would further delay the structural shifts on which sustained recovery depend. With UK gross domestic product still 4 per cent below its pre-crisis peak, this depression would be longer and costlier, in terms of lost output, than the Great Depression of the 1930s, as I noted four weeks ago.

Adam Posen’s speech:

What is to be done? The first task is to abandon what Adam Posen, an outside member of the monetary policy committee, calls “policy defeatism”. As he argued in a new speech: “Throughout modern economic history … every major financial crisis-driven downturn has been followed by premature abandonment – if not reversal – of the . . . stimulus policies that are necessary to sustained recovery. Every time, this was due to unduly influential voices claiming some combination of the destructiveness of further policy stimulus, the ineffectiveness of further policy stimulus, or the political corruption from further stimulus.”

It is vital, then, to sustain demand. With fiscal policy set on kamikaze tightening and conventional monetary policy almost exhausted, that leaves “quantitative easing”. Mr Posen recommends a great deal more of it, starting with “a minimum of £50bn in gilt purchases in secondary markets” though he now boldly recommends something closer to £75bn or £100bn, in light of the dire external environment. Lowering long-term interest rates would surely provide at least some benefit. But Mr Posen recommends two institutional innovations, as well, aimed at enhancing supply: a public bank or authority for lending to small businesses and an institution for securitising loans made to small and medium enterprises. An alternative would be for a new agency to take the tail risk on normal bank lending to SMEs. That would be a far more sensible way for the government to promote credit to small business than general guarantees to banks.

The chief economist of the Bank of England disagrees:

Up pops Spencer Dale, the Bank of England’s chief economist, as if on cue, with arguments that the UK’s sharp productivity slowdown indicates a permanent reduction in potential output and its growth. He also suggests that part of the recent productivity shortfall is due to reduced innovation by financially constrained smaller businesses. He offers no evidence for this theory.

An analyst at a British think tank disagrees with the Bank’s analysis:

The striking fact, as Bill Martin at the Centre for Business Research in Cambridge has noted in an important paper, is that productivity slowdowns and output declines have occurred across the board. This makes it likely that the poor productivity reflects weak demand.

Mr. Wolf’s preference:

Personally, I would favour the “helicopter money”, recommended by that radical economist, Milton Friedman. This would be a quasi-fiscal operation. Central bank money could pass via the government to the public at large. Alternatively, the government could fund itself from the central bank, directly. Better still, the government could increase its deficits, perhaps by slashing taxes, and taking needed funds from the central bank. Under any of these alternatives, the central bank would be behaving like any other bank, creating money in the act of lending.

In current circumstances, a policy of direct financing of government by the central bank should recommend itself to monetarists and Keynesians. The former have to be worried by the fact that UK broad money (M4) shrank by 1.1 per cent in the year to July 2011. The latter would have to be pleased that governments could run still bigger deficits without increasing their debt to the public.

Some will argue that a policy of direct financing by the central bank must be inflationary. This is wrong. No automatic link exists between central bank money and the overall money supply. Above all, the policy would be inflationary only if it led to chronic excess demand. So long as the central bank retains the right to call a halt, that need be no serious danger.

A far greater threat is that a prolonged period of feeble demand would undermine supply, impoverish the country and bequeath a legacy of huge public debts. The big risk, in short, is now of a lost decade. Act now. That must not happen.

Financial Times

• Editorial, “Greece’s tragedy is made at home“

If the Greek state stops paying salaries and pensions, that is a tragedy – but one of Athens’ own making, which others should not take it upon themselves to prevent.

• Martin Wolf, “Why breaking up is so hard to do“

US banks have an exposure of €478bn ($650bn) to Greece, Ireland, Italy, Portugal and Spain.

• Ralph Atkins, “Marked by a miracle“

“The German approach is principles first,” says Peter Bofinger of Würzburg university. “We may get Götterdämmerung but it doesn’t matter, we stuck to our principles.”

• Peter Spiegel, “Debate rages over source of euro rescue funds“

. . . where will the money for the new rescue system come from?

• Alan Beattie, “Eurozone crisis has making of horror sequel“

You hear two polarised arguments about fiscal policy in a debt crisis: one, austerity never works; two, you don’t get out of debt by taking on more debt.

• Yao Yang, “Don’t expect China to ride to the euro’s rescue“

China’s long-term goal is to make the renminbi an international currency, but this will take time. In the meantime, its interests are clearly served by a strong euro.

New York Times

• Landon Thomas, “Greece nears the precipice, raising fear“

Total Greek public debt is about 370 billion euros, or $500 billion. By comparison, Argentina’s debt was $82 billion when it defaulted in 2001; when Russia defaulted, in 1998, its debt was $79 billion.

Spiegel Online

• Horst Seehofer, “We won’t abandon Greece if it leaves the euro“

Eurobonds just means collectivizing our debts. We don’t go along with such a scheme under any circumstances.

Bloomberg

• Ramesh Ponnuru, “Strong Countries, not Greece, should ditch euro“

The economies of France and Germany are so large that a policy designed for the euro zone as a whole would inevitably be a better fit for their needs than for those of the countries on the zone’s periphery.

. . . 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.

Like me, Martin Wolf is back from vacation or, as he would say, holiday. Unlike me, Mr. Wolf is one of the world’s best and best-known observers of the economic and financial scene. So, when he describes the leaders of the United States and Germany in the following manner, his words shouldn’t be taken lightly.

In neither the US nor the eurozone, does the politician supposedly in charge – Barack Obama, the US president, and Angela Merkel, Germany’s chancellor – appear to be much more than a bystander of unfolding events . . . Both are – and, to a degree, operate as – outsiders. Mr Obama wishes to be president of a country that does not exist. In his fantasy US, politicians bury differences in bipartisan harmony. In fact, he faces an opposition that would prefer their country to fail than their president to succeed. Ms Merkel, similarly, seeks a non-existent middle way between the German desire for its partners to abide by its disciplines and their inability to do any such thing. The realisation that neither the US nor the eurozone can create conditions for a speedy restoration of growth – indeed the paralysing disagreements over what those conditions might be – is scary. [My emphasis]

As the topmost of these charts shows, none of the six largest high-income economies has surpassed output levels reached before the financial crisis began almost three years ago. The psychological impact of this fact is immense: in Mr. Wolf’s words, “The realisation that neither the US nor the eurozone can create conditions for a speedy restoration of growth — indeed the paralysing disagreements over what those conditions might be — is scary. [My emphasis]

After noting that yields on 10-year U.S. and German government bonds are nearly as low as were Japan’s in October 1997 (as shown in the middle chart), Mr. Wolf asks whether Japanese-style deflation will afflict the two most important Western economies. His answer is that “one big recession could surely bring about just that.” This, he says, is “a more plausible danger than the hyperinflation that those fixated on fiscal deficits and central bank balance sheets find so terrifying.” For what it’s worth, I’m in total agreement with him. High unemployment and low capacity utilization aren’t a recipe for hyperinflation.

Considering the recent bounces in U.S. and European stock markets, Mr. Wolf’s observation that “stock markets have taken a battering” seems a little too extreme. At the same time, it lends further support to his assertion that “it is hard to argue that they have reached a point of capitulation.”

If capitulation were to occur, how far might the U.S. stock market fall? It was in August 1982 that the great bull market that ended in 2000 began.  At that time, the market’s valuation was a third of its current level.

Mr. Wolf doesn’t say whether he thinks a similar collapse is in the offing. The answer, he says, “depend[s] on when and how the great contraction ends.” But he’s not optimistic:

The risks of a vicious spiral from bad fundamentals to policy mistakes, a panic and back to bad fundamentals are large, with further economic contraction ahead.

In his next column, he will offer his recommendations on avoiding another downturn. The key, he says, “is not to approach a situation as dangerous as this one within the boundaries of conventional thinking.”