AMERICAN FUTURE

Earlier this month, the European Central Bank announced an emergency loan program known as “longer-term refinancing operations,” or LTROs. The program will become operational tomorrow (Wednesday). The Financial Times says that the ECB expects strong demand for the loans, which will be available in “unlimited” quantities.

The purpose of the program, which enables banks to avail themselves of three-year loans at extremely favorable interest rates, is to ease the severe strains in the eurozone’s financial system. If demand for the loans is strong, it should reduce the likelihood that banks will substantially shrink their balance sheets (by selling assets and reducing new loans to their customers) to meet their funding needs (which are especially large in early 2012). The hope, then, is that the LTRO will improve the economic performance of countries in the eurozone. It’s important to note, however, that this provision of additional liquidity doesn’t attack the eurozone’s fundamental problem: severe and persistent balance-of-payment imbalances among its members.

The funding problem that the LTRO is aimed to ease is having a contagion effect. Asset sales by European banks have put pressure on securitized mortgage prices in the U.S. Instead of selling distressed assets in their home markets, the banks are selling assets elsewhere (as encouraged by their governments).

In combination with the sharp drop in Spanish short-term interest rates that took place today, the imminent start of the LTRO program may be responsible for the sharp rally in the U.S. equity markets. If demand is as strong as the ECB expects, contagion fears could ease, allowing for a short-term bounce in the stocks of financial institutions holding mortgage-backed securities.

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A Financial Times video explains the workings of the eurozone’s financial plumbing and how it might leak if one or more countries exit from the currency union’s membership. The hard-copy is here.

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Excerpts from an FT editorial:

Europe’s economic prospects are deteriorating frighteningly fast, and the world outlook is darkening in step with the Old World’s woes. Unless the world’s leaders manage to pull together soon, we should brace ourselves for a second phase of the credit crisis that will be even worse than the first.

[...] A credit crunch is gaining force, and Europe’s economy grinding to a halt because of it. This is making the twin crises – bank and sovereign – harder to resolve and is hitting emerging economies whose credit is drying up and whose export markets are withering. If the ECB cannot stimulate growth, governments must do so, and fast.

Today the whole world badly needs Europe to grow. Long-term growth and rebalancing are sine qua non for overcoming the debt crisis, but short-term recovery is a greater priority. Austerity by those who must should now be compensated by stimulus from those who can.

My sentiments, exactly.

Marc Schulman, “A Golden Future?,” (August 2011)

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

Deutsche Bank, “Is the Euro today the Gold Standard of the 1930s for European Economies?,” (December 2011):

The 1930s in Europe was a slow moving game of falling dominoes with countries one by one leaving the narrow confines of the Gold Standard after chronic growth problems that a fixed currency system intensified. There was a definite trend in the 1930s that saw those countries that left the Gold Standard seeing a much quicker recovery from the Depression than those that stayed on for a number of years into the latter half of the decade. Figure 12 shows a case study of six countries currencies relative to Gold in the 1930s. We’ve rebased them to 100 at the start of the series. In order of leaving the Gold Standard, we had the UK (left September 1931), Sweden (also left September 1931), US (April 1933), Belgium (March 1935), France (September 1936) and Italy (October 1936).

Interestingly, by the middle of 1937 all had devalued by at least 40% to Gold except Belgium who had devalued by around 30% in 1935. France, which held on until September 1936, then saw its currency collapse by nearly 70% in the three years up to WWII. Figure 13 then shows the same six countries nominal (left) and real (right) GDP performance over the same period.

The UK and Sweden, which left the Gold Standard earliest (September 1931) in this sample, saw a ‘relatively’ mild negative growth shock compared to the other four. In contrast, France which stuck to Gold until late 1936 saw growth notably under-perform until they left the standard. Interestingly as discussed above, France later saw a dramatic 3 year 70% devaluation to Gold which helped restore nominal GDP close to that of the UK and Sweden by the end of the 1930s. However, in real terms they were still the laggard at this point. The worst slump of all was that seen in the US between 1929 and 1932 where they lost nearly half the value of their economy in nominal terms and nearly 30% in real terms. However, the bottom pretty much corresponded to the end of the Dollar’s gold convertibility and subsequent devaluation. From this point on, the recovery was fairly dramatic until the 1937 recession we’ll discuss below. Overall, Figure 13 does indicate some fairly strong evidence that growth did seem to respond to currency debasement and that countries which left this later ended up with weaker economies for longer and also, in France’s case, a more dramatic end devaluation.

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.

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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.

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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.

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.

John Hicks? I remember his name gracing a journal article or two I read long ago in one of my economics courses. Until I read this op-ed by Brad DeLong, I had totally forgotten what Hicks wrote and why it was important enough to be included in the course’s reading list.

DeLong brought up Hicks’ name as part of his apology (an apology from an economist?) for being so wrong for so long. At various times during the past decade or so, DeLong convinced himself that yields on U.S. government securities simply had to go up. He had lots of company. But yields have gone down, not up.

Enter John Hicks:

Hicks, one of the clever young Brits dotting i’s and crossing t’s in the writings of John Maynard Keynes in the 1930s, was responsible for the workhorse formulation of Keynesian economics — the IS-LM model — that has been the bane of many an intermediate macroeconomics student. It was his version of the IS-LM model that formalized and elevated a key insight: that interest rates paid by creditworthy governments would remain low after a financial crisis. This formulation holds even in the face of enormous budget deficits that greatly expand the supply of government bonds.

Ah, yes, the good old IS-LM model! Now I remember. How could I forget all those painstakingly drawn, complex diagrams. But I digress.

We’ve all been hearing about “flights to safety” for years now. Yields drop, prompting companies to issue more bonds and the incentive for individuals to save declines. A new equilibrium is established — in theory.

But here’s the rub:

The decline in interest rates and the rise in savings are accompanied by an increased desire among businesses and households to safeguard more of their wealth in cash. As a result, the speed with which cash turns over in the economy, the velocity of money, falls. And as the velocity of money falls, total spending falls, workers are fired, and their savings evaporate with their incomes.Thus the equilibrium turns negative, with high unemployment and low capacity utilization.

And that’s where we are today. In the 1930s, it was called a “liquidity trap.”  Today’s terminology is “deleveraging.” Consumers desirous of reducing their indebtedness aren’t interested in putting themselves further into hock (assuming they can find lenders willing to lend to them), even though interest rates are historically low.  Some major corporations with huge and growing cash on their balance sheets have issued new debt, not to fund expansion, but as insurance policies. Memories of the closing down of the credit markets during the financial crisis won’t soon fade away.