Thursday, October 27, 2011

Today's links

Today's quote: "Leverage can have different economic functions, but in these cases it simply disguises a lack of money." Wolfgang Munchau


1--Europe's crisis may end up in a violent blow up; interview with James Galbraith, Daily Ticker
Excerpt: (Video--Euro endgame)

2--Overwhelming Majority--Merkel Wins Parliament Vote on Fund Leveraging; Der Speigel

Excerpt: The German parliament has voted in favor of the controversial leveraging of the euro rescue fund by a large majority, with 503 out of 596 members of parliament backing the motion, 89 opposing it and four abstaining. The outcome is expected to strengthen Chancellor Angela Merkel at a summit on the debt crisis in Brussels on Wednesday night.

German Chancellor Angela Merkel won strong backing as expected for the planned leveraging of the euro rescue fund in a parliamentary vote on Wednesday.

Of 596 votes cast, 503 members of parliament voted in favor of the motion, with 89 no votes and four abstentions. The motion had cross-party backing from the parties in Merkel's coalition and from the opposition Social Democrats and Greens.

The leveraging, intended to boost the firepower of the €440 billion rescue fund, is part of a package of measures designed to tackle the debt crisis and protect the single currency. Other steps are expected to include a Greek debt cut of up to 60 percent and a plan to recapitalize European banks to shield them from the resulting writedowns of their bond holdings.
The vote is expected to strengthen Merkel's position in summit talks in Brussels on Wednesday night.

3--Europe's non solution, Credit Writedowns

Excerpt: But the eurozone’s chief policy makers continue to ignore this fundamental point and therefore, steadfastly avoid utilizing the one institution – the European Central Bank – which has the capacity to create unlimited euros, and therefore provides the only credible backstop to markets which continue to query the solvency of individual nation states within the euro zone. The ECB is so loath for everybody to agree on a Greek default, on the grounds that they bear "the loss" even though it is a notional accounting loss that has no bearing on their ability to create euros until the cows come home. By contrast, when you get national governments funding the European Financial Stability Fund (EFSF), then it does ultimately threaten the credit ratings of France and Germany once the markets begin to call their bluff on how far they're prepared to go to support this political fig-leaf called the EFSF. And because NONE of these countries is sovereign in respect to their currency (they USE the euro, but they don't ISSUE it), it expands the potential insolvency problem, taking Germany down along with the rest.

The market pressures are most acute today in respect of Greece, but the broader concern is that speculators will eventually look toward the bigger PIIGS, such as Italy, and this is where the issue of the European Financial Stability Fund’s structural weaknesses come into play.

Let’s not get bogged down in numbers. The EFSF could have 440 billion euros behind, 1 trillion, 2 trillion, even 10 trillion euros, but it all comes back to the funding sources. The French are right: it makes no sense to implement this program without the backstop of the ECB, which is the only entity that could make any guarantees credible, by virtue of its ability to create unlimited quantities of euros.

Both the leading policy makers within the euro zone and market participants continue to conflate two distinct, but related issues: that of national solvency and insufficient aggregate demand. Policy makers want the ECB to do both, but in fact, the ECB is only required to deal with the solvency issue. When you do that in a credible way, then you get the capital markets re-opened and you give countries a better chance to fund themselves again via the capital markets. It means you do not actually need several trillion dollars, because you have a credible backstop in place – a central bank that can create literally trillions of euros via keyboard strokes and thereby address the markets’ concerns about national solvency. At this point, the bonds of the various nation states become less distressed and the corresponding need for massive banking recapitalization goes away.

4--The ECB: Unwilling Saviour, The Street Light blog

Excerpt: The ECB is really the only institution that can establish a backstop in eurozone sovereign debt markets that is completely credible. This would be especially effective if the ECB targeted an interest rate for Spanish and Italian bonds rather than a quantity of intervention, as I've suggested previously.

But there's another reason that it would be appropriate for the ECB to be at the heart of the solution. In a recent paper (pdf) Paul DeGrauwe points out that an essential ingredient to the crisis is the fact that the adoption of the euro meant that sovereign nations in the eurozone could no longer borrow in their own currency. As he puts it, "in this sense member countries of a monetary union are downgraded to the status of emerging economies." The difficulty this creates is that since the central banks of these countries can no longer provide unlimited domestic currency liquidity to the government, default becomes a possibility in a way that it was not before euro adoption.

The solution to this flaw in the system is to have the new, joint central bank -- the ECB -- take up the role that individual central banks previously had of ensuring that their own government would never have to default on domestic currency debt simply due to liquidity problems. If the ECB were to assume that role today, default would be completely taken off the table as an option for investors to worry about in the markets for Spanish and Italian debt, which would guarantee that this crisis could no longer spin out of control as it is currently threatening to do.

Regardless of whether European leaders agree use the ECB as the immediate solution to the crisis, I would argue that if the eurozone is to survive in the long run, the ECB is going to have to be explicitly granted the authority -- and indeed the responsibility -- for doing just that. If they want to have a common currency and all of its benefits, the eurozone countries need to accept the drawbacks that come with it. And one of those drawbacks is that the ECB will have to not just be the guardian of the eurozone's inflation rate, but will also have to be an effective guardian of Europe's financial system, even at the potential cost of slightly higher inflation during certain limited episodes.

5--Leaked Greek bailout document:

Expansionary fiscal consolidation has failed,
Credit Writedowns
Excerpt: Below is the leaked Greek bailout document that everyone has been talking about. Yesterday, the Financial Times wrote:

Greece’s economy has deteriorated so severely in the last three months that international lenders would have to find €252bn in bail-out loans through the end of the decade unless Greek bondholders are forced to accept severe cuts in their debt repayments.

The dire analysis, contained in a “strictly confidential” report by international lenders and obtained by the Financial Times, is more than double the €109bn in European Union and International Monetary Fund aid agreed just three months ago.

-EU looks at 60% haircuts for Greek debt - FT.com

Here is my understanding of what the Troika analysis demonstrates about the European Sovereign Debt Crisis. We have embedded the document at the bottom of this post.

This leaked Troika "debt sustainability analysis" submitted to the EU Summit yesterday will no doubt be a part of the deliberations in the Greek debt restructuring proposals to be hammered out by Oct. 26th.

Point 1. A. on the first page is a pretty open and blatant admission that expansionary fiscal consolidation (EFC) has proven to be a contradiction in terms, at least in Greece. Moreover, there is a serious policy incompatibility problem, at least over the intermediate term horizon, with efforts at internal devaluation (ID) - that is, attempting nominal domestic private income deflation in order to improve trade prospects when one has a fixed exchange rate constraint.

This latter point is further amplified in the "stress test" scenario discussed on the bottom of page 5, which I think we all know is soon to become the Troika's base case scenario. They stop short of recognizing that their demands and the actions they have imposed on Greek policymakers are setting off a Fisher debt deflation implosion of the Greek economy.

But clearly, the EFC policy is rupturing any semblance of a social contract, and ripping the social fabric to shreds as well.

6--Felix Zulauf: "The die is cast", The Big Picture
Excerpt:

• We are on a spiral caused by mass credit creation, excessive borrowing, reckless spending, and a enormous credit crisis. The end result is inevitable, and most likely unavoidable.

• There will be yet another bailout in the US and QE3 (or more) — but not until the situation gets much worse; That refers to both the market and the economy.

• Of all the currencies in thew world, the US Dollar is the least ugly. That says less about the Greenback than it does about the Euro and Yen.

• The Eurozone was problematic since its inception. You cannot have a monetary union but not simultaneous fiscal union.

• Watch for rising populism in response to economic turmoil. It is already happening in Europe, and will eventually come to the US.

• The political situation in Europe is unlikely to improve until the crisis is much worse. The same is likely true in the US.

7--Philip Pilkington: My European Nightmare – An Infernal Hurricane Gathers?, Naked Capitalism

Excerpt: Here is the key point though: the report essentially states that the current austerity measures are going to butcher the Greek economy. Even if haircuts are taken – and even if these work in bringing down the debt load, which is a big ‘if’ – the Greek economy is assumed to be in for two decades of sluggish growth. (Once again, I’ll point out that, as far as I can see, even this pessimistic report remains too optimistic in this regard).

That leads to the obvious question: do the Eurocrats know all this? Before it was always implicitly assumed that they did not. It was assumed that they were simply deluded about economic recovery in the periphery; not bloody-minded about the implications of austerity. But now we have to question this narrative.

Hence, my nightmare becomes ever more real. What this report suggests is that the Eurocrats know well what they are doing. They are imposing destructive austerity measures – and, let us be frank, pointless asset-stripping drives – on the periphery knowing full well what effect these are going to have.

So, why are they doing this? Well, in light of current evidence we should raise the unpleasant question: is there not the chance that this is really a cynical power-grab? The elites in the core countries have found their political status boosted immeasurably by the present crisis. They will moan that this crisis is awful, of course, but secretly they must know that it is upping their political profile immeasurably and putting them in important decision-making positions.

And so, what if we are moving into a situation where the Eurocrats establish an iron-grip on the periphery through financing arrangements that essentially allow them full control over the imposition of highly destructive economic policies?

Here’s how I see this nightmare scenario unfolding:

Firstly, it is becoming increasingly recognised – most notably by the French and the IMF – that, in order for the Eurozone financial system to regain a modicum of stability, the ECB must step in and back the EFSF. In essence, the ECB must become a sort of unofficial ‘Lender of Last Resort’. If this situation comes about, the Eurocrats will have the ‘unlimited firepower’ – that is, the ECB’s ability to issue currency – with which they can essentially control the bond markets.

If the Eurocrats find themselves in this position they may well opt to keep the periphery bond markets on life support while continuing to insist on austerity… all the while, fully acknowledging – as laid out above in the secret document – what this austerity will mean in real terms: perpetual and unending suffering in the periphery.

Thus the Eurocrisis will be a financial crisis no more. Instead what we will have is the core countries tightening the vice of austerity on the imploding periphery. As can clearly be seen from the projections in the document discussed above, there will be no endgame here and this situation will carry on indefinitely....

the document leaked from within the structures of Europower strongly suggests that the Eurocrats know exactly what they are imposing on the periphery. This further indicates that, come hell or high water, they are going to stick to their guns regarding austerity. Assuming that this state of affairs is not going to last for two decades or more, the game-change is then sure to come from within the periphery countries.

Last time we saw such austerity policies being forcibly imposed on a country within Europe – I refer, of course, to the debt extractions that took place after WWI – we got Hitler. Greece, of course, is far too small a country to produce a Hitler. But that is not to say that it could not produce something a little smaller, but for that, no less dangerous to the Greek people. A Pinochet, for example.

8--Dear bondholders, you are invited to…Ft Alphaville

Excerpt: ...The full statement from the euro summit is out.

The details begin on page 4 and, as reported, private Greece bondholders are “invited” to take a 50 per cent haircut, while the official sector will contribute up to €30bn. This is expected to take the debt:GDP ratio of Greece to 120 per cent by 2020. There’s also agreement to leverage the EFSF up to four or five times, with both the bond insurance and the SPV options being accepted.

First, the haircuts:

The Private Sector Involvement (PSI) has a vital role in establishing the sustainability of the Greek debt. Therefore we welcome the current discussion between Greece and its private investors to find a solution for a deeper PSI. Together with an ambitious reform programmefor the Greek economy, the PSI should secure the decline of the Greek debt to GDP ratio with an objective of reaching 120% by 2020. To this end we invite Greece, private investors and all parties concerned to develop a voluntary bond exchange with a nominal discount of 50% on notional Greek debt held by private investors. The Euro zone Member States would contribute to the PSI package up to 30 bn euro. On that basis, the official sector stands ready to provide additional programme financing of up to 100 bn euro until 2014, including the required recapitalisation of Greek banks. The new programme should be agreed by the end of 2011 and the exchange of bonds should be implemented at the beginning of 2012. We call on the IMF to continue to contribute to the financing of the new Greek programme.
In terms of leveraging the EFSF:

19. We agree on two basic options to leverage the resources of the EFSF:

• providing credit enhancement to new debt issued by Member States, thus reducing thefunding cost. Purchasing this risk insurance would be offered to private investors as an option when buying bonds in the primary market;

• maximising the funding arrangements of the EFSF with a combination of resources from private and public financial institutions and investors, which can be arranged through Special Purpose Vehicles. This will enlarge the amount of resources available to extend loans, for bank recapitalization and for buying bonds in the primary and secondary markets.
20. The EFSF will have the flexibility to use these two options simultaneously, deploying them depending on the specific objective pursued and on market circumstances. The leverage effect of each option will vary, depending on their specific features and market conditions, but could be up to four or five.

9--Vital Signs: Consumer Confidence Tumbles, WSJ

Excerpt: Americans’ outlook became more downbeat this month. In October, an index of consumer confidence fell to 39.8 — the lowest level since March 2009 — from 46.4 in September. It isn’t clear if the drop reflects a worsening economy or if consumers’ bleaker outlook will incline them to spend less. Indeed, the survey the index is based on showed that in October, more people said they planned on buying a major appliance than in September. (See chart)

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