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Tuesday, November 29, 2011

When Even the Poles Plead for German Leadership...

When Polish Foreign Minister Radoslaw Sikorski feels compelled to make a dramatic appeal for Germany to show more leadership in the crisis, we know we are up sh-t's creek.

According to Reuters,

"You know full well that nobody else can do it," he said in a speech in Berlin Monday evening, referring to efforts to save Europe's monetary union. "I will probably be the first Polish foreign minister in history to say so, but here it is: I fear German power less than I am beginning to fear German inactivity. You have become Europe's indispensable nation."

I would rather say Europe's imbecile nation. I mooted the point that Germany, the ECB, the European Commission, somebody, anybody, might be pursuing a hidden agenda, but now I'm convinced Merkel, Schaeuble and Draghi are intent on outdoing Bruening and going down in history as the world's greatest gratuitous economic blunderers. I fail to perceive any logic in their public pronouncements. It should be clear by now that fiscal austerity and central budgetary control, not to mention ECB fiddling while Italian bond auctions burn, are not going to save the Eurozone. Some modicum of a basic understanding of the origins of the crisis are a prerequisite for solving it, and these people do not seem to partake of any. Not that Germany and other EU countries do not possess outstanding economists who have been providing sensible policy advice all through the crisis (such as Peter Bofinger in Germany and Paul de Grauwe in Belgium). So the incorrigibility of the central bankers and politicians is really inexplicable. They seem to be trapped in a simplistic, moralistic universe, not unlike Bruenings obstinate clinging to the idiotic Notverordnungen that led to Europe's twenty years of despair.

So I'll just throw my hands up in disgust and hit the beaches. Let's all enjoy the little bit of life we are still vouchsafed while the imbecilic politicians do their best to destroy it.

Monday, November 28, 2011

Why the Eurozone is (was) like a CDO

Eva and I flew into Goa on Saturday morning, so I'm just coming up to speed on the state of the world. Unfortunately, the state of the world (i.e., the Eurozone as far as I am concerned) is showing no signs of coming to its senses. Merkel is still blaming the other member governments for fiscal irresponsibility (not low German wages), and thinks a last minute installation of central fiscal administration, should this even be possible, will accomplish anything except make the situation worse (that is, as long as austerity is the call to arms). The ECB is still sitting on the fence and washing its hands of the affair, as if it were the central bank of a different planet. So the expedition to Mt. Euro has gone astray and looks like the heroic tomfoolery of Scott's expedition to the South Pole.

In the meantime, after moving into our superior cottage up the hill, in among the palm trees, I had a minor satori that the Euro was the currency-zone equivalent of a CDO (collateralized debt obligation, of subprime mortgage notoriety). Why that? The Euro, like a multi-tranche CDO, combines assets of different creditworthiness into a pooled asset which, by dint of financial engineering, has a higher creditworthiness than the weighted average of its components. The Euro amalgamated different countries with varying creditworthiness, from the marginal like Greece to the gold-standard like Germany, and, despite the no-bailout-clause of the Maastricht treaty, allowed them all to enjoy near-German creditworthiness. Spreads over German Bunds began to disappear and everyone could now borrow on near-German terms. This was even better than if, like in a normal currency union, the risks of the constituent parts were simply pooled by a Federal government (like in the US), with a bonus due to the gains of diversification. Countries like Greece were now benefiting from borrowing rates well below anything they deserved as independent countries, and even better than the weighted-average creditworthiness of the entire Eurozone, had sovereign debt been entirely mutualized in Eurobonds from the beginning. A CDO, in other words, distilling triple-A status from the dross of subprime mortgages.

The reason? As far as I can see, the 'senior tranche' of the Eurozone - the AAA-rated countries like Germany, France, the Netherlands, Austria - was assumed to be ready to pluck the chestnuts out of the fire should the EZ ever get into difficulties. Thus, the 'senior tranche' bootstrapped the creditworthiness of the group through implicit CDO-like financial engineering above the average of its underlying assets. But after the 2008 world crisis, and even more, after the haircut on Greek debt, the curtain was jerked from the emperor's new clothes and, just as in the subprime mortgage crisis, the structured asset was revealed to be naked. The irony is that the creditworthiness of the EZ member countries, due to the competitiveness straightjacket of the common currency, is now lower than if they had remained independent, and plummeting fast.

Wednesday, November 23, 2011

Tuesday, November 22, 2011

The Slippery Slope or, Is There Method in This Madness?

Why is the Eurozone like a bunch of mountaineers, roped together in a line, dangerously ascending an icy precipice overlooking a chasm, and not a group of solid economies, pooling their resources and reserves to create, via the laws of diversification and scale, a more stable and robust economic entity? After all, EZ indebtedness and deficits are lower than those of the US, the UK or Japan. The way things now work, one climber after another is slipping off the ledge and falling into the chasm, pulling the next candidate with him by the rope, the Euro, that was originally meant as a safety device. As more and more climbers slip off the precipice, the weight on the remaining climbers only increases, accelerating the tragedy and making a mockery of the rope.

But the situation is even worse than this. Well before the first climber started slipping, the lead climber was surreptitiously loading the other climbers' backpacks with stones (otherwise known as current account deficits). And a helicopter to whisk the climbers off the mountain and land them on flatter terrain was not available because the pilot did not consider it to be his job.

The Eurozone is in free fall because markets, rightly, have woken up to the fact that sovereign debt issued by countries that do not possess a central bank is almost worthless, even more worthless than the debt of emerging market countries issued in hard currency. The latter can at least devalue their national currencies to increase their export competitiveness, and adjust their central bank discount rates, while the former are locked into a currency they do not control and cannot defend.

The ECB has shown itself to be the central bank, not of the Eurozone as a whole, but in essence of Germany and the Bundesbank, the lead climber. Thus as the crisis has unfolded, yields on German Bunds have fallen while spreads on other EZ debt have soared, even on AAA rated ones like France, the Netherlands and Austria.

So today, once again, the Bundesbank's Jens Weidmann says that Italy and Spain should be able to solve the crisis by their own efforts, without ECB intervention. The only thing we have to fear is fear itself, i.e., a crisis of confidence. And Merkel reiterates that austerity, austerity, austerity is the only solution. How can they fail to see that the absence of a central bank backstopping (not financing) periphery EZ debt, and periphery austerity, are leading inexorably to exactly the crisis of confidence they think they can exorcise with incantations of more austerity?

Or is there method in this madness that we mere mortals are unable to perceive? A darker plot to impose a (Brussels/Paris/Berlin based?) Eurocratic dictatorship over recalcitrant peripheral, and with the increasing unpopularity of the bailouts, also core democracies, as intimated by former EU official Bernard Connolly (see Milken Institute 2011 panel and his 2002 Dark Vision document)?

I'm not much of a fan of conspiracy theories, but one is forced by the Euro crisis to make a choice between two incredibly difficult assessments. Either the German government and Bundesbank are being unbelievably obtuse, acting against their own long-term interests, and are just 'unbelehrbar' (German for incorrigible). Or they are complicit in some darker antidemocratic project that we mortals can only faintly adumbrate, a project that has already brought down the democratically elected governments of five EZ countries (Portugal, Ireland, Greece, Italy and now Spain), with two of them now being governed by Eurocratic unelected governments. The peripheral countries' governments are now essentially impotent to carry out any policy except that dictated to them by Germany. That's why the election of a new conservative government in Spain, and the consolidation of the Monti government in Italy, have brought them no relief on the interest rate front. The future of the Eurozone is being decided exclusively in Frankfurt and Berlin, and my impression is that these people do not have the faintest idea what they are doing. But I could be wrong, which might just be even worse.

The self-destruction of the Eurozone will be one of the signal events of modern European (and world) history. But whether it was the result of method or of madness will be a matter for future historians to decide.

Saturday, November 19, 2011

Speed and Overwhelming Force Meet the Two Deadly Sins

Yesterday I pilloried German economist Wolfgang Franz for what he viewed as the"deadly sin" of central banking: intervening to support illiquid/insolvent governments.

With a credit crunch in the Eurozone looming and ECB President Mario Draghi passing the buck to EZ governments and the EFSF to do the rescuing themselves, I find the words of former IMF chief economist Simon Johnson, writing in 2009 in the Atlantic Monthly, salutary:
In a financial panic, the government must respond with both speed and overwhelming force. The root problem is uncertainty—in our case, uncertainty about whether the major banks have sufficient assets to cover their liabilities. Half measures combined with wishful thinking and a wait-and-see attitude cannot overcome this uncertainty. And the longer the response takes, the longer the uncertainty will stymie the flow of credit, sap consumer confidence, and cripple the economy—ultimately making the problem much harder to solve. Yet the principal characteristics of the government’s response to the financial crisis have been delay, lack of transparency, and an unwillingness to upset the financial sector.
Of course, he's referring to the US Treasury and the Fed in 2008/2009, but it describes the Eurozone and the ECB even better.

Thus we now have two deadly sins of central banking: ongoing monetarizations of government deficits, and failure to decisively prevent a financial panic. Looks like we are going to get two for the price of one.

Friday, November 18, 2011

Austerity is the Problem, Not the Solution

And inflation isn't the immediate danger either.

Angela Merkel and the Bundesbank have demonstrated once again that they just doesn't get it. In a speech yesterday in Berlin, she ruled out letting the ECB act as lender of last resort, proving one may have a PhD in physics and still not understand the rudiments of economics (but then, how many economists know anything anymore about those old Keynesian - and Fisherian - canards effective demand, debt deflation, financial panics and liquidity traps).

Instead, German economists are obsessed with the inflation of 1923 ("That path “belongs to the deadly sins of a central bank,” Wolfgang Franz, chairman of the German Council of Economic Experts, an official panel that advises the government, said in an interview with the Frankfurter Allgemeine newspaper" - excerpt from the same NY Times report). This from an old colleague of mine at the University of Stuttgart, who may know some conventional wisdom about labor markets but evidently hasn't an inkling about bank runs, financial panics, cascades in complex systems, and the lender of last resort. The issue is not whether the ECB proceeds to open-endedly finance the deficits of Greece, Ireland, Italy and Spain (soon to be joined by France, Belgium, Austria...), but whether it declares a creditable commitment (like the Swiss National Bank has made) to prevent a firesale of their sovereign debt and a flight to security (to German Bunds, dollars, gold, Swiss francs). Such a declaration would actually avoid having to buy up these country's debt to any large extent, while purchases in drips and drabs without such a commitment just buy time and waste money. (If the commitment somehow were not credible enough to intimidate markets, then the jig is up and we can all go home. But it has to be seriously tried.)

Why aren't German economists more obsessed by the lessons of 1931 - the Brüning austerity "Notverordnungen" ("emergency decrees") that induced mass unemployment, spiraling deflation, the collapse of the Weimar Republic, the discrediting of democracy and market capitalism and the rise of the Nazis, which until then had been a marginal party? The inflation of 1923 was ended, not by austerity, but by a currency reform that wiped the slate clean of the domestic war debts (not reparations) that were unredeemable anyway after the lost war. Inflation was a lousy way of doing the job - destroying the life savings of large parts of the middle classes, but the economy then turned around and growth resumed strongly until the New York stock market crash of 1929. (By the way, buyers of German WWI war debt were allowed to leverage their purchases by using previous purchases as collateral, something the American ambassador James W. Gerard, in his memoir "My Four Years in Germany", predicted would bring them no end of grief in the postwar period. Sounds familiar? Securitization avant le lettre!)

They have learned the wrong lesson - 1923 instead of 1931 - and are not going to admit they're wrong. Instead, they apparently will stick to austerity to the end, with one Eurozone country after another being sucked into the vortice of self-imposed sovereign default. Mind you, these are all countries that would have been perfectly viable economically on their own (maybe Greece is an exception...), if they weren't straight-jacked into the Euro corset. None of them was any more guilty of fiscal mismanagement than Germany (Ireland could have regulated its banking sector more carefully, but then it was providing a service to the rest of the EU's risk-loving banking community, acting as a Trojan Cayman Island). What they weren't guilt of was German "Lohndumping" - constraining their wages to stagnation, so that they systemically lagged productivity for over ten years, just avoiding deflation and accumulating cost advantages in the export sector at the expense of domestic demand (Germany having a good traditional industrial specialization in high-end cars, specialized capital goods and industrial chemicals also helped).

So it looks at the moment like we are condemned to relive the gratuitous policy blunders of 1931 (see my 25 Sept blog), with all the consequences like mass unemployment, bank runs, and the rise of xenophobic and racist extreme right parties. All useless sacrifices to the gods of 1923 because, inexplicably, we are unable to learn the lessons of 1931. Even though austerity naively looks like the answer to a debt crisis (belt tightening), in fact, by inducing a collapse of domestic demand and a fall in nominal wages, it actually increases the effective debt burden and induces investors to flee. If we haven't learned this lesson by now from Greece, Italy, and Spain, apparently we never will.

Why don't the lovers of naive economic morality tales and sartorial metaphors reason instead as follows? To pay off our debts, we have to roll up our sleeves, increase employment and work harder (at frozen wages), not fire workers, depress activity, and thereby lower productivity (note to business cycle wonks: productivity is procyclical). Choose your morality tale, choose your historical catastrophe wisely.

Thursday, November 17, 2011

Last Man Standing

Now that it is clear that the Eurozone is in a free-fall unraveling (see e.g. Wolfgang Münchau in Der Spiegel), with panic enveloping the sovereign debt of every country except Germany (even such paragons of virtue as the Netherlands and Finland), the solution is clear. If Germany will not agree to the ECB acting as lender of last resort, as somebody must to stop a financial panic, then it should leave the Eurozone and let the remaining countries put their house in order themselves.

This is much simpler without Germany than with it:
  1. First, the rump Euro will devalue with respect to the new DM, restoring the rump EZ's competitiveness with respect to Germany (Germany was always the outlier in the unit labor cost ranking);
  2. The remaining EZ members can abandon the masochistic and self-defeating austerity approach (not that this absolves them from other important reforms);
  3. Germany will be left sitting on devalued Euro sovereign debt and will have to massively bail out its banks;
  4. Everyone else will enjoy windfall profits on the appreciating German sovereign debt they own (assuming it is redenominated one-to-one into DM, as it must be for German domestic creditors);
  5. The rump EZ can finally empower the ECB to act as lender of last resort and restore their national creditworthiness. (Greece might still be a problem...)
Hats off to Germany for being the last man standing, but it will be a Pyrrhic victory over its European partners that will only bring it grief. A serious attempt to create a workable, mutually advantageous Eurozone would have been preferable, but too much Borniertheit stood in the way. RIP

Post mortem exam question for economists: why was a domino effect hidden within the governance structure of the Eurozone, but not in the Dollar, Pound, RMB and Yen zones?

Wednesday, November 16, 2011

We Now Welcome the Financial Times Deutschland to Meltdown Economics

Thomas Schmoll in today's Financial Times Deutschland calls it "core meltdown" - the exploding spreads between German Bunds and other Eurozone bonds, now including even previously healthy states like Austria and the Netherlands. Welcome to meltdown economics!

This is something many of us have been predicting for months. If you build a leaky, ramshackle boat (the Euro currency zone) and pilot it against the laws of effective demand, bailing out water with a small bucket once it starts falling apart is not going to help for long. And drilling new holes below the waterline (aka austerity) does not help things either. You need an immediate battening of the hatches (a credible and unlimited commitment of the central bank to scare off attacks) and a plan to increase buoyancy (create effective demand).

The problem with the Euro was that it had secret little time bombs built into it. Once they were activated, they took on a life of their own. There's no point blaming the markets or the speculators. If you build in false incentives and governance structures and no automatic stabilizers, once the ship starts capsizing the process only gains momentum as people rush around on the deck, every man for himself.

It's a lot like nuclear reactors. The uranium fuel is clad in zirconium cans. Once the core exceeds a certain temperature, the zirconium starts reacting with the cooling water and releases hydrogen (something experts for years denied could happen). Any spark will now set off a hydrogen explosion, leading the reactor to self-destruct. Blame the spark, blame the operators (Chernobyl), blame the tsunami (Fukushima)? Or blame the design, which was inherently unstable to a loss of coolant accident such as could be triggered by a single valve jamming (Three Mile Island).

Martin Wolf on Rome's Burning

Martin Wolf in the FT makes an interesting case for Europe (i.e., Germany) saving Italy from self-immolation. Unfortunately, he seems to suggest that this can only be done by Germany coughing up lots of dough. Why this is both economically and politically not a sensible approach is explained in my comment on his article (but his charts are well worth examining - click on the link on the left half way down the text):
What is more important than new governments in Italy and Greece is a new economic approach in Germany. Letting the ECB act as lender of last resort and pursuing German expansion and upward wage revision would be a much more effective and socially just approach than deflation and austerity in the periphery. It would not even cost Germany anything, would compensate in a timely manner for the slacking off of external export demand, and address the competitiveness problem constructively. The notion that Germany should bear the costs of a periphery condemned by its own wage restraint to basket-case status is economically senseless and a political nonstarter. Especially when a mutually profitable solution is available - core expansion - once the blinders of received wisdom are abandoned. If the new Italian and Greek governments' only raison d'etre is to force more deflation on their peoples their prospects are bleak.

Tuesday, November 15, 2011

German Intransigence Crumbling as EZ Spreads Explode?

Deutsche Bank chief economist Thomas Mayer, in today's Financial Times Deutschland, calls for "unlimited commitment to intervention" from the ECB to stop the collapse of the Eurozone as spreads on Italian, Spanish and French bonds over German Bunds get out of hand (see yesterday's blog "Is France Next?"). This just after Bundesbank President Jens Weidmann reiterated the no-lender-of-last-resort orthodoxy yesterday (blog "All Quiet on the German Front"). Will the walls of German orthodoxy crumble before the Eurozone is toast? If the Deutsche Bank can see the light, there's still hope for the Bundesbank and the German government. But is there time?

Let the EconoMonitor Speak (While I Get Back to Explaining the Industrial Revolution)

You won't find more trenchant analyses of the Euro crisis than these blogs on Roubini's EconoMonitor (from ‘EconoMonitor Highlights,’ 15 Nov. 2011). The complacency and sangfroid of Jens Weidmann yesterday in Frankfurt in the face of an oncoming freight train called market panic/the "Lehman moment" are breathtaking (see Jack Ewing in yesterday's NY Times).

We are now thinking about the unthinkable. Many are saying that we are watching a slow motion train wreck as the risk is rising that the Eurozone will break up. So now what?  Nouriel Roubini, Rebecca Wilder, Randy Wray and William Oman weigh in:

Monday, November 14, 2011

Is France Next?

If this isn't a meltdown signal, I don't know what is (Source: Reuters, 10 Nov 2011; current quote 14 Nov 15:00 GMT+1: 1.49):