Are ECB Target2 Balances Ever Risky?

Izabella Kaminska is a very talented and intelligent writer for FTAlphaville and I try to read everything she writes, because she makes you think.  I will continue to read what she writes.  When she wrote yesterday that ECB Target2 balances are a big deal, I was thrown for a loop and wondering what am I missing.  I even reached out to another financial and economic professional for a give and take discussion.

Kaminska cites the March BIS Quarterly which shows that Target2 balances have substantially increased as the result of the Asset Purchase Program but CDS spreads have remained stable.  She then concludes that the capital flight during the 2012 Greek crisis was a big deal which resulted in Target2 balances increasing and creating "financing" by Target2 credit National Central Banks, such as the Bundesbank in Germany.  She also concludes this was a failure of the transmission mechanism and cites a paper on the old Soviet Union's International Investment Bank in an attempt to draw a comparison of flows and a failure of the transmission mechanism.

I have written about Target2 twice in 2015 (here and here) and discussed it with economic and financial professional in the United states and other countries.  Additionally, as I have previously cited, Whelan published an excellent paper on Target2 and how it works in 2012.

I am going to try to keep this simple.

The stable CDS spreads with increasing Target2 balances show the Asset Purchase Program is working.  In fact Footnote 3 in the BIS March Quarterly cites the BIS November 2016 Quarterly which states, "The ensuing upward trend in TARGET balances largely reflects the settlement of these cross-border transactions by central banks and, therefore, does not signal renewed stress in financial markets."

Target2 credit balances are money created by the ECB and not by financing from the credit National Central Banks.  National Central Banks are only liable for losses at the ECB to the extent of their Capital Key ratio, which with Germany is 17.9973%.  With respect to the APP, National Central Banks are only exposed to 20% of any APP losses which would be distributed according to the NCB's Capital Key ratio. 

With respect to the study on the Soviet Union's International Investment Bank, its failure was from pricing, industrial capacity, governmental policy, access to international markets, and a weak Soviet ruble unsuitable for international trade.  It is an interesting study of a failure of the transmission mechanism.  However, the ECB and Target2 during 2012 demonstrates the success of a transmission mechanism.  While the ECB balance sheet shows spikes in 2012 and currently, they are from two different causes and both speak to the maintenance of financial stability. 

The IIB transferable ruble loans to Soviet Block countries creating foreign currency denominated debt for those countries has some similarity to every eurozone country having its debt in a foreign currency (euro), but the eurozone is a monetary union (without a fiscal transfer mechanism) with a central bank (ECB) exercising monetary policy.

When would Target2 levels constitute a risk?  Any risk to Target2 would be a risk to the eurozone itself.  This is why arguments against Target2 have been arguments against the credibility of the euro as a currency and attempts to argue the euro is on its way to a currency crisis.  While I have long maintained the euro is treading towards a currency crisis, the crisis is dependent on growing political risk fed by a defective monetary union without a fiscal transfer mechanism which uses destructive austerity to compensate and only creates negative economic growth, more unsustainable debt, and a growing eruption of political unrest which is swelling to possible political risks in Italy and France. 

People are suffering.  Greece, which is already at depression economic levels, is again facing demands for more destructive austerity from the EMU and has never recovered from the EMU enforced coup in 2012 or the monetary warfare waged by the ECB in 2015.  Spain has had a temporary government for so long it may have forgotten how a real democratic parliament functions.  Spanish and Italian banks need support.  Portugal was allowed to keep its government on condition it did what the EMU wanted.  Cyprus had its citizens bank deposits taken away from them. It is no surprise people are unhappy.  And nobody really wants to ask how strong German banks, not just the large international banks (like Deutsche Bank and Commerzbank) but the national, savings, and landes banks really are, particularly since Germany has resisted including all its banks in ECB stress tests.

How serious would the political risk have to be?  If you look at the CDS spreads of 2003 euro bonds and 2014 (which have CAC provisions) bonds, you can see the increased political risk with the spreads between the two doubling to 40 basis points.  This perceived political risk ignores the possibility of an eurozone country actually exiting the EMU, changing its countries bond laws and abrogating CAC's, and redenominating its debt from the euro to its own fiat currency.  Just using Target2 balances as a base example, it is easy to see that if Greece and Portugal both left the EMU, the EMU could easily survive with its monetary credibility tarnished.  However, if Spain and Italy left and defaulted on Target2 and redenominated euro debt, it would create a significant loss and change in remaining eurozone countries Capital Key ratio.  Even if France left, it would create a significant change in remaining countries Capital Key ratio and create damaged euro credibility.  A currency depends on its credibility to survive.

Could the eurozone survive as a monetary union without Spain and Italy if they defaulted on Target2 and redenominated their euro debt?

The political risks are growing and they are not supportive of democracy. 


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The Unfolding Pan-European Debt Crisis

The stock market, desperate for any irrational exuberance, is trading up today on the "hopes" of a European solution to the Greek economic troubles, while the actual information is extremely conflicted and indicative that a European solution is not yet nascent.

Trichet is returning early from the Australian conference of central bankers fueling speculation that the EU would have a special meeting, although ECB governors were again reaffirming the ECB does not have clear bail out authority and any decision to help Greece must be a political one.  The constant refrain is Greece must carry out its EU austerity plan.  In the meantime, a new EU economic team has been formed and there is speculation that the ECB unannounced exit plan may have to be delayed if it threatens to further destabilize market concerns about Greece, Spain, and other euro monetary countries.

We have previously documented that the banking problems in Greece, Spain, Portugal, and Ireland have all led to budgetary deficit problems and called for the EU and ECB to create Euro bonds to help solve the problem, because we do not think the IMF possible solution will be acceptable to the EU or Greece, because it also does not address the problem of a multi-national currency with no monetary policy to correct national competitiveness gaps which significantly limits national fiscal policies.  Greece has publicly said an IMF solution would send the worst possible signal.

The global debt controversy, which swings between deficit hawks and the efficiency of targeted economic spending, is overplayed even to the extent of what would be a proper Keynesian action plan.  German sentiment clouds both economic debate and what is best for the EU as a whole.

The EU needs to get its member nations to put the problems in perspective.  It is an opportunity for the EU to stand up and directly address the problems caused by a multi-nation currency in individual euro countries, who no longer have monetary policy options available to coordinate with fiscal policy.  The fact that the Eurozone is not an optimum currency area is obvious, but the creation of a two-currency European Monetary Union does not solve the multi-nation individual country economic problems relative to the multi-nation currency; it would only be a synthetic end run around a crumbling bridge.

Joseph Stiglitz is calling for national authorities to teach the derivatives speculators a lesson.  As Stiglitz has documented, another part of the problem is how Goldman Sachs helped the prior Greek government hide debt.  Yet, the primary hedge funds involved in driving the derivatives attack on Greece and Spain, which also drives the CDS costs of other nations up globally, are those of Goldman Sachs, J. P. Morgan, and three other hedge funds.  These attacks on sovereign debt for transitory profit are an example of a systemic risk which could throw the global economy into a double dip and depression.

While the myths and facts of this Eurozone debt crisis are many and not being fully debated and addressed for long term solutions, the final analysis is that failure to deal effectively and efficiently with the debt crisis risks sovereign debt contagion fueled by derivatives speculators and a global double dip into recession of unknown length.  The banks in each of these euro countries are intimately involved in the creation of this debt crisis which was facilitated by the euro and its effect on each individual country's economy in creating either asset bubbles or negative competitiveness gaps requiring public spending to pick up the slack of private spending or both. The excess leverage in the banking systems of these countries, and Ireland is the large powder keg in the background, is symptomatic of the difficult balancing act which must be done if a multi-national monetary policy is to work for the benefit of all member nations.  The leveraged banking problem is deep and significant; it is the problem which should be addressed urgently and is being masked by European Union monetary policy and the sovereign debt issues.  The creation of Euro bonds would be a step towards putting some flexibility in EU monetary policy and providing some teeth in individual member nation's ability to properly control their fiscal policy.  The alternative is a pan-European debt crisis which spreads from nation to nation around the world.  Ireland's bank debt dwarfs Iceland and the United Kingdom's debt level is even higher with government guarantees.  The EU and ECB need to come up with an end game that acknowledges the banking and sovereign debt as economic problems requiring monetary, regulatory, and fiscal coordinated responses, which facilitate fiscal policy responses appropriate for each member nation, and effectuate the euro as a true multi-nation currency.

Attempts to provide loan guarantees or otherwise put a thumb in the dike will not protect other EU nation's banks from the fundamental leverage problem and how it is acerbated by the euro.  Until a real, substantive coordinated plan actually emerges, the rumor mills will grind away.

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Did the EU Council Just Kick the Can?

As the week ended and the EU Council meeting of March 24/25 concluded, it was as if the week had never begun and all of the prior and continuing debate on a competitiveness pact and  extending the EFSF and establishing a permanent ESM, the bitter Irish question of their higher interest rate, the Irish consideration of default of guaranteed debt which is not national debt exposing senior bond holders of Irish banks, the German and French canard of Ireland's corporate tax being too low when it actually generates more tax on corporate income than other eurozone countries with lower corporate taxes, and the week's events in Portugal, with rising interest rates on its debt and CDS  and short term debt maturing in May and June, rejecting austerity and the international market's adamant speculation it must kneel to EU/IMF bailout, having its government resign had been some funky dream with phantom giants.

It was as if, while peering into the magic mirror, the reflection of another severe financial crisis which could cost European banks 250 billion euro vanished.  Never mind that the proposed ESM funding mechanism was a convoluted everyone guaranteeing everyone by using an inverted capital structure in which, if there was actual need, it would cause a reflexive price action in the bonds.  Here comes an important EU Council meeting with laborious and contentious  preparation at a time when the Irish hold a default trump card, Portugal was rejecting an austerity budget forcing the resignation of its government bringing the specter of another EU bailout front and center under intense flood lights, Spain's banks capital funding is being questioned (will the German banks ever be properly tested?), Greek revenue is declining on higher taxes and fees, the rigorousness of bank stress tests remain negotiable, rising interest rates in Ireland, Greece, and Portugal as the eurozone continues to take no timely and effective action until it is too late, spreading anti-austerity demonstrations and protests in Greece, Portugal, and the UK as well as other eurozone countries, the Finns saying they will vote on no issues until after their April elections, nationalist political movements in France, Finland, and the Netherlands, and the never ending bitter internecine German national political tragic-comedy.  Knock, knock, is any body listening, watching, or paying attention?  Are there no clear fiscal solutions which are not two speed divisive and destructive?

Yet, the proposed ESM was viewed to be divisive.  After a third round of stress tests, Ireland may have to pump 27.5 billion euro into Irish banks which would exhaust 80% of the 35 billion euro bond fund set up last year by the EU.  With Ireland standing to lose over 35 of revenue if the corporate tax was harmonized, many in Ireland thought that it would be best to have no deal, and not play the trump yet, rather than a bad deal if Germany threw its weight around and France continued to tag along.  Germany actually seems to be unable to understand finacial risk figures with German banks having 21.4 billion euro exposure to Irish banks and 64.7 billion euro in loans to Irish businesses.  All of the ESM restructuring talk predictably sent the bonds of Ireland, Greece, and Portugal spinning.  However, much of the restructuring being discussed is just a deepening of the pit with those servicing the bonds having to accept lower wages while the bondholders do not share in the union and keep wages high.  Ireland is contracting not growing.  Ireland is very dependent on exports and is still recovering from 2009, although its 2010 current account balance deficit is only about one fourth of the 2009 deficit.  Portugal has a deteriorating cash position despite believing it has enough to get through debt maturities in May if not June, however, the political situation was untenable to the degree that the ruling party pushed a no confidence vote scenario.  While many believe there is no eurozone crisis as long as Spain remains sustainable, the value of its banks assets are constantly being questioned with mortgages on the books being, perhaps, overvalued by as much as 45% laying the ground work to pressure rates up despite Spain trading very much like Italy in the bond market.

The pessimism surrounding the EU Council meeting was pervasive and on the the 24th Wolfgang Munchau voiced his three scenarios, including break up if Germany continues to insist on limited liability.  Danske Bank in its three scenarios was even darker with default, Germany withdrawing, and eurozone total breakup with possibilities of revolution in parts of Europe.  The EU itself had only a four item agenda: current crisis resolution, future crisis resolution, the pact for the euro, and the Commission’s proposal for reform and extension of the stability pact.  To which was added Libya.  What Europe got was a less substantial ESM with more funding commitment starting in 2013 which gave Merkel political cover in Germany and with an extended funding period over five years beginning in 2013 just after elections in Germany.  The conclusions of the meeting were limited, soft, contradictory, and avoided action on any problem facing the eurozone.  This was seen as a great victory in Germany.  Of course, the day after the meeting the worry over debt and commitments and liabilities  as well as the absolute need to punish surfaced, without any consideration of the effects of haircuts on bonds would have to German banks.

In the rest of Europe the reality was quick to set in with the realization that Greek and Irish bonds have already been discounted making any buy back program inadequate.  The ESM cannot have a triple-A status and an effective lending capacity of 500 billion euro.  The ECB began working on an emergency plan to provide 60 billion euro in medium term liquidity to Irish banks.  A "major" European default still remains the biggest threat to the global financial market.  All of the fanfare in Germany, France, and Italy are premature in the face of Portuguese instability.  The EFSF would in effect be collateralizing or wrapping bonds of restructured bonds which would be guaranteed by the eurozone as a whole.  As of Monday the 27th, Portuguese bonds will not be eligible for delivery in any of the RepoClear single A €GC basket, although LCH.Clearnet will continue delivery of Portuguese government bonds.

Portugal is going to have to come up with some bridge financing from the core eurozone or other international or private sources to insure it can get through June debt redemptions.  Ireland is waiting to see if they will get help with their banks and, if Portugal is forced into bailout, what interest rate they get.  Greece is fighting mounting demonstrations and tax protests.  Anger is spreading against the inequity of austerity is condemning countries forced into austerity, lower wages, and personal family financial sacrifice by the eurozone rules to a future of no growth or very slow and low growth, if they are lucky, while the benefactors (the eurozone countries that export to them) continue to profit from their current account surpluses generated by the faulty construction of the monetary union and refusal to allow the formation of an effective fiscal union.

The EU Council has kicked the can down the road to June.  Will they kick it even further down the road in June until, as is their usual practice, it is too late to act decisively in a timely and effective proactive manner?  The bond vigilantes have been betting NO and winning; there will, consequently, always a next victim until they run out of eurozone countries.  At what tipping point will this credit crisis be recognized as a currency crisis and the global financial market catches contagion?

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Leftovers -- Radio Show 5/8/2010

On the 4th of May the stock market went into correction and this meant, if you listen to me, you would have been out of individual stocks and ETFs (which were not part of a well diversified portfolio or fully hedged portfolio) by the end of May 5th.  This would have meant that the wild flash decline and subsequent recovery would not have affected your positions, because all 8% stop-loss or stop-loss limit orders would have been executed by the end of 5 May or sold manually.  The wild crash and recovery on 6 May is from unknown causes but appears to have resulted from several factors starting with a NYSE slow down in trading which caused orders to be sent for execution to electronic markets, a large S&P 500 mini sell order, and algorithmic computer trading programs kicking in and/or defaulting to 1 penny prices as the result of electronic market, with no market makers, sell volume.  Tupperware, which had been a subject of a listener question a few weeks ago, fell 14.8% for the week.

NYSE subsequently decided to cancel orders executed within an approximate 20 minute time period on 6 May if the price was substantially below the immediately prior market prices.

Monthly Jobs report showed an increase of 290,000 jobs minus 66,000 Census temporary jobs equals an increase of 224,000.  Official unemployment increased to 9.9% from 9.7%.  Official discouraged workers is 17.1%, but, if you use the 1994 calculation, discouraged workers are approximately 22%.

U.S. retailer sales were weaker than expected up only .5% at stores open at least a year which was far below the 1.5% expected.  Even discount stores saw a decline in sales.  This continues to show the recovery is too dependent on consumer spending and consumers are not spending with continuing long term high unemployment.

The number of people working part time for economic reasons was unchanged at 9.2 million.  The Employed to population ratio went up to 58.8% from 58.6%.

Tom Duy in his Fed Watch blog said that the inventory drain has become apparent and prices are edging up again.  He doubts that consumer spending can be sustained, because it has been heavily supported by falling savings rate, while income growth less transfer payments remains stagnant.  We have growth but it is growth which leaves the economy limping along and heavily dependent on policies which stimulate consumer spending.  He stated the opinion that outsourcing over the last twenty years has left the U.S. structurally dependent on trade deficits.  Inflationary growth continues in China and other Asian countries like South Korea and Indonesia, while the U.S. needs to decrease imports.  With the Fed is keeping interest rates low , there is not sufficient growth to alleviate unemployment.  He sees a declining value of the dollar as necessary to spur exports, but I have to disagree, because increased exports would require competitive products being sent to countries that are decreasing exports.  I do not see that happening.  A stronger dollar would bring foreign money into the U.S. as a safe haven for investment and would provide more buying power for U. S. businesses abroad..He also cannot understand that the eurozone countries will not benefit from euro devaluation, because the current account balances of each country are not fiscally adjusted within the eurozone.  Rather than internal devaluation (cut wages, raise taxes) those eurozone coutnries with current account balance deficits need targeted investment to stimulate growth and adjust nominal wages and labor units.

The Pragmatic Capitalist noted that the rise in the Libor parallels the spike in Greek sovereign CDS.  It is happening because banks are starting to not trust each other.  It is apparent that the Libor is reacting to counterparty risk.

China raised required bank reserves 50 basis points to 17% for big lenders and the banks were told to reign in credit issuance.  The central bank is stepping up its open market operations in the attempt to drain liquidity.  It wants to reduce new lending this year by 22%.

It appears the bailout of Greece by the EMU and the IMF will encompass approximately 110-115 billion euro available over three years with 80 billion from EMU and 30 billion from the IMF.  The Greek parliament passed an austerity package needed to receive the bailout and Germany approved their first year payment of funds for the bailout.  The money will be in the form of loans at approximately 5%, which is high.  The ECB suspended its minimum credit rating threshhold on sovereign debt to allow Greece to participate in ECB lending programs, even if their debt is further downgraded.  Trichet, the ECB chairman, said Greece is a special case and he is confidant Greece will do what it must do.  French President Sarkozy said the EU needs a mechanism in place to defend the euro.  Germany reiterated there needs to be more rigorous enforcement of the deficit limitation rules and a closer monitoring of sovereign government finances by the EU.  Germany sees speculation against the euro and a repetition of the 1931 currency crisis in its insistence on deficit reduction rather than targeted investment to spur growth in those euro countries with current account balance deficits, because they have non-competitive exchange rates and there is no method for fiscal adjustment within the eurozone.

Hussman sees the Greek problem as a violation of transversality in which there needs to be a well defined  present value of debt in order to credibly pay off debt.  Greece has insufficient economic growth; it is accruing high interest rates payable in a currency it cannot devalue.  Without transversality, the price of a security can be anything the investors like.  Transversality forces the price of an asset to be equal to the discounted cash flow value. He thinks the Maastricht Treaty would have to be changed to allow for larger budget deficits to achieve anything from the bailout other than short term results.  He believes the budget discipline imposed upon Greece will be hostile to GDP and tax revenues making it more difficult for the bailout to succeed.

Martin Wolf, in "A bailout for Greece is just the beginning" published in Financial Times (copy the title and Google search to get past the Financial Times paywall), thinks the 110 billion euro bailout will be enough to take Greece out of the debt market for two years only.  The agreement specifically prohibits any debt restructuring.  The plan sets 2014 as the year in which deficit will be less than 3%.  To get to that Greece will have to endure a cumulative decline in GDP of at least 8%.  He believes Greece may be unable to avoid debt restructuring.  "Given the huge fiscal retrenchment now planned and the absence of exchange rate or monetary policy offsets, Greece is likely to find itself in a prolonged slump."  While Greece needs to fiscally adjust nominal wages, the debt burden will actually become worse.  In his opinion more money will be needed is restructuring is ruled out.  In my opinion, the bailout should be closer to 140 billion euro and Greece should be allowed to restructure debt by extending the maturity dates of all debt by five years.  Wolf sees the bailout as rescuing European banks and not Greece.  Wolf believes the eurozone must either allow sovereign default or create a true fiscal union and funds sufficient to provide fiscal adjustment when needed.

The eurozone has a single central bank tied to disparate national fiscal policies and there is no mechanism within the EU to respond to fiscal adjustment needs of individual countries.  There are no EU taxes, no EU distributed spending, and no EU bonds or debt.  Some would like a common tax policy and EU review of sovereign budgets.  I believe there should be a Euro bond and, rather than being tax based, guaranteed by the sovereign nations of the eurozone combined with a Fiscal Adjustment Fund to respond to the special needs of individual countries in need of GDP growth and fiscal adjustment of nominal wages and labor units or in need of more internal consumption like Germany.

Spain sold 3.09 billion euro of 5 year bonds with a yield of 3.6% up from 2.8% from the issue sold in March.  The bid-to-cover was 2.4 up from 1.5.  The spread between Spanish bonds and German bonds has grown from 80 basis points to 160 basis points in two weeks.

Bullard, the St. Louis Fed President, said a sovereign default in Europe could threaten the continuing recovery in the U.S.  However, Greece cannot default without totally withdrawing from the EU, which would be a potentially greater bombshell than default in my opinion.  Rather than a debt crisis, this is, in my opinion, a credit crisis and the risk is that interbank lending may become frozen in Europe and create a global crisis.

Nomi Prins had an excellent article on how proposed financial reforms are basically not touching hedge funds, private equity and trading abuses of banks, and the lack of proper risk management in the financial banking system.

The Consumer Metrics Institute had an very good article on how the collection and time period of GDP numbers are ancient history by the time the quarter of record is completed and shifts of just two weeks in either direction could have profound effects using their sampling during Q4 2009 and actual Q4 2009 results.  In their opinion demand side numbers are continuing to contract indicating a possible double dip.

Roubini had a strange fear inspiring article in which he fears U.S. debt will result in either inflation or default, but it is not true, in my opinion, that debt equals inflation.  Inflation expectations are high and may be growing although we are presently in a deflationary situation.  However, in my opinion, there is the risk of inflation as the Fed exits from its $2.3 trillion balance sheet by selling mortgage backed assets after all liquidity programs have ceased.  It has tried very hard to increase U.S. banks capital ratios and liquidity at the expense of long term continued high unemployment.  This will be a very difficult balancing and timing act that may go in spurts as the Fed adjusts to market response.  As long as the Fed continues low rates, it cannot begin an exit and sell assets.  I think Bill Mitchell would agree with me.

Bank analyst Meredith Whitney is steadfast in her opinion there will be a double dip in housing and that banks are "under-reserved".

AIG Q1 profit was $1.21 per share or $1.45 billion net.  Just one week ago it drew down another $2.2 billion from the New York Fed loan facility for a total net loan of $21.6 billion plua $5.8 billion in interest and fees.

According to the Fed, banks have tightened credit card terms and loan standards for small businesses which is tightening credit and restraining the economy, although consumer and business demand for laons has declined.

Consumer spending is up as savings is going down.  Savings are being spent.  U. S. personal income was up .3% in March, but spending was up .6%.  This is not sustainable without jobs and income growth.

ISM U.S. service sector index was flat at 55.4 for April and march; employment was down to 49.5 from 49.8.

ISM manufacturing index was up to 60.4 from 59.6; new orders were up to 65.7 from 61.5; inventory was down to 49.4 from 55.3; production was up to 66.9 from 61.1; customer inventory was down to 33.0 from 39.0; prices were up to 78.0 from 75.0.

U.S. factory orders were up 1.3% in March and February was revised up to 1.3% from .6%.

GM sales were up 6.4% April vs year ago.
Ford  was up 24.7%.
Toyota was up 24.4%.
Hyundai was up 30%.
Chrysler was up 25%.

According to a Hewitt study, retirees will need 15.7 times final annual salary with 4.7 times coming from Social Security and only 18% will have that.  On average workers accumulate 13.3 times annual salary leaving 2.4 times as a shortage.  Defined Benefit participants are likely to have 74% of needs.

Consumer borrowing was up 1% annualized for March ($1.95 billion).

Canada's finance minister, Jim Flaherty, said high unemployment and fears of a renewed credit crunch could harm economic recovery and there is need to be cautious.

German retail sales were down 2.4% in March but up 2.7% vs year ago.

Producer prices in the eurozone were up .6% in March and up .9% vs year ago.

Brazil's industrial output was up 2.8% in March.

China's National Bureau of Statistics sees 9% growth and a 4% increase in consumer prices.

Indian consumer prices are projected to rise 7.5%.

Australian retail sales were up .3% in March (expected .8%) after dropping 1.2% in February.

German industrial output was up 4% in March for its biggest gain in ten months.

The Federal reserve FOMC policy makers have agreed to sell some of its $1.1 trillion MBS assets but remain divided on timing and extent as too soon and/or too much too fast will hurt recovery.

Australia increase interest rates by 25 basis points to 4.5% for the sixth time in seven months.

Moody's placed Portugal on review pending a credit downgrade.

ECB held its interest rate to 1%.

Spanish GDP was up .1% in Q1 (first in six quarters) and it is seen as exit from recession by some.  I prefer to see two successive quarters and, if Spain adopts a EU austerity program, it will go back into recession.

Vanguard ETFs are now commission free at Vanguard.

GMAC changed its name to Ally Financial.  2010 Q1 profit is $162 million vs <$675 million> year ago.  Its troubled mortgage unit --- Residential Capital --- had a $110 million profit.

Two money losing airlines (United and Continental) will merge.

Pending U.S. existing home sales were up 5.3% in March and February was revised up to 8.3%.

U.S. personal bankruptcies were up 15% in April.

Freddie Mac Q1 was <$6.7 billion> and wants another $10.6 billion from the U. S. Treasury.



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Leftovers -- Radio Show 2/27/2010

Tyler Cowan and Felix Salmon both commented on Gary Gorton's new paper, "Questions and Answers about the Financial Crisis", with regard to the use of repos creating fragilities in the banking system.  Banks no longer just use deposits as funding sources.  The use of repos as funding sources creates a systemic risk, because the bond market depends on the denial of risk and when risk becomes questioned, the bond market comes to a grinding halt.  We should not try to guarantee repos as we guarantee deposits, but all systemic risks should be regulated and decisions made on how commercial banks function and investment/trading banks function.

China's banking regulator told commercial banks to restrict new lending to local governments and stop lending to those projects backed only by expected fiscal revenues.

China has performed some stress tests of potential yuan appreciation.  The tests which concentrated on the textile, shoe, garment, and toy exporters found that every percentage point of yuan appreciation would erode one percentage point of their profit.

While derivatives traders are still betting the euro will continue to slump, any speculation that the euro is doomed or will fade away is misplaced.  It is here to stay, although the EMU needs to restructure its trade and monetary policies, as well as how it applies the Stability and Growth Pact.

The Greek central bank governor said the Greek balance of payments gap is unsustainable.  As we have been saying, a crucial part of the current problem is the fixed trade exchange rates between the Eurozone countries, which create competitiveness gaps.  The Greek central bank governor said, "The balance of payments deficit is not sustainable. A policy mix which will bring back the macroeconomic and microeconomic imbalance and improve the economy's competitiveness and productivity is needed to restore sustainability."

The economist, Carlo Bastasin, has written that the IMF cannot help Greece, because it is less able to address the problem of restoring equilibrium  in the current account balances within the Eurozone.  The Greek fiscal deficit and the loss of competitiveness are connected, because a current account deficit (imports over exports) will make it more difficult for the Greek government to raise taxes to cover the public deficit.  "...If Greece's growth prospects are more limited, its existing debt burden is more onerous."  To avoid this, the domestic demand of Greece's trade partners needs to increase.  "In other words, the Greek problem is the mirror image of the 'hidden' German problem", which needs to increase domestic demand and lower labor costs.  You cannot solve the Greek imbalances without correcting the German imbalances.

The role of large banks and hedge funds in threatening the survival of Greece and the value of the euro in order to make short term derivative trading profits is drawing the attention of other European countries and there is a growing consensus that regulatory action may be necessary as the credit default swaps are increasing systemic risk. 

The ECB refuses to release information as to how many Greek bonds are on its balance sheet as the results of its repo operations.  It is speculated that many of the Greek bonds, of which there are approximately 270 billion euro total, which were held by European banks are now in the possession of the ECB and 37 billion held by Greek banks.

After the EU commission visit, the Greek prime minister said that the worst fears of the Greek economy had been confirmed and the Greece would miss its deficit reduction efforts if it did not carry out more spending cuts which have already sparked demonstrations.  The EU commission indicated that Greece may be able to cut its deficit by 2% rather than the 4% goal. There is increased antipathy between Germany and Greece, which will hinder Greece's ability to obtain EU support for its deficit reduction program.

Portugal has said it is under no pressure to speed up bond sales as 20% of its financing needs have been met for the year.  Portuguese bonds are the worst performing in the region.

The Bank of Spain is considering raising the minimum amount banks must hold in provisions of potential losses in property assets.  Many experts believe Spanish banks will face a new housing crisis in the coming months.  They may have to absorb between 100,000 and 150,000 homes immersed in foreclosure cases.

The Irish government is being forced by the EU to take a 15.7% stake in the Bank of Ireland PLC in lieu of a 250 million euro cash dividend due the government despite the need to contain government deficits.  The government holds 25% preference shares in both the Bank of Ireland PLC and Allied Irish Banks.

Italy has the second largest debt and is considered to the economy of the Eurozone according to the economist Robert Mundell, who won the Nobel prize in 1999 for research which lead to the creation of the euro.  Italy's economy contracted .2% in Q4 and risks falling back into recession.  It has 1.8 trillion euro in debt, which is five times that of Greece and one-quarter of the Eurozone debt.

US Treasury auctions: 
30 year TIPS, $8 billion, yield 2.229%, bid-to-cover 3.33, foreign 42.4%, direct 15.1 in what was seen as a weak, soft demand.
2 year Treasury, $44 billion, yield .895%, bid-to-cover 3.33, foreign 53.6% (high) and 100% filled, direct 8.2%.
5 year Treasury, $42 billion, yield 2.395, bid-to-cover 2.75, foreign 40.3%, direct 12.8%.
7 year Treasury, $32 billion, yield 3.078%, bid-to-cover 2.98%, foreign 40.3%, direct 17.2%.



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Portugal Refuses to Be Held Hostage

Portugal has consistently iterated that it has no desire for any EU and/or IMF bailout.  Portugal has consistently railed against the international market pressures betting on bailout which have forced up bond and CDS prices and has fought back with private placements and short term borrowing to avoid locking in high interest rates for long periods.  Portugal refuses to be held for ransom by an international market which is playing the historical incompetence (original Spanish text here) of the eurozone countries, the ECB, and the EU, which has consistently waited until it is too late to respond to the fiscal union needs of the eurozone members resulting from the structural deficiencies of the euro and its eurozone exchange rates.

While Portugal has committed to austerity to please the eurozone rules, its sincere attempts have meet with increasing political opposition, public protests, and little eurozone help.  If Portugal had its own fiat currency, would the international bond market be as concerned about its ability to grow?  What the international bond market recognizes is the dependence of eurozone members upon the willingness of other eurozone members to act together for mutual self-interest within a monetary union which has no functional fiscal union mechanisms of fiscal support.  The willingness to support each other has been perverted (original Spanish text here) by a fear of debt, by a fear of sharing debt, by a fear that union means not just taking but giving, and this fear is so great that the body stench of fear is overpowering in its pervasiveness, in its intellectual panic and dreading, and in its crowding out of rational, critical analysis and consistent, collective resolution.

While the ECB has stepped in to buy Portuguese bonds to marginally keep interest rates down, they did not do so in a manner which did not influence the market rate as a market maker would have done and the market has broken down consistently in Greece, Ireland, and now Portugal.  The ECB is a central bank with no sovereign funding base relying on contribution assessments which must be ratified.  The good faith credit of a sovereign nation with a fiat currency depends on its perceived ability to tax and collect revenue, promote output, and create fiscal policy.  The eurozone has created the euro as if it were based on a gold standard, which it is not, while failing to provide for fiscal transfers, fiscal account balance adjustments, the fiscal means to promote growth, and a unified debt issuance facility, preferring to leave each member to issue euro denominated debt which is at least, if not more, as dangerous as if it were a sovereign nation with a fiat currency issuing foreign denominated debt.

While the German and the Austrians were trying to convince each other the EFSF was big enough for improved conditions and the Germans were trying to find ways to evade the upcoming European bank stress tests, Portuguese bonds were setting off alarms and moving up towards crisis levels in February despite, almost as if independently driven, Portugal's strong efforts to find alternatives to debt auctions, such as syndication.  When that happens then sovereign related corporate debt also begins to hike and become broken.  Still, Portugal continued to raise money but at higher rates and with lower credit ratings.  ECB liquidity operations were helpful but not significant given Portugal's banks may not have been able to issue debt to foreign investors for at least a year.  With falling tax collections and revenue in Greece, Ireland challenging why its bailout interest rate is higher, a cold reception to EU finance ministers permanent EU bailout fund, and the market saying Portugal will have to ask for a bailout, Portugal remained adamant it would not ask for a bailout, despite an austerity driven contracting economy, as bond interest rates rose for all three.

It was as if no matter what Portugal did financially or economically or politically, the Gods of Debt were orchestrating its fate without regard to human effort or purpose.  A new, more severe austerity budget was being proposed against strong popular and political opposition by the Portuguese government of Prime Minister Jose Socrates and the market could smell the spoils of political defeat.  The austerity budget was overwhelming defeated with only the Prime Minister's party members voting for it.  This left Portugal with the need to raise 20 billion euro this year, a Prime Minister resigning, and the EU Council meeting convening.  Portugal's deficit may be revised up to 8% for 2010 and analysts woke up to the effect of the rising Irish bond rates, which exploded in September, had on other eurozone countries like Portugal, at the same time Germany is throwing the whole permanent bailout fund proposal back on the table for renewed debate.

Still, Portugal remained defiant it would never ask or accept a bailout having seen what happened to Greece and Ireland, but the market just shrugged it off as what they all say before it happens.  All of the warnings have been essentially ignored by the eurozone and the ECB until Portugal is on the brink and facing elections with no credible government to ratify any bailout, even if one is forced upon them.  The failure of the eurozone to proactively support member nations and promote growth with fiscal policy leaves Portugal's bonds heading towards 8% and no real government and a EU council which has continually kicked the can down the road.  The Pact of the Euro basically proposed a mechanism for future crises, has been solidly criticized as too punishment oriented and not enough resolution oriented, and exposes the currency as unstable.  With early estimates of a Portuguese bailout at 70 billion euro ($99 billion), creditor countries are scrambling for cover.  Any actual bailout may cost 80 billion euro with another 37 billion euro in maturing private Portuguese bank debt up in the air, as if the Portuguese central bank and government could come up with it without the help of the ECB.  The whole agenda of the European Council has been thrown in disarray with the likelihood that nothing of substance will be accomplished: no permanent bailout fund, no action on Irish interest rates, no competitiveness pact, no current or future crisis resolution, and no reform and extension of the stability pact.  The Finns are not prepared to support anything with elections in April.  The Germans have intensified their internal political squabbling and are demanding that their ESM capital injections be delayed until after the German 2013 elections as well as an insistence in providing financial assistance only when it is too late to prevent bailout and just prior to financial collapse.

What remains beyond the grasp of the eurozone countries with the predominant preoccupation with debt and transfers to debtor nations is the root problem is one of low growth (original Spanish text here) and an inability to recognize that growth requires not austerity and government debt reduction but economic stimulation through fiscal policy with government spending efficiently concentrated on the creation of output and jobs.  With the turmoil of German politics, the rise of nationalist parties in France, Finland, and the Netherlands, and popular anti-austerity protests growing in Greece, Ireland, Portugal, and the UK, the eurozone is converging fast towards a showdown between those creditors who preach the sins of debt while raking the money in and those who realize their only hope is growth.   Spain is a trillion dollar economy, the fourth largest in the eurozone, and has a smaller debt to GDP ratio than Germany.  If Portugal is made hostage to a bailout and forced to continue to pay ransom to the bond vigilantes, then the pressure will turn to Spain.  Without growth Spain cannot survive.  The consequences to European banks are horrendous, particularly for German and French banks.  One-third of the assets of Spain's banks are composed of private and government sector exposure to Portugal (original Spanish text here).  German banks have three times more activity in Portuguese banks than Spanish banks do.  French banks have twice the exposure to Portuguese public debt compared to Spanish banks.  One could go on with individual countries banking exposure to Greece and Ireland which can be found in the Bank of International Settlements data.

The root problems are not new, but the major players are flying blind in their sleep, trembling in fear of growth for all.

On very directly related subjects, we have recently written:

German Economists & Eurozone Insolvency
The Eurozone's Murder-Suicide Pact
Ireland's Indentured Servitude

and more past:

Ireland Betrayed
Germany's Irish Hair Shirt
On the Road Out of Ireland
Ireland's Bad Bank
Denial and the Pan-European Debt Crisis
The Unfolding Pan-European Debt Crisis
Greece, Spain, and the Euro Trojan Horse


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European Economic Commentary Week Ended 4/3/2011

As other investment advisors have told me, institutional investors are blasé about the global financial threat inherent in the eurozone currently, because they either believe the eurozone will just keep muddling along or it is doomed to collapse and the ECB and EU will provide sufficient backstop; these high level investors just do not want to think about the threat to the global financial system.  Interestingly, the same holds true for the high probability of a housing double dip in the United States and a financial system which has become more concentrated and systemically dangerous, more politically powerful,  and has successfully resisted significant regulatory change.  At the same time China is on the brink of slowing and slowing rapidly until it suddenly jumps back on economic growth with excessive investment.  In the past, I have characterized the Chinese adjustment problem as similar to a driver in an automobile with two accelerators and two brakes.  These are all serious potential threats to the global financial system.

Last week we wrote about "Reorganizing Irish Banks" in which the ECB has refused to provide necessary medium term bridge financing, in which the EU is not willing to discuss lower interest rates for loans to Ireland, and the Irish people are becoming increasingly dissatisfied with how other European banks and countries are being beneficially fire-walled at the expense of the Irish people.  That article took a lot of the European commentary for the week, but much has been left.  I realize my former weekly "Economic and Market Commentary" were very popular, but they took an average of eight hours or more to organize and write and after two weeks I was only half finished with the week ending 12/25/2010.


While the QNA report showed annual declines in Ireland's GDP and GNP were <1%> and <2.1%>, the year to year quarter comparison showed a real GNP gain of 2.7% and a GDP decline of <.6%>.  The nominal effects on the budget deficit were not encouraging for a country which does not have a fiat currency.

During 2010, the average price for a house in Ireland dropped 10.8%.

In the UK anti-austerity demonstrations were allowed by authorities to get out of hand, despite knowing the plans of fringe groups to be disruptive and destructive in other wise peaceful demonstrations.  The UK Chancellor defended the austerity cuts as necessary to create growth and jobs.  As we have written numerous times, there is significant economic theory from different economic theoretical schools which shows the opposite will happen, except for a small elite class.  Meanwhile, UK productivity is disappearing, although I doubt it is the result of rising business regulation and more the result of less demand creating less investment.

In France right wing nationalists have softened their speech to appeal to larger segment of the French population and are gaining support.  The True Finns, a nationalist party, is expected to get 18-30% in the elections in Finland.  The nationalist party in the Netherlands, as the third largest party, remains a policy influential coalition partner in the government.  In Germany, the nationalist concerns with immigration, debt and budgets, and EU fiscal transfers have caused divisions which have allowed the left Greens and SPD to benefit in Baden-Wurttemberg state election.

Greek unemployment was up to 14.8% in December and austerity is making the social problems more toxic.  Increased demonstrations and strikes are occurring and increased fees and taxes are being ignored by the people.

It has been popular to blame the current eurozone problems on unit labor cost in the different countries and the degree of debt to GDP.  While the period after the adoption of the euro did show a significant increase in unit labor costs, except for Germany, debt was not a problem until the global financial crisis.  Since nominal depreciations are precluded in the eurozone and fiscal transfers are not sufficiently available in the monetary union which has failed to provide fiscal union, the common currency is central to the problem.  Looking at unit labor costs in relation to other competitiveness indicators would appear to show that it is a misguided analysis and that internal devaluations will not work as the real lack of competitiveness comes in the export basket of each nation --- and I would add in what they import.  Unfortunately, movements towards fiscal centralization have been to enforce fiscal stringency and not to reduce the problems of a common currency.  Consequently, continued austerity, as the Australian economist Bill Mitchell has inveighed, will mean a slow, sluggish recovery in Europe.

While Spain has been actively building a firewall against contagion, its efforts to bolster the capital strength of its banks is being constantly questioned.  The merger of four Spanish cajas (savings banks) failed when they asked for 2.78 billion euro from the Fund of Orderly Bank Restructuring after the Bank of Spain had estimated their need at half that amount (1.45 billion euro).  Later in the week, another savings bank, CAM, was not able to complete a merge and the Bank of Spain began hunting for a buyer.  This has been seen by many as a prelude to what will come.  While the Bank of Spain has estimated savings banks capitalization needs at 15 billion euro, others are estimating 23.6-29.2 billion euro.  I have maintained for some time the Spain is the keystone and will be the next target after Portugal whether it deserves to be or not.  Meanwhile the Bank of Spain is estimating unemployment will rise to 20.7%.  This unemployment is wide spread across age and education. While the EU dithers and looks to punish rather than preemptively help, Norway's (not in the eurozone) sovereign wealth fund is looking to invest in Spanish companies. 

The new Basel III bank rules, which German banks are fighting, may mean that European banks have to raise 2.3 billion euro in capitalization at the same time insurers, at the same time as the largest buyers of bonds, are be forced to limit bond purchases under the EU Solvency II rules.

Portuguese debt yields soared.  The resignation of Portugal's government means it will be very difficult to negotiate a bailout, which is not politically popular in Portugal, during an election.  S & P downgraded Portugal's five largest banks for what was essentially seen as not financial reasons but the political situation.  The Portuguese opposition party has endorsed a plan of budget cuts without tax increases as a conservative attempt to gain votes despite heavy public opinion against austerity.  The Portuguese government maintains it can meet its bond redemptions in 2011, although there are those who say it will not have the liquidity to meet May redemptions.  The government also announced it had a budget deficit of 8.6% rather than the target 7.3% in 2010.  When Portugal did sell 1.6 billion euro of short term bonds due June 2012, it was at 5.793% versus 4.331% on one year bonds sold on March 16th, just two weeks earlier.

A German finance minister has joined several other European countries in suggesting covered bonds be included in Level 1 assets as there are not enough sovereign bonds to fulfill the asset level needs for banks.

As we wrote last week, the European Council's emergency funding creation the ESM is being recognized as a threat to the perceived credit worthiness and credit ratings of peripheral countries, because it would require default and/or restructuring of debt for assistance.  Portugal and Greece were both downgraded by S & P on concerns the ESM would force them to restructure debt and S & P called the ESM a negative game changer.  Even the Italians have shown skepticism and referred to the ESM reforms as the Germanization of the euro.  The French, despite France's faithful companion role with Germany, have expressed the observation that the ESM is imperfect and requires immediate revision. While the ESM has been hailed as the Grand Bargain, it has failed to create an exit from crisis at an acceptable political cost, it has complicated the fiscal costs of the financial crisis, and it has failed to create a mechanism which will deal with and prevent fiscal crisis in a system which does not allow orderly fiscal transfers.  Munchau has also pointed out the ESM "Grand Bargain" will be phased in and not fully funded until 2018 to appease German voters, everyone is guaranteeing everyone, the EFSF has no capital making default a risk to guarantors and is the emergency mechanism until 2013, and the fiscal adjustments of a guaranteed payment will not be politically acceptable to national governments.  Institutional ownership of Greek and Portuguese bonds has melted away to the point where not even short, via demand to borrow bonds, positions are dead. The S & P lowered Ireland's credit rating to BBB+ from A- citing the  possibility of restructuring under the ESM.  The IMF is, according to Der Spiegel, rumored to be urging the Greek government to restructure its debt now with lower interest rates, extended maturities, or actual haircuts on the debt.

The ECB has informed Ireland that if it wants a medium term funding facility, it will need to guarantee the debt.  Prior to the release of the Irish bank stress tests, the Bank of Ireland made a plea to the government to avoid nationalization.  The ECB does not fear default by Ireland or other peripheral countries, because the central banks of all eurozone countries are borrowers from the ECB, which means the risk is piling on other central banks and money flows from one national central bank indirectly through the eurosystem.  This means, for example, that Germany has actually provided more funding than estimated.  The European banking system is highly interconnected with, for instance, German banks exposed to 22% of Greek external debt, 21% of Spain's external debt, 20% of Ireland's, and 14% of Italy's.  While the ECB sees hidden burden sharing, the Irish do not see burden sharing.  The eurozone is flying without a safety net and with a higher possibility of a potential significant drop in aggregate demand than is discounted.  The ECB and the eurozone cannot afford a sovereign default and, yet, the newly designed emergency fund would require default and restructuring before assistance is given a country.  How is the ESM "Grand Bargain" not the the Grand Shaft for the peripheral countries?

Despite having been rebuffed by the ECB on lower interest rates on its bailout, Ireland still intends to argue for lower interest rates at future EU meetings and with the visiting IMF team.  As I have argued in past articles and as was discussed in the above paragraph, if the ECB ultimately fails to provide the medium term funding facility, is the ECB willing to take the blame for the ECB and other European national central banks being left with what would remain of the Irish banks and the losses of the Irish bank senior bond holders, who are banks in Germany, France and the UK among others.  Politically, the new Irish government sees no possibility in turning back on their election promises to the people.  Some informed commentators in Ireland believe the recent bank stress tests did not disclose anything which was unexpected and the more serious problem are domestic and international market commentators who do not understand Ireland's financial condition and have ulterior publicity motives in claiming default is inevitable.  What begs the question is, how will the Irish government answer to its people if the ECB and European Council run the country for the greater benefit of mainland Europe?

The possibility the ECB will raise the interest rate in response to German inflation is ignoring the very negative economic impact such a move will have on the peripheral countries.  It will be like throwing oil on the fire.  While some might argue that inflation will cause greater cohesion in unit labor costs as Germany adjusts internally, it is still acknowledged that ample discord will result within the eurozone over inflation and the ECB response.  Jurgen Stark has confused the states within the fiscal union of the United States with the nations of the eurozone and jumps from the Fed does not create policy for individual states (because they are part of a fiscal union with fiscal transfers) to the ECB cannot tailor monetary policy for individual eurozone (which has no fiscal union) countries.  They are not comparable except in contrast.  As far as Stark and others are concerned, including the ECB, the peripheral countries can suck it up and suffer.  The German view prevailed at the European Council and provided limited liabilities in an emergency funding ESM mechanism, which will not take effect until 2013 but is now negatively affecting the peripheral countries credit worthiness and ratings.  The German viewpoint is actually accelerating the problem of domino credit attack and crisis on one eurozone country after another.  Bill Mitchell has elaborated in lengthy detail on how the eurozone is pursuing the wrong goals.

This completes this European/eurozone economic commentary for the week ended 4/2/2011.  It took over six hours and I have not touched any market commentary for that week or any general economic commentary, or United States, China, Japan, or the Middle East of which I have plenty left.

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Euro Deal Euphoria or Wake?

The announcement of a euro deal emerging from the EU Summit on the "debt" crisis yesterday pleased the markets, but it has solved nothing  and appears to have a 100% chance of failure.  In fact the deal only further exposes the the fundamental construction weaknesses and limits of the euro which has doomed it to failure.

How far can you kick a can down the road with a dead cat inside?  Apparently, only one day.  Italian bond yields exceeded 6% at auction today.

Auerback, Wolf, and De Grauwe, among others, have called for the ECB to step up and be a lender of last resort consistent with the role of a central bank.  Unfortunately, the ECB by Treaty construction and ECB rules and establishment is not a real central bank and does not have the independent authority to buy bonds, issue currency (the NCBs issue currency under a rigid ratio per nation with the ECB limited to 8% for clearing purposes), or provide liquidity without difficult collaterization guidelines being met.  The ECB in setting interest rates has shown an inclination to be overly concerned with headline, rather than core, inflation which has caused rates to raised at least one time to far and maintained unchanged rather than lowering rates which has primarily served Germany and France at the expense of the deficit countries.  The ECB can only buy bonds on the secondary market and only of prescribed credit quality.  In its attempts to buy bonds on a limited basis to assist in relieving credit pressure and yields, it has faced significant political opposition from surplus countries which has caused it to act as a Fiscal Enforcer and threaten and/or hold back needed liquidity to NCBs in Ireland, Greece, Portugal, and Italy to force national politicians to enact budget cuts and austerity measures despite no public support in those countries.  The role of a real central bank is monetary policy with the ability to provide liquidity, buy bonds, set interest rates, and promote monetary stability as well as act as a clearinghouse.  To get the ECB to act as a real central bank would require Treaty changes and a complete change in the rules and functions of the ECB.  There is not enough time.

Trichet has even recommended a Finance Ministry for the eurozone, but what good would a Finance Ministry have if there is no fiscal transfer mechanism, eurozone taxing authority, and relinquishment of national sovereignty by member countries?  The EU and the eurozone has suffered for too long the determination of sovereign policy in member countries by an elite which is defiant of democratic approval.

Munchau has repeatedly expressed doubts on the leveraging proposed for the EFSF and the SPV which will apparently be created.  Has everyone forgot how disastrous the big banks SPVs were going into the recent Great Financial Crisis?

Sarkozy is promoting the involvement of China when this would only worsen the economic problems as I and Tim Duy have written citing Michael Pettis.

The 50% "voluntary" haircut is not enough and it is unlikely there will be 100% private participation and 1.4 trillion euro EFSF funding is not enough, particularly if European bank's liquidity and recapitalization is eventually challenged.  Additionally, it is popular to overlook the very negative direct effect these haricuts would have on Greek banks if Greece stays in the eurozone.

Many commentators have questioned the jury-rigged euro deal's attempt to structure 50% haricuts as not a defined default triggering CDS.  In fact, in just one day, Fitch has said the 50% haircuts do constitute a default and will affect Greece's credit ratings send the euro down.

The eurozone crisis band aid approach of temporary patches is not sustainable and is just setting the stage for recession and the eternal re-emergence of the very same problems.

Is the eurozone a monetary union with a stable currency benefiting all of its members or is it a tontine in which the last remaining country becomes the Imperial power and the other countries its colonies?  Meanwhile, Greece, Ireland, Portugal, Italy, and Spain are being repeatedly raped and France has been moved to the credit rating coming attraction.


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Edward Hugh Links: On the Eurozone Crisis

Despite the misplaced hope of the stock markets this past week, the eurozone is headed towards a decision point the leaders of the eurozone do not want to face.  I heavily research the eurozone macroeconomic issues as well as China, because they have global implications.  The eurozone could quite easily unravel with a Greek default within the euro or the need to bailout Spain or Italy.  A currency crisis would ensue and European banks and, quite probably, banks globally could have significant liquidity problems as the interbank market freezes up with the possibility, if nations are not prepared to fund liquidity through their central banks and governments, of some banks failing.

Edward Hugh is an intellectually eclectic British born macroeconomic economist who lives in Barcelona.  Whether one agrees with his conclusions or not, he always has something important worthy of consideration to say.

Here are some observations on eurozone and China PMI showing slower growth.

Ireland is being advertised by the eurozone as a success story to sooth the egos of the newly indentured (to European banks) Irish people.  What is going to happen to Ireland, which is a trade surplus exporting country dependent on exports for its economic recovery, as the global economy continues to slow down?

High Noon is approaching for Greece

Italy has low growth, an aging population, and is the third largest economy in the eurozone.  Can they make the penalty kick?

I have repeatedly stated privately that the breakup of the eurozone into a High euro and a Low euro will only create two stage productions of the same play with different lengths of production and the same tragic ending.  Here is Hugh's take on the subject.

Here he discusses recession risks in Germany.

Here he reviews the recession warning on the eurozone periphery.

Here he covers the flashing red lights for eurozone growth.

Hugh correctly identifies Italy, not Spain, as the elephant in the room.

How can Greece devalue?

Eastern European growth is very dependent on Germany.

Why Spain's economy is more different than you think.

The eurozone crisis is imploding.  If it will not accept a democratic fiscal transfer mechanism the euro is doomed and the international bond markets have recognized this for some time.  The euro is not a fiat currency which can be devalued and as such is a foreign currency, economically, for each and every eurozone country, which means their national debt is denominated in a foreign currency (the euro).  Consequently, no eurozone nation can guarantee its debt.

Being informed on the issues involved requires reading many different viewpoints.  There is a debt crisis, because this is a currency crisis and it could lead to a bank liquidity crisis and potentially to a global depression.

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Has Germany Castrated the Euro?

The German Bundestag now has the legal authority to require the German government to submit all EU proposals which will have budgetary effect to the Bundestag for approval prior to negotiation committing Germany to any agreement.  This virtually prevents the German executive from negotiating any substantive EFSF or other economic support for the eurozone as a whole, or particular member countries, through the EU, ECB, or EFSF.

Despite early French-German discord, there was some renewed hope that a 3 trillion euro package could be put together for the EFSF only to have the German Finance minister quickly and very publicly state that no miracle cure will emerge from tomorrow's EU Summit on the eurozone's sovereign debt crisis and further stating that the process for resolution will take much longer into next year, which has again placed focus and pressures on bank credit and liquidity rather than the more centrally important issue of sovereign risk in a monetary union without any fiscal transfer mechanism.

The EU Summit tomorrow will not only be a disappointment, but it could well be the ultimate stone thrown on the victim of European union.  The 3 trillion euro package has been reduced to 2 trillion and now they are again talking of 1.3 trillion with no additional public sector haircuts beyond 50%, when it is obvious is needs to be much larger if not 80% or more, at the insistence of the ECB, although that would only amount to a 22% writedown of Greek debt and far too little money to provide bank recapitalization and sovereign credit support.  European banks alone face a potential 7 trillion loan contraction.  A conservative economic stabilization fund would need at least 10 trillion if bond buying to support sovereign credit is included to provide some (this is an off the cuff figure and would only be a temporary solution as the political problems will lengthen the process) time to politically provide either the necessary treaty changes with democratic approval for fiscal union or a planned orderly default and withdrawal of Greece from the eurozone.

Already France is being threatened with a ratings downgrade by Moody's and the S&P is warning of an EMU downgrade blitz.  European officials and economists have lost focus on the big picture in attempts to defend cherished political and economic policies which defy real economic data.  While Munchau has maintained the optimal fix would be a democratic fiscal union with the alternative an unacceptable public recapitalization of European banks, this, in my opinion, would only further the depth of sovereign risk and potentially endanger democratic rule.  Munchau has asserted that the choice will be between fiscal union or break up.  Martin Wolf has essentially agreed in the need for fiscal union as first aid will not remedy the eurozone internal balance of payments crisis which is at the heart of the euro currency crisis, as Michael Pettis has clearly described as an economic imperial and colonial relationship.

The European Commission's assessment report has been leaked which shows the total unsustainability of current program and proposals and further discloses the ECB does not agree with the private sector involvement scenarios.  The full leaked version can be found here.   As Rob Parenteau and Marshall Auerback have asserted in private email communications (of which I was a copied recipient), this document substantially documents not only the unsustainability of current programs but refutes current austerity economic polices as indefensible.  In another private email to them from Martin Wolf, he has indicated that Greece's present problem is one of economic flows, which is correct for the current situation in which Greece's debts are denominated in a foreign currency (euro) and default would gain Greece little.

However, any planned, orderly default by Greece would require an immediate take it or leave it redenomination of all Greek debt, public and private, into the new Greek currency.  This would establish an economic stock in which the economic flows are secondary as a fiat currency sovereign nation which taxes cannot become insolvent. The market would decide the haircuts and devaluation.  Most economic speculation has assumed any Greek default would be within the euro which would be suicidal sacrifice on the alter of European union on the part of the Greece, whose citizens do not appear to want to slink into the darkness of slavery quietly.

The EU Summit tomorrow will not only be a disappointment, it may well be a defining moment of existential despair.  In that despair, what choices will the different people of Europe make?

UPDATE:

Here is a post by Rob Parenteau entitled "Leaked Greek bailout document: Expansionary fiscal consolidation has failed" which can be found at Credit Writedowns here.


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