The Avoidable Catastrophe

European Union leaders concluded their latest summit, with their usual small solutions to enormous problems.  Here is a link to their release, detailing their new agreement.  They have decided to offer up more funds for member state bond market stabilization and redoubling their efforts at austerity, which has only exacerbated this problem thus far (including a ridiculous tax on countries that go over the 3% rule).  They still have Italy contributing 17% and Spain 11% of the EFSF funds, which sounds ridiculous given the fact that they are currently mired in severe deficits and Italy is already paying high interest rates to service its debt.  The only good thing to come out of this summit was that nobody has left the Euro (yet).

During the summit, fears and rumors led to multinational corporations reportedly moving their money from countries rumoured to be exiting the Euro to presumed safe countries.  That also probably compounded the bank runs problem in Greece.

Despite markets being up Friday, these problems will likely continue as none of the them have really been solved.  This means that none of the uncertainties that have created deflationary conditions in southern Europe will go away, and the economic conditions will continue to deteriorate.



European leaders signing the Treaty of Rome in 1957



Speculation of this variety does not help, but for countries that could be forced out or leave the Euro, this could amount to an economic catastrophe.  Their country will likely be almost immediately bankrupt unless Eurozone countries agree to continue bailout loans, or a bailout fund through the IMF.  It is hard to imagine that their currency will have any reputation as a store of value.  Their central banks will have little in the way of credibility to create monetary policy.  This will leave these countries in something like a liquidity trap because any monetary policy they try to employ will have little effect.  Deflation will be immediate and substantial, and it will be difficult to turn that around towards inflation or GDP growth.

A liquidity trap is defined as the point that monetary policy is no longer effective because bonds and money are perfect substitutes.  This situation is slightly different, because there will likely be so little demand for bonds, coupled with little central bank credibility that they will not be able to hold down interest rates to stimulate the economy in a meaningful way.  This means that monetary policy will be an ineffective tool to stimulate the economy.  Similarly, these countries will likely not have full sales of their bond offerings, and will have to cut government expenses even more significantly.  GDP will almost assuredly nosedive.  This should be classified as something worse than a liquidity trap because it will be a situation where neither monetary nor fiscal stimulus will be possible.

IS-LM in a Liquidity Trap (Krugman)

What would be left of the Eurozone will not be spared from a significant contraction.  Mark Cliffe of ING speculates that the new currencies would plunge.  His white paper speculates on a full break up of the Euro, but similar movements would be felt from select countries exits.  Similarly, northern European countries will inevitably feel the effects of the severe economic contractions of southern European countries in the form of contractions of their own.  These contractions could last a year in the case of northern Europe and years of severe contraction for southern economies.

The only possible heroes are the European leaders, but it looks as though they are still not truly believing in their own shared destiny.  The main villain can easily be viewed as the European Central Bank (ECB).  Their strong currency position has strained the growth of southern European countries, and even this Spring, they raised rates because of inflation fears.  Thursday, they cut rates, but at a paltry .25%; when Greece, Spain and Italy were literally having capital streaming out of their banks, economy, and even geography.  Much of this agreement seems to be stressing an increased ECB role, but hard to imagine them doing what is necessary to help southern economic conditions.  They will be acting as the operating agent of the EFSF and ESM funds to purchase sovereign debt.  Hopefully they will be more active in that pursuit, than they have in monetary policies.


Solution:

I would argue that there is still time and opportunity to avoid this recession.  I think the best solution is to pool credit risk.  An agency such as the European Stability Mechanism or the European Financial Stabilization Mechanism or another more robust agency could purchase all the debt of all member nations, and in turn issue Euro bonds.  The Eurozone, in total, has a debt to GDP ratio of 85%, which is below the United States and within an acceptable range.  The Euro as a currency has and would continue to have significant transaction demand, and the ECB would continue to have legitimacy and credibility for creating monetary policy.

Creating a true fiscal union (as opposed to the current proposal which merely acts as an enforcement agency of the 3% rule) would also be important to insure that this does not become a repeated problem, and (of course) to pay down the Eurobonds, and pool more government expenses.  These two solutions (Eurobonds and fiscal union) might cause Eurozone nations to rethink whether they actually want to remain in the currency.  It is hard to imagine EU members that have not adopted the Euro join this arrangement which would leave countries like the U.K. and Sweden out.  For that reason, I think secondary treaties such as a greater European community (but explicitly non-EU) would be important for keeping important commercial and economic ties, while being excluded from a federal system and unified currency and bonds.

It does not look like enough European leaders are interested in this arrangement.  I think we are still staring at a difficult situation in Europe that hasn't really been solved.  If conditions continue to deteriorate, European leaders will be forced to hold another summit, and who knows how much longer bond markets are going to tolerate these half-steps.  They're barely tolerating it now!

If countries leave the Euro, France and Germany will instead likely be somewhat forced to bail out banks that will be overexposed to southern European debt or too weak to withstand this recession (Commerzbank, which is trading at an awfully low price of € 1.37 might be the first) or face a more severe recession of their own.  Southern Europe will be have negative economic growth for years.  It should be considered a failure of leadership that Europe was not able to find a way towards this solution over the past year and a half.

Is Europe Equipped for this Financial Crisis?

European finance ministers met last weekend in Wrocław, Poland without reaching an agreement on Greek debt.  Decisions like this are difficult for any political process, but the scale of this problem and the nature of Europe's political power structure leaves me wondering if Europe will even be able to come to an agreement on any bail outs, bankruptcy, or similar issues.  There is not a strong federal infrastructure, which means that any agreements are constructed somewhat ad hoc and dependent upon near consensus to reach a feasible agreement.  So it seems that there are many ways that these intense negotiations could derail, and a difficult road to a potential agreements.


Wrocław, Poland (photo: Stefan Schlautmann)

There are many ideas being floated to solve these issues.  One includes a larger role for the European Union (E.U.), others include Euro bonds.  Philipp Rösler, Vice Chancellor of Germany, is calling for new procedures that would allow Greece or other nation states in the European Union to declare bankruptcy.  He has also announced his opposition to Euro bonds.  In an op-ed for Die Welt, Rösler continues to oppose increased central powers in Brussels, instead preferring a code for member state budgets and sanctions against straying countries.

Philipp Rösler (photo: Liberale)

Rösler plays a new, but pivotal role in the European sovereign debt crisis.  He has recently assumed the Chair of the Free Democrat Party (FDP) in Germany.  This is the party that helps Chancellor Angela Merkel's Christian Democratic Union (CDU) party form a majority in the Bundestag.  Rösler has only been chair since May when Guido Westerwelle stepped down following terrible regional election results.  The party declined further in last Sunday's elections in Berlin.  The FDP has declined after not delivering on promises to lower taxes.

82% of Germans are unhappy with the way that the German coalition government has handled the European sovereign debt crisis.  With disapproval levels so high, German political instability could be an additional hurdle to any European debt negotiations.  Germany has a parliamentary system, so while the next scheduled election isn't until the Fall of 2013, another election could happen earlier if Merkel cannot survive a no-confidence vote.  In that case, a snap election would be 60 days after the dissolution of the Bundestag.  Rösler stated this week that his party remains committed to that coalition.


Merkel's Union party is still atop the polls as of this month with 31% support, but Social Democrat party gains are threatening to overtake them with 29%.  Because there are five semi-viable parties in Germany, coalition governments are the norm.  The question is: how long can the FDP continue to stay in a coalition while their numbers are plummeting?  Will they need to make a change in political stance in order to maintain their viability?

COMPLEX INTERNAL POLITICS

This shows some of the complexity problems that Europe is dealing with.  Every member state has their own political processes that their politicians are trying to gauge and win.  These domestic politics may be at odds with larger continental politics.  For instance, at the negotiations in Poland, Finland was demanding collateral for their loans, which likely contributed to the non-agreement.  It is doubtful that one party kept that group from agreeing to more loans, but it shows how difficult it will be to satisfy everyone.  In cases such as these, how can markets truly judge which way governments will act?  These uncertainties are adding to market pressures.  With Greek default looking increasingly likely and even imminent, markets are wondering what a Greek default would look like, and how it will impact the Euro.

This lack of certainty is fueling frustration.  83% of Germans recently said that they were dissatisfied with the amount of information that they received regarding current European events.  These events have been difficult for me to judge, but I always assumed that was because I was on this side of the Atlantic.  I can't tell if I should be happy, relieved, or more worried that continental Europeans are just as frustrated as I am at the lack of information coming out of Athens and the other capitols of Europe.

Tomorrow, Greece has interest payments on two bonds worth over 768 million euros bonds to pay.  They have said that they have enough cash to pay them, but there was also a recent story that less than 75% of banks are going to repurchase Greek debt when it comes due again.  If fewer institutions are willing to buy Greek debt at any interest rate, there is little that anyone can do to stop a default.  If Greece does default, I don't know if anyone knows exactly what that will mean.  Will they stay in or out of the E.U.?  Will they stay in or out of the Euro?  Are those mutually exclusive?  If they stay in, how are other countries affected by Greek commitments?  If they stay in, how much sovereignty do they retain?  Do they become a second tier nation within the E.U.  Also, if Greece does default, wouldn't they actually need to devalue whatever currency they have anyways to regain their competitiveness?  There really are so, so, so many questions.

This situation is likely to continue deteriorating, with any Greek default only adding to problems in Italy and other economies.  Even if there were a strong popular consensus, I think it will be difficult for the European Union to arrive at large decisions like this in crisis situations.  Given their current fractured opinions, compromises seem even more difficult, and as such, a catastrophic financial crisis seems more likely.

Leonard Cohen - "Everybody Knows"

The German Dilemma

Simon Maughan of MF Global summed up the current European financial situation very well when he was interviewed last Wednesday on Bloomberg Surveillance.  He posed the question:

Spoken like a true banker, but that is Germany's current dilemma.  Maughan also spoke about Basel III and other European financial issues.

Simon Maughan on Bloomberg Surveillance (MP3) via Bloomberg

Tracking Fear

As you may have noticed, I like Google Trends.  What's not to like?  It's a cheap and easy way to find out what people are interested in!  With the recent recession and fears of a double dip, I thought it might be a good way to track interest or fear of recessions.  Directly below is a chart from the somewhere in 2003 to the present for global searches of the word "recession."

As you might predict it jumps almost out of nowhere in what was still the peak of business cycle in 2007.  Then about a year later it jumps again in the winter of 2008 to its highest level.  This is before Bear Stearns collapsed, but right about when the stock market began collapsing around the week of January 21st.  The financial panic of 2008 can also be observed in September during the Lehman Brothers, A.I.G., etc crisis and in October when TARP almost didn't pass the U.S. Congress and stock market was pushing considerably lower amid heavy volatility.  Since then it has more or less tapered off until a jump in the past couple weeks.  Also note that the chart is divided in half by the initial stock collapse.  Before that, the chart is at very low levels, and after that it is always higher.  The searches to news correlate well (which is typical) but the initial January 2008 searches clearly overwhelm the news items.  This shows that the public was proportionately much more interested in news about a recession than the media was able to report.  Because recessions are an example of negative news and involve elements of expectations, this can be considered a way of tracking Google users' fears of a recession.  To the extent that Google is used, this can be considered a measure of the general public's fear as well.

Another feature of Google Trends is that you can break it up by country.  So I thought it might be interesting to see how the word "debt" tracks in countries with ongoing sovereign debt problems.

GREECE

Greece, shows (at first glance) that the Greeks only started looking for debt in 2011, which would be suprising because they had an earlier bailout in 2010.  Upon closer inspection, the chart shows that the Greeks were spiked their searches off the chart in the past couple months, and that is likely why early amounts do not show very well.  This is due to the way that Google trends displays its data.  It scales the data based on the average of the time period selected, so in the Greek chart the only part displayed is such an outlier that it blows out almost the entire chart.

PORTUGAL

SPAIN

ITALY

GERMANY

FRANCE

UNITED STATES

In most of the other European countries, the charts show a defined peak around the times of the first Greek bailout in May 2010, and the most recent Greek bailout and other recent uncertainties.  Portugal has a slightly different schedule and peaks around the Fall of 2010.  I'm not certain as to why, there isn't a corresponding news jump.  Both Spain and Italy are peaking right now, which makes sense because Italy just introduced another round of austerity measures and both their news cycles are showing jumps as well.  Germany is a bit of an odd ball in this group in that they seem to have a low level of interest in debt, with some pronounced peaks during this crisis, but low levels at all times.  France shows recent volatility, that would coincide with recent rumors of a debt downgrade.  The United States also shows low levels that spike with their recent debt downgrades.