How bad will it be?

Gradually everyone is inching towards the probability that the eurozone will break up. How bad will this be? We’ve had various studies having a stab at the economic cost. Naturally some forecast draconian falls and the end of civilisation in Western Europe, even war. I liked Gideon Rachman’s article today, suggesting that there’s a good chance that it won’t be as bad as the alarmists are saying. Of course the political elite in Europe have a vested interest in painting a dire picture. Scare tactics are the oldest ploy in the political playbook.

I think we can rule out war. What’s the point and who gains from it? There’s no powerful casus belli. Sure we could see the rise of nationalism and political extremism, but I can’t see a war.

Redenomination of euros into national currencies poses huge logistical and economic problems, but, in the end, are they insurmountable? My answer is no, they are not. The biggest headache is how to deal with the banking systems. I guess some kind of recapitalisation and bad bank strategy, perhaps with new banks being built out of the old is the way it will have to go.

No doubt the short-term will be awful, with all sorts of unexpected problems and an arbitrary redistribution of wealth. However, the longer-term could be a lot brighter:

1. Debt forgiveness in one form or another has to happen before the European economy can grow vigorously again. This will happen in a euro breakup.
2. Trade and capital flow imbalances can be addressed with flexible currencies. This is at the root of the eurozone problems, so the removal of this problem would be unequivocably a good thing.
3. Competitiveness will be restored to the periphery. This is not just in a eurozone context, but a global context. A fall in the currencies of the periphery would unleash an export boom and help these countries trade their way out of their problems.
4. The breakup of the euro could meaningfully erode the power of the European Commission, which is holding back European growth with its over-regulation.
5. While there would be a sharp fall in GDP, growth thereafter could be quite strong. This was the experience after the gold standard was abandoned in the 1930s. The table below shows how countries in the 1930s showed a strong recovery after they abandoned gold. As I have argued before, the closest parallel with the 1930s is the rigidities of the gold standard and the eurozone.

The best thing for Europe would be the end of the eurozone, preferably a managed breakup over the Christmas period. In the short-term there would be a severe drop in GDP, just through the dislocation of the banking system and broader economy. However, I believe that the European economy would prove more resilient that the doomsayers predict and that, with the restraints removed, growth over the remainder of the decade will be a lot stronger, albeit from a lower base.

Hope in the gloom

Today we saw two very bad pieces of news. First was the new order data for industry in Europe, which was dire. Secondly, we had the failure of a bond auction in Germany. Perversely, these both might be good news. The new order data means that a recession is almost certain in Europe. This means that the ECB will have the excuse to cut interest rates and loosen the monetary spigots. In Germany, industrialists are going to start to put pressure on the politicians to switch from austerity to stimulus and to shift from fear of moral hazard to monetary flexibility.

The failure of the German bond auction is a pivotal event, in my view, as it shows the crisis is beginning to impact the core. We’ve already seen spreads widen in the “satellite” core (Austria, Belgium, Finland, Netherlands), but for Germany to have problems selling its debt is a real shaker. This is not to say that the politicians will come up with a solution, but the market is forcing the pace and Merkel is getting nailed for her lack of decisive action.

Inevitably, it is impossible to say where this leads, but the game is coming to boiling point and something will have to give. Will Merkel and Draghi blink? If they don’t, the markets will push them over the edge, especially with shut down of private sector funding for the eurozone banking sector. The pressure is now so extreme that both Merkel and Draghi will be forced to capitulate. If they do, then the short-term relief rally could be powerful. I can’t see the underlying problems being addressed, but traders might get an early Christmas present. Who would want to be a fund manager in this environment?

It’s been quiet here

I’ve been quiet on this blog, in contrast to markets and economies. To be honest, I’ve been watching the unfolding drama with horror. Even in my worst nightmares, I didn’t think the politicos could make quite such a hash. It’s all been so obvious. Back in February 2009, I wrote a note called “Depression Lite”, where I looked at the parallels between the Great Depression and the credit crunch. In it, I suggested that the closest parallel was between the eurozone and the straightjacket of the gold standard. To quote:

“If currencies cannot float, then the adjustment process will need to be by other mechanisms. By widening government bond spreads within the Eurozone against German government bonds, markets are beginning to raise interest rates against several countries, increasing their cost of funding. However, there are really only three ways that these imbalances can be rectified ultimately.

Germany could indulge in a massive domestic demand stimulus that would help the deficit countries to export their way out of their problems. Under the gold standard, this is exactly what Germany would have been forced to do, by expanding its money supply and increasing economic growth, sucking in more imports. It is extremely unlikely that Germany would follow this policy option.

There are two other policy options. The deficit countries could have a very severe recession in the hope that the elasticity of imports is greater than the elasticity of exports. Alternatively, wages could be cut to restore competitiveness. Cutting wages would be an extremely difficult policy move for governments to execute. Therefore, it is likely that the deficit countries will face an extended period of contraction or low growth and restructuring to restore competitiveness. It is also likely that this will be accompanied by a high level of unemployment as shedding labour will be the principal avenue open to corporates to reduce cost bases.“

It’s just been so obvious. No amount of austerity is going to work, in fact it is self-defeating. I’m just in despair over the whole thing. I’m glad I’ve retired.

What is really worrying me at a deeper level is the breakdown of trust in markets and in political systems:

1. The interbank market in Europe has virtually ceased to exist. Banks are funding themselves from the ECB’s nipple. US, Asian and UK banks are slashing their exposures. Will this mistrust spread beyond the eurozone? CDS spreads are widening for US and UK banks. Deposits runs are happening in Greece and Italy and likely to spread. Why should depositors trust either the banks or the ECB, if the ECB refuses to be lender of last resort? At least in the US and UK, you know you’ll get your money back because the Fed or BoE will print it.
2. MF Global looks like a huge case of fraud and a breakdown of regulatory oversight. If $1.2bn really has gone missing, then Mr. Corzine could be wearing orange overalls soon. Just as worrying is how the NY Fed only recently allowed MF to be a primary broker. Also what were the various regulatory bodies doing, especially the SEC and the CFTC? Can anyone trust a broker any more? It will be interesting to see whether end customers start to avoid the futures markets.
3. The unintended consequence of the eurozone finessing the Greek default so that it is not a credit event is that many are now questioning whether CDS contracts are worth the paper they are written on. If hedges turn out not to be hedges, then a huge layer of leverage will have to be unwound. In the long run, strangling the CDS market might be a good thing, but there’s a time and a place and now is not the time or the place.
4. The imposition of technocratic governments is a hugely risky ploy. Sure, in the short-term, the dysfunctional governments of Greece and Italy may improve but their democratic legitimacy is called into question. Will the populaces really stand for seemingly endless austerity being imposed on them? The fundamental contract between people and government has been ruptured. The people will revolt. Now they can blame foreign interference rather than taking responsibility for themselves.

We are in for a horrible crisis over the next 12 months or so. Christmas could be a time when there is an extended bank holiday in the eurozone as panicked depositors try to get their cash out. I think it’s that serious. Don’t forget in the US in 1933, the banks were closed for a week to sort out the mess.

We are in for the mother of all resets. A lot of debt will default. A lot of banks will go bust. Unfortunately, most of our policymakers have their heads in the sand.

The good news is that if the euro blows apart (and hopefully the renminbi peg gets blown up in the backwash), it will, eventually, set the scene for a spectacular rebound in growth. When you look at major crises that entail severe falls in output and bankruptcies (Asia and Argentina, to name just two), a couple of years after the dust has settled, economies enjoy a very strong recovery. If the current whole rotten edifice gets blown away in the next year or so along with the attendant rigidities, then there must be some hope that by 2013 or 2014, we might see a decent recovery. The depths will have to be plumbed first. Let’s hope the social and political fallout doesn’t short circuit the process.

Kyle Bass is more eloquent than me

What can I say?

I’ve refrained from further comment on the eurozone recently as the quality papers have done a good job. We are near the end of the road. Either the ECB becomes a true lender of last resort or there are some serious fiscal transfers or it’s game over. The next few weeks will tell. Whatever happens, the dithering has locked in a recession for Europe. Well done the politicos. Another fine mess you’ve got us into.

The cancer of fixed exchange rate regimes

Fixed exchange rate regimes are probably the most pernicious and damaging economic constructs of the past hundred-odd years. Initially they always seem attractive. They provide stability and certainty. Often they restore confidence, shattered by a previous crisis. However, every single time they end in another crisis or catastrophe. They are like a cancer. At first they seem benign, but as they mature, they infect the whole economic body and ultimately cause a catastrophic collapse.

While the gold standard prior to World War I is seen by some as some kind of halcyon era of prosperity and stability, for many countries it was not. For instance, the US struggled to maintain confidence in its committment to gold, especially in the absence of a central bank. It suffered numerous runs on both its gold reserves and its banks. Real economic activity and employment suffered huge swings and there were a number of very deep recessions and one depression. It was not just the US, many countries suffered similar experiences. The pre-war gold standard was hardly an advert for a fixed exchange rate.

If the gold standard prior to the First World War, was a flawed system, then the return to gold after the war was possibly even worse. There’s no need here to go into the whys and wherefores of the Great Depression, but it is hardly controversial to pin a significant amount of the blame on to rigidities that the gold standard introduced to the economic system. A major cause of the depression was “cheating” by the Bank of France which refused to stimulate the money supply in line with an influx of gold. This caused a shortage of gold at the end of the 1920s and beginning of the 1930s which led to severe downward pressure on the money supplies of the UK, Germany and to some extent the US. In 1931, this led to the UK abandoning the gold standard. The start of the economic recovery of every nation in the 1930s can be traced to the time that it abandoned the gold standard and the fixed exchange rate system.

After the Second World War, the world went back to a fixed exchange rate system, this time based on the dollar but ultimately on the dollar’s convertibility into gold. As with all fixed exchange rate mechanisms, it started well in the immediate post-war recovery. However, soon cracks started to appear. With the dollar being used as a reserve currency, dollar shortages were a frequent problem, especially for countries in Europe, none more so than the UK. Draining of dollar reserves often led to stop/start economic policies and economic volatility. Towards the end of the 1960s and early 1970s, the strains started to tell on the dollar. In 1971, Nixon ended dollar convertibility into gold (partly because the French demanded gold for their dollars!) and the era of global fixed exchange rates came to an end.

The next major attempt at fixing exchange rates was the European Exchange Rate Mechanism (ERM). Introduced in 1979, the ERM was semi fixed to start with and various realignments were carried out periodically. The ERM is famous for the ignominious departure of the UK in 1992, sterling having lasted less than two years in the mechanism. In 1993, the bands for the French Franc had to be widened, but the ERM did provide an increasing level of stability for the core European currencies, leading to the establishment of the ECU and finally the Euro. The example of the UK provided a warning that even large, highly developed economies might be incompatible with a fixed exchange rate mechanism. However, those warnings were ignored. The success of the late stage ERM and early euro may have been due, in part, to the illusion of the “Great Moderation”, which engendered all sorts of risk toleration.

However, there was another warning of the dangers of fixed exchange rates before the end of the 1990s in the shape of the Asian Crisis. Asian countries had pursued a dirty fixed exchange rate policy against the dollar since the early part of the decade. Many countries ran balance of payments deficits and saw speculative investment bubbles. Excessive dollar liabilities built up, putting strains on maintaining currency parities. You know the rest of the story. One by one, countries were forced off the dollar peg and savage recessions ensued. It wasn’t just Asia, Argentina went even further and instituted a currency board from 1991. The peg to dollar finally collapsed in 2002, having suffered a huge economic crisis, the shock waves of which are still being felt today.

You would have thought with all the evidence suggesting that fixed exchange rates are almost impossible to manage for an extended period of time and that they cause enormous economic dislocation and hardship both prior and post abandonment, that the architects of the eurozone might have been a bit more cautious and careful in their construction of the single currency. But, no, the apparatchiks know best. Fatally, they failed to have any mechanism to deal with the inevitable trade and capital flow imbalances or shifts in competitiveness. Unlike almost any other currency in the world, there was no true lender of last resort. Criminally, they allowed Germany and France to flout the rules almost at the outset, undermining any respect for a rules based system on public sector borrowing. I could go on, but, by now you know the picture.

In the context of a 100% failure rate for fixed exchange rate currency mechanisms, is it surprising that we are seeing the failure of the euro? Given the gut wrenching adjustments being imposed on countries by unelected bureaucrats, what is the likelihood of some kind of uprising? Are we surprised that the eurozone is on the cusp of a depression?

Some times the failure of exchange rate policies can work for good. Arguably, the Asian Crisis had a positive outcome both economically and politically. Equally, the outcome can be darker. The rise of fascism and Hitler owed much to impact of the Great Depression on Germany. For most of the post-war period, Europe has been a model of liberal democracy, but this is now increasingly under threat. On the one hand, unelected bureaucrats in Brussels are usurping power and sovereignty. On the other hand, there is an undercurrent of popular unrest which could morph into a nationalist backlash. It is possible that the breakup of the eurozone will bring a more democratic European Union, but it would be foolish to bet on it. History shows that, more often than not, economic and social crises provide a platform for extremists to grab power.

Historical parallels with 19th century US

If you got a couple of minutes, it’s worth reading this short article at VOX on the parallels between the eurozone crisis and the US banking system in the 19th century. It’s not just the imbalances that doom the eurozone to failure but the lack of a proper mechanism for co-insurance of the banking system and the inability of the ECB to act as lender of last resort. The current arrangements are a recipe for runs on the banking sector. Watch out!

“Those who don’t know history are destined to repeat it.” Edmund Burke

 

 

 

Debtors’ Prison

So we have a new Greek government. Will it make any difference? Not a lot. As Roger Bootle points out, the Greek drama has raised the possibility that countries might exit the eurozone and even the EU. Hitherto, politicians have refused point-blank to countenance this possibility. The Greeks have done everyone a favour by pushing Merkozy to the brink. As Bootle says, there are three forces that the politicians cannot control:

1. Markets
2. Economics
3. Voters

Markets have no confidence in politicians who spout twaddle at every turn. The economic logic of trade and capital imbalances, the lack of currency flexibility and the deflationary consequences of excessive austerity march on, despite the fantasy of the politicos. The voters are getting restless. How long before populist movements win power?

The periphery is in the modern-day equivalent of the debtors’ prison. The irony of the debtors prison is that it denied the inmate of the capacity to repay his debt by depriving him of the ability to work. Often relatives had to come to the rescue to repay what was owed. If they didn’t then the debtor would remain languishing in jail. In this case rich uncle Germany has refused to do the necessary.

By imposing an excessive level of austerity, the eurozone apparatchiks have guaranteed the failure of their policy. Countries cannot escape their debt traps through deflation, they need growth. Current policy ensures the opposite. Look at how Greece’s forecast GDP growth (shrinkage) has declined over the past year. The numbers built into the austerity plans don’t bear even cursory examination.

It’s interesting how the press coverage from respected economists has developed over the past few months. Almost everyone is homing in on the imbalance issue and the absurdity of current policy. Perhaps it’s only the English speaking press, but anyone who reads The Economist or the FT must realise that the eurozone cannot work as it is currently configured.

We are entering a very dangerous phase, where politicians have become almost totally detached from reality and bad policy decisions are being made. They are a little bit like Hitler in his bunker, fantasising about miracle weapons to win the war. If Hitler had accepted that defeat was inevitable in 1944, many lives and much destruction would have been avoided. I’ve got a horrible feeling that we are heading for the economic equivalent of the fall of the Third Reich.

Super Mario..beep,beep…game over

Cutting interest rates was a good start but ruling out allowing the ECB to act as lender of last resort was foolish. However, distasteful the thought of monetising budget deficits is, the only way to stop the sovereign debt rot and backstop the banking system is for the ECB to step in with the monetary howitzers (never mind the bazookas). It could always back this up by saying it will sell the debt back into the market once the situation is calmer.

At the moment the key concern of investors is the return of capital, not the return on capital. Hence, basket cases like the US and UK have very low government bond yields, despite government finances being in at least as bad a shape as many eurozone countries. At least investors know they will get their money back. It might be devalued in real terms, but they will definitely get it back.

Monetising budget deficits will not cure the underlying problems of trade and financial imbalances, but it will remove the pervasive air of crisis and provide some breathing space to work out some long-term solutions. The Greek farce shows that the politicians and eurocrats have lost touch with reality (if they were ever in touch in the first place).

It is as well never to underestimate how stress makes human beings make bad decisions. Unlike traders, these guys are not used to reacting quickly to events, which is why they hate the markets. They dislike situations where they lack control. It’s easy to mandate the shape of a banana, but they can’t control the global economic machine. Instead of deflecting and guiding they try to make water flow uphill. Like King Canute, the water is lapping around them. However, unlike King Canute, they refuse to face the true nature of their situation.

If the ECB continues to refuse to act as the ultimate guarantor of the eurozone system, then it is doomed to fail. It’s probably doomed to fail anyway, but better an orderly demise than chaos. At the moment we have chaos. Why would anyone lend to a eurozone bank or a government? Would you take a chance with your money that it won’t be returned? The eurozone needs to restore a measure of trust and certainty very quickly.

I had a daydream

I had a daydream yesterday that Wolfgang Schäuble was being interviewed by Jeremy Paxman who asked the questions that no-one has put to the eurocrats yet.

Paxo: “Good evening, Mr Schäuble. Can we clarify what is the ultimate purpose of the austerity measures that are being imposed on the stressed countries? Presumably it is aimed at reducing the indebtedness of those countries over time to a sustainable level.”

Schäuble: “Yes, this is true. These countries have borrowed too much. They must live within their means and pay back the debts they owe. They need to show the same kind of discipline that Germany showed in the years after reunification and the introduction of the euro.”

Paxo: “If countries are to reduce their overall level of indebtedness, both government and private sector, surely this means that they must run a balance of payments surplus, as Germany has done.”

Schäuble: “Yes, that is right. Germany has shown that the best way to be financially prudent is to run a trade surplus.”

Paxo: “Overall the trade balance of the eurozone is about zero. About two-thirds of eurozone trade is intra-eurozone. That implies that the countries with trade deficits would have to move into a trade surplus with their eurozone partners to be able to repay the debts that they owe them”

Schäuble: “Yes..”

Paxo: “So that implies that the countries that have trade surpluses would have to run trade deficits to allow the highly indebted countries to repay their debts.”

Schäuble: “Errr…”

Paxo: “And the only way to do that would be for the trade surplus countries to stimulate domestic demand and to increase their own levels of debt.”

Schäuble:  sound fx (spluttering sound)

Paxo: ” Additionally, the trade surplus countries would have to accept higher inflation so that the stressed countries can adjust their relative competitiveness without crushing deflation, which would produce widespread defaults on their debts.”

Schäuble: sound fx (deafening silence)

Paxo: “So, Mr Schäuble, what’s the answer?”

Schäuble rips off his microphone and storms out of the studio.

Just a couple of charts to remind Mr Schäuble of the countries involved and the scale of the adjustment needed.

Eurozone countries current account surpluses and deficits (selected countries)

Source: FT, IMF

Eurozone countries current account surpluses and deficits (selected countries) as % of 2010 GDP

Source: FT, IMF, LCTN*

*Lemmings Can Teach Nothing

Repeat after me

It’s the financial imbalances. For every surplus there must be a deficit. It’s an accounting identity, not an economic theory. Will the eurocrats ever learn????

Bank sector retrenchment and QE

A friend sent me a very interesting note a couple of weeks ago. It featured a couple of illuminating charts.

The first showed bank assets since 2008. The point was made that eurozone banks haven’t even begun to de-gear yet, while US and UK banks are nearly three years into de-gearing. As a rule of thumb, banks shrink their balance sheets for about six years after a serious bust. There’s a fair bit of academic and central bank research to back this up, so it suggests that the US and UK are going to suffer at least another three years of credit starvation and weak economic growth. It could be longer, as the financial crisis has been so pervasive and it is doubtful that emerging markets can provide enough countervailing growth to offset the retrenchment in developed markets.

It is frightening that the eurozone banking system has failed to use the recovery in markets and economies (however weak) to strengthen balance sheets and reduce leverage. This means they are entering the critical phase of the eurozone crisis in a highly vulnerable state. The capital needed to ensure the solvency of the banks is likely to be a multiple of the mooted €100bn. Not only that, history teaches that when banks raise capital (or are forced to), they usually also shrink their assets.

Hence, the credit crunch in the eurozone is likely to become even more severe. Given the commitment to austerity, the unwillingness of Germany to stimulate domestic demand, the reluctance of the ECB to act as lender of last resort and the aversion to monetise government deficits, the eurozone is facing the mother of all credit crunches. Furthermore, in the absence of quantitative easing by the ECB, the shrinking of bank balance sheets and the pressure to cut budget deficits is likely to precipitate a collapse in the money supply.

In short, the eurozone is set up to be a deflation doom machine, similar to the US in the 1930s. Of course, it may not come to this as the political will to inflict endless austerity and penury on the periphery is starting to crumble. Greece is leading the way and Italy may soon follow.

The second chart neatly shows why the Bank of England has indulged in two rounds of quantitative easing. The retrenchment of the banking sector, shown by M4 lending in the monetary statistics has been almost exactly offset by the BoE’s QE programme. This has meant that the money supply has held steady rather than collapsing and has prevented a collapse in economic activity, rocketing unemployment and deflation.

Indeed, it has allowed inflation through the mechanism of a falling sterling exchange rate and rising import costs (mainly food and energy). In this way, the inevitable erosion in living standards is being achieved through a fall in real wages but, crucially, not in nominal wages. Hence, the overindebtedness problem is, to a certain extent, being inflated away.

In contrast, in the eurozone, there is huge downward pressure on wages, but in most countries this is being transmitted through mass unemployment. The chart also shows what will happen to the money supply in the eurozone if the ECB doesn’t institute a programme of QE: the money supply will collapse.

If the UK has at least another three years of banking sector shrinkage to come, and the BoE seeks to maintain the level of M4, then there is going to be more QE. The Bank can probably afford one more round of gilt purchases, but after that it faces a dilemma. It will be difficult to buy more gilts, as it would own too much of the gilt market. It will have to start buying corporate bonds or perhaps packages of banking sector assets. This is going to cause a real philosophical problem for Mervyn King, given his stance on moral hazard.

One last observation is that, considering the amount of banking sector balance sheet shrinkage in the UK and US, it is actually quite commendable that economic growth has not been that different to the eurozone, where bank lending has not shrunk. To me, this suggests that the US and UK economies are far more resilient than many commentators would credit. Clearly there are structural features in the US and UK, which have helped to mitigate the retrenchment in the US and UK banking sectors. This may be partly down to better access to capital markets, but, perhaps also due to more flexible economies. I wouldn’t want to over-egg this point, but it does give some cause for optimism over the longer term.

It also suggests that the eurozone needs to encourage a shift away from bank finance towards capital market funding mechanisms. Additionally, the eurozone (and wider EU), desperately needs to increase the overall flexibility of the European economy.

Buckle your seat belt, Dorothy

My favourite film line comes from The Matrix. Just as Neo is about to be extracted from The Matrix, strange things to start happen. A mirror distorts and Neo asks what is happening. Cypher says the immortal line: “buckle your seat belt, Dorothy, ’cause Kansas is going bye-bye”.

That’s my reaction to the news that the Greeks are going to call a referendum on the bailout deal. The commercial banks and investment banks are frightened of sharing the fate of Dexia and MF Global. Why would they not re-trench back to a position of safety? In the rush for the exits, more banks will suffer cardiac arrests. Unfortunately they will remain in The Matrix and die, just like Mouse.