Friday, April 25, 2014

Debt, banks and the shaky state of the euro

Simon Johnson mentions a key factor in the high-risk game German Chancellor Angela Merkel is currently playing with her austerity policies in the eurozone (The Future of the Captured State Project Syndicate 04/22/2014):

With the exception of the United Kingdom, the extreme free-market view gained less traction in Europe in recent decades than it did in the US; nonetheless, the challenge of implementing financial reforms in the eurozone is actually more difficult. Governments regard domestic banks as important buyers of sovereign debt. The banks argue that more effective regulation would limit credit and slow the pace of economic recovery.

As a result, the authorities in Germany and France (as well as Japan) have consistently resisted increasing capital requirements, despite widespread agreement that doing so is an essential part of effective re-regulation. Their opposition has undermined international efforts to build a more resilient system – and it will likely hamper efforts to put the European economy on a sounder footing.
People like Yanis Varoufakis and Wolfgang Münchau have been warning for years that European banks are seriously undercapitalized and need to be fixed. Which, if done right, would recognize that some considerable portion of them are effectively under water.

Merkel doesn't want to do this. And she doesn't want countries like Greece and Spain to get the haircut on their public debt that the financial world more-or-less takes for granted they will have to have at some point.

Hans-Werner Sinn, head of the IFO Institute and a stone austerity advocate for the eurozone countries, is right (up to a point!) about the state of Greece in the following way, even if it is one of those even-a-stopped-clock-is-right-twice-a-day moments (Hans-Werner Sinn Accuses Troika of Misleading the Public CESIfo Group 04/24/2014):

"Greece is on the verge of bankruptcy and would have been obliged to declare itself insolvent a long time ago if private credit had not been replaced by low-interest credit from the community of states. All of the forecasts of Greece’s debt sustainability published by the Troika and the EU in recent years have been based on highly exaggerated estimates of growth. The only reason that Greece can now access market credit again is the explicit and implicit promise of a bailout by the community of states and the ECB, which effectively means that Greece's debts would be repaid by the taxpayers of other countries in the case of a crisis," Sinn concluded. [my emphasis]
To quote Varoufakis again on the recent Greek bond sales that defenders of the austerity program generally want to claim as a sign of success (Greece's Grand Decoupling, the Nuclear Option and an Alternative Strategy: A comment on Münchau 04/14/2014):

Why would a self-interested investor buy these new bonds, in view of the unsustainability of the country’s overall debt? The answer is, of course, that Berlin and Frankfurt have signalled to investors that there is nothing to worry about. That, while Greece’s debt will be, eventually, haircut with the same probability that the sun will rise against from the East tomorrow, these particular bonds will not be touched. Indeed, they have been led to believe that the ECB (via OMT or some other pretext), perhaps with the participation of the ESM, will stand behind these bonds. Similarly with banks like Alpha and Pireus that are immersed in non-performing loans: the Governor of the Bank of Greece has clearly stated that stress and quality assurance tests should "not be too strict lest they deter investors". Statements of this sort (by the, by the bye, former VP of Pireus Bank who moved straight to the office of Central Bank Governor) give heart to investors that new shares issued by these banks will be supported by active 'gaze aversion' on the part of the regulators; by a committed attempt not to look too seriously into the banks’ asset books.
Sinn seems to be saying something like this in the quote above, although he may be using some signal of a different spin in his phrasing that I don't recognize.

This is the dance that Merkel and the eurozone have been performing since 2009. Haircutting the unsustainable debt in Greece, Ireland, Italy, Portugal and Spain would hammer the undercapitalized European banks, including Germany's. Merkel avoided that by forcing those countries to take on new debt to keep up interest payments on the old while also adopting Herbert Hoover/Heinrich Brüning-style austerity policies. As basic macroeconomics would lead us to expect, those economies shrank. Which meant that the debt burden got bigger in relation to their GDP, which meant their ability to pay was less, which required new refinancings and more austerity, which made their economies shrink more, which ... well, that's the picture.

Europe is not on the verge of deflation if not already well into it, meaning the prospects of a long-term economic stagnation - 10 or 20 years if Japan's experience is a measure - is staring them in the face.

Sinn's column on Europe's Next Moral Hazard Project Syndicate 04/24/2014 shows what an austerity-friendly view he takes of the whole thing. Throwing the well-established macroeconomics of depression and deflation to the winds, he writes:

An increase in public debt causes a short-term surge in demand, helping to increase the degree of capacity utilization and keep unemployment in check. However, new debt is nothing but a form of dope, reducing pressure to take painful measures that would improve competitiveness and capacity growth. (my emphasis)
Spokespeople for the One Percent are always urging that "painful measures" be taken. Painful the 99%, in other words.

Sinn uses an example so off-base that one has to wonder whether he means it seriously:

One only needs to look at the United States to see how dangerous – and indeed unsustainable – the eurozone’s path has become. When one of the US states runs up too much debt, creditors become jittery and austerity measures are introduced to avert the risk of bankruptcy – as has happened in the past few years in California, Illinois, and Minnesota.

But all of that occurs while the debt/GDP ratio is still minimal and clearly below 10%, because creditors know that no one will come to their aid. The Federal Reserve will not buy their government bonds, and the federal authorities will not issue any guarantees.

In Europe, by contrast, easy access to the local printing presses before and after the foundation of the ECB, together with the new fiscal rescue mechanisms, ensure that investors start to become nervous only when debt ratios are 10-20 times as high. As a result, the debt level rises until it spirals out of control.
Eurozone countries like Germany and Spain have states and provinces that do their own borrowing, too. But the United States has national bonds that are backed by the full faith and credit of the United States. Despite the smoke-screen Sinn attempts to toss up, the eurozone does not have common eurobonds. Borrowing has to be done at the national level, not the eurozone level. And the ECB technically doesn't have the authority and responsibility to backstop those national bonds the way a national bank has for national bonds.

Sinn seems perfectly content to have a "lost decade" or two in the eurozone economy.

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