Famous Last Words

Greek finance minister Evangelos Venizelos just uttered a phrase that may well end up being filed under 'famous last words' one day. According to Bloomberg:

„Greek Finance Minister Evangelos Venizelos said today his country is not the euro area’s central problem and that additional measures are needed to meet Greece’s budget targets.

“Greece is not the euro area’s central problem, nor can it be the catalyst” for a financial crisis, Venizelos said at an event in Washington today. Greece “is not capable of causing a domino effect of pan-European dimensions.

Venizelos added: “The IMF is expected to extend the maturity of the Greek loans to allow for a longer time” for the lending to boost competitiveness.“

He is of course correct that Greece is 'not the euro area's central problem'. The central problem is the fractionally reserved banking system (a topic that curiously remains completely taboo and has so far not been discussed at all – one wonders why?) and the construction of the EMU as a self-destructive system due to the 'tragedy of the commons' effect, as Philipp Bagus has so aptly pointed out. Alas, saying that 'Greece is not capable of causing a domino effect of pan-European dimensions' is like saying that 'Thailand could never trigger a pan-Asian currency and economic crisis' back in 1997. Readers may recall that this is exactly what happened – small, seemingly inconsequential Thailand triggered a crisis that eventually engulfed all of Asia and ended with Russia's default in 1998. Argentina's 2001 default meanwhile may well be regarded as an 'aftershock' of the Asian crisis.

Of course it would not be correct to accuse Thailand of having been the sole 'reason' for the Asian crisis, just as a similar charge would not hold in the context of Greece and the euro area crisis. However, due to the interconnectedness of the  global economy and financial system, the failure of the weakest link in the chain is what usually triggers the crisis. Recall that the Asian crisis (and Argentina's crisis for that matter) was the result of 'currency pegs' failing. In this particular case, the countries concerned had pegged their currencies to the US dollar, which at the time had strengthened considerably. Similar to what the euro area's periphery experienced in 2003-2007, the 'Asian tigers' went through a massive economic boom due to their interest rates being held at too low a level as a result of the peg. Their current account and trade balances went deeply into deficit while their currencies strengthened along with the dollar, all the while eroding their competitiveness.

Obviously, the euro's basic design flaw is very similar. There is no practical difference between a 'peg' and a common currency. If we were using sound money (i.e. a form of money the supply of which can not be expanded by the central bank and the commercial banking system willy-nilly), then using a common currency, perhaps a currency tied to fixed anchor, would not represent a problem. We often hear today that the 'gold standard failed' in the 1930's as it ushered in deflation. However, this is a convenient distortion of history by the central planners who don't want to give up fiat money and fractional reserves. The major example that is often used to assert the alleged failure of the gold standard is the UK, which first suspended the gold standard to enable the inflationary financing of WW1 and then reintroduced it. What is usually left out of the narrative is that Britain made the mistake of returning to gold at the pre-war parity, in spite of having massively inflated the money supply in the meantime. It should have been obvious that this would result in a sudden money supply deflation and the attendant economic problems. The authorities were trying to pretend that the inflation that had occurred in the time of the suspension of the gold standard could simply be wished away.

The fact is though that we do not have sound money, that commercial banks are fractionally reserved, enabling them to expand the money supply at will, and that central banks are accommodating this money supply expansion by making the necessary reserves available. As we have pointed out before, the idea that all a central bank needs to do in order to ensure smooth economic development is hew to a 'price stability' policy is a dangerous fallacy. This fallacy has been cemented over the years due to the semantic confusion attending the meaning of the term 'inflation'. The rate of of change of CPI is not what inflation really is. It is merely one of its possible effects. Inflation is the expansion of the money supply in 'the broader sense' as Ludwig von Mises put it, this is to say the expansion of 'money proper' (bank notes in the fiat money system) as well as that of perfect money substitutes in the form of fiduciary media, i.e, deposit money created from thin air.

This monetary system is the cause of the boom-bust cycle that has now brought forth the crisis. There is simply no way to avoid future crises as long as this monetary system remains in place. It does not matter how many new regulations are foisted on the banks, or how big the EFSF bailout fund's resources become. All these measures are mere band-aids that fail to address the central problem. Mr. Venizelos thus is correct that 'Greece is not the euro area's central problem', but he fails to say out loud what exactly the central problem is, something he has in common with his fellow euro-area politicians and eurocrats.

Why nobody stops to ask how exactly it comes that the euro area's banks are short of capital and teetering on the brink of insolvency remains a mystery. If we were to guess, we would say that the faith in the idea that central planning of money in a fractionally reserved fiat money system is possible in principle has not yet been sufficiently shaken. However, the fact is that it is not possible, regardless of the good intentions of the planners. The very same basic problem that besets central planning in socialist command economies – the calculation problem – in a wider sense also besets central banks. Socialist economies fail because there are no market prices for capital goods, which makes it impossible to sensibly allocate scarce resources and plan production. Central banks fail because they can not 'know' what the social rate of time preference is. They try to create a 'fixed point' (their target interest rate) in a highly dynamic system on the basis of an assessment by a handful of bureaucrats who are allegedly able to judge 'what interest rate the economy needs'. Moreover, as the central bank-led fiat money system enables the fractionally reserved banks to expand credit and deposit money to the fullest extent possible due to minuscule reserve requirements and the central bank's willingness to replace their funding whenever a run on deposits occurs, the economic distortions produced by the expansion of fiduciary media can grow to unprecedented proportions. Let us not forget that every cent of 'money from thin air' leads to exchanges of nothing for something, thereby weakening the economy's pool of real savings. It also creates a misleading picture of how big a pool of savings is actually available, with the inevitable result that capital is malinvested and ultimately consumed. This is therefore the 'central problem', but judging from the debates among the monetary and political elites, it remains completely ignored.

Meanwhile, the EU's commissioner for economic and monetary affairs, Olli Rehn, also uttered what may soon become 'famous last words'. In a speech at the Peterson Institute (a pro-interventionist 'think tank' that dispenses advice to economic planners) he once again stressed what the EU 'won't allow to happen':

European leaders will not allow an uncontrolled default of Greek debt and will not let the country leave the euro zone, the European Union's economic and monetary affairs commissioner said on Thursday.

In a speech to the Peterson Institute for International Economics, Olli Rehn did not explicitly rule out the possibility of Greece defaulting, which many economists now see as inevitable.

"An uncontrolled default or exit of Greece from the euro zone would cause enormous economic and social damage, not only to Greece but to the European Union as a whole, and have serious spillovers to the world economy. We will not let this happen," Rehn said.

He said the 17 countries in the currency bloc needed to work harder on pooling their "economic sovereignty", which might allow proposals such as jointly issued bonds – which some see as a solution to the crisis – to work.

"The euro area member states need to go further in pooling economic sovereignty to prevent policies that harm other member states and financial stability," Rehn said.”


(emphasis added)

Rehn also opined on the ratification of the latest bailout plan, which has  apparently been delayed further, into mid October:

“The July 21 deal on a second Greek bailout and expanding the eurozone emergency fund will be ratified by member states by mid-October, EU monetary affairs chief Olli Rehn and a spokesman said Saturday.

"We are confident that all euro area member states will ratify the agreement," Rehn said in a statement to the International Monetary and Financial Committee, the International Monetary Fund's policy advisory board.

A spokesman for Rehn said the target was mid-October. So far fewer than one-third of the 17 eurozone members parliaments have approved the deal.

Given Rehn's well deserved reputation as the euro-area's most reliable contrary indicator,  it is probably high time to batten down the hatches.

In the meantime, Greece has admitted that it has failed to meet yet another target, this time in the context of the privatization program. There is now a push by several euro-area countries to renegotiate the July agreement on the Greek bailout to allow for an 'orderly default'. More on this further below.


Is More Leverage The Solution?

Not surprisingly, the squabbling eurocrats became the target of scorn by other G-20 members at the G-20/World Bank/IMF gabfest in Washington. Their lack of decisiveness was summarized by former White House economic advisor Austan Goolsbee as follows:

In Europe, they've kind of turned this into a bad Monty Python skit, where, you know, the guy comes out and says, 'We need to act,' and the next one says, 'You're right, let's draft — no more talking…, 'I second the motion. Let's start doing something,'" said Austan Goolsbee, formerly chief White House economic advisor. "I mean, they're not actually doing anything. They just keep agreeing that they're going to work in concert.

The pressure has pushed the eurocrats toward considering Tim Geithner's idea of leveraging the EFSF with the help of the ECB. The main idea seems to be to transform the EFSF into a bank that can use the bonds it buys as collateral with the ECB to leverage its capital up to 1:5. The 'advantage' of this method is that it bypasses democratic control and would apparently not require any further adaptations of existing EU treaties that in turn would need to be ratified by parliaments.

Not surprisingly, this idea is not finding unanimous approval – Lorenzo Bini Smaghi is the first ECB board member to publicly endorse the idea, while  German officials are more cautious. As the WSJ reports on Bini Smaghi's endorsement:

“We need to understand what the EFSF [European Financial Stability Facility] can do…. Markets want more," Bini Smaghi said, referring to the expanded capabilities of the fund under the terms of a July 21 agreement that has yet to be ratified by most of the 17 parliaments of the zone.  Once the agreement is enacted, the EFSF will be able to give precautionary funding to countries experiencing financial difficulties, to buy government bonds on secondary markets and to recapitalize ailing banks.

But this agreement has failed to ease market tensions, which have turned their focus this summer from the bloc's periphery to larger countries such as Spain and Italy, fearing they could become the next victims of contagion from Greece's debt woes.

"This is not sufficient … We need to look at possible leverage," Bini Smaghi said.

The idea of leveraging the resources of the EFSF against those of the ECB to dramatically increase its firepower in the event of a crisis has been one of the main talking points behind the scenes of the IMF annual meetings. It has gained some traction among euro-zone countries, with French and European Union officials in particular backing it, although German officials have expressed opposition.

Euro-zone countries need to take decisive steps to reassure investors on their capacity to pay back their debt, and dispel the uncertainty created by governments' mishandling of the bloc's debt woes, "Politicians think they know better…. But in the decision-making process they have not understood how markets work," Bini Smaghi said.  Bini Smaghi's comments reflect the ECB's critical view on an agreement struck between France and Germany last year to involve private bond creditors in sharing potential losses due to unsustainable public debt.

Countries "need to make clear that they will pay back their debt" even at the cost of tough fiscal adjustment and even if they have to sell assets to raise the necessary money, Bini Smaghi said. They also need to demonstrate to markets that they have sufficient backstop resources to support any euro-zone nation encountering financial difficulties, he added.

Bini Smaghi repeated that central banks are also ready to act.  "We have policies that ensure unlimited amounts of financing for banks so long as they have collateral", he said. ECB president Jean-Claude Trichet has already said the amount of bank collateral is "huge," Bini Smaghi stressed.”

The latter remark tells us that ECB funding of euro area banks is set to explode further. Watch for another large increase of the ECB's balance sheet over coming weeks. As noted elsewhere in this context:

“The ECB may also step up its own crisis-fighting as soon as next month, Governing Council members Luc Coene and Ewald Nowotny said in Washington. Potential measures include the revival of 12-month loans to banks and Coene didn't rule out cutting the 1.5 percent benchmark interest rate. JPMorgan Chase and Royal Bank of Scotland Group Plc predict a 50-basis point reduction when policy makers gather Oct. 6.

ECB President Jean-Claude Trichet, attending his final IMF meetings before retiring Oct. 31, said the ECB "stands ready" to keep supplying unlimited liquidity to banks and pressed lawmakers to ratify the EFSF.


(emphasis added)

We've characterized the EFSF as being similar in structure to a CDO, or better a sub-prime financing vehicle enhanced by dubious guarantees, but this latest idea would take it one step further. It seems the method for getting the ECB to engage in a massive inflationary push is finally taking shape. As noted above, the Germans are skeptical, but we have a feeling they will eventually give in. They are in any case outvoted at the ECB's board. Some notable quotes emanating from participants at the summit have been compiled by the WSJ. First the Germans:

“Wolfgang Schaeuble, German finance minister: "We won't come to grips with economies deleveraging by having governments and central banks throwing – literally – even more money at the problem." [right on, ed.]

Juergen Stark, European Central Bank executive board member: "It is a fallacy to think that loose monetary policy can solve the large structural problems we are facing. Central banks must not become the victims of their own success and should not become overburdened." [What success? ed.]

A few other notable quotes:

“Olivier Blanchard, chief IMF economist: "Clearly the danger is in Europe. First, you have to make clear that the other countries are not like Greece." [that tack has been tried already. 'Ireland is not Greece', 'Portugal is not Ireland', and so forth. Hasn't worked, ed.]

Christine Lagarde, IMF managing director: "The bad news is that there are downside risks on the horizon, and they are piling up."  [you don't say, ed.]

Lawrence Summers, former U.S. Treasury secretary: "If a generous sovereign from Mars paid off Greek debt, the fundamentals of Europe in crisis would not be altered." [Surprise! Larry was awake! For once we actually agree with him, ed.]

Gao Xiqing, president, China Investment Corp.: "We can't just go save someone. We're not saviors. We have to save ourselves." [Bwahahaha…truer words were never spoken, ed.]

For more interesting quotes see also this compilation.

Of course, Jürgen Stark has in the meantime resigned from the ECB, so he can no longer influence the decision-making process. As we have mentioned before, his replacement Jörg Asmussen is more likely to go along with controversial applications of monetary policy. Moreover, while Schäuble is correct that 'central banks literally throwing more money at the problem' (i.e, the Bernanke method), isn't going to solve anything, he seems willing to go along with expanding the EFSF's firepower anyway. As noted in an AP story:

“For weeks, eurozone leaders have been insisting that they had charted their way out of the crisis at a summit in July, when they decided to give the region's bailout fund new pre-emptive powers and reached a preliminary deal on a second massive rescue package for Greece. But Schaeuble and other European officials indicated at the Washington get-together that behind the scenes there is a push for a fundamental change in strategy.

This new strategy foresees boosting the firepower of the eurozone's rescue fund — the European Financial Stability Facility — through a complicated scheme that could allow it to tap loans from the European Central Bank or leverage its euro440 billion ($590 billion) lending capacity in some other way.

"Of course we will use the EFSF in the most efficient way possible," Schaeuble said, when asked whether he supported the idea of leveraging the fund. The German finance minister declined to explain what that would look like in practice, but said that there would be ways of getting around opposition from the German Bundesbank to using funding from the ECB, the central bank for the 17 nations that use the euro as a common currency

"There are other ways of creating a leverage effect than recourse to the ECB," Schaeuble said.”

The various ways in which the EFSF could be leveraged (aside from becoming a bank) are discussed in this Bloomberg article. In any case, as Reuters reports, there is no agreement whatsoever on how to proceed, how big the amounts involved are going to be or any other details regarding the 'EFSF leveraging' proposal. It seems highly unlikely that financial markets will be impressed by such vague promises. Moreover, S&P has in the meantime weighed in with an announcement that leveraging the EFSF would likely have 'ratings consequences', including on the currently still pristine credit ratings for France and Germany as well as the AAA rating enjoyed by the EFSF itself. S&P notes that leveraging via the ECB seems to be the politically most painless solution, which is of course quite correct. Inflation always is.

In addition to all this we would point out that Mr. Schäuble (and to our surprise, Mr. Summers) had it right the first time: the fundamental problem can not be solved by throwing more money at it.

Lastly, Olli Rehn may yet torpedo the whole idea merely by making optimistic comments about it.



Olli Rehn, the incarnation of the risk-less trade: simply bet against anything he says.

(Photo: European Commission)



Greek Default No Longer Taboo

Meanwhile, there are new rifts opening between various euro area nations over how to proceed with regards to Greece. Germany and the Netherlands seem to be inching closer to letting a default happen. This is of course sensible, as it is simply impossible for Greece to pay its debt. On the other hand, renegotiation of the July agreement before it is ratified throws the whole process back to square one, which means the markets will continue to assume that there will be contagion from the default. The fact that the eurocrats have begun to squabble again is by itself probably sufficient to unsettle the markets further. From the same AP story quoted above:

Schaeuble also indicated that a preliminary deal for a voluntary contribution by the private sector as part of a second, euro109 billion bailout for Greece reached in July may no longer be sufficient, given the worsened economic situation recently discovered by international debt inspectors.

The July deal, which is still being negotiated with banks and investment funds, foresees a cut of 21 percent in the value of Greek government bonds — a haircut that most analysts say is way too small.

"What the involvement of the private sector (in a second bailout for Greece) will look like will be decided when we have the troika report," Schaeuble said, referring to a review of Greece's austerity efforts by representatives of the European Commission, the ECB and the IMF. He declined to comment on how much bigger the haircut for Greece's creditors may have to be.

Germany, supported by Austria and the Netherlands, is now pushing for an "orderly default" by Greece, which would involve larger losses for Greece's private creditors than foreseen in the July deal, said a European official.

A second official confirmed that a reopening of the July deal was supported by "the usual allies," shorthand for other rich eurozone countries. Both officials were speaking on condition of anonymity because of the sensitivity of the issue.

The push does not yet amount to a clear plan, and the European Commission and the ECB are concerned that Germany may be overestimating the eurozone's ability to contain the crisis, said the first official. "We don't really have strong firewalls," he said, adding that the crisis has already affected Italy and Spain.

Both IMF Managing Director Christine Lagarde and French Finance Minister Francois Baroin insisted at news conferences during the Washington meeting that the eurozone should stick to the July agreement — signaling further divisions over the best way forward.”

If the summit was supposed to deliver clarity on the Greek situation, it has failed to do so. For more on the growing discord over the July agreement see also this story in the WSJ. As the article notes en passant, the euro area's budding banking crisis has just become a tad worse due to Moody's downgrading eight Greek banks on Friday:

“Earlier Friday, Moody's Investors Service downgraded the credit ratings of eight Greek banks by two notches. The ratings firm cited losses resulting from the banks' holdings of Greek government bonds as well as increasing concerns about the impact of a recession and fragile liquidity and funding positions.”

and ibid:

The European Union has no plans to speed up recapitalization of banks that came close to failing the stress tests published in July, a European Commission spokesman said Friday.

Having no plan seems par for the course for the European Union, but the banking crisis seems unlikely to wait around for the gestation of new plans. Instead it is simply getting worse by the day. This would be no problem if not for the fact that the example of Argentina is a reminder that once a crisis of the fractionally reserved banking system gets out of hand, one can expect the property rights of depositors and savers to be sacrificed to the 'common good' (which consists of bailing out the banks by hook or by crook).  Meanwhile, Deutsche Bank CEO Joseph Ackerman is, perhaps not too surprisingly, in the camp that thinks throwing more money at the situation is absolutely essential.




Wolfgang Schäuble, photographed as he spots Evangelos Venizelos at the G-20 gabfest.

(Photo: Reuters)



A long term chart of the Euro-Stoxx Bank Index. Back at its 2009 crisis low. This area should actually provide some support to bank stocks – click for higher resolution.



In an interview on German TV, German chancellor Angela Merkel also weighed in on the crisis (we happen to have seen the interview and think it actually was quite an effective PR coup for Mrs. Merkel vis-a-vis her domestic audience).

As this summary of the interview at Bloomberg suggests, Mrs. Merkel is no longer strictly opposed to national bankruptcies. At the same time she indicated that Greece would likely get the next bailout tranche – not so much because anyone believes that Greece can ever pay up, but because the necessary 'firewalls' to defend the rest of the euro area against the inevitable contagion effect are not in place (she didn't say it outright in the manner we are putting it here, this is reading between the lines). In short she didn't make a secret of her desire to buy more time.


Euro Area Credit Market Charts

Below is our usual collection of charts of CDS spreads, bond yields,  euro basis swaps and a number of other charts. Prices in basis points, with both prices and price scales color-coded where applicable. These are as of Friday's close. As can be seen, on Friday panic continued to reign in the credit markets. CDS on Greece made a new high  at over 5,800 basis points,  however our euro area bank CDS index managed a small pullback.

One thing that increasingly commands our attention is the move in CDS on JGB's. Japan's public debtberg has long been regarded as impervious, but as we have noted here on several occasions, it remains the quintessential 'gray swan' (a gray swan is a black swan everybody knows about, where only the question of timing is not yet settled). We want to keep readers abreast of developments in areas which are not necessarily on everyone's radar screen at the moment for the simply reason that this will help avoid nasty surprises. We don't know if the move in CDS on Japan is simply in sympathy with the moves in euro area sovereign credit default swaps, but there is always a chance that the finance minister's 'dreadful dreams' will come true.



5 year CDS on Portugal, Italy, Greece and Spain – a new high for Greece and Portugal, but CDS on Spain and Italy pull back a little – click for higher resolution.



5 year CDS on Ireland, France, Belgium and Japan – new highs for Belgium and Japan. The breakout in CDS on Japan's government debt is a rather worrisome side effect of the euro area's debt crisis. To be sure, at just above 140 basis points it is not yet reason for grave concern – the 200 basis points we find CDS on France at are a good sight more troubling – but it's a move in the wrong direction, and it's accelerating – click for higher resolution.



5 year CDS on Bulgaria, Croatia, Hungary and Austria – all once again moving to fresh highs on Friday – click for higher resolution.



5 year CDS on Latvia, Lithuania, Slovenia and Slovakia – the breakout from the bullish triangles we have previously highlighted has resolved in a 'parabolic' move higher – click for higher resolution.



5 year CDS on Romania, Poland, Slovakia and Estonia – the same goes for these charts. A huge jump in CDS on Romania by the way – up 55 basis points on Friday alone – click for higher resolution.



5 year CDS on Saudi Arabia, Bahrain, Morocco and Turkey – once again, CDS on Turkey and Middle Eastern countries are rallying further as well – click for higher resolution.



5 year CDS on Germany, the US and the Markit SovX index of CDS on 19 Western European sovereigns. Not surprisingly, the SovX keeps making new highs. It is absolutely astonishing to see an average of CDS on 19 Western European sovereigns trade at 365 basis points. A new high for the move for CDS on US treasuries as well – click for higher resolution.



Three month, one year and five year euro basis swaps – there was actually a tiny bounce in the 'euro-doom' trio on Friday – presumably due to the ECB's very vocal promise of providing 'unlimited liquidity' – click for higher resolution.



Our proprietary unweighted index of 5 year CDS on eight major European banks (up from seven previously – the index now contains CDS on BBVA, Banca Monte dei Paaschi di Siena, Societe Generale, BNP Paribas, Deutsche Bank, UBS, Intesa Sanpaolo and Unicredito). A slight pullback on Friday, in concert with a bounce in European bank stocks (the 'G-20 hope trade') – click for higher resolution.



Inflation-adjusted yields resume their plunge. The entire increase in inflation expectations occasioned by 'QE2' has now been erased – click for higher resolution.



10 year government bond yields of Ireland, Greece, Portugal and Spain – Spain's bond yields are coming in due to continued ECB purchases – click for higher resolution.



10 year government bond yields of Italy and Austria, UK Gilts and the Greek 2 year note.  The rally in 'safe haven' bonds is probably overdone by now. And yes, Italy still looks horrendous and the Greek two year note is back at yielding 70% again – click for higher resolution.



5 year CDS on Australia's 'Big Four' banks. As expected, the triangle consolidation has led to a big breakout move here as well. It is interesting that  the market doesn't differentiate between these banks in terms of credit risk. This actually makes sense, as they all depend on overseas wholesale funding and are all exposed to the housing bubble. Needless to say this is a major warning sign for Australia's economy, and by inference also for China's – click for higher resolution.




Charts by: Bloomberg, BigCharts.com



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2 Responses to “Euro Area Update – More Leverage Mooted Amid Endless Squabbling”

  • roy_partridge:

    Pater –

    With the major bailout, I under the rally in Euro stocks. I was surprised with the rally in the Euro.

    This should be Euro currency negative and Gold positive. Also I would have expected the CDS on the banks to decline.

    Appreciate your comments on these inconsistencies.

    • Hi Roy,

      in the short term, such inconsistencies often appear and may not necessarily be very meaningful. I would agree with you that longer term, the leveraged EFSF bailout scheme is euro-negative and gold positive. In the short term it may help stocks and other risk assets and should drive CDS spreads somewhat lower, but to what extent will largely depend on the details and the speed of implementation.

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