13 August 2011

Global Economic Meltdown and the Euro

A good friend of mine -let's call him Feroze, to protect the innocents- sent me a message asking if we are seeing the end of the Euro. He was also wondering if the so called market forces are nuts to try to damage Eurozone countries. Feroze is a successful restaurateur and knows about investor behavior and market forces. His question echoes the BBC's Business Editor Robert Peston who asked the same question in British English, as in "Are Markets Bonkers?":
Are lenders to government, creditors of banks and investors in shares behaving in the kind of way that would guarantee them the kind of losses that presumably they would wish to avoid?
 I ask this question, because there is something of a paradox about investors' and creditors' current obsession with whether huge economies - the US, Italy, Spain and latterly France - will be able to repay all their debts. 
 The natural reaction of the governments of these countries, when they fear that it will become harder and more expensive for them to borrow, is to do what they think their creditors want - which is to introduce austerity measures, to reduce their respective deficits, the gap between what they spend and their tax revenues.    (...)
Now here's the thing.
With economic growth in the developed Western economies so weak, these austerity measures are convincing investors and creditors (the same ones who don't want to lend to Italy and Spain, or different ones?) that the risk of a slide back into recession has become larger. 
My take is that, despite Feroze's and Peston's reasonable questions, markets are indeed very sane. The crazy ones were the observers who gleefully cheered on massive austerity measures, as I pointed out.

Markets aim to achieve two goals.

One is to let everyone know that recession and unemployment are the issues, not deficits, as Very Serious People (VSP) seem to claim.

Two, they are pressuring Eurozone countries, not because they want to see their economies destroyed but to force them to issue Eurobonds which will be backed by the entire EU, including (especially) Germany and all the other smaller and healthy economies.

Markets Want Protection Against Upcoming Recession

After the S&P's petulant downgrade of US debt, contrary to all predictions, markets dumped stocks and rushed to US Treasury bonds. This is how Krugman put it
Bear in mind that deficit hawks have been warning for years that interest rates on U.S. government debt would soar any day now; the threat from the bond market was supposed to be the reason that we must slash the deficit now now now. But that threat keeps not materializing. And, this week, on the heels of a downgrade that was supposed to scare bond investors, those interest rates actually plunged to record lows. 
What the market was saying — almost shouting — was, “We’re not worried about the deficit! We’re worried about the weak economy!” For a weak economy means both low interest rates and a lack of business opportunities, which, in turn, means that government bonds become an attractive investment even at very low yields. If the downgrade of U.S. debt had any effect at all, it was to reinforce fears of austerity policies that will make the economy even weaker.        
Yves Smith (guest blogging at Salon) makes the same point and argues that the markets are rationally moving to Treasuries as austerity measures will likely lead to deflation, the kind that crippled Japan during their so called Lost Decade. And during deflationary times, bonds and cash are the two refuges for investors and ordinary people.
Despite the hysteria that the downgrade of US debt would lead to US funding costs rising and Treasuries crashing, instead we've had stocks crashing and Treasury prices rising sharply. That's completely rational. The policies being implemented as a result of this contrived budget crisis are deflationary. For non-economists, as much as inflation has been touted as a major financial problem over the last 30 years, deflation is widely acknowledged to be Economic Enemy Number One. And high quality bonds like Treasuries are the place to be in deflation.
Both Smith and Krugman also highlight the fact that with borrowing costs so low, it is almost criminal not to inject money into the economy. And they claim that the major examples set by the return of the Great Crash in 1937 and the painfully slow recovery of Japan during the Lost Decade are not lost to the markets and they are clamoring for a major stimulus package which will lead to growth.

Nouriel Roubini, who rose to fame as one of the very few economists who predicted the 2008 crisis and its aftermath, joins the chorus to ask for more stimulus. But, as before, he is not very hopeful.

Central banks should keep pumping money into the world’s economies, the European Central Bank should cut interest rates to zero, and it should buy up Spanish and Italian government bonds to keep those countries from imploding, he wrote.
“Another recession may not be preventable. But policy can stop a second depression. That is reason enough for swift and targeted action,” Roubini said.
It may be worth noting that, writing before the current fluctuations (7 August), he predicted the rise in Treasury prices:
He called the downgrade in the U.S. long-term credit rating by Standard & Poor’s Corp. “misguided,” though he expects it will lead to a paradox, “U.S. Treasuries will probably remain the world’s least ugly safe asset” and rise in price, cutting yields.
Markets Want Their Risky Investments Insured By EU

The Euro was built upon a loose and shaky foundation. Maastricht Treaty set up a few basic parameters about inflation, budget deficits and debt to GDP ratio, known as the Maastricht or Convergence Criteria. But it did not provide any fiscal integration about spending and taxation. In times of economic boom, it is relatively easy to force governments to stay within those parameters but in bust times, it is much harder to find common grounds among widely different economies.

After all, how do you have a Europe-wide inflationary policy when some economies, like Germany, are over heating, whereas others, like Italian or Spanish economies are contracting (or like France, teetering between growth and contraction)? One group needs higher interest rates to avoid inflation, the others require near zero interest rates to salvage any chance of recovery. What is the ECB to do?

What the markets are saying is that Europe will have to make a choice about the Eurozone. It will either let it go (or confine it to a smaller group of countries with structurally similar economies) or move quickly towards further integration. They know which alternative they prefer and they have been pushing to bring that about.
In the eurozone, calls for tighter integration are gathering political momentum. Germany's Foreign Minister, Guido Westerwelle, said that the eurozone is "facing a forked road". 
The choice is between "less Europe" or "more Europe" he told the BBC. "We think it is necessary to answer this crisis with more Europe," he said. 
Such a plan could involve expanding the eurozone's bailout fund massively, perhaps to as much as two trillion euros, and to guarantee the debt of countries such as Portugal and Italy.
In return these countries would have to accept more central control over their tax and spending. Such a solution was ruled out by eurozone leaders - but that was before the current markets meltdown.
Actually, it is more than just better financed bailout funds, bond holders want individual sovereign debts to be merged into Eurobonds that are backed by the entire EU. This is the only way they can avoid a painful haircut (and given current risk premiums they extort, a well-deserved one) as I suggested using the Irish example. They have been selectively attacking several European economies to force politicians realize that they will not let up until this goal is achieved.

I am saying selectively on purpose. Simon Johnson, former IMF Chief Economist, wrote this more than a year ago:
At the moment Germany and France are the safe havens.  Bond yields in France fell sharply the last two weeks, while Spain’s yields rose, and would have increased much more were it not for ECB purchases. 
But who is really safe in Europe?  With France running an 8% GDP budget deficit (for 2010) and a debt/GDP ratio of 83.6%, should we be confident they are safe while Spain is not (with debt/GDP at 65%)?  France’s thirty years of budget deficits do not bode well for anyone expecting an immediate strong fiscal response.  In many ways Spain appears better placed to take tough actions than France.
They started out with Ireland and hinted at Portugal. Then they hinted at Spain. Then they hinted at Italy, while allowing France to pretend to be Germany's economic equal (despite its weak fundamentals as the quote indicates). And now they are hinting at France. The endgame is that they will not stop until all European debt is collateralized by the entire EU.

It is a big gamble. The bond holders know that Germany, Austria, the Netherlands, Finland and a few others could simply let the Euro die and form a so called Neue Deutsche Mark zone and do very well for themselves. But they also know that politically, letting the Euro die and leaving France behind (with Franco-German bloc having been the symbolic core of the EU) might not be feasible, as it might lead to a deeper disintegration of Europe. And they are gambling that no European politician would allow that.

They know that the only other likely scenario is a tighter fiscal integration. It would calm the markets as they will get what they want: a rock solid bond collateralizing debts for which they initially got paid handsome risk premiums.

But it is a big question mark whether Europeans would allow centralized spending and taxation policies. Especially, if they realized that these were brought in on the insistence of bond holders.

My money is on bond holders.

I wonder what my friend Feroze would say.
Well, George Soros intervened. He is a hero of mine, so what can I say?

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