Sunday, September 18, 2011

What's Up With Europe?

Treasury Secretary Geithner just returned from a whirlwind trip to Europe, where he visited with European Finance Ministers and gave them his considered opinion on what to do in the current debt crisis: lots of liquidity, he said; do something like our TALF program (Term Asset-Backed Lending Facility) which began in early 2009 and ended in 2010; let banks and sovereigns supply assets, then load them with liquidity provided by the European Central Bank (ECB). Apparently, his words were not well received, at least not by the very solvent, inflation hawk, Northern Europeans (Austria, Germany, Netherlands, Finland).

Geithner was telling the Europeans to do exactly what he and Bernanke did in 2009-2010. In a huge and essentially invisible lending program, the Fed put out about $16 trillion in short-term lending to pretty much any bank, here and abroad, that asked for money. This was only made public when Bloomberg took the Fed to court over a Freedom of Information Act request for what they loaned out during this period. If they had needed Congress' approval, it never would have been given. Take a look at the following chart, where I show M1 money supply (currency, bank reserves, demand deposits) and what happened to our core inflation rate (CPI less food and energy prices):

There was an enormous increase in money supply during and after the crisis, and another surge now, driven in part by QE2 (Quantitative Easing, Phase 2). You will notice that this money supply surge has had no effect on inflation, which ought to give inflation hawks pause, but doesn't.

Why was Geithner poorly received? The inflation hawks of Northern Europe are fiercely opposed to providing unconditional liquidity to weak sovereigns and weak banks; neither the sovereigns (Greece etc.) nor their banks deserve it, and such a process would lead to serious inflation and a debasing of the Euro. And the solvent sovereigns will eventually have to pick up the pieces.

Let's look at a telling example of the growing market distress, reflecting differing levels of "discomfort" with different sovereigns. The chart shows the trends in the cost of credit protection (ensuring against default) for the Eurozone countries:

Greece, Ireland and Portugal top the chart, followed (not much behind) by Italy and Spain (PIIGS - Portugal, Italy, Ireland, Greece, Spain; although some are now reversing that and writing GIIPS). The market expects Greece to default, and most probably Ireland and Portugal as well.

One of the problems is the amount of sovereign debt they need to roll over in the next year (taken from Europe on the Brink, a briefing report by the Petersen Institute):

So what has changed? Presumably all this debt didn't arise overnight. Somehow the European sovereigns have been able to roll over their debt in prior years. Why is this seen to be such a problem now? And herein lies the rub. When Greece (and then Ireland) had to formally ask for fiscal relief in a formal manner, the system began paying attention in a very different way; the "decision-making troika", the ECB, the EU, and the IMF did what the IMF has been doing for many years: demand serious austerity measures and cuts to government spending before providing assistance.

The Eurozone's monetary system worked on quite relaxed and seemingly safe rules, practices, and underlying assumptions: there will never be a sovereign default (the ECB with its own fiat currency - the Euro - would see to that); banks under Basel III were allowed, in fact, encouraged to stock up on sovereign bonds on their balance sheets, and were not required to hold any risk capital against this asset class; the ECB accepted sovereign paper as collateral and loaned at low rates with only modest haircuts (only recently did they make some adjustments for the credit-rating of the sovereign issuing the paper). A sovereign, running short, could tell their banks to buy their paper; the banks would do so, and take the paper to the ECB, and get the cash to pay for the bonds to their sovereigns.

But when Greece ran very short and made a formal request for a bailout, everything began to change. What had been invisible subsidies of weaker sovereigns through monetary transactions, suddenly became visible in the request for bailouts. Here's a remarkable chart that shows the extent to which Germany(and other Northern European countries) has been funding the GIIPS:

These are "cross-border" payments that would be paid off annually in sovereign countries not part of a currency zone, but in Europe are allowed to accumulate. Normally invisible. But when the discussion becomes political, fully visible now, and sure to incite nationalist sentiments. "Why should we pay for the profligate Greeks, Irish, Portuguese, etc," say the Northern Europeans. And so it begins.

Which brings us to today. The ECB could make this all go away by declaring that there will be no sovereign or bank defaults, that the ECB stands ready to provide whatever liquidity is necessary, and that they will provide whatever funding the weaker sovereigns need to get them through the crisis. 

Would this calm the markets? The inflation hawks will strenuously disagree, but many economists would say yes. This is, in effect, what Secretary Geithner was counseling. Will the ECB do this? After all, deficit/inflation hawk Trichet is leaving his post as head of the ECB, and Mario Draghi from a Southern Country - Italy - is soon taking the helm. Might he reverse Trichet's course? It's possible, but I seriously doubt it. The deficit and inflation hawks have, this far, carried the day. They fear a huge outburst of inflation and a debasement of the Euro if the ECB were to provide all this liquidity. Germany fears that they will have to pick up the tab of the eventual sovereign defaults, through their large share in the capital base of the ECB.

So what will happen? The Petersen Institute lists three possibilities: first, individual European sovereigns get really tough in their austerity programs and convince the markets that budgets will balance; second, there is a hard rejection of the current "moral hazard"/unconditional liquidity guarantee by the ECB, leading to sovereign and bank debt restructuring on an organized, structured basis; and third,  a "muddling along" strategy that satisfies no one and leads to disorganized sovereign and bank defaults.

I think it's too late for number one. Number two would require political consensus that I don't see yet. So number three - muddling along until something blows up, is where I come out.

How soon? One week. Six months. And most likely, somewhere in the middle.

What will happen here? Gretchen Morgensen had a great piece in the New York Times this morning where she says that "What is Over There Will Be/Is Already Over Here." One of the key unknowns is which banks in the US have written the over $60 billion of credit insurance (CDS, or Credit Default Swaps) on European sovereigns and banks, and will they be able to deliver. She also points out that though US Money Market Funds have pulled back from Europe, they still have huge exposure to European banks.

A crisis in Europe will be a crisis here. Geithner and Bernanke will provide liquidity like lightning. But I still think it will take down one or more US banks.

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