After the months of buoyant markets, a return to crisis-type headlines seems troublingly familiar, even though the perturbations of the last day or so are a pale shadow of the worst months of the crisis. And some are making the bull case. For instance, a headline at Clusterstock trumpetss, “Yesterday’s Bloodshed Sent The VIX Soaring 20%, Which Means Today Markets Will Rebound.”
But the Greece problem exposes several fracture lines. The most immediate is the strain on the euro. The monetary union left a lot of critical issues and mechanisms in the “to be sorted out later” category, and “later” has arrived. One long-noted problem is the limits on member nations in using fiscal and monetary policy, and the expected large differences in economic performance have resulted. The immediate problem for Greece is its interest rates have spiked up in the last few days based on the belief that its government debt burden is unmanageable; the only ways out look to be a rescue, either from the IMF (presumably on draconian terms) or the EU (which also looks set to keep Greece on a short leash), or the other choice, to abandon the euro, devalue its currency, and default. Gillian Tett points out that the dramatic increase in yields on Greek government bonds isn’t entirely the result of shifting investor perceptions; some ECB collateral rules played a role:
Back in the autumn of 2008,…the ECB loosened the rules which govern how banks can get central bank funds. In particular, it let banks use government bonds rated BBB or above in ECB money market operations, instead of merely accepting bonds rated A-, or more.
This was initially presented as a “temporary” policy, slated to last until late 2009. But last year the ECB extended the policy until the end of 2010. Thus, during 2009, banks which were holding Greek bonds have been merrily exchanging these for other assets via the ECB. This, in turn, has helped to support Greek bond prices (and, by extension, Greek banks that hold a large chunk of outstanding Greek bonds).
Until recently, many observers thought – or hoped – that this policy would be extended again, perhaps until 2011 or beyond. For although Greek debt currently has a credit rating that meets the old ECB rules, there is a good chance the debt will be downgraded this year. This creates the risk that Greek bonds will be excluded from any newly tightened ECB regime.
Earlier this year, senior ECB officials indicated that they intended to “normalise” the policy, as planned, at the end of 2010, as part of their exit strategy. That has removed one key source of support for Greek debt (and spooked investors, such as German insurance companies, which also hold large chunks of bonds.)
The prospect of a Greek sovereign debt crisis has stoked worries about EU members with high-debt profiles, particularly Portugal, now in the throes of a political crisis. As the Financial Times notes:
Portugal moved towards a political crisis on Thursday night as its finance minister appealed to opposition parties not to defeat the minority Socialist government over a regional finance bill that he said would undermine the country’s international credibility.
In a televised address, Fernando Teixeira dos Santos said opposition proposals to allow the Portuguese islands of Madeira and the Azores to increase their debt would have “grave consequences for Portugal’s public accounts” and send “the worst possible message” to financial markets.
His warning came as Portuguese bonds and shares came under fire for the second day running as concerns over sovereign debt spread from Greece to other high-deficit countries in the eurozone.
Tett also made an assessment consistent with what I have seen among blog readers, both in comments and via e-mail. The views here seem polarized. One camp doubts the ability of the EU to cope with this crisis, particularly since it could well redound to European banks, which are even more fragile than their US peers. The other sees this as a different sort of challenge:
To many European bankers and politicians, however, the focus on raw numbers misses the point. To them, this story is not just about economics, but politics, and the determination of a generation of leaders traumatised by the second world war to maintain European unity, almost at any cost. And as the price of Greek debt has tumbled, and yields have risen, doughty figures at the heart of Europe are increasingly likening this to an “attack” on the euro, on a par with, say, the attack on sterling launched by George Soros two decades ago. The potential for some form of political backlash is running high.
But no matter how this drama resolves itself, the odds of collateral damage are high. First, these sovereign debt crises are a frontal assault on the main mechanism used to cope with the global financial crisis: liberal use of government debt, both to recapitalize wounded banks and to compensate for a sharp fall in private sector demand.
Despite brave talk of an end of the downturn, financial markets have been riding on liquidity-driven bubbles that are well ahead of fundamentals. And in particular, Nouriel Roubini has discussed the danger of the unwind of a dollar carry trade. If financial institutions are exposed (directly through bad trading bets or losses on customer margin loans or counterparty failures), we could see another acute crisis episode. The resumption of the crisis should call into question the efficacy of the previous rescue methods, but all the authorities appear to have gone into “Mission Accomplished” mode and have not engaged in post-mortems to devise better crisis responses.
Second, we have the real possibility of an outbreak of protectionism. The US has announced that it intends to double exports in the next five years. But it is impossible for all countries to run trade surpluses; if some nations run surpluses, others have to have deficits. So that goal already increases the potential for friction.
The US has started crossing swords with China, albeit first on what our press has depicted as lesser issues, but they may not look so “lesser” to China, such as Obama’s scheduled visit with the Dalai Lama, the US plan to sell $6 billion of arms to Taiwan, and this doozy:
The United States plans to unveil later this decade a new conventional “Prompt Global Strike” (C-PGS) system. It will enable the US to instantly carry out a massive conventional attack anywhere in the world in an hour or less…..
[Dr. Jeffrey] Lewis [director of the Nuclear Strategy and Nonproliferation Initiative at the New America Foundation] points to a recent meeting, a so-called US-China Track II exchange, involving many US and Chinese participants, which demonstrated how the Chinese may have been caught off guard by the way in which C-PGS has suddenly appeared on their radar screen.
“US participants tried to explain the problem with making a ‘no first use’ promise. What would happen, they asked, if the United States attacked China’s nuclear forces with conventional weapons? Would China still adhere to its ‘no first use’ promise?” said Lewis. “The Chinese side did not understand that the Americans were engaging in a clumsy ‘thought experiment’ that was purely illustrative, but instead believed that they had been subjected to a very serious threat of coercion. Such misunderstandings are inevitable and, in fact, this is why Track II discussions are essential. It simply illustrates the point that Chinese and American strategists have yet to think through what impact [C-PGS] will have on strategic stability.”
Yves here. I don’t buy this “aw, shucks, those Chinese misunderstood us! We were just havin’ a nice theoretical chat!” The folks who do high level defense related work think far more carefully about negotiations and game theory than the vast majority of private sector types do (for instance, Daniel Ellsberg, who worked at RAND before taking assignments at the Department of State and the Pentagon, was a key figure in the development of decision theory). So the fact that this little talk came off sounding like a threat was unlikely to be an accident.
So how does this play into European woes? Well, unless the EU patches up some rescues, pronto, we are likely to see a period of euro weakness. When trade plunged during the acute phase of the crisis, China’s surplus actually grew. Even though its exports fell, its imports shrank more. By contrast, Japan’s surplus went into a deficit and the Eurozone took a hit. This result came about because the yen spiked relative to the dollar and China held its currency peg to the greenback (by all accounts, it should have risen further). As conditions normalized and the dollar weakened, the renminbi depreciated along with it. Some analysts argue that the RMB is even more undervalued than it was in 2008.
So US-China relations are getting fractious, and the US is no longer so keen to be the world’s superconsumer. If euro weakens (and on top of that the EU goes into a slump), that will reduce China’s exports. The US and China (and EU) are starting to engage in tit-for-tat trade retaliation (the Chinese are now taking aim at US chicken). Of course, the lesson of the Great Depression is that protectionism hurts the trade surplus country worst, so China has the most so lose, but they may not be able to restrain their punitive impulses.
But there may be a bigger lesson from the Depression that no one wants to consider. The Carmen Reinhart-Kenneth Rogoff work on financial crises finds that periods of large international capital flows are associated with banking crises. Now, liberalized trade does not have to lead to large international capital flows, but it sure seems to.
Dani Rodrik has posited the existence of a policy trilemma:
I have an “impossibility theorem” for the global economy that is like that. It says that democracy, national sovereignty and global economic integration are mutually incompatible: we can combine any two of the three, but never have all three simultaneously and in full…
To see why this makes sense, note that deep economic integration requires that we eliminate all transaction costs traders and financiers face in their cross-border dealings. Nation-states are a fundamental source of such transaction costs. They generate sovereign risk, create regulatory discontinuities at the border, prevent global regulation and supervision of financial intermediaries, and render a global lender of last resort a hopeless dream. The malfunctioning of the global financial system is intimately linked with these specific transaction costs.
So what do we do?
One option is to go for global federalism, where we align the scope of (democratic) politics with the scope of global markets. Realistically, though, this is something that cannot be done at a global scale. It is pretty difficult to achieve even among a relatively like-minded and similar countries, as the experience of the EU demonstrates.
Another option is maintain the nation state, but to make it responsive only to the needs of the international economy. This would be a state that would pursue global economic integration at the expense of other domestic objectives…. The collapse of the Argentine convertibility experiment of the 1990s provides a contemporary illustration of its inherent incompatibility with democracy.
Finally, we can downgrade our ambitions with respect to how much international economic integration we can (or should) achieve. So we go for a limited version of globalization, which is what the post-war Bretton Woods regime was about (with its capital controls and limited trade liberalization). It has unfortunately become a victim of its own success. We have forgotten the compromise embedded in that system, and which was the source of its success.
So I maintain that any reform of the international economic system must face up to this trilemma. If we want more globalization, we must either give up some democracy or some national sovereignty. Pretending that we can have all three simultaneously leaves us in an unstable no-man’s land.
Yves here. The implication of this may be that a fall in trade, perhaps not as dramatic as what occurred in the 1930s, may be a necessary element of a return to stability. No one seems to be thinking along those lines. And that increases the odds that we will get that result, not via design, but via protectionist responses that escalate into trade wars.