European Leaders Promise to Save Major Banks, But Fail to Adopt EU Plan

So far, the statement released this afternoon US time out of a Euro summit amounts to an attempt at reassuring hand-waving but in fact was merely a restatement of the status quo. The group of European leaders did agree on a set of principles, but it remains an open question whether they will be able to act quickly or boldly enough in the fact of the mounting financial crisis.

And one principle was troublesome: that each country is on its own as far as its banks are concerned. Some banks, such as Deutschebank and UBS, are too big for their countries to save should they founder. Hypo was brought down by an Irish acquisition. The statement may have been crafted in part to keep pressure on German banks to support the Hypo rescue, and may be a practical necessity right now, since the public at large does not yet recognize the depth and extent of the risk in the EU, but it seems unwise to take a hard position on such a central issue.

From the Wall Street Journal:

European leaders pledged at a weekend summit to protect the continent's banks from the spiraling global financial crisis. Their resolve is already being put to the test as two European banks required fresh rescues.

At an emergency meeting in Paris on Saturday, the leaders of France, Germany, U.K. and Italy said that, unlike in the U.S. where Lehman Brothers was allowed to file for bankruptcy, European governments would stand in to prevent any bank from failing.....

Yet, so far, proposals for unified anti-crisis rules -- such as a mult-billion euro banking bailout fund -- have been abandoned for fear they would be impossible to govern. Instead of concrete decisions, therefore, the four EU leaders decided on Saturday to a list of principles. Among them: though the leaders agreed that each country will be responsible for handling problems within its own banking system -- including coming up with possible sanctions for the heads of any failed banks -- they promised to keep each other informed of their actions.

They said they would jointly consider ways to amend some accounting standards -- such as the mark-to-market rule -- that have pushed several banks into uncontrolled, downward spirals.

From Bloomberg:

European leaders pledged to bail out their own nations' banks while stopping short of a regional rescue effort to deal with the global credit crisis.

At a summit in Paris yesterday, leaders of France, Germany, Britain, Italy, Luxembourg, the European Central Bank and the European Commission agreed to ease accounting rules, seek tougher financial regulations and weaken enforcement of competition and budget laws.

``Each government will act according to its own methods and its own means but in a coordinated manner with the other European states,'' French President Nicolas Sarkozy, who called the meeting, told reporters....

Europe ``is still a dwarf compared to the U.S.'' in terms of willingness to spend, said Laurence Boone, an economist at Barclays Capital in Paris. The statement on supporting banks ``is not a progress. It's the same as before the summit.''

Germany appears to be the stumbling block. Again from Bloomberg:

Hours before the summit, Dominique Strauss-Kahn, managing director of the International Monetary Fund, met Sarkozy to press the need for agreement. ``Collective action is even more necessary in Europe than in the U.S. because Europe is more complex than the U.S.,'' he told reporters. ``Action must be taken quickly and in a concerted manner.''

German Chancellor Angela Merkel's opposition underscored the hurdles to forging a unified front. ``Each country must take its responsibilities at a national level,'' she told a joint press conference after the summit.

The group agreed on coordinated policies on deposit guarantees and on having another summit soon to hash out fundamental reform. Bloomberg again:

Sarkozy said that ``all actors'' must be supervised, including rating firms and hedge funds. Executive-pay systems must also be reviewed, he said.

``We want a new world to come out of this,'' Sarkozy said. ``We want to set up the basis for a capitalism of entrepreneurs, not speculators.''

Anticipating increased spending, declining tax revenue, and government bank takeovers, they called for ``greater flexibility'' in the application of European Union competition and budget rules.

The last statement is an admission that the Stabilization Pact, which limits borrowings and fiscal deficits by EU members, is kaput.

Will Euro Bank Woes Take Down the EU?

We have been asserting for many moons that despite having lower incidence of US style, "another quarter, another writedown" behavior, European banks are actually in weaker condition than their US counterparts. That's based on the view of a buddy who has top level regulatory connections here and in Europe, and it seems plausible given the fact that European regulators let their bank operate with lower equity levels than US banks can.

Not only have events started confirming this view, but, with a banking crisis starting to take hold in the EU, the stakes are high. The EU lacks a mechanism for rescuing banks; the responsibility falls to national central banks. The rescue over last weekend of Fortis demonstrated that several central banks, shepherded by the EU, can make a coordinated rescue. But will this prove to be a one-off or a model? The biggest banks in Europe, starting with Deutschebank and UBS, are similarly too big for their home country central bank to salvage in case of a meltdown.

Ambrose Evans-Pritchard, who admittedly has an appetite for drama, contends that the survival of the monetary union itself is in play.

From the Telegraph:

It took a weekend to shatter the complacency of German finance minister Peer Steinbrück. Last Thursday he told us that the financial crisis was an "American problem", the fruit of Anglo-Saxon greed and inept regulation that would cost the United States its "superpower status". Pleas from US Treasury Secretary Hank Paulson for a joint US-European rescue plan to halt the downward spiral were rebuffed as unnecessary.

By Monday, Mr Steinbrück was having to orchestrate Germany's biggest bank bail-out, putting together a €35 billion loan package to save Hypo Real Estate. By then Europe was "staring into the abyss," he admitted. Belgium faced worse. It had to nationalise Fortis (with Dutch help), a 300-year-old bastion of Flemish finance, followed a day later by a bail-out for Dexia (with French help).

Within hours they were all trumped by Dublin. The Irish government issued a blanket guarantee of the deposits and debts of its six largest lenders in the most radical bank bail-out since the Scandinavian rescues in the early 1990s. Then France upped the ante with a €300 billion pan-European lifeboat for the banks. The drama has exposed Europe's dark secret for all to see. EU banks took on even more debt leverage than their US counterparts, despite the tirades against ''le capitalisme sauvage'' of the Anglo-Saxons.

We now know that it was French finance minister Christine Lagarde who begged Mr Paulson to save the US insurer AIG last week. AIG had written $300 billion in credit protection for European banks, admitting that it was for "regulatory capital relief rather than risk mitigation". In other words, it was underpinning a disguised extension of credit leverage. Its collapse would have set off a lending crunch across Europe as banking capital sank below water level.

It turns out that European regulators have allowed even greater use of "off-books" chicanery than the Americans. Mr Paulson may have saved Europe.

Most eyes are still on Washington, but the core danger is shifting across the Atlantic. Germany and Italy have been contracting since the spring, with France close behind. They are sliding into a deeper downturn than the US.

The interest spreads on Italian 10-year bonds have jumped to 92 points above German Bunds, a post-EMU high. These spreads are the most closely watched stress barometer for Europe's monetary union. Traders are starting to "price in" an appreciable risk that EMU will break apart.

The European Commission's top economists warned the politicians in the 1990s that the euro might not survive a crisis, at least in its current form. There is no EU treasury or debt union to back it up. The one-size-fits-all regime of interest rates caters badly to the different needs of Club Med and the German bloc.

The euro fathers did not dispute this. But they saw EMU as an instrument to force the pace of political union. They welcomed the idea of a "beneficial crisis". As ex-Commission chief Romano Prodi remarked, it would allow Brussels to break taboos and accelerate the move to a full-fledged EU economic government.

As events now unfold with vertiginous speed, we may find that it destroys the European Union instead. Spain is on the cusp of depression (I use the word to mean a systemic rupture). Unemployment has risen from 8.3 to 11.3 per cent in a year as the property market implodes. Yet the cost of borrowing (Euribor) is going up. You can imagine how the Spanish felt when German-led hawks pushed the European Central Bank into raising interest rates in July.

This may go down as the greatest monetary error of the post-war era. The ECB responded to the external shock of an oil and food spike with anti-inflation overkill, compounding the onset of an accelerating debt deflation that poses a greater danger. Has it committed the classic mistake of central banks, fighting the last war (1970s) instead of the last war but one (1930s)?
After years of acquiescence, the markets have started to ask whether the euro zone has the machinery to launch a Paulson-style rescue in a fast-moving crisis. Who has the authority to take charge? The ECB is not allowed to bail out countries under EU treaty law. The Stability Pact bans the sort of fiscal blitz that has kept America afloat. Yes, treaties can be ignored. But as we are learning, a banking system can implode in less time than it would take for EU ministers to congregate from the far corners of euroland.

France's Christine Lagarde called yesterday for an EU emergency fund. "What happens if a smaller EU country faces the threat of a bank going bankrupt? Perhaps the country doesn't have the means to save the institution. The question of a European safety net arises," she said.

The storyline is evolving much as eurosceptics predicted, yet the final chapter could end either way as the recriminations fly. Germany has already shot down the French idea. The nationalists are digging in their heels in Berlin and Madrid. We are fast approaching the moment when events decide whether Europe will bind together to save monetary union, or fracture into angry camps. Will the Teutons bail out Club Med? If not, check those serial numbers on your euro notes for the country of issue. It may start to matter.

German Minister: US Over as Financial Superpower

The unravelling that started with the Freddie and Fannie conservatorship has exacted a toll not just on dollar-denominated paper but on financial assets around the world. As they have fallen, so too has the standing of the US, which zealously promoted liberalized capital markets and saw US firms establish dominant positions when those rules were adopted.

America already had few friends thanks to our prosecution of the war in Iraq, and our reputataion is testing new lows. From the Telegraph:

In a remarkable outburst at the German parliament, Mr Steinbrück said the world would never be the same after “Black September”. He demanded a sweeping code of regulations to “civilise the financial markets” and clamp down on speculators.

Mr Steinbrück announced a swingeing eight-point plan to reorder the global markets - which will heighten fears in the City of London of interference by the European Commission.

“The US will lose its superpower status in the global financial system,” he said, predicting a new multi-polar order where power is spread across the globe.

“The financial crisis is above all an American problem. The other G7 financial ministers in continental Europe share this opinion,” he said, a pointed turn of phrase that excludes Britain’s Alistair Darling.

“This inadequately regulated system is now collapsing, with far-reaching consequences for the US financial market and contagion effects for the rest of the world,” he said....

Senior politicians in France and Germany have in recent weeks called for a radical shake-up of the market system. A powerful EU faction that has always been hostile to the City of London – which is known in Brussels as “the casino” – see this crisis as a rare chance to ram through irreversible changes.

“They want to regulate the capital levels of every firm and partnership, limit takeovers and regulate asset stripping. In short, they want to regulate the Anglo-Saxon version of capitalism out of existence,” said John Whittacker, MEP and UKIP’s economic spokesman.

Mr Steinbrück said the deft response of the world leaders in recent days had averted catastrophe. “Crisis management worked. We did not have a collapse of the international financial system,” he said.

Mr Steinbrück said the drive for short-term profit and huge bonuses in the Anglo-Saxon world was the root cause of the gravest crisis in decades. “Investment bankers and politicians in New York, Washington and London were not willing to give these up,” he said.

Update 3:45 AM: More on the same speech from the Financial Times:

He later told journalists: “When we look back 10 years from now, we will see 2008 as a fundamental rupture. I am not saying the dollar will lose its reserve currency status, but it will become relative.”

The minister, who has spearheaded German efforts to rein in financial markets in the past two years, attacked the US government for opposing stricter regulations even after the subprime crisis had broken out last summer.

The US notion that markets should remain as free as possible from regulatory shackles “was as simplistic as it was dangerous”, he said.....

The US, Mr Steinbrück said, had failed in its oversight of investment banks, adding that the crisis was an indictment of the US two-tier banking system and its “weak, divided financial oversight”.

He blamed Washington for refusing to consider proposals Berlin had made as it chaired the Group of Eight industrial nations last year. These proposals, he said, “elicited mockery at best or were seen as a typical example of Germans’ penchant for over-regulation”....

Mr Steinbrück’s proposals include a ban on “purely speculative short selling”; a crackdown on variable pay for bank managers, which had encouraged reckless risk-taking; a ban on banks securitising more than 80 per cent of the debt they hold; international standards making bank managers personally responsible for the consequences of their trades; and increased co-operation between European super visors.

$5 Trillion Needed to Stop Bank Crisis, Says Japanese Expert

Ken Ohmae, former head of McKinsey's Tokyo office (disclosure: I have a passing acquaintence with him and he was enormously well regarded in his day despite being a tireless self-promoter) says that the Paulson program is grossly inadequate and the magnitude of the US crisis is so large that a $5 trillion international facility is necessary.

The quid pro quo of any international program is that the US would be put on a short leash, probably not as severe as the one to which Indonesia and Thailand were subject to in the Asian crisis. But the US is not good at austerity and has never been in the position of not being in the driver's seat, so this sort of initiative would no doubt be rejected until it is too late for it to have much impact.

From Bloomberg (hat tip reader Saboor):

Treasury Secretary Henry Paulson's $700 billion plan to buy devalued assets from financial companies is ``a joke'' because it doesn't go far enough to calm markets, said Kenichi Ohmae, president of Business Breakthrough Inc.

Ohmae, nicknamed ``Mr. Strategy'' during his 23 years as a McKinsey & Co. partner, called for a $5 trillion ``international facility'' to be made available to financial institutions. The system could be modeled on one used by Sweden during its banking crisis in the early 1990s, he said.

``This is a liquidity crisis,'' Ohmae said at an investor forum hosted by CLSA Asia-Pacific Markets, the regional broking arm of Credit Agricole SA, in Hong Kong yesterday. ``The liquidity has to be so big that people won't get panicky.''...

Ohmae, 65, is the author of management books including ``The Mind of The Strategist,'' ``The Borderless World'' and ``The End of the Nation State.'' Business Breakthrough, founded in 1998, provides online management training.

One way of funding the $5 trillion facility would be through contributions from foreign exchange reserves in China, Japan, Taiwan, the Gulf states, the European Union and Russia, Ohmae said.

An international relief effort on that scale might be difficult to coordinate, said Robert Howe, founder of Hong Kong- based hedge fund manager Geomatrix (HK) Ltd., which oversees $32 million. ``I doubt the practicality of getting international cooperation on something like this,'' he said.

Ohmae compared the current financial crisis with Japan's 15- year economic decline that began in 1989. Both started with a property bubble, which wiped out companies' equity when it burst, and like in Japan, the current one could lead to escalating bankruptcies as banks worried about their own survival rein in lending, he said.

The financial-market upheaval may lead to slower growth in China and the reversal of the commodity boom as ship orders are canceled and steel supply dumped, said Ohmae. What Ohmae called Japan's ``Viagra'' economy and Australia's ``dig and deliver'' boom may also fizzle as China weakens, he said.

Against the backdrop of a potential global market panic, Paulson's plan is insufficient, said Ohmae.....

``He wants to fix problems one by one as if he were still the chief executive officer of Goldman Sachs,'' he said. ``He has to take his CEO hat completely off and come up with a systemic solution as opposed to a one-by-one solution.''

China and Japan Post Deteriorating Growth

Two stories on Bloomberg discussed how the world's export powerhouses, China and Japan, are feeling the effects of the global slowdown.

First on China, which seems inclined to weaken the yuan to defend growth. That's a mixed blessing for the US. A stronger dollar hurts the export sector, the one sunny area of the economy, but means the Chinese will need to keep buying dollar assets to keep the yuan down.

China's industrial production grew at the slowest pace in six years on weaker export demand, power shortages and factory shutdowns during the Olympic Games.

Production rose 12.8 percent in August from a year earlier, the statistics bureau said today, after gaining 14.7 percent in July. That was less than the 14.5 percent median estimate of 22 economists surveyed by Bloomberg News...

``Growth concerns and moderating inflation will make the authorities more likely to cut reserve requirements and slow yuan appreciation,'' said Wang Qian, an economist with JPMorgan Chase & Co. in Hong Kong. She estimates the reserve ratio will fall 50 basis points from a record 17.5 percent by year's end, dropping to 15 percent in 2009.

Of the yuan's 6.7 percent gain this year against the dollar, only 0.1 percent has come this quarter, after policy makers shifted in July to placing extra emphasis on sustaining growth rather than cooling inflation. A stronger currency hurts exporters by pushing up the prices of their products....

As many as 67,000 medium-sized and small companies posted losses in the five months through May, according to the National Development and Reform Commission. In Guangdong province, an export hub, the number of toymakers fell more than 70 percent in the first seven months from a year earlier, as more than 3,600 shut down, the official Xinhua News Agency reported.

Policy makers have already loosened loan quotas -- restrictions on how much banks can lend -- and raised export-tax rebates for garments and textiles.

Extra infrastructure spending is another possible tool for stimulating economic growth to prevent a slump.

And on Japan:

Japan's economy contracted more than the government initially estimated last quarter after figures showed businesses cut spending...

Bank of Japan Governor Masaaki Shirakawa said last week growth in the world's second-largest economy is likely to ``remain sluggish for the time being.'' With little room for interest-rate cuts or government stimulus, Economic and Fiscal Policy Minister Kaoru Yosano said there's ``nothing to be done but wait'' for the country's export markets to recover.

``Japan's economy will keep slowing at least until the end of this year,'' said Hiromichi Shirakawa, chief Japan economist at Credit Suisse Group in Tokyo. ``Compared with previous recessions, this one will be very shallow. We're at the deepest point of the downturn now.''...

Stalled growth and the fastest inflation in a decade have created a dilemma for the Bank of Japan, which will probably have to keep interest rates unchanged for the rest of the year, according to economists surveyed this week. At 0.5 percent, Japan's key rate is the lowest among major economies...

Slumping U.S. demand has forced exporters including Toyota Motor Corp. to cut production and jobs. A Kyushu-based Toyota subsidiary reduced output of sport-utility vehicles by at least 10 percent and fired 800 workers since June.

Markets outside the U.S. are also deteriorating. The European economy shrank for the first time in almost a decade last quarter, and EU Commissioner Joaquin Almunia said this week that the outlook is ``unusually uncertain.''...

Even as exports weaken, economists say companies are better able to withstand the slowdown because they have shed the excess workers, factory lines and debt that contributed to a decade of economic stagnation in the 1990s.

Emerging Markets Outflows Highest Since 1995

Note the not-pretty pattern. The flow of funds out of emerging markets has reached the high-water mark of the period leading into the Asian, then Russian financial crises of 1997-1998. However, after recovering from the damage of this period, emerging markets as a whole enjoyed a period of strong growth. In theory, their economies are bigger, and by virtue of running currencies pegged to the dollar, many also have large foreign exchange surpluses, which will enable them to defend their currencies (a fall in currency prices is a nasty outcome, since they often have foreign currency denominated debts).

Nevertheless, focusing on averages obscures where pain is acute. Vietnam, India, Korea and Russia a all are looking more than a tad wobbly, with their currencies under pressure. Although the Chinese stock market has taken a nosedive, the country has exhibited significant inflows of hot money looking to benefit from a yuan revaluation.

From the Financial Times

Outflows from emerging markets bond and equity funds reached $29.5bn over the past three months, the highest level since at least 1995, with withdrawals gathering pace over the past week.

Investors headed for the exits as rising fears over slowing world growth and the state of the banking system over the past week added pressure on emerging markets – which were already reeling from weaker commodity prices, inflationary pressures, a stronger dollar and geopolitical concerns.

Investors switched $1bn out of equity and fixed income funds on Monday, one of the highest daily outflows since records began in 1995, said EPFR Global, the data provider. Last week there were outflows of $1.6bn, bringing the total since June 4 to $29.5bn, the largest three-month figure since 1995.

Nick Chamie, head of emerging markets research at RBC Capital Markets, said: “Since July, investors have finally become aware of the severity of the global slowdown. The emerging markets are a leveraged play on global growth, so in a serious downturn, investors will naturally sell them.”....

The benchmark MSCI emerging market index fell 1.27 per cent to 857.44, the lowest level since March 2007. The fall extended its decline to 4.8 per cent over the past week and 22 per cent over past three months.

The hardest hit stock markets in dollar terms are Ukraine, which has fallen 58.8 per cent this year in part on geopolitical worries; China, down 57 per cent amid fears it had risen too far on a bubble; Hungary, down 49 per cent on worries over growth; Pakistan, down 46.7 per cent amid political turmoil; and Vietnam, down 46.4 per cent in the face of a sharp rise in inflation.

Russia been under pressure, with the benchmark RTS index down 4.4 per cent yesterday and 46 per cent since its May 19 peak.

Emerging market sovereign bond yield spreads have risen to 330 basis points over Treasuries – highs not seen since mid-2005 – from 300bp at the start of last week amid rising risk aversion.

Bonds of the four Bric countries – Brazil, Russia, India and China – have also been hit by rising interest rates this year.

Update 1:00 AM: Brad Setser has a post on the very same subject, but focusing on the implications for currency values. Some key statements:

Joanna Slater of the Wall Street Journal notes that many countries that were resisting pressure for upward appreciation are now selling dollars to defend their currencies. I very much agree with the quote from Lisa Scott-Smith:

....As investors retreat from places they used to favor, many of them emerging markets, it creates a new worry for central banks in these countries.

When too much capital was flowing in, their main problem was that such flows put upward pressure on their currencies. A stronger currency makes exports more expensive abroad, harming trade competitiveness. To curb currency appreciation, central banks would buy dollars, and that led to a large accumulation of reserves.

Now “that is unraveling the other way,” says Lisa Scott-Smith of Millennium Global Investments, a London currency manager with $13 billion in assets. With investors unloading local stock and bond holdings, central banks find themselves “on the other side of the trade, trying to smooth currency weakness instead of strength.”

Read it here.

What Global Rebalancing (aka The End of Foreign Funding Spree) Looks Like

A very useful post comes from Robert Dekle, Jonathan Eaton, and Samuel S. Kortum at VoxEU. The authors steer clear of the "when will global imbalances end" question (as in when will China, Japan, Taiwan, and the Gulf States tire of funding our current account deficit) to focus on one at least as important: "what will it take to achieve rebalancing?"

The analysis will warm the hearts of dollar bears and comes to a conclusion that might surprise some readers: Japan comes out better than China. However, the paper looks at the "pure" case of a perfect rebalancing, something we will never see. There will no doubt be overshoots by some countries, failures to adjust enough by others. But at a minimum, this post gives an idea of how far the dollar needs to fall for the US to get its house in order.

Bottom line: if you are an American and plan on seeing the world, better do it sooner rather than later.

From VoxEU:

A correction of international imbalances seems inevitable. What will that entail? This column presents estimates of the changes in trade flows required to rebalance the world’s current accounts and analyses which countries will bear the burdens of adjustment.

The US runs the largest current account deficit in the world. In 2006 the US deficit reached $788.1 billion, nearly 6% of US GDP and more than the surpluses of Japan, Germany, and China combined. The US deficit has been financed largely through the accumulation of US liabilities by foreign central banks. As their appetite for US IOUs can only be finite, a predominant view is that a reversal in the US trade deficit is inevitable. As Herbert Stein diagnosed a similar situation long ago, "If something can't go on forever, it won't."

While the dynamic forces driving trade imbalances remain too poorly understood to allow us to say with much precision when a correction will occur, our understanding of what drives international trade can tell us a lot about what a correction will look like when it does happen.

What must happen to fully rebalance the US current account?

What would a full "correction" of current account imbalances mean for the value of the dollar, the relative size of the US economy, and US living standards? What sort of adjustments inside the US economy will be needed? What will happen to the major surplus countries as well as to smaller players whose economies are tightly linked to the US, such as Canada and Mexico? To answer this question, we must have a way of linking trade flows – in particular US exports and imports – to economic factors such as the real exchange rate, US GDP, etc. Here the gravity model comes in.

A successful venture in international trade has been the gravity model of bilateral trade. Pioneers in econometric modelling, such as Tinbergen (1962) and Pöyhönen (1963), observed that trade between country A and country B followed a simple formula. Exports from A to B correlate very well with the size (e.g. GDP) of country A's economy multiplied by the size of country B's economy divided by the distance between them. For a long time, this relationship lacked a theory. More recent work, particularly by Anderson (1979) and Deardorff (1998), tied this relationship to standard models of international trade. In Eaton and Kortum (2002), two of us developed a particular model that allowed for production of a large number of goods that can be traded but at a cost. A feature of this model is that an increase in exports can occur at both the intensive margin (selling more of the same good) and the extensive margin (selling a broader variety of goods).

Recently we have adapted this framework to address the US current account question (Dekle, Eaton, and Kortum 2008). Fitting the model to 2004 data on GDP and bilateral trade flows among 42 countries, we solve for the new equilibrium in which trade in manufactures (the major component of the current account imbalances of the big players such as the US, Japan, Germany, and China) adjusts to eliminate all current account imbalances. While achieving exactly this outcome would be a remarkable coincidence, the exercise gives some sense of the magnitudes rebalancing would entail.

The effects of correcting international imbalances

We perform this exercise making different assumptions about the flexibility of national economies in adapting to a rebalanced world. How easily can productive resources (most importantly workers) move between the production of non-traded goods and manufactures? How easily can countries expand exports by increasing the range of products that they can produce and sell abroad?

Table 1 presents a synopsis of our results (for a handful of countries) in the two most extreme cases.

Flexible case: Economies are fully flexible in both respects. Workers can seamlessly change sectors, and countries can seamlessly change the portfolio of products that they sell in different markets.

Inflexible case: Workers are stuck in their initial sectors and exports to a market can adjust only at the intensive margin, by selling more or less of the same set of goods.

One can think of the first scenario as reflecting the ultimate long-term consequences and the second the immediate effect of a sudden change.

For each scenario, Table 1 reports in the first column the percentage change in the country's GDP relative to world GDP. This change is likely to correspond most closely to the change in the country's exchange rate. The second column reports the percentage point change in the share of manufacturing in the country's GDP. The third column reports the percentage change in GDP deflated by the change in local prices (click to enlarge):


Beginning with the second column, we note that in either scenario adjustment requires a substantial increase in the size of the US manufacturing sector, between 3 and 3.5 percentage points. The reasons behind the change in the two scenarios are different, however. In the flexible case US manufacturing expands because resources move there. In the inflexible case, the wages of workers in manufacturing rise relative to those in the rest of the economy.

Looking at the implied change in GDP (first column) and considering the flexible case, we see that the change in the relative sizes of the different economies under the flexible case is quite modest. The US as a share of the world economy falls by just 4.5% while Japan's rises by 3.3%. The inflexible case, however, requires a much more radical realignment in the relative size of the major economies. The US declines by nearly 30% relative to the world while Japan grows by over 26%. (Combining the numbers, the adjustment would require over a 50% devaluation of the US dollar in terms of the Japanese yen).

Turning the implications for the change in real GDP (third column), we see that large changes in relative GDP translate into much more muted changes in real GDP. For instance, the real GDP of the US falls by only 2%. The reason is that the more the US relative wage (and hence relative GDP) needs to decline to make US exports (e.g., tractors, wide-bodied aircraft) more competitive abroad, the lower the price of what Americans produce for themselves (e.g., medical services, personal training, auto repair), which comprise the lion's share of what Americans (and other people) spend money on.

The outcomes for the large surplus economies (Japan, Germany, and China) are the reverse image of those for the US. Note that in either scenario the US pulls down the relative GDPs of Canada and Mexico, even though Canada starts out running a surplus and Mexico only a small deficit. The reason is that these countries' largest foreign customer shrinks substantially. Despite the decline in the size of the Canadian economy, Canadian GDP can buy more, since goods from its largest foreign supplier have gotten much cheaper still. Hence its real GDP rises.

To summarise, the realignment that is necessary depends on flexibility, with more flexibility requiring less adjustment. Even if movements in relative GDP's are substantial, however, once price changes are taken into account real effects are much more modest.

The adjustment in progress

In fact, there are signs that the correction has already begun. From 1 March 2007 to 1 March 2008 the value of the US dollar declined by nearly 18% against the Canadian dollar, over 16% against the Mexican peso, by nearly 14% against the Euro, and by over 8% against the Chinese yuan. Various trade-weighted exchange rates reported by the IMF show a US dollar decline of 10 to 13% from the first quarter of 2007 to the first quarter of 2008. During this same period US merchandise exports grew 18.4% and merchandise imports grew 12.7%. Some of this growth is the consequence of the commodity boom. But even removing soybeans, corn, and wheat from exports leaves growth in the remaining categories of US exports at a hefty 16.8%. Moreover, if imports of crude oil are taken out, US spending on imports grew by only 5.9%.

Much larger changes than these are needed to bring the US current account into balance. How much more of a dollar decline is needed depends on how adaptable the US economy is at moving resources into the production of goods that are exported or used to replace imports and on how successfully it expands the range of products it can produce and sell abroad.

Summers: "The global consensus on trade is unravelling"

Readers may know I am not much of a fan of Larry Summers' occasional comments in the Financial Times. He has a tendency to come forth with views of how things work that sound nice but too often are at odds with facts on the ground.

His latest offering scores better than previous offerings as far as engagement with reality is concerned, although it has a few attention-grabbing departures.

Summers starts by lamenting that international economic polities are getting short shrift in pre-election debate (ahem, have they ever been front burner?) and warns:

The next administration faces the prospect of having to make the most consequential international economic policy choices in a generation at a time when the confidence of governments in free markets is being increasingly questioned.

This statement sound reasonable until you think about it. It presupposes that the next administration is an actor capable of making unilateral decisions that will affect the international game board. A growing theme on the FT's comment pages is that we are in a multilateral world, and key international bodies such as the IMF and World Bank need new governance arrangements that reflect the important role and economic weight of developing economies (even that sobriquet is looking dated).

Brad Setser keyed in on the likelihood of the US facing circumscribed policy choices:

I don’t think it is realistic for the US to expect to be able to rely as heavily as it currently does on other governments for financing without giving up at least a bit of policy autonomy. The enormous holdings of Agencies by the world’s central banks (along with the Agencies held by US domestic banks) are — in my view — a constraint on the options available to US policy makers struggling to get ahead of a seemingly still deepening credit crisis.

Oddly, Summers in the very next paragraph notes how the fast the emerging world has risen and again draws some debatable inferences:

The current distribution of regional economic power is unlike anything that was predicted even a decade ago. The rise of the developing world, its growing share in global output and far greater share of global growth, is perhaps a quantitative but not a qualitative surprise. The qualitative surprise is this: with almost all the industrial world in or near recession, much of the momentum in the global economy is coming from countries with authoritarian governments that are pursuing economic strategies directed towards wealth accumulation and building up geopolitical strength rather than improving living standards for their populations. China, where household consumption has now fallen below 40 per cent of its gross domestic product – which must be some kind of peacetime record – is the most extreme example. Similar tendencies, however, can be seen in other parts of Asia, Russia and other oil exporting countries.

Um, it's taken Summers this long to realize China, and before it, Japan, took a mercantilist stance towards the US? We noted in an earlier post:

While Summers admittedly undercuts that argument later by discussing how a more open economy can come out a net loser if its trade partners are better competitors, there is a more basic reason to take this idea with a grain of salt: we have lower trade barriers because some of our biggest partners (read Japan and China) are mercantilist and fundamentally have no intention of opening their markets very much; the advanced European economies regard maintaining surpluses and protecting labor as priorities, which again limits how much they will concede. We have lower trade barriers because we enter into negotiations with different premises and aims (at least historically) than our counterparts. (Some would also argue that our trade policy is designed more to benefit major US multinationals than the broader populace; that is harder to prove but may not be inaccurate.)

This is far from a new line of thinking. William Greider, for instance, made similar observations in 2005. At a minimum, trade negotiators with China and Japan have confronted this syndrome for years; many of our other trading partners play the game with more finesse.

Summers then has three rambling paragraphs which discuss, quelle horreur, how these developing countries, via their success in trade or by sitting on lots of oil, caused trouble:

The pressure created by the investment of these surpluses was one of the big factors driving the excesses that preceded our financial problems.

Note this comes perilously close to suggesting a causal relationship between high trade surpluses abroad and our financial meltdown. Back to Summers:

But the problems are much deeper than the question of who sits around the negotiating tables. For all the disagreements over the past decades, there has been a shared premise behind international economic policy discussions – the goal of increased economic integration, the spread of market institutions and more rapid growth for all nations. While companies may compete, the premise has been that nations co-operate to build a stronger economy in the interests of all.

Readers are welcome to correct me on this one, but whose consensus are we discussing, exactly? Again, China and Japan might give lip service to grand pronouncements while keeping their eye on the ball of what the gives and the gets were at the negotiating table. China, for instance, rebuffed Paulson in his recent entreaties to open its financial markets to foreign players. In fact, one could make a case that any country with a pegged currency (or as with China, a dirty float) is committed to maintaining a trade surplus, which means their commitment to achieving specific national outcomes ranks above any vision of international cooperation. And frankly, that's a rational stance.

Note that despite Summers' rhetoric, the US has not adhered strictly to this vision either. We've entering into bi-lateral and regional trade agreements, something the internationalists have decried.

Development economist and Harvard professor Dani Rodrik pointed out that deep economic integration, democracy, and national sovereignty cannot be pursued at the same time:

Sometimes simple and bold ideas help us see more clearly a complex reality that requires nuanced approaches. 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 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.

I've omitted Rodrik's discussion of choices, which might interest some readers. Again, to Summers:

It is no longer clear that this premise remains valid. Nations are increasingly preoccupied with their relative economic standing, not the living standards of citizens. Issues of strategic leverage and vulnerability now play a bigger role in economic policy discussions.

Hhhm. One might argue, as Thomas Palley has, that the US has pursued economic policies without regard to the standard of living of our citizens. Again, who are these unnamed countries preoccupied with their relative standing? That charge does not ring true for the UK or EU. One assumes Summers at a minimum means China, and he's way off base. Joseph Stiglitz has determined that if you take China out of the equation, there has in fact been no reduction in global poverty (note that the improvements in conditions among the world's poor has been one of the strong arguments for more liberalized trade). And China remains committed to rapid growth, which will again benefit its citizens. What Summers means is that China needs to switch from export driven growth to a more balanced economy with a more robust consumer sector. It would be more useful if he would say so directly.

Instead, he again comes at his argument in a round-about way:

At the same time, it is unclear which underlying driver of global growth will replace the one in place for the past decade – the US as importer of last resort. Global growth has depended on US growth, which has depended on the US consumer; and the US consumer has depended on rising asset values first of stocks and more recently of real estate. With falling house prices and a challenged financial system, US consumer spending is falling. The US is no longer in a position to be a net source of demand for the rest of the world. Indeed, with the drop in value of the dollar, US growth – which had been focused on imports and which had enabled the export-led growth of other countries – is a thing of the past. Already, Europe and Japan are in or are very close to being in recession.

The current global policy debate is a cacophony. It is all very well to advocate increased US saving and a cut in the US current account deficit but the process for bringing it about will mean less US demand for foreign products. That will put pressure on jobs and output growth in other countries if no countervailing measures are put in place. Conversely, the return of a stronger dollar without other policy changes will raise US demand for exports but at the price of cutting demand for domestically produced goods and compounding the recession.

These problems will be with us for some time. They may not be at the top of anyone’s agenda right now. But the success of the next administration could depend on its ability to engage with a wider range of global economic stakeholders, on a broader agenda, at a time when disagreements are increasing not just about means but also about ultimate ends.

I suspect there was never as much agreement about "ultimate ends" as Summers suggests. Other countries fell to the US lead when the US was more powerful economically. Long-standing differences of perspective that were suppressed are now being exposed.

Summers is vague about what needs to happen if there is to be anything resembling an orderly transition. Mohamed El-Erain, former head of Harvard Management and co-CEO of Pimco, has been far more specific, and also intimated that the sort of discussions that Summers recommends have been held and failed. From an FT comment by El-Erian:

Whatever happened to the debate on global payments imbalances?...At its roots, the policy solution called for simultaneous implementation of three sets of measures. First, a reduction in US domestic aggregate demand to contain imports and encourage a shift to exports. Second, an increase in consumption in Asia and the Middle East, including having China adopt a higher and flexible exchange rate. Third, structural reforms in western Europe to enhance the growth potential of the global economy....

The policy solution stalled because of a basic co-ordination problem, or what is known in game theory as the “prisoners’ dilemma”. While all parties had an interest in the outcome, any individual party that moved first risked being worse off if others did not follow. With multilateral co-ordination mechanisms such as the Group of Seven industrial countries and the International Monetary Fund lacking representation and legitimacy, there was no way to provide parties with sufficient assurances that their actions would be accompanied by others. As a result, no one took sufficiently meaningful action.

Now I am most certainly not privy to high-level policy discussions, and when this piece ran, expressed some doubts as to how far these discussions went. However, El-Erian said with some certainty that the idea of a coordinated approach was dead on arrival. He viewed the outcome as not pretty:

Under this scenario, the question for markets is no longer whether the global imbalances adjust. They will. Instead, the focus should be on the collateral damage of the adjustment process – damage that is region-specific given differences in policy flexibility and initial economic and financial conditions. In the US, look for renewed pressure for further fiscal stimulus and a monetary policy that, while appropriate for the US, is too inflationary for the rest of the world. In Asia and the Middle East, the spike in inflationary pressures may inadvertently slow the move towards more efficient tools of indirect economic management. In Europe, expect attempts to bypass fiscal responsibility guidelines in order to mute political protest.

Those who would like to read El-Erian's article and our commentary can find them here.

US Export Boom Leaves Manufacturing Largely Behind

We have been skeptical of the idea that a weak dollar would be the boon for US manufacturing that many thought it would. The reason? The best possible outcome would be to see a resurgence in manufacturing, since manufacturing has higher potential for productivity gains than does the service industry (although getting back some of those service jobs that have been offshored would be nice too). In the long run, economic growth is a function of demographic growth and productivity increases.

So why did we think manufacturing would not come back? Consider what has been lost: plants have closed, workers with specialized know-how have moved on. Rebuilding those industries won't happen overnight. It would take a significant investment of funds for equipment, training, and start-up costs. With currencies volatile and China now less inclined to see the yuan rise, who is going to bet that the dollar will stay weak long enough for new entrants to make a go of it?

That isn't to say that manufacturing might not eventually come back to the US. But it will take sustained dollar weakness, perhaps even evidence of a shift away from the greenback as reserve currency. And the dollar is not the only part of the equation. High fuel prices are leading manufacturers to rethink their supply chains, with increasing emphasis on having more manufacturing and assembly closer to the customer. That consideration may bring some manufacturing back to the Americas, but it might wind up in Mexico.

As an aside, I have been told by people with good industry knowledge that the US ceded far more manufacturing than it needed to, that some public companies moved manufacturing overseas because it was what Wall Street wanted (this from C-level employees of said public concerns). Similarly, the US lost much of its shoe manufacturing because Interco went bankrupt under too much LBO debt and the speed of the unraveling led a manufacturer that could have been salvaged being liquidated.

That being said, existing US manufacturers could pick up more orders from overseas with a weak dollar. But the ones that woud benefit are players with established international distribution. And per this article from the New York Times by Louis Uchitelle, even for those companies, the degree to which domestic factories have benefitted is not as great as popularly believed.

From the New York Times:

Exports are the bright spot this year in an otherwise bleak economy. But the world is not suddenly snapping up made-in-America goods like aircraft, machinery and staplers. The great attraction is decidedly low-luster commodities like corn, wheat, ore and scrap metal.....While the surge in commodities is a welcome relief, it is an unreliable prop for an industrial power.

“The historical data tell us clearly: don’t get too used to commodity export booms; as any third world country will tell you, they tend to go away pretty quickly,” said L. Josh Bivens, a trade expert at the labor-oriented Economic Policy Institute..... “Over a long period,” Mr. Bivens said, “commodities contribute right around zero to export growth.”....

An analysis of trade data by the federal Bureau of Economic Analysis illustrates just how lopsided the gains have been between manufactured goods and unprocessed commodities.

All exports of goods and services in the first half of the year rose at a $52 billion annual rate, adjusted for inflation, up 7.1 percent. Commodities accounted for 41 percent of the increase and manufactured products contributed just 12 percent, the bureau reported. (The figures strip out such items as arms sales and exports to American territories, like Puerto Rico and the Virgin Islands.)

Such unevenness, favoring commodities, is unusual, given that manufactured products, even by this definition, account for 40 percent of the nation’s exports, while commodities make up only 26 percent and services 30 percent. Indeed, not since the bureau began compiling detailed trade data in 1977 have commodities outpaced manufactured exports for two consecutive quarters.

Weakening demand abroad accounts for some of the decline. But the manufacturers themselves acknowledge that they gradually undercut their ability to export as they moved more and more production to factories overseas. Bringing that production back to this country, so that it could be exported, would dismantle global networks constructed relentlessly over the last 25 years.

“We have achieved a worldwide manufacturing base, and we are not going to shut down our factories overseas,” said Franklin J. Vargo, vice president for international economics at the National Association of Manufacturers. “But on the margin, we will shift a little bit of manufacturing back to the United States.”....

The contrast with commodities, which cannot be shifted overseas, is striking. John Hardin Jr. and his son, David, focus their attention on growing as much grain as they can on 2,500 acres near Indianapolis, counting on exports to absorb their harvest. Meanwhile, Sarah Bovim, a Whirlpool Corporation executive, points to expanding global operations at her company, where production abroad has eclipsed its exports.

“We are looking to expand in emerging markets,” Ms. Bovim said, “which means we are looking to set up shop there.”...

Whirlpool is proud of its exports but intent on manufacturing more abroad. Ms. Bovim, who is Whirlpool’s director of Congressional relations and trade policy, speaks with equal enthusiasm about sales from the company’s factories abroad and those in the United States. Both are up, she says, and she cites sales of washing machines and dryers to make her point.

Machines that load clothes from a door on top are made only in the United States, principally at a plant in Clyde, Ohio, and are exported to satisfy overseas demand. A newer and increasingly popular model, one that is loaded from a door in the front, is made only at factories in Germany and Mexico.

Whirlpool recently opened its Mexican plant, deciding to bypass the United States....

Many American manufacturers argue that as factories spread across the globe, exporting is no longer an effective means of competing against sophisticated and ever more numerous local manufacturers. In addition, as American companies set up operations in, say, China, they insist that their suppliers locate nearby, for quick and efficient delivery — and that draws more manufacturers overseas.

It is certainly a reason that Parker-Hannifin, a Cleveland-based manufacturer of hydraulic pumps and industrial controls, is expanding overseas, said Tim Pistell, the chief financial officer. “Our customers just love for us to make our stuff near their new operations,” Mr. Pistell said, “and if we do, they reward us with a lot of business.”...

Currency fluctuations rarely alter these long-term commitments, and profits stay abroad. “Most of the money we make overseas, we keep there,” Mr. Pistell said, “and then plow it back into growing the business overseas.”

The Bureau of Economic Analysis, tracking this trend for all of America’s multinational companies, says 70 percent of the multinationals’ operations — measured in employment, investment and value added in turning metal into aircraft or wood into furniture or silicon into computer chips — take place in the United States.

That, however, is down from nearly 75 percent in 1999 and, as the shift overseas continues at many manufacturers, commodities inevitably jump to prominence from time to time.

China Desk

Brad Setser thinks that China is again holding the RMB down to maintain export volume in the face of softening global demand. From the comments (my emphasis):

China prefers subsidizing US consumption of Chinese goods to subsidizing Chinese consumption of Chinese goods... if China’s foreign asset accumulation continues at $800b a year, it will add $3.2 trillion to its foreign portfolio over the next four years — more than it added in the preceding twenty...

Bloomberg also points out that by dodging the debt bubble bullet China's banks have drifted to the top of the market cap tables as well as providing some of the only investment gains for their competitors:

Chinese banks hold three of top six spots among the world's largest financial companies based on market value... The Chinese banks owe their rankings in part to having avoided almost all of the $480 billion in writedowns and credit- market losses that have sent bank stocks tumbling worldwide... Only two years ago, the world's biggest banks were led by Citigroup Inc. and Bank of America Corp. of the U.S. and UBS AG in Europe... ICBC's unaudited figures... show first-half profit rose more than 50 percent... Beijing-based China Citic Bank Co. said earnings jumped more than 150 percent in the same period. China Construction Bank followed, saying net income may have advanced more than 50 percent... Chinese funds and companies spent $19.3 billion buying stakes in Blackstone Group LP, Morgan Stanley, Barclays Plc, Fortis and Johannesburg-based Standard Bank Group Ltd. since May 2007 that are now worth $7 billion less on paper... China Investment Corp.'s $5 billion purchase of a 9 percent stake in New York-based Morgan Stanley, the second-biggest U.S. securities firm... has declined 18 percent... The $200 billion sovereign wealth fund also invested $3 billion in shares of New York-based Blackstone, manager of the world's largest buyout fund, only to see their value decline 41 percent... By contrast, foreign banks' investments in Chinese financial firms have fared much better, showing $50 billion of paper profits... HSBC is sitting on a $16 billion gain... Bank of America, which bought 9 percent of China Construction Bank for $3 billion in 2005, has a $14 billion paper profit...

And, for those many investors bullish on both oil and the RMB, has the FT got a deal for you:

Shareholders in Petrochina have approved a plan for China’s largest corporate bond sale by a listed company... up to Rmb60bn ($8.77bn) through one or more tranches of bonds with maturities of up to 15 years... In the first half of this year, 21 listed Chinese companies issued a combined Rmb74.5bn of domestic bonds. While tiny compared with more developed economies, this amount was 6.35 times larger than the corresponding period last year...

The moment of truth for the un-coupling thesis is at hand; as pretty much everyone agrees (which is a sign for extreme caution) that there will be a post-olympic slump in China. In order to beat the rush, the IHT has already come out with their announcement: "China's post-Olympics economic slowdown has started before the Games have even begun."

New orders at Chinese factories plunged last month. Exports are barely growing, after adjusting for inflation and currency fluctuations. The real estate market is weakening, with apartment prices sinking in southeastern China... Any slowing of growth, which has been spurred in part by China's herculean investment program to showcase the Olympic Games that open this week, could prove a shock to Chinese workers who have been receiving double-digit pay increases each year... any significant slowing below its recent pace of 11 percent or more a year would also make it much harder to find jobs for the millions of people moving from rural areas to cities each year in search of work. Economists have been forecasting growth of 9 percent to 10 percent over the coming year, and these estimates are being ratcheted downward.

I'm pretty sure this is just MSM type spin and speculation - no sources, no hard data. Rodger Baker at Stratfor is also concerned at the difficulty business VIP's are having getting visas for the Olympics, and reads into this a wider post-Olympic crisis lurking:

China’s rapid and contradictory economic and security policies, rising social tensions, and seemingly counterproductive visa regulations appear to be signs of a government in crisis. They are the reactionary policies of a central leadership trying to preserve its authority, stabilize social stability and postpone an economic crisis. At the same time, we see signs that the local governments, and even organs of the central government, are putting up steady resistance to the announcements coming from Beijing... It may be that the contradictory policies Beijing is tossing around these days will simply fade away after September and things will get back to “normal.” But already, Chinese officials are downplaying the previously hyped political and economic benefits of the Olympic games. They are now warning that economic conditions may not be so strong in the future, and at least internally discussing the distinct possibility that at least certain regions of China are facing the same economic crises faced by their mentors Japan, South Korea and the Asian tigers.

A few more specific items which may argue against the post-olympic slump thesis:

China's tax revenues rose 30.5% in the first six months of the year. The country collected about $472 billion on a surge that reflected corporate profits in 2007. Almost half of the tax revenue came from value-added, consumption and turnover taxes, which rose 22.4 percent, 18.5 percent and 25.7 percent, respectively. Import tariffs showed the fastest growth, rising 34.9 percent to 395.6 billion yuan, followed by stamp tax on securities trading, which rose 34.2 percent to 83.7 billion yuan.

China's booming Internet population has surpassed the United States to become the world's biggest, with 253 million people online... a 56 percent increase from a year ago... The United States had an estimated 223.1 million Internet users... Total revenues for China's Internet companies soared to 40.5 billion yuan ($5.9 billion) in 2007, up 48.6 percent from the previous year... revenues should keep growing at an annual rate of at least 30 percent in coming years, reaching 137.5 billion yuan by 2010... By contrast, U.S. online advertising revenues alone in 2007 were $21.2 billion (145.2 billion yuan)... China's online population should keep growing by 18 percent annually, reaching 490 million by 2012...

A survey of 3,591 US companies with annual revenues of $25 million or above ranked China as the most favourable location for offshore investment... India was second with 45.1 percent, followed by Mexico with 30.1 percent, the United Kingdom with 25.4 percent and Canada with 22 percent.

An update: Setser doesn't see signs of a slow-down yet, and has a good chart showing that the month to month variation isn't large enough or serially trending.

(Posted by Paul from Technology Investment Dot Info)

EU Pondering Restricting Sales of Securitized Debt (Updated)

This item came from reader Chris, who passed along a tidbit from Wolfgang Munchau's Eurointelligence daily newsletter. I can't provide a link to the story itself; checking around the Eurointelligence site, it seems to be an e-mail only product, and the piece in question is based on a German news story.

The proposal is odd. It would restrict EU banks from selling securitized products unless the seller retains a stake of 10% or more. Given that the banks have quite a lot of US paper, constraints on purchases would seem more sensible (assuming that the intent is the obvious, which would be to restrict this activity).

Perhaps the logic is that the EU will use this move as a basis for demanding that the US institute reforms of its securitized debt market, or it will impose similar restrictions on buyers. I'd be interested in hearing of any other theories.

Chris also believes "cracking news story" = "breaking news story".

From Eurointelligence:

FT Deutschlands leads today with a cracking news story according to which the European Commission is planning to put severe restriction on the ability by banks to participate in the global credit market. The most important of these restrictions concerns a rule that it will only be legal to sell securitised debt instruments, such as asset backed paper or the more compilcated collateralized debt obligations if the issuer retains a stake of at least 10 per cent. (We find this is a very sensible attempt of a regulation, and perfectly compatible with the original intention of the securitisation business. The fact the banks were able to see credit products without retaining a stake was clearly one of the factors that help create the credit bubble.)

The European Commission also wants banks to restrict the amount they lend to other banks to no more than a quarter of their tier one capital.

It is no surprise that the European banking lobby is howling with protest, saying that more transparency will do the job.

Update 10:50 PM: Per an anonymous reader, it appears the Eurointelligence piece had an important translation error:

There seems to be a translation error in the Eurointelligence snippet. They write of a proposed restriction on what European Banks can sell. In actuality, the FTD article is about a proposed restriction on what European Banks can buy ('kaufen'); i.e. only securitizations in which the seller keeps 10%.

This makes it an effective rule regardless of what non-European governments decide to do about the securitization market, even if they decide not to act. The result would be that European Banks could no longer buy nonconforming securities from anywhere in the world, leading to some protection of European Banks from such toxic waste as repackaged US subprime debt or whatever the future will bring.

In fact, the article emphasizes the bailout of banks like IKB at (German) taxpayers' expense because of their extensive investments in US subprime debt.

"Is America too big to fail?"

The headline of this International Herald Tribune article (hat tip reader Saboor) is a real sign of the times. The short answer is our policies assume the answer is yes, but if we don't course correct, that assumption is likely to be tested.

Specifically, the argument goes, our trading partners will continue to be willing to finance our trade deficits because they depend on the US as an export market. But the flaw in that logic is that our friendly money sources are not only providing the dough for the trade deficit, but also for the interest we pay on their debt. As our external obligations keep growing, a higher proportion will go to interest. At some point, the benefits are going to look less clear.

From the International Herald Tribune:

In the narrative that has governed American commercial life for the last quarter-century, saving companies from their own mistakes was not supposed to be part of the government's job description....

So it made for a strange spectacle last weekend as the current Bush administration, which does cast itself in the Reagan mold, hastily prepared a bailout package to offer the government-sponsored mortgage companies, Fannie Mae and Freddie Mac. The reasoning behind this rescue ... The mortgage giants were too big to be allowed to fail...

Commercial banks from South Korea to Sweden hold investments linked to American mortgages. Their losses would mount if American homeowners suddenly couldn't borrow. The global financial system could find itself short of capital and paralyzed by fear, hobbling economic growth in many lands...

All through Japan's lost decade of the 1990s and afterward, American officials chided Tokyo for its unwillingness to let the forces of creative destruction take down the country's bloated banks and the zombie companies they nurtured. The best way out of stagnation, Americans counseled, was to let weak companies die, freeing up capital for a new crop of leaner entrants.

But as Japan's leaders engaged in bailouts and bookkeeping fictions to keep banks and companies breathing, they offered those words of justification now heard here: The companies were too big to fail...

Today, among strict adherents of laissez-faire economics, the offer to bail out Fannie and Freddie is already being criticized as a trip down the Japanese path of putting off immediate pain while loading up the costs further along.

For one thing, this argument goes, taxpayers - who now confront plunging house prices, a drop on Wall Street and soaring costs for food and fuel - will ultimately pay the costs. To finance a bailout, the government can either pull more money from citizens directly, or the Fed can print more money - a step that encourages further inflation.

"They are going to raise the cost of living for every American," said Peter Schiff, president of Euro Pacific Capital, a Connecticut-based brokerage house that focuses on international investments. "The government is debasing the value of our money. Freddie and Fannie need to fail. They are too big to save."

Using public money to spare Fannie and Freddie would increase the public debt, which now exceeds $9.4 trillion. The United States has been financing itself by leaning heavily on foreigners, particularly China, Japan and the oil-rich nations of the Persian Gulf. Were they to become worried that the United States might not be able to pay up, that would force the Treasury to offer higher rates of interest for its next tranche of bonds. And that would increase the interest rates that Americans must pay for houses and cars, putting a drag on economic growth.

Meanwhile, as American debts swell and foreigners hold more of it, nervousness grows that, someday, this arrangement will end badly. The dollar has been declining in value against other currencies. Some foreigners have begun to hedge their bets by buying more euros.

"Obviously, this is going to come to an end," Schiff said. "Foreigners are not charitable organizations, and they're going to demand that we pay them back."

No single country owning large amounts of dollar-based investments is inclined to dump them abruptly; nobody aims to start a panic. But fears have begun to grow that one day a country may get spooked that another is about to dump its dollars - and that could trigger pre-emptive panic selling.

"Foreigners could decide it's just not worth the risk and sell," says Andrew Tilton, an economist at Goldman Sachs. "The really dire scenarios have become a lot more likely than they were a year or two ago."

Still, as Tilton and others are aware, one fundamental reality continues to offer assurances that foreigners will still buy American debt: In the global economy of the moment, the United States itself is too big to fail.

The logic for that assurance goes like this: The American consumer has for decades served as the engine of world commerce, using borrowed cash to snap up the accouterments of modern living - clothes and computers and cars now manufactured, in whole or in part, in factories from Asia to Latin America. Eliminate the American wherewithal to shop, and the pain would ripple out to multiple shores....

In other words, in the estimation of people in control of money, the United States cannot be allowed to collapse, just as Fannie and Freddie cannot be allowed to fail. Too much is riding on their survival.

The central truth of that logic still seems to be apparent as the Treasury keeps finding takers for American debt.

So the government offers its rescue of the mortgage companies, and foreigners keep stocking the government's coffers. "They don't want the U.S. to go into the worst downturn since the Depression," Tilton says.

But all the while, the debt mounts along with the costs of an ultimate day of reckoning. Debate grows about the wisdom of leaning on foreign credit, and about how much longer Americans will retain the privilege of spending and investing money that isn't really theirs.

Bailouts amount to mortgaging the future to stave off the wolf howling at the door. The likelihood of a painful reckoning is diminished, whil