Satyajit Das: European Death Spiral – End Games

By Satyajit Das, the author of “Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives”

Politics now increasingly dominates the economics. Commenting about the EU bailout of Ireland, the Irish Times referred to the Easter Rising against British rule asking: “was what the men of 1916 died for a bailout from the German chancellor with a few shillings of sympathy from the British chancellor on the side”. An Irish radio show played the new Irish national anthem to the tune of the German anthem.

In Greece, the severe cutbacks in government spending have resulted in strikes and violent protests on the streets of Athens. Faced with cutbacks in living standards, Europeans are fighting back. The Rolling Stones’ late sixties anthem has been resurrected in Europe: “Everywhere I hear the sound of marching, charging feet, boy/ Summer’s here and the time is right for fighting in the street, boy.”

In many countries, governments, often unstable coalitions, are struggling to pass legislation, implementing necessary spending cuts or tax increases. In Ireland, the opposition parties have promised to re-negotiate the bailout package if elected at an election due early in 2011. In Germany, the paymaster and strength behind the EU, Europe’s biggest tabloid Bild asked “First the Greeks, then the Irish, then…will we end up having to pay for everyone in Europe?”

In December 2010, a special EU meeting, convened to discuss the situation, provided a clear pointer to how events might evolve. At the meeting, the German view, set out by Chancellor Angela Merkel, prevailed.

The meeting rejected any attempt to increase the scope and amount of the existing bailout facilities. The E-Bond proposal was quietly shelved. The EU agreed to formalise the ESM through a short amendment to the Lisbon Treaty. The new facility would be inter-governmental with any Euro Zone member having a national right of veto. The facility was highly conditional, capable of being triggered only as a last resort.

A key element was the requirement for “collective action clauses”, effectively forcing lenders to bear losses. The provision, which must be included in all European government bonds after June 2013, would require the payment period to be extended in case of a crisis. If the solvency problems persisted, then further extension of maturity, reductions in interest rates and a write-off in the principal would occur. In addition, new bailout funds would automatically subordinate existing debt and have to be paid back first.

Chancellor Merkel’s position reflects the views of the German constitutional court, which endorsed European economic and monetary union prescribed in the 1992 Maastricht treaty only on the basis of the treaty’s no-bail-out provisions. This influences the need to impose losses on investors.

It is clear that the stronger members of the EU, led by Germany, have decided to limit future liability in bailouts. As membership of the Euro prevents large devaluation of the currency, economic adjustment will require reduction of the budget deficit and deflation. As Greece and Ireland demonstrate, more rigorous deficit cutting may not return the countries to solvency. The EU proposals implicitly recognise that over-indebted countries cannot sustain currency debt levels. The reduction of the debt burden will have to come through restructuring or default, with creditors taking losses.

Unless confidence returns rapidly or the EU changes its position, it seems restructuring or defaults by several peripheral European sovereigns may be unavoidable. Investor concerns that the Greek and Irish did not solve the fundamental problems may be confirmed. The safety nets are now seen as unlikely to be large enough to rescue larger countries, like Spain and Italy, if they require support. Investors will need to take losses.

Large volumes of maturing debt mean that the test is likely to come sooner than later. The heavily indebted European sovereign states face $2.85 trillion of maturing debt in the period to 2013. Portugal, Italy, Ireland, Greece and Spain have bond maturities of $502 billion in 2011. The financing needs of Greece, Ireland, Portugal and Spain over the last quarter of 2010 and 2011 are Euro 320 billion, rising to Euro 712 billion if Italy is included. In addition, private sector borrower in these countries face maturities of $988 billion of corporate bonds and $200 billion of syndicated bank loans over the same period. Likelihood of low economic growth, failure to meet IMF plan targets, further banking sector problems and credit downgrades exacerbate the risk.

A Faraway Continent

In the prelude to World War 2, British Prime Minister Neville Chamberlain dismissed the German occupation of Sudeten arguing that it was “a quarrel in a far away country between people of whom we know nothing.” North American and Asia have been bystanders as the European crisis developed. Increasing concerns are evident, as European problems now threaten global recovery.

China, which contributed around 80% of total global growth in 2010, has expressed growing concern about the problems in Europe. Trade between China and the EU, its largest export market, totals around $470 billion annually, contributing a trade surplus of Euro 122 billion for China in the first nine months of 2010. Any slowdown in Europe would affect Chinese growth. China is also a major holder of Euro sovereign bonds, standing to lose significantly if problems continue. China has indicated preparedness to use some of its $2.7 trillion of foreign exchange reserves to buy bonds of countries such as Greece and Portugal.

A slowdown in China would affect commodity markets, both volumes and prices, and commodity exporters such as Australia, China and South Africa. Minutes of a 7 December 2010 from the central bank of Australia, one of the world’s best performing economies, indicated increasing concerns about developments in Europe.

A continuation of the European debt problems, especially restructuring or default of sovereign debt, would severely disrupt financial markets. Losses would create concerns about the solvency of banks, in particular European banks. In a repeat of the events of September 2008 (when Lehman Brothers filed for bankruptcy protection and AIG almost collapsed) and April/ May 2010 (prior to the bailout of Greece), money markets could seize up, as trust about the ability of parties to perform contracts evaporated. In turn, this volatility would feed through into the real economy, undermining the weak recovery.

Unless resolved, the European debt problems will affect currency markets and through that channel the global economy. Any breakdown in the Euro, such as the withdrawal of defaulting countries or change in the mechanism, would result in a sharp fall in the new currencies. In turn, this would, in the first instance, result in large losses to holders of debt of those countries from the devaluation.

Depending on the new arrangements, the US dollar would appreciate abbreviating the nascent American recovery. This may compound existing global imbalances and trigger further American action to weaken the dollar. Further rounds of quantitative easing are possible, setting off inflation and de-stabilising, large scale capital flows into emerging markets. In turn, the risk of protectionism, full-scale currency and trade wars would increase. A breakup of the Euro would adversely affect Germany, which has been growing strongly. A return to the Deutschemark or, more realistically, an Euro without the peripheral countries may result in a sharp appreciation of the currency, reducing German export competitiveness.

As the Australian central bank noted in its December 2010 minutes: “… the deterioration in the situation in Europe over the past month had increased the downside risks to the global economy. How this would ultimately play out, and the implications … were difficult to predict. It was possible that conditions could settle down, as they had after the episode of financial instability in May. Alternatively, an escalation of the current problems was not out of the question. If this prompted a fresh retreat from risk-taking in global financial markets, it would probably have more impact … than any trade effect.”

End Game

Events since the announcement of the bailout package in early 2010 have been reminiscent of 2008. Then, the optimism following bailouts of Bear Stearns and other troubled American banks produced premature. The promise of China to purchase Portuguese bonds is similar to the ill-fated investments of Asian and Middle-Eastern sovereign wealth funds in US and European banks.

Eventually with each successive rescue and the reemergence of problems, the capacity and will for further support diminished. The EU rescue of Greece and Ireland are also reminiscent of US attempts to rescue its banking system, with more and more money being thrown at the problem. The strategy was defective, preventing the creative destruction required to restore the system to health. The actions may have doomed the economy into a protracted period of low growth, laying the foundations for future problems.

At the time of the Greek bailout, the real question was: “If Euro 750 billion isn’t enough, what is?” Increasingly, markets fear that there may not be enough money, to solve the problem painlessly.

In 11 May 1931, the failure of a European bank – Austria’s Credit-Anstalt – was a pivotal event in the ensuing global financial crisis and the Great Depression. The failure set off a chain reaction and crisis in the European banking system. Some 80 years later, European sovereigns may be about to set off a similar sequence of events with unknown consequences. As Mark Twain observed history may not repeat, but it may rhyme.

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  1. Jim Haygood

    ‘A key element was the requirement for “collective action clauses”, effectively forcing lenders to bear losses. The provision, which must be included in all European government bonds after June 2013, would require the payment period to be extended in case of a crisis.’

    Since this provision constitutes an embedded option benefiting the borrower, it obviously will have to be paid for via a higher coupon rate — the last thing highly indebted countries need. Not to mention that it’s an advance indication of bad faith (as in, ‘We really can’t afford this loan, so we might extend the term at the slightest hiccup in the economy’).

    It’s hard to find a pure hedge to offset the risk of such an adverse event, although a kind of mutant CDS might develop to insure against and explicitly price the risk.

    Meanwhile, in a classic head-fake contrarian outcome, Portugal sold its bonds at 6.7 percent — well below the feared 7 percent threshold — and rumors say that everyone, even the German faction, is on board to expand the European rescue fund.

    Happy, happy! Are we flipping houses yet?

  2. pjwrites

    I have a suggestion for what ails the world.

    Clawbacks from every individual in the “investing world” who participated in the financial fraud. Take back all “profits earned” over the past 5 years by the gamblers and their partners in crime and voila! The world is saved.

    If you have money enough to “invest” in digital pieces of “paper” with nothing but air behind them, you probably have too much money – or no Office Depot nearby.

    But please don’t worry, “investors”, we promise to put your hard-earned “profits” to good use.

    We might even build you an Office Depot in the ‘hood.

    1. Mrgalak

      The difference between the US and Europe is a common national identity, forged in the independence struggle. Europe consists of national states with a long history of wars. The German population will not tolerate semi-permanent financial transfers on a large scale to Southern Europe.

  3. Paul Tioxon

    A side from the purely financial considerations, the rearing of the ugly head of politics muddies the clear waters of compartmentalized intellectual activity. Germany is learning the price of not only an economically integrated Europe, but a politically united federation of States. It is now the richest and most powerful of those states and with it, comes great responsibility. If Germany makes so much its wealth from exports, yes, it may have to pay for the weaker links in the chain. It is more than just unseemly to resent propping up the rest of the world that sends you hard currency to the benefit of your surplus national trade balance.

    While Europe has not integrated politically to the extent of the USA, it is following the consequences of the logic of its current economic integration. Lyndon Johnson remarked that he enriched the rural, relatively poorer South, with money he taxed out millionaires in Manhattan. It is not news to the de industrialized and de militarized citizenry where the jobs started to go in the 1960s, South of the border, the Mason Dixon border.

    The rise of the sunbelt came out the hide of the Northeast and Mid West. Germany should not looked so shocked and surprised. The tribute it must pay for a new European social order will come out their hides, at least it is not to their deminishment as a Teutonic Rust Belt.

  4. Bernard

    This gets really disturbing. how long can this go on? or is this just a charade? is there really stability in the present system. how can this system just go on the way it is. the system still endures and seems to outlast the seemingly unsolvable problems. the constant appearance of the crash coming now and yet never coming.

    Wishing for the crash to end the Banks and the vampire squid’s devouring the Western World’s money. the thought of “How long can this last?” and the disaster we’d all be in if it does come, and if i get my wish to stop the Thievery.

    just such a looming presence that won’t go away.

  5. Hugh

    This post is shot through with odd phrases:

    “In many countries, governments, often unstable coalitions, are struggling to pass legislation, implementing necessary spending cuts or tax increases.”

    Necessary why? This is austerian certainly but many of us would question why such deflationary, anti-growth policies are necessary or wise.

    “the stronger members of the EU, led by Germany, have decided to limit future liability in bailouts”

    How is Germany stronger when its banks carry so much exposure in all this? This seems to be another repetition of the line that exporting nations are inherently virtuous and importing nations spendthrift. I find this characterization not only dumb but unhelpful. If PIIGS importing countries are spendthrift, what is to be said of the idiot German banks who made so many bad loans to them? And if those loans had not been made just how long could a country like Germany kept up its exports? In a mutually dependent relationship, there is no weaker or stronger and we really should move away from this model.

    “European problems now threaten global recovery”

    What global recovery? All I see is a bunch of failed elites engaged in blowing bubbles and the umpteenth round of extend and pretend. Please explain to me in what universe this constitutes recovery.

    “Unless resolved, the European debt problems will affect currency markets and through that channel the global economy.”

    Look if European elites were going to fix their euro and debt problems, they would have done it by now, or at least started. They haven’t. They won’t. But we haven’t fixed our problems either. Nor the Chinese theirs. So this isn’t about how we get out of this. It’s about who blows up first and takes the others with them.

    “the risk of protectionism, full-scale currency and trade wars would increase”

    We already have protectionism everywhere but here, and we would and should have it here to some extent if it were not for the corporatist neoliberal free traders that dominate both Democratic and Republican Administrations. We have massive currency and trade imbalances already in the world. Global elites are too greedy and stupid to moderate them so yes, these provide other foci for potential explosions.

  6. Jockel

    Excuse my English. This is a very interesting series of articles, even though the tone becomes a little too dramatic towards the end. It is not too bad when the financial system is blown up again. The last downturn did not cause any important changes to the way how banks work overall and what individual incentives inside them work towards systemic instability. Obviously, it is not only that the debtors sold too much debt, it is also that the debt holders bought too much.

    So in a very naive way: cancel the euro and all the related debt, start the euro2, guarantee private savings in the new currency, write off everything else, let the banks cry and figure out rules on how to protect both – seller and buyer – from a reoccurrence of such a thing.

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