I must confess I don’t stay on top of the blow by blow of the ever-devolving Eurozone mess. The broad lines of the trajectory look all too predictable. The officialdom could patch up things for quite a while if the powers that be let the ECB monetize the debt (eventually, you could have an inflation problem, but with the EU and global economy so slack, “eventually” will take quite a while to show up).
However,everyone in positions of authority seems to believe in certain-to-fail-much-faster austerity instead. So the permissible short-to-medium term fixes involves lots of complicated programs, multi-party negotiations, and in some cases, political approvals. The timeline for the governmental maneuvering seems badly out of line with what Mr. Market requires. And to make matters worse, an earlier deal on a Greek funding, which involved bondholders taking a 21% haircut, is now deemed not to be punitive enough to banks. While that is narrowly true, having this deal come unglued could be the detonator that sets off a crisis chain reaction.
And from a wider vantage, none of these remedies address the real issue: Germany wants to keep running big trade surpluses to the rest of Europe, but does not want to keep funding its partners’ current account deficits. It can’t have both wishes but is unwilling to give either one up.
Things have gotten so ludicrous that you can now read contradictory stories in the Financial Times mere days apart (I’m not criticizing the FT but the apparatus that does the messaging). The day before yesterday, Eurozone banks “threatened” that they’d have to be nationalized if the haircuts on the aforementioned Greek funding deal were increased from 21% to 50%. Note credible estimates as early last year put the level of writedowns needed on Greek debt at a minimum of 50% (75% was not an uncommon number) and Greece has undershot forecasts repeatedly since then.
The idea that nationalization is a horrible outcome to anyone other than bankers shows how far down the rabbit hole we’ve gone. But aside form that, recognize the implication: increasing the haircuts from 21% to 50% on Greek debt would tank banks. Even if we use the total amount of Greek debt outstanding, €350 x .29, we get €102 billion. But that figure is high, since what is relevant is the debt held by banks, not the total. A FT Alphaville story reported the private debt target for participation in the earlier restructuring plan (the goal was 90% participation) was €135 billion. Gross that up and you get €150 billion, and take 29% of that, and you get €44 billion.
If a mere incremental €44 billion loss across Eurobanks is such a devastating event, the banks are pretty wobbly as it is. Mind you, we all know that, but the banks have just said that, loudly and publicly. And pretty much no one expects the resturcturings to stop with Greece.
Yet today, the FT tells us that European officials thinks the level of recapitalization needed is a mere €80 billion. Earth to base, if they are so fragile that €44 billion in losses will allegedly put a lot over the edge, they need a lot more dough than that. The prevailing estimates of the magnitude of the combined banking/sovereign is in the €2 to €3 trillion range. This measure is not a solution, and it falls so far short that it’s an embarrassing and dangerous admission that the European financial leadership isn’t merely politically constrained, it’s utterly clueless. At best, the authorities must view this action as tantamount to administering a shot of adrenaline to the heart of a failing patient.
Except in their case, as opposed to the intervention below, they have only sugar water in the syringe. No one told them, apparently, that placebos don’t have a high success rate in emergency rooms.
The pink paper continues with this surreal account:
The European Union’s estimate of the necessary recapitalisation effort compares with a recent Inernational Monetary Fund report that identified a €200bn hole in banks’ balance sheets stemming from sovereign debt writedowns. It also falls far short of analyst estimates that banks might have a capital deficit of up to €275bn.
People familiar with the outcome of an emergency stress test of Europe’s banks said the European Banking Authority, which ran the exercise, had suggested that about €80bn should be raised.
So we know where this absurd figure came from, the Eurzone’s phony stress tests. They are now making the mistake of believing them. And get this part:
A fierce political debate has started over almost all the main assumptions used in the analysis but people familiar with the discussions expect any changes to reduce, rather than increase, the estimated shortfall…
There is duly discouraged coverage in a separate FT story that recaps the current state of play, in case you like studying self-immolation. The key section:
To meet the challenge, Europe’s leaders are trying to solve three simultaneous problems by Sunday night: putting Greece on a solid foundation through a second bail-out; re-establishing confidence in Europe’s largest banks by ordering them to raise capital; and giving the newly empowered €440bn eurozone rescue fund more firepower so it can ensure Greek difficulties do not spread to Italy and larger financial institutions.
But as the summit gets closer, senior European officials are warning that the complexity of the three interlinked problems are so enormous, the differences between Paris and Berlin so large, and the time so short that a credible deal may prove out of reach.
One senior European official, noting that Berlin has begun playing down expectations, says: “They’d rather talk it down now than explain why there’s a disaster on Sunday.”
The faulty logic is that this disaster is the result of recent actions. It was bound to happen when the banks were not brought to heel in the wake of the 2008 crisis. But even now, no one seems to be drawing the right lessons or focusing on the real issues.
In ECONNED, we discussed four possible reasons for the failure to undertake fundamental reforms. The last one was:
Paradigm breakdown, meaning key elements of the current system are no longer viable, but that is a possibility that no one is prepared to face, since the old system seemed to work well for a protracted period. Thus the authorities reflexively put duct tape on the machinery rather than hazard a teardown…
The situation we are in now echoes that of the Great Depression. Although scholars still debate its causes eighty years later, a persuasive view comes from MIT economics professor Peter Temin. Temin, in his Lessons from the Great Depression, first sets forth the prevailing explanations and explains why each falls short. He argues that the culprit was the impact of World War I on the gold standard.
Recall that starting roughly in the 1870s, major European economies increasingly adopted the gold standard, and a long period of prosperity resulted.74 The regime was suspended in the UK and the major European powers during the war. Afterward, they moved to restore it, sometimes at considerable cost (England, for instance, suffered a nasty downturn in the early 1920s). But the aftereffects of the war meant the Edwardian period framework was unworkable. The deflationary forces they set in motion could have been countered by countercyclical measures after the Great Crash. But that was impossible with the gold standard. Indeed, as Temin notes, “Holding the industrial economies to the goldstandard last was about the worst thing that could have been done.”
Now readers may have trouble with that comparison, particularly since the conventional wisdom is that our policy responses have been so much better than those of the early 1930s. But the key point here is that the institutional framework locked the major actors into a particular set of responses. They were not able to see other paths out because they conflicted with an architecture and a set of beliefs that had comported themselves well for a very long time. It’s hard to think outside a system you grew up with. And remember, the gold standard did not break down overnight; the process took more than a decade.
If this view is correct, we are in a protracted period of muddled and futile to damaging policy actions until the old system is proven to be beyond redemption. If we are lucky, a combination of new thinking and successful experiments will put us on the road to a new order. But at this juncture, it’s hard to find reasons to be optimistic.