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November 2, 2011

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Posted: 02 Nov 2011 12:06 AM PDT


Posted: 01 Nov 2011 03:42 PM PDT

Tim Duy:

Aftershocks, by Tim Duy: The reality of the worsening European situation came home to roost on Wall Street this week. Last week's "summit to end all summits" offered up only broad brush strokes to begin with, and even those were rapidly erased by plans for a Greek referendum on the deal. A rumor circulated earlier today that the referendum was dead, but that has since been refuted by the Greek government. It appears that either the Greek government collapses or the referendum will occur - and neither outcome is good for market participants looking for certainty in these uncertain times.

Let me suggest this as well - that even if Greece comes back on board with the existing agreement, the damage is already done. Three thoughts today:

A deepening Eurozone recession is inevitable. Even if full-blown financial crisis is avoided, the cost will be continued austerity programs that will sink the Eurozone economy ever deeper into recession. This will only exacerbate the problems facing European banks as nonperforming loans rise, which will be on top of the credit contraction to follow plans to have banks recapitalizing themselves with private money by next summer.

The unintended consequences of the EFSF. The EFSF was already a farce to begin with, underfunded and relying on leverage to cover up a lack of money. The farce continued as European leaders sought handouts from China to fund a project they themselves were not committed to. Then the lack of details within the latest plan is hampering the ability of the EFSF to issue debt. From the FT (hat tip to Zero Hedge):

The bond from the European financial stability facility will seek to raise €3bn ($4bn) and will be in 10-year bonds rather than a 15-year maturity because of worries over demand, say bankers. A 10-year bond is more likely to attract interest from Asian central banks than a longer maturity.

Bankers familiar with the issue said the EFSF had been considering a €5bn issue. However, the EFSF has denied this, saying it had always sought a €3bn issue...

...EFSF officials decided to price this week because market conditions might deteriorate if they hold off any longer, according to bankers.

The bond is expected to price at yields of about 3.30 per cent, about 130 basis points over ­Germany, the European market benchmark. This represents a big mark-up since the middle of September, when existing 10-year EFSF bonds were trading at about 2.60 per cent, only 70bp over Germany.

Now the insurance component of the EFSF is blowing back in their faces. From the FT:

"It is kind of ironic: it is Draghi's first day. His first decision is 'yes, buy Italian bonds'," said Gary Jenkins, head of fixed income at Evolution Securities. He added that the move to make Europe's rescue fund, the European financial stability facility, issue insurance on new Italian and Spanish debt was deterring buyers: "They have created a situation where the only people buying Italian debt are themselves."

A trader of Italian government bonds said: "It was meltdown at one point before the ECB came in. There were no prices in Italian government bonds. That is almost unheard of in a big market like Italy. There were just no buyers and therefore no prices."

By not creating a backstop for previously issued bonds, the Europeans have clearly identified those bonds at risk of default. If the Europeans are not willing to buy or insure the bonds, why should investors? Answer: They shouldn't. Consequently, the ECB was forced to do what it hates, buy Italian debt, and even then yields climbed above 6%, nearing levels that many believe is the point of no return for Italy.

Moreover, one should question the what is the meaning of "insurance" for Europe. I can't imagine the ESFS actually making good on any promises to insure bondholders, as the Europeans appear adept at defining defaults as "voluntary" and therefore not credit events covered by insurance.

Will the ECB be Europe's white knight? I think we all agree that lacking a lender of last resort, Europe has something of a credibility problem. As in, no credibility. And it has been pointed out repeatedly that the ECB could step into this role. After all, we are talking about the future of the Euro, which should be something of a concern for central bankers. And, as noted by Kash Mansori at The Street Light, by guaranteeing a price for Italian debt, the ECB would like have to buy far less than they think. But here is the problem - why should the Italians get an ECB backstop at 6%, while the Irish pay 8% and the Portuguese 12%? Politically, the ECB needs to backstop either everybody equally or nobody. Setting a ceiling on Italian debt alone risks setting off a firestorm of public anger within those nations already struggling under the weight of austerity programs. And note that even if the ECB does come into the fight, the will only do so in return for additional austerity. In other words, they might stave off financial collapse, but not recession.

Bottom Line: No matter how many summits they have, there is no easy out for the Europeans at this point.

"A Walk Down Memory Lane with John Taylor"

Posted: 01 Nov 2011 03:33 PM PDT

David Glasner is displeased with John Taylor (for good reason, as he documents in the full post):

A Walk Down Memory Lane with John Taylor, Uneasy Money: John Taylor has had a long and distinguished career both as an academic economist and as a government official and policy-maker. He is justly admired for his contributions as an economist and well-liked by his colleagues and peers as a human being. So it gives me no pleasure to aim criticism in his direction. But it was pretty disturbing to read Professor Taylor's op-ed piece ("A Slow-Growth America Can't Lead the World") in today's Wall Street Journal, a piece devoid of even the slightest attempt to make a reasoned argument rather than assemble a hodge podge of superficial bromides about the magic of the market and the importance of fiscal discipline and sound monetary policies. It is almost surprising that Taylor failed to mention motherhood, apple pie, and American flag while he was at. Even more disturbing, Taylor proceeds, with no hint of embarrassment, to trash the half-hearted attempts by the Federal Reserve to use monetary policy to promote recovery even though the Fed's policies are similar to, though much less aggressive than, the "quantitative easing" that he applauded the Japanese government and the Bank of Japan for adopting from 2002 to 2004 to extricate Japan from a decade-long period of deflation and slow growth starting in the early 1990s. ... Oh my what a difference four or five years make. Things do change, don't they?

"Politics: The Beginning and the End of the Euro"

Posted: 01 Nov 2011 10:35 AM PDT

The view from Europe:

Politics: the beginning and the end of the Euro, by Antonio Fatas: As much as economists have been wondering for years about the economic benefits and costs of sharing a currency, such as the Euro, the decision to create the Euro area and to be one of its members has always been a political one. As an academic, I have written about the costs and benefits of sharing a currency and my work has led me to the belief that, in the case of the Euro, the benefits outweigh the costs. When I have had an occasion to present my work in this area to those in charge of making the decision (politicians) I always realized that economic arguments matter very little when there are political constraints. ...
The countries that are part of the Euro area joined under different political agendas. There is the core (France, Germany) who has been driving European integration through the years (for reasons linked to the end of WWII). There is the periphery (Greece, Spain) who wanted to be like the core. With relatively low income per capita, their societies aspired to converge not only in terms of development but also from an institutional point of view to the levels of the rich Euro partners. And this was the reason why these countries supported every step of European integration, including membership to the Euro area.
And now are looking at the possibility of exit. In the last months, when I have been asked whether Euro exit was a possibility I have always said that it would be economic suicide for any country to leave the Euro area. But economic and political incentives are not always aligned and I have also argued that I could imagine a country leaving the Euro area if the political dynamics of the country produce a potential referendum where the question of Euro membership is simply read as "us versus them". In that environment you could imagine a country leaving the Euro area simply because its citizens have lost faith in the European project and the other countries are seen as enemies not allies. ...
Today the Greek government has surprised other Euro members and financial markets announcing a referendum on the last Euro bailout plan. This can be the end of the Euro, at least in some countries. Given the difficult economic situation in Greece and Europe, a "No" vote is not just possible but very likely. And while the vote will be just on the details of the plan, it will be seen as a referendum on the Euro. And ... there will be no second chance to repeat the vote if we do not like the outcome. And my fear is that just the announcement of a vote and the anticipation of that scenario might lead to a crisis months before the referendum takes place.

See also Paul Krugman and Robert Reich.

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