EUCOM Economic Analysis - Part I

[Surferbeetle]

Given Mr Dallara's position, experience, access to information, and credentials it might be worth our time to revisit the received wisdom that 'a central bank can print to it's heart's content' and does not need to worry about the quantity and quality of it's assets.

The real world is not simple, constraints (consequences) exist, and central banks are not perpetual motion machines. Serious inflation and hyperinflation has visited central banks in Israel, Zimbabwe, and Germany (among others) which thought excessive printing was the answer. Devaluation and flight to quality accompanies excessive printing by central banks. Open market operations are the mechanism by which central banks use assets such as special drawing rights, government bonds, foreign currency, and gold to increase or decrease the amount of base money in the system. The quality and quantity of central bank assets in Europe are a concern in many quarters, keeping in mind that while the European Central Bank is in charge of Euro policy, nations participating within the 17 member Eurozone each have their own central bank. The ECB has mechanisms to encourage, regulate, and protect itself from the Eurozone financal system.

As unemployment spreads across Southern Europe we see the amount of private savings deposits decrease and the number of non-performing private and corporate loans increase, which leads to bank failures at a certain point. Banks are then nationalized, broken up, and sold to save the system since many are TBTF and associated losses are socialized via higher taxes. Tax revenue, however, is also adversely affected by unemployment. State cost and revenue structures become dangerously unbalanced and nations, like Greece, default on their obligations and harm their societies. Since South and North are interconnected via economics (even if the EU and Eurozone dissolve), contagion spreads.

IMO this financial crisis writ large is a turning point for Europe. Very broad brush, the continuum as i see it, ranges from Peace to War via the political continuum of Federalism to Fragmentary Nationalism. The failure of the Holy Roman Empire and the resultant history may be worth consideration...although it is noteworthy that military expenditures within Europe are very low while educational standards are very high this time around.

We will probably see a bit more movement after the upcoming Greek elections and after the next meeting (at least 18 so far according to some reports) of senior Eurozone members on this crisis...if the bank runs don't overtake the political process.

Bottom line, craven politicians eventually have to make hard choices because central banks are not magical institutions that can fix all societal ills by endless printing.

• Israeli Inflation from an International Perspective, by Stanley Fischer and David Orsmond, IMF Working Paper WP/00/178, http://www.imf.org/external/pubs/ft/wp/2000/wp00178.pdf
  
• Hyperinflation, from Wikipedia, the free encyclopedia, http://en.wikipedia.org/wiki/Hyperinflation
  
• Devaluation, from Wikipedia, the free encyclopedia, http://en.wikipedia.org/wiki/Devaluation
  
• Flucht in den Franken: Die Angst vor der grossen Welle, Von: Armin MllerFoto: Peter Frommenwiler, HANDELSZEITUNG 1220, 20.05.2012 | 09:25, http://www.handelszeitung.ch/invest/...-grossen-welle
  
• Open market operation, from Wikipedia, the free encyclopedia, http://en.wikipedia.org/wiki/Open_market_operation
  
• Monetary base, from Wikipedia, the free encyclopedia, http://en.wikipedia.org/wiki/Monetary_base
  
• Special drawing rights, from Wikipedia, the free encyclopedia, http://en.wikipedia.org/wiki/Special_drawing_rights
  
• Finanzkrise, Wo ist unser Gold?, Mittwoch, 08.10.2008, 10:57 · von FOCUS-Redakteur Uli Dönch http://www.focus.de/finanzen/doenchk...id_338834.html
  
• European Central Bank, from Wikipedia, the free encyclopedia, http://en.wikipedia.org/wiki/European_Central_Bank
  
• Eurozone, from Wikipedia, the free encyclopedia, http://en.wikipedia.org/wiki/Eurozone
  
• Frozen Europe Means ECB Must Resort To ELA For Banks
  By Dara Doyle and Jeff Black - May 25, 2012 4:01 AM MT, Bloomberg News, http://www.bloomberg.com/news/2012-0...ights-dim.html
  
• Unsecured Creditors Face Losses In EU’s Plan For Failing Banks
  By Jim Brunsden and Ben Moshinsky - May 26, 2012 3:43 AM MT, Bloomberg News, http://www.bloomberg.com/news/2012-0...-banks-1-.html
  
• Bankia Seeks 19 Billion Euros From Spain For Cleanup
  By Charles Penty and Emma Ross-Thomas - May 26, 2012 7:05 AM MT, Bloomberg News, http://www.bloomberg.com/news/2012-0...structure.html
  
• Holy Roman Empire, from Wikipedia, the free encyclopedia, http://en.wikipedia.org/wiki/Holy_Roman_Empire
  
• Greek legislative election, June 2012, From Wikipedia, the free encyclopedia, http://en.wikipedia.org/wiki/Greek_l...ion,_June_2012

[Firn]

I think it is worth to point out that much of the economic discussion comes with an US point of view, rather similar to recent military matters. In both cases great resources and stable&strong institutions in law, economy and politics are almost taken as given. Add to that the dominance of the dollar in the world economy and you have a rather unique case. In short some central banks have more freedom of action then others. (A old wise local proverb concerning wealth and card games says that it is easy to stink with the trousers full of ****)

I mostly agree with what you wrote, but I really think we have still room for aggressive actions by the ECB. The recent bank troubles in Spain are terrible news. Three years into the crisis we still have much overrated assets on the balance sheets and with the economy in ever deeper crisis and the housing market worse then ever much needs to be written down. The banks need capital and credit, so the taxpayer and the ECB have to step up. The NYT had recently a couple of good articles:

As Bank Loans Dry Up in Spain, Small and Medium Businesses Fight for Life

Despite the mergers and injections of capital from the banking bailout and reconstruction program begun by the government in 2009, there has been no improvement in lending. According to the Bank of Spain, credit to the private sector fell in March, as it has virtually every month since the fall of 2009. Some businesses say they do not even bother asking for loans anymore.

Getting loans to start a company may be even harder. “How are you going to get new businesses going if there is no one willing to take a risk and lend you money?” said Edward Hugh, an economic guru who blogs on Spain’s economy. “The problems become circular and self-perpetuating.”

Banking officials agree that the restructuring has made credit harder to come by, but they say they can do little about it. “The banks here are asked to provision more capital to guard against loan losses,” an official from CECA, the Spanish savings bank association, said. “And if they are asked for more capital, then the possibilities of giving credit are limited.”

Giant Lender in Spain Asks for Billions to Fend Off Collapse

MADRID — Spain’s banking crisis worsened Friday as the board of Bankia, the country’s biggest mortgage lender, warned that it would need an additional 19 billion euros ($23.88 billion), far beyond what the government estimated when it seized the bank and its portfolio of delinquent real estate loans earlier this month.

A bit to explain the German point of view: Germany Looks to Its Own Costly Reunification in Resisting Stimulus for Greece

MUNICH — When Germany wants to understand Greece and the crisis afflicting Europe it not only looks south to the Continent’s periphery but also turns inward, to the former East Germany, still struggling more than two decades after German reunification.

To an extent not often appreciated by outsiders, the lessons provided by that experience — with the nation pouring $2 trillion or more into the east, by some estimates, to little immediate benefit — color the outlook and decisions of policy makers and the attitudes of voters, a majority of whom would like to see Greece leave the euro zone, polls show.

[Surferbeetle]

I think it is worth to point out that much of the economic discussion comes with an US point of view, rather similar to recent military matters. In both cases great resources and stable&strong institutions in law, economy and politics are almost taken as given. Add to that the dominance of the dollar in the world economy and you have a rather unique case. In short some central banks have more freedom of action then others. (A old wise local proverb concerning wealth and card games says that it is easy to stink with the trousers full of ****)

Wow! Almost spilled my beer when I read that one.

Well, the beauty of SWJ/a free market of ideas/the inter-webs is that anyone is able to take a position and advance/defend it if they can, everybody learns something in the process, and hopefully the, uh, cream rises to the top.

So, as we watch the slo-mo bank-run and hear the whooshing sound of big money running to the hoped for safety of Bunds and Treasuries I am wondering how all this recent activity impacts the monstrously large, global over the counter derivatives market (~ 600 trillion USD in the second half of 2010 keeping in mind that the combined GDP of the EU was in the neighborhood of 16 trillion USD in 2010) beyond further politicizing the regulatory frameworks? BIS says that interest rate swaps are the largest component of this market, JP Morgan has recently been in the news in this arena, and I wonder who is next...

OTC derivatives market activity in the second half of 2010, Monetary and Economic Department, May 2011, http://www.bis.org/publ/otc_hy1105.pdf

After contracting by 4% in the first half of 2010, total notional amounts outstanding of over- the-counter (OTC) derivatives rose by 3% in the second half, reaching $601 trillion by the end of December 2010 (Graph 1, left-hand panel, and Table 1). Notional amounts outstanding of credit default swaps (CDS) continued to contract, falling by 1% after the 7% decline in the first half, while outstanding equity-linked contracts shrank by 10%. Gross market values1 of all OTC contracts went down by 14%, driven mainly by the 17% decline in the market value of interest rate contracts. CDS market values fell by 19%. Overall gross credit exposure2 dropped by 7% to $3.3 trillion, compared with a 2% increase in the first half of 2010.

J.P. Morgan’s losses reveal market chaos, By David Weidner, MarketWatch, May 11, 2012, 3:16 p.m. EDT, http://www.marketwatch.com/story/jp-...aos-2012-05-10

Already two alternate narratives are making their way into the media. The first is that J.P. Morgan’s $2 billion trading loss and $800 million or more blow to earnings is the result of some rogue in England known in the markets as the London Whale. See MarketWatch report on J.P. Morgan loss.

The second narrative is one told by The Financial Times in the aftermath: that this loss is inconsequential.

“So far the numbers are not enough to dent J.P. Morgan’s balance sheet, nor its capital-adequacy ratios much, nor its ability to return money to shareholders,” the publication said in its “Lex” column, adding that it would only serve to give “ammo” to bank critics.

[Watcher In The Middle]

This is the type of situation that scares me:

Europe continues to fight the wrong battle, and continues to spread contagion risk.

It is clear that Greece has had a solvency issue now for over 2 years. The ECB and Troika chose to treat it as a liquidity problem. Maybe, they could have argued that in early 2010, but by the summer of 2011 it was obvious to any credit observer that the problem was solvency, yet they continued to treat it as one of liquidity. That is scary because if they feel to see the problem correctly now, they will fail miserably. Not only is the problem clearly solvency, but now forced currency conversion has been added to the mix. Any “solution” from the EU must now address that risk, and it is not the same as solvency. Programs that can protect against solvency may do nothing for the redenomination risk.

Not only did Europe fail to address the problems, but in spite of convincing themselves that all these programs prevented contagion risk, they actually ensured contagion risk. That contagion risk, that they forced on themselves is now coming back to haunt them, and must be carefully addressed in any policy “solutions”.

Europe Fighting the Wrong Battles Again with Dangerous Consequences

Want to see the really scary parts? - check out those pie charts. 82% of the interest due on bonds are to either ECB bonds (29%) or Troika loans (53%). Only 18% is private sector.

And then take a look at the Greek indebtedness maturing within the next 6 years - only 2% is private sector.

When I read the entire post - there's just no out. And it's obvious that there's no workable 'firewall' to make a practical solution of "What happens in Greece stays in Greece".

What are the implications for political/society instability when Greece implements the Drachma - it's not only devaluation risk, but also conversion risk. The conversion risk may be a greater problem.

[Surferbeetle]

When I read the entire post - there's just no out. And it's obvious that there's no workable 'firewall' to make a practical solution of "What happens in Greece stays in Greece".

What are the implications for political/society instability when Greece implements the Drachma - it's not only devaluation risk, but also conversion risk. The conversion risk may be a greater problem.

You post some interesting links and ask some interesting questions, which make me think about how the 'discussion' between the philosophers Immanuel Kant (22 April 1724 – 12 February 1804) and Thomas Hobbes (5 April 1588 – 4 December 1679), regarding the primacy of Democracy or that of State Power, compares to today's events.

"Greece: Western Mistress, Eastern Bride" is how Robert D. Kaplan leads off the chapters describing Greece in his book: Balkan Ghosts (A Journey Through History). The turbulent political and economic history described comes across as very much a Hobbesian world:

"Greece is Europe's last port of call, where the Balkans begin to be dissolved completely by the East. As such, approaching from the opposite direction, Greece is also where the oxygen of the West begins to diffuse the crushing and abstract logic of the Mesopotamian and Egyptian deserts."

Can Syzriza (or any other Greek political party or movement), credibly gain the acquiescence of the populace, negotiate a compromise with the EU, and manage to sustainably extract, appropriate, and regulate Greek capital without causing strife? If so, extend and pretend may still be a possibility. Access to commodities, geography, history of civil war, diaspora size, education, ethnic and religious composition, political incidents, changes in GDP, etc are all tea leaves that may be examined to gauge the possibility of internal national strife (protests or otherwise). Meanwhile, Christine Lagarde of the IMF has bravely started a public discussion regarding the relative wealth of EU members (~ a combined GDP of 16 trillion USD in 2010) and the role that taxation plays in Western Society, but that is only part of the puzzle. I think you are right about the importance of conversion risk, this along with macro imbalances, fiscal policies, and 'North and South' concerns of EU members, may all be memes too far at the moment (for developing political consensus)? As a result, capital controls are being actively looked at. At this point then it appears to me that the actions of the EU, and surrounding nations, seem to be more focused upon political and economic concerns than those of significant social unrest.

Long story short: I am still in European financial equities. Things change all the time, so we will see what comes...

• Balkan Ghosts (A Journey Through History), Robert D. Kaplan, ISBN 0-679-749810
  
• Seeing the Elephant (The US Role in Global Security), Hans Binnendijk and Richard L. Kugler, ISBN 1-59797-100-6
  
• Strong Societies and Weak States, Joel S. Migdal, ISBN 0-691-01073-0
  
• Leashing The Dogs of War (Conflict Management in A Divided World) edited by Chester A. Crocker, Fen Osler Hampson, and Pamela Aall, ISBN 10-929223-96-X
  
• Greek Civil War, From Wikipedia, the free encyclopedia, http://en.wikipedia.org/wiki/Greek_Civil_War
  
• Israel-Cyprus Deal On Gas As Lebanon Won’t Negotiate, by Eduard Gismatullin - Apr 19, 2012 6:26 AM MT, Bloomberg News, http://www.bloomberg.com/news/2012-0...on-energy.html
  
• Greeks Must Stop ‘Trying To Escape Tax,’ Lagarde Tells Guardian, By Mike Harrison - May 26, 2012 12:04 AM MT, Bloomberg News, http://www.bloomberg.com/news/2012-0...-guardian.html
  
• Swiss eye capital controls if Greece goes, by Alice Ross in London and Haig Simonian in Zurich, May 27, 2012 5:47 pm, Financial Times, www.ft.com
  
• Notfallszenario der Nationalbank, SNB prüft Einführung von Kapitalverkehrskontrollen, sollte die Euro-Krise eskalieren, Sebastian Bräuer, Daniel Hug, 27. Mai 2012, NZZ am Sonntag, http://www.nzz.ch/aktuell/wirtschaft....17055832.html

[Watcher In The Middle]

The real issue with Greece that I see is that both the ECB and the Troika are the primary (and immediate) creditors to Greece. If Greece just decides to default on their 'deal' and fail to implement the austerity programs, then both the Troika & ECB cut them off. So Greece goes into default. But their money (the Euro) is still at it's full convertibility rate, ie Greek euro = Italian euro = French euro = German euro.

So, the result will be expanded bank runs in Greece (assuming there's any money left in Greek banks), Portugal, Spain, and possibly Italy. Why? Because nobody wants to go back to their original pre-euro currency, because if you are in one of the PIIGS and you have to have your money revert back to the national (pre euro) currency, you just suffered an immediate devaluation in your holdings. Move your money into Euros - immediately. And get the money in your hands.

So, the smart move is to make a hard withdrawal of your money in euro (or dollar) denominated currency. It's already been happening, and now it's accelerating.

The smart money says that to stop the outflow (bank runs), the EU has to kick Greece out of the euro & force Greece to move to the drachma.

But the problem with doing that is that once you start that process, the ECB and Troika holdings of Greek sovereign debt (and non-sovereign Greek debt) just basically became radically devalued, if not functionally worthless. And those are big numbers. But it doesn't just stop with Greece.

So what does the ECB and the Troika do? They have got no good options.

Truth of the matter is that right now Greece holds the cards. They've just shown Portugal, Spain, Iceland, and Italy the way to deal with this situation. IMO, they get to 'party on' while other (primarily the Northern European) nations get to keep picking up the tab.

Not to worry. In 6 months or so, when the US finances melt down (say January - April, 2013), we'll make the entire European quandary look like a sideshow.

[Watcher In The Middle]

Then we get this:

Spain may recapitalize Bankia (BKIA.MC) with Spanish government bonds in return for shares in the bank which last week asked for rescue funding of 19 billion euros ($24 billion), a government source said on Sunday.

Bankia could use the sovereign paper as collateral to get cash from the European Central Bank, forcing the ECB to get involved with restructuring Spain's banking sector, laid low by lending to property developers in a boom that ended in 2008.

Another 19 Billion Euro Bailout - for Bankia

Short summary:

1) Spanish government source
2) Float what amounts to be 19 billion euros of junk bonds
3) Sells them off to the ECB at face value.
4) Uses the proceeds to "recapitalize" Bankia.

Greece all over again....only on a far larger (and completely unaffordable) scale.