November 22, 2011 8:09 pm

To the eurozone: advance or risk ruin

By Martin Wolf


Investors are increasingly loath to trust the debt of many eurozone sovereigns. That is the most important lesson of recent events. Many European politicians wish to declare war on the markets.
They need to remember that they want people to buy their debt..As of Monday, spreads over German bunds were more than 60 basis points (0.6 percentage points) in Finland and the Netherlands, 152 points in Austria, 155 points in France, 292 points in Belgium, 466 points in Spain, 480 points in Italy, 650 points in Ireland, 945 points in Portugal and 2,554 in Greece.

For most members, such spreads are manageable. Even Italy and Spain could live with current yields for a while, albeit not indefinitely. What is worrying is that stresses in eurozone public debt markets are rising: Ireland is the only member to have had a significant decline in spreads, though to what is still a penal level.

There are three explanations.

The first is that investors realise that a number of eurozone countries are at a far greater risk of insolvency than previously thought.

The second is that eurozone sovereigns lack a true lender of last resort. They are what Charles Goodhart of the London School of Economics calls “subsidiary sovereigns”. Their debt bears a risk of outright default rather than mere monetisation. Fearing default, investors create illiquidity, which turns into insolvency. The greater the proportion of foreign creditors, the more plausible default becomes: investors know that politicians are more unwilling to default to their own citizens than foreigners. But, as a result of the currency union, foreigners hold a higher proportion of sovereign debt than before: half of Italian public debt is held abroad.

The third explanation is that there is break-up risk. No currency union is irrevocable. Even countries do not survive forever. But a currency union among discordant states is far more fragile than a country.

The first explanation does not work. Spain’s debt and deficit position is not obviously worse than the UK’s. Yet the UK is paying just 2.2 per cent on 10-year bonds, against Spain’s 6.6 per cent. The explanation for this gulf must be the risks of illiquidity and break-up. These risks are also related: if illiquidity were to cause default, countries might well exit. That is not inevitable. But it is conceivable, given the massive shock a default by a significant sovereign would cause.

So what is to be done? Last week, I moderated a discussion of this topic at a conference in honour of Paul de Grauwe of Leuven University in Belgium. I concluded that the eurozone confronts three interwoven challenges. The first is to manage the illiquidity in markets for public debt markets. The second is to reverse the divergence in competitiveness since its launch. The third is to create a regime capable of ensuring less unstable economic relationships among its members. Behind this list is a simple point: people have to believe that members will fare better in than out if they are to trust in the euro’s future.

Take each of these points in turn.

First, vulnerable countries simply cannot eliminate illiquidity or break-up risk, on their own. Promises of austerity that are bound to make the economy weaker undermine credibility rather than strengthen it. Interest rates have to be capped at manageable levels. How this is done is a second order question.

Some combination of the European Financial Stability Fund with the European Central Bank seems a logical route, as Peter Bofinger of Würzburg University and George Soros suggest. Unfortunately, potent interventions are unlikely, because of a misguided ideological resistance. Vulnerable sovereigns will be left to dangle. Yet, if spreads were capped, but not eliminated, countries would still retain a strong incentive to curb their deficits and lower their debts.

Second, a great part of the loss of competitiveness of peripheral countries must be reversed. But, as Germany should know from its experience in the last decade, this would be far easier if inflation were relatively high in partner countries. The ECB should seek to ensure enough demand in the years ahead to facilitate the improvement in competitiveness now needed in peripheral countries. By this standard, the ECB has been unsuccessful. Growth of broad money has collapsed and nominal and real gross domestic product have been far too weak (see chart).

Now that fiscal austerity is the rule, the ECB ought to be delivering a strongly expansionary policy, instead of the most restrictive policy of any of the big central banks of advanced countries. In current circumstances, the ECB’s mantra about price stability in the medium-term risks becoming lethal. As one official in Brussels remarked to me quite recently, the ECB risks being remembered by historians as the magnificently orthodox central bank of a failed currency union. Is that how the members of its council want to be remembered? I suspect not.

Unfortunately, adjustment may, in some cases, still fail. In that event, the eurozone would face one of three dire alternatives: a permanently depressed member; a member on permanent external life support; or an exited member. I know of no way to make these choices palatable.

Finally, consider the eurozone’s future regime, political and economic. It seems to me that three lessons shine out from the crisis. First, as André Sapir, of the Université Libre de Bruxelles pointed out at last week’s conference, the eurozone’s financial sector must be regulated by a common regulator and backed by a common fiscal authority. Second, the eurozone would, at the least, benefit enormously from a unified bond market that covered a big portion of member country debt. Finally, there needs to be more effective discipline over the structural and fiscal policies of the member states.

But none of the above would (or should) be acceptable to democracies without a substantial move towards a political union. Yet everything we have recently seen and heard suggests that this development, ruled out in the 1990s, would be even harder now.

The eurozone, in sum, has to advance or risk disintegration. In a pamphlet I wrote some 15 years ago, I argued that “not only is the absence of shared political culture and a common political process an obstacle to enduring success; the European Union also lacks the constitutional structures to make the centralised exercise of politically sensitive powers legitimate”. The eurozone must now prove me wrong.
Copyright The Financial Times Limited 2011.

11/23/2011 10:33 AM

Financial Paralysis

Europe Short on Cash as Bond Fears Deepen

By Stefan Kaiser

The euro zone is stuck in a double crisis. On the one hand, investors are no longer interested in purchasing sovereign bonds. On the other, banks with such bonds on their books are being treated with extreme caution.
A massive financial crisis threatens -- and it could be worse than the last.

Josef Ackermann is a busy man this autumn. Hardly a day goes by that the Deutsche Bank chief, despite his impending departure from the bank, doesn't hold a speech on the current financial crisis that has gripped Europe. And more often than not, his talk centers on the immense problems faced by the sovereign bond market. Nobody, it would seem, wants state bonds anymore.

Germany's top banker is not alone with his concern about the problem. The entire financial world is in turmoil this autumn. Once seen as iron-clad investments, state bonds are no longer seen as secure -- particularly since the European Union agreed to a 50 percent debt haircut for Greece in October. It can, warned Andreas Schmidt, president of the Association of German Banks, earlier this week, no longer be taken for granted that countries can turn to the capital markets to finance their budgets.

The truth of Schmidt's statement became readily apparent this week. On Tuesday, Spain auctioned off three-month and six-month bonds, a sale that in normal times would be quick and easy. Interest rates of 3 to 4 percent on such sales are normal. But this week, Madrid had to pay 5.11 percent and 5.23 percent respectively, the highest it has had to pay on such bonds in 14 years -- and up significantly from the 3.30 percent it paid on six-month paper as recently as October 25. Even Greece didn't have to pay as much on a similar offering recently.

And the problem isn't just limited to indebted euro-zone countries. Banks too have run into difficulties as a result of the sudden aversion to sovereign bonds. Most of them, after all, have significant amounts of sovereign bonds on their balance sheets -- making other banks extremely wary of lending to them. Indeed, the European Central Bank said on Tuesday that 178 banks borrowed €247 billion in one-week loans from the ECB -- the most since early 2009 when the last financial crisis was at its peak.

Mistrust of EU Bonds
"There is, at the moment, a collective mistrust of European sovereign bonds and banks," said Eugen Keller, a financial market expert with the Frankfurt-based private bank Metzler.
US money market funds have long since withdrawn from the European common currency zone. American and British banks have also become extremely careful when it comes to doing business with European financial institutes. "The willingness of investors to engage in banks on the longer term is not particularly pronounced," Deutsche Bank head Ackermann said in describing the phenomenon.

Were the ECB not on hand to provide banks with cheap money -- since 2008, it has been allowing banks to borrow as much as they need to overcome liquidity shortfalls -- the situation would look much worse, Ackermann added.

In an effort to win back investor faith, European banks are doing everything they can to clear their books of state bonds. According to an estimate from the US investment bank Goldman Sachs, the 55 largest European banks reduced their holdings of Italian bonds by €26 billion just in the three months between the end of June and the end of September -- roughly a 30 percent decrease. Holdings of Spanish bonds have also plunged by a similar percentage, equating to €6.8 billion. The trend is likely to have continued in October and November.

Most of the bonds shed by the banks have likely landed on the balance sheet of the ECB, which has been on a bond-buying spree since May 2010 in an effort to push down sovereign bond interest rates.

But the effort has not been met with unreserved success. So far, the ECB has amassed euro-zone bonds worth €195 billion -- and the interest rate on Italian bonds still edged up to 6.8 percent on Tuesday. That is down from the highs of earlier this month, but still worryingly close to the 7 percent mark that is widely considered to be unsustainable on the long term.
Ultimate Survival
Still, many feel that the ECB is not doing enough and would like to see it embark on a gigantic bond shopping spree in an effort to calm the financial markets. But the ECB has remained resistant to being turned into Europe's lender of last resort -- a position vehemently supported by Germany's central bank and by Chancellor Angela Merkel.

But the problem is not likely to disappear overnight. And the longer the double-crisis -- of state debt and bank liquidity -- continues, the more dangerous it will become for the ultimate survival of the euro. The two are, after all, dependent on each other. Countries need liquid banks to purchase their bonds and the banks need financially solid states as guarantors of the state bonds on their balance sheets. At the moment, neither half of the relationship is functioning properly.

Over the weekend, the world's largest sovereign bond buyer Pimco sounded the alarm. "This is just a repeat of what we saw in 2008, when everyone wanted to see toxic assets off the banks' balance sheets," Christian Stracke, head of research for Pimco, told the New York Times.

Keller, the analyst from Metzler, also sees parallels. "Back then, it was shoddy US real-estate loans that was causing the banks problems," he says. "Today it is the European state bonds that everyone thought were so safe."

The comparison with 2008 is frightening. Following the fall of the investment bank Lehman Brothers, the entire financial system faced collapse. And this time, the condition of the markets is, if anything, even worse: The crisis has eaten its way deep into the credit system. The entire method by which
European countries access money is under threat -- and by extension, so too is European prosperity.

Keys in Berlin

It is a situation that has become unsustainable on the long term. If Europe is not able to quickly re-establish faith in European sovereign bonds, a downward spiral of fear and debt could be the result.

The key to preventing that spiral from gaining momentum lies in the hands of the German government. Germany is, at the moment, the only euro-zone country that investors continue to trust unreservedly -- which can be seen in the low interest rates that Berlin must pay on its sovereign bonds.

It is a trust that Merkel's government is hesitant to loan out, as would be the case were so-called "euro bonds" -- essentially a pooling of euro-zone debt -- to be introduced. Experts, though, think that the chancellor will soon be forced to buckle. "I think that it is only a question of weeks before we have to say: all for one, one for all," says Keller.

The implication is clear. Either Germany will have to guarantee the debts of other euro-zone countries in the form of euro bonds. Or the ECB will have to jump in and buy massive quantities of bonds from highly indebted currency zone members. A third alternative doesn't exist.

Europe’s banks must be forced to recapitalise now

Mohamed El-Erian

November24, 2011

Just when you think the European crisis cannot get much worse, Wednesday’s shunned Bund auction showed that it can. With this, the risks for the global economy as a whole, and for virtually every country, increase materially.

Given this week’s developments, there should be no doubt in anyone’s mind that what started out as a dislocation in the periphery of the eurozone has now decisively breached the firewalls protecting the outer core and is seriously threatening the inner core. Unless this is countered quickly, European policymakers will find it even harder to catch up with the crisis, let alone get ahead of it.

Europe must still stabilise its sovereign debt situation. But this is now far from sufficient. Policymakers must also move quickly to contain banking sector frailties, and do so using a more coherent approach to the trio of capital, asset quality and liquidity.

In the eyes of the markets, the capital cushion of Europe’s banking system as a whole is no longer sufficient to support its balance sheet. This concern is not limited to the markets. Judging from their eagerness to dispose of assets, bank managements also believe that balance sheet delevering is key to the institutions’ survival and wellbeing.

In today’s environment, selling begets more selling; and it is not just about other unhealthy balance sheets also being forced to delever. The vast majority of healthy balance sheets -fortunately there are still a few - are reluctant to engage. Some are even taking risk off further, including those that believe that this enhances their relative market standing. It brings to mind the period of ”macho provisioning” by US banks during the Latin American crisis of the 1980s. Ironically, this may be intensified by Tuesday’s announcement that the Federal Reserve will impose another stress test on large American banks.

None of this helps liquidity management. Not surprisingly, a growing number of European banks are now either materially or wholly dependent on the European Central Bank and related facilities (such as the national emergency liquidity assistance programmes).
The situation is particularly acute for those that previously relied on wholesale funding, which has essentially disappeared, and those suffering deposit outflows, which are accelerating in very troubled countries such as Greece.

All this makes it very hard for the banking system to get back on side quickly, especially at a time when three other issues are making it difficult to manage balance sheet risk. First, traditional asset diversification no longer affords the same degree of risk mitigation given the scope and scale of the European crisis. Second, with historically low interest rates on government bonds issued by the strongest economies, such holdings offer only limited protection in today’s environment. Third, confidence in market-based hedging instruments, including credit default swaps, is eroding due to uncertainty about what will happen to them during major market dislocation.

Problems in the banking sector have a nasty habit of accelerating and amplifying crises. Indeed, they significantly increase the risk of policymakers losing control. It is therefore critical for Europe to add this policy challenge to an already longto do list.

Europe must now go well beyond the steps proposed at the October 26 summit. In addition to specifying higher prudential capital ratios, governments must now bully banks to act immediately. Where private funding is not forthcoming, which should now be the presumption for a growing number of banks, recapitalisation must be imposed, in return for fundamental changes in the way financial institutions operate and burdens are shared.

The urgent stabilisation and reform of the banking system is one of the five key areas that will determine the future of the eurozone. With little time to waste, success will also require progress on the other areasnamely, more appropriate reform programmes on the part of heavily-indebted economies, a better delineation between solvency and liquidity cases, more effective circuit breakers from the ECB, and decisions on the urgent strengthening of the institutional underpinning of the eurozone (as currently configured or in a smaller version).

Europe’s already long list of ‘must do’s is getting longer and harder by the day. Denial, obfuscation and further dithering by policymakers serves only to make the situation even more daunting, and the eurozone’s future more uncertain.
The writer is the chief executive and co-chief investment officer of Pimco


NOVEMBER 23, 2011

It's Still Possible to Cut Spending: Here's How

The obvious place to begin is the repeal of ObamaCare. We also need to empower the states, streamline the federal government and modernize Medicare and Social Security.

After two months of talks, the super committee announced failure on Monday to agree on reducing federal deficits by $1.2 trillion over the next decade. But as the late economist Herb Stein once remarked: If something cannot go on forever, it won't. That applies to the mounting budget shortfalls. But how?

President Obama's answer is higher taxes. But he can't be serious. Just accommodating his spending plans over the next decade requires across-the-board tax increases of 20%. Over the next 25 years, taxes would need to rise across the board by 60%.

Instead, what is needed is spending reform that offers goals, specifics and ways to blend fiscal responsibility with modernizing government. This includes near-term action on discretionary spending and longer-term action to reform entitlements and reduce the growth of Social Security and Medicare. Then revenue contributions can be addressed in the context of tax reform.

The first goal is to reduce federal spending to a healthier 20% share of GDP from today's bloated 25% within a decade. A tall order, yes, given the profligacy of the last few years. But it can be accomplished by eliminating unnecessary federal programs, empowering states, and reforming and streamlining government.

The obvious place to begin is repealing ObamaCare and its expansion of spending. Programs like the federal Community Development Fund, which should fall under state and local or private responsibilities, can be axed. So can intercity and high-speed rail grants, which lack plans to make rail competitive, and duplicative education programs.

We should also let states experiment with alternatives to our current one-size-fits-all federal solution. The best example is Medicaid, which should be converted into a block grant. Replacing federal matching support with block grants eliminates state incentives to attract additional federal subsidies, while allowing states to manage Medicaid more efficiently. Federal Medicaid costs should be capped at growth of 1% over the inflation rate.

The federal work force can shrink through attrition, and employee compensation can be adjusted to private levels. We should cut costly applied research in fields such as renewable energy at the Department of Energy, focusing only on basic research. And the Davis-Bacon Act, which inflates the price of federal construction projects by requiring high-cost union labor, has to be repealed.

These three approaches would bring federal spending down to 20% of GDP. Yet as ambitious as they are, these won't solve our long-term budget problems, which reflect yawning deficits in Social Security and Medicare.

Regarding Social Security, the program first needs to be made solvent and sustainable over the long term. In particular, program outlays need to grow more slowly to allow for rising costs in health-care entitlements. Second, we must modernize Social Security by making it more effective in protecting low earners and more conducive to personal saving and the longer work lives needed in today's economy. These changes will require a strong minimum benefit, gradual increases in the retirement age, and slowing benefit growth for more affluent Americans.

As a pro-growth measure, we should also eliminate the Social Security payroll tax for all individuals age 62 and older to encourage individuals to keep working and to increase their attractiveness to employers. In that vein, we should also eliminate the retirement earnings test that reduces benefits for early retirees who continue to work.

Our long-term budget problems are dominated by Medicare's unfunded liabilities of tens of trillions of dollars. But changes must preserve Medicare's role of assisting lower- and moderate-income Americans. As with Social Security, Medicare's eligibility age should be increased gradually, and we should promote work by eliminating the Medicare payroll tax for individuals 62 or older.

A more modern version of traditional Medicare would replace Parts A, B and D with comprehensive benefits including coverage for catastrophic costs and prescription drugs. Simpler cost-sharing would be offered—with one deductible for inpatient and outpatient services and a common coinsurance rate for all services.

Medicare would be placed on a budget through premium support, which would let beneficiaries choose among competing health plans, much like federal employees do now. Subsidies would be larger for lower-income or higher-health-risk individuals. The annual growth would be determined by Congress along with other spending priorities.

And what about taxes? Incorporating revenue increases into forward-looking budget planning requires care. For the plan to be pro-growth, marginal tax rates must not be raised. That leaves base-broadening by reducing tax expenditures and tax preferences. With this in mind, Congress should agree on a revenue target for the decade, then deliver on this target via tax reform.

Merely extending the 2001 and 2003 tax cuts is not the most pro-growth policy. Fundamental tax reform need not be revenue-neutral, as the Bowles-Simpson Commission plan—which would raise net revenue through broadening the tax base—indicates. And reform can be progressive. But tax reform is important for ensuring that deficit reduction promotes economic growth as well as budget austerity.

It is unfortunate that many members of Congress and much of the public don't understand that America's fiscal problems can be solved almost entirely by altering the trajectory of government spending. President Obama's leadership failure here is obvious.

If something cannot go on forever, it will stop. But even with the super committee's failure we may be able to avoid a sudden, calamitous stop—and provide a government worthy of the 21st century for all Americans.
Mr. Hubbard, dean of Columbia Business School, was chairman of the Council of Economic Advisers under President George W. Bush.
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