June 19, 2012 6:12 pm

A bitter fallout from a hasty union

By Martin Wolf
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Marry in haste; repent at leisure.” Full of impetuous ardour, Germany’s partners seducedsome might say blackmailed – the continent’s most powerful economy into sacrificing monetary independence two decades ago. But, as the prince in Giuseppe di Lampedusa’s Leopard remarked of his own indissoluble union: “Fire and flames for a year; ashes for thirty.” Now is the eurozone’s time of ashes.



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Heads of government of the group of 20 leading countries who do not come from the eurozone must feel like marriage counsellors trying to reconcile partners far too different in character and values to live happily together. The careless lending before 2007 aggravated the danger. That carelessness, exacerbated by the notion that the marriage made all equal, has made the crisis far worse.

 

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Those whom borrowing afforded a standard of living above what they could afford are being forced to accept a plunge into poverty. Not surprisingly, they resent the change.





The Greeks, unhappiest of all, have apparently chosen a government of parties slightly less unenthusiastic about the agreed programme than the others. Antonis Samaras was an opportunistic opponent of austerity in opposition, while his party, New Democracy, bears a full share of responsibility for the pre-crisis mismanagement. Much trouble lies ahead: Alexis Tsiparas of Syriza, the far-left party, has 27 per cent of the vote already. He will be only too happy to exploit rising public anger.



Spain is hoping for a €100bn bailout of its banks but, alas, one that benefits the creditors of banks at the expense of the creditworthiness of the government. At current rates of interest, it is only a matter of time before Spain requires a fiscal rescue. That would exhaust the available resources of the eurozone. It also risks turning a proud country into a dependency, with frightening results for stability.



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Italy’s fiscal deficits are far smaller than Spain’s, but its rollover problem is bigger. According to the International Monetary Fund’s Fiscal Monitor, Italy needs new financing equal to 28.7 per cent of gross domestic product this year, far above Spain’s 20.9 per cent (see chart). Moreover, what follows the government of Mario Monti, due to leave office next year, is an enigma.
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To this one must add the divergence of views on economic policy between France and Germany. François Hollande’s parliamentary victory will add to the stress. The coming debate over what a growth strategy means, while necessary, risks becoming quite heated.



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Why, then, does anybody imagine that this difficult marriage can endure? One answer is that most citizens of the eurozone wish it to do so. The most powerful, however, is that people are (rightly) terrified of the consequences of a break-up. As time passes, finance is becoming more national. But economies remain highly integrated. Not least, today’s EU has been built around the euro. It cannot be assumed that the integration would survive a break-up. It would certainly represent a violation of treaty commitments.



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The marriage may have been foolish. But a divorce would be terrifying. It is against this background that we must assess the views of the dominant partner: Germany. According to a translation I have received from the German embassy, Angela Merkel, Germany’s cautious chancellor, told the Bundestag last week that she wishes to say to “all those who...are intent on persuading Germany that we need eurobonds, stability funds, a European deposit guarantee scheme, many more billions and much more: yes, Germany is strong”. Moreover: “We’re convinced that Europe is our destiny and our future... But we’re also aware that Germany’s strength isn’t infinite.”


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Furthermore: “Quite apart from the fact that these seemingly simple proposals...are unfeasible in constitutional terms, they are completely counterproductive. They would make mediocrity the yardstick for Europe. We would thus be forced to abandon our goal of maintaining prosperity in the face of international competition.”



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To all this she added: “The fiscal compact is a first step towards combining greater unity with greater control at the European level. And it’s going to be vital that national powers only be relinquished when it is clear that this will involve independent supervision of the European institutions.” In sum, she made three crucial points: first, Germany is not about to stump up more money; second, everybody in the eurozone must become like Germany; third, when and only when strong rules and credible controls exist at the European level might Germany accept any further losses of national sovereignty.




These positions raise big questions. Is there time available to impose these new rules and procedures, given the huge internal imbalances, wide divergences in competitiveness and severe fiscal pressures? Moreover, does Germany have any flexibility over positions that are partly prudential, partly constitutional and partly moral? My guess is the answer to these questions is: No.



Yet whatever the answers might be, it is evident that Germany’s approach guarantees continued strong austerity in the vulnerable countries and, in all probability, mediocre growth in the eurozone. That, in turn, ensures the recurrence of political and economic crises, even if the eurozone survives. If the marriage counsellors wonder why they must endure all this, the answer is clear: this time, Germany intends to secure the behaviour it wants from its partners.



I can envisage five outcomes: first, a happy marriage, on Germany’s terms, albeit after a painful period of adjustment; second, a miserable marriage, which endures because a break-up is too costly; third, a degree of mutual accommodation, in which the north becomes more southern and the south more northern; fourth, a partial break-up, with the remaining members moving into one of the three previous categories; and, finally, total break-up. What is certain is that Germany will not get the eurozone it wants easily or swiftly. If partial or total break-up is avoided, the period of difficulty will be long and painful. The crisis of the eurozone is likely to be a very long-running soap opera – if it does not end in tragedy.


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Copyright The Financial Times Limited 2012.


As Part Of Its NEW QE Q&A, Goldman Warns Of Possibility For $50-$75 Billion "Flow" Program

Submitted by Tyler Durden on

06/18/2012 19:07 -0400


Not like it should come as any surprise that the bank that first among peers "discovered" that flow, not stock matters, implying the Fed may literally never be able to stop monetizing, is expecting the FOMC to "ease monetary policy on June 20", but nonetheless here is the full just released Q&A from Goldman's Jan Hatzius, who just happens to be a Pound and Pence drinking buddy of former Goldmanite Bill Dudley, who just happens to run the New York Fed. Connects the dots. Implicit is that a big dollop of Large Scale Asset Purchases is imminent.


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That said, if the Fed does disappoint on June 20, and merely extends the maturity of bonds that it will sell as part of a Twist extension from 3 to 4 years, as the bond market appears to be implying (as first warned by Zero Hedge), then all bets are truly off. On the other hand, note where Goldman says: "However, it is also possible that the program would be specified as a "flow" of purchases of perhaps $50bn-$75bn per month." If that happens, gold is going to $2000, $3000, hell, $10,000 very soon, as it means the Fed will not stop printing ever again. Period.



From Goldman:



FOMC Preview: QE or Not QE (Hatzius)

We expect the Federal Open Market Committee (FOMC) to ease monetary policy on June 20, in response to the weaker economic data and increased downside risks from the intensifying crisis in Europe.





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The form of the easing is a closer call. Our baseline is a new asset purchase program that involves an expansion of the balance sheet, but an extension of Operation Twist and/or a further lengthening of the short-term interest rate guidance in the FOMC statement beyond the currentlate 2014formulation are also possible.


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Q: Will the FOMC ease monetary policy?



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A: Probably. Although renewed Fed easing by mid-2012 has been our forecast all year, we felt more uncertain about this view a few months ago given the temporarily better data and the apparent shift of the Fed's reaction function in a more hawkish direction. But at this point, we would be quite surprised if we saw no easing this week.



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Q: Why?




.A: In her June 6 speech, Vice Chair Yellen listed three alternative criteria for further easing:


…[i]f the Committee were to judge that the recovery is unlikely to proceed at a satisfactory pace (for example, that the forecast entails little or no improvement in the labor market over the next few years), or that the downside risks to the outlook had become sufficiently great, or that inflation appeared to be in danger of declining notably below its 2 percent objective... (emphasis ours).



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We believe criterion 1 has been met. As shown in Exhibit 1, we expect the committee to lower its forecast for real GDP growth and raise its forecast for the unemployment rate significantly in the Summary of Economic Projections to be collected at the meeting. If we are right in thinking that the "central tendency" forecast still shows the unemployment rate at 6.9%-7.6% at the end of 2014, many committee members may view this pace of improvement as insufficient, and be inclined to ease accordingly.
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Exhibit 1: Out Estimates for the Fed's Summary of Economic Projections…




Criterion 2 may also have been met given the deterioration of the European crisis and the tightening of financial conditions of about 30 basis points (bp) since the April FOMC meeting. This tightening is a key reason why our statistical model of FOMC decisions implies that additional easing in June is likely.



.Criterion 3 has probably not been met in the committee's view. As shown in Exhibit 1, we expect only the headline inflation forecasts to be revised downward, while the core inflation numbers are likely to be largely unchanged. However, our own view is that there are signs that underlying inflation pressure is actually starting to come off quite sharply, so this criterion may well be met at a subsequent meeting.



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In addition, it is important to note that a decision not to ease is tantamount to a tightening. The reason is that the impact of unconventional easing--unlike that of conventional short-term interest rate policy--"decays" over time. This is the implication of our own research, and Figure 9 in Yellen's speech shows that Fed officials have come to the same conclusion. We estimate that this "decay" would push up the 10-year Treasury yield by about 30 basis points (bp) between now and the end of 2013 if no further balance sheet action is taken and the forward guidance is not extended, and Yellen's estimates seem to be similar.



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This decay factor kicks in only gradually, so one could argue that it need not be a reason to expect further easing in the near term. However, there are two other reasons besides the decay to believe that the impact of not acting could be sizable even in the near term. First, the market now clearly discounts some probability of easing, so financial conditions would likely tighten if the Fed did nothing. And second, we have found that a small part of the impact of asset purchases on bond yields occurs via the "flow" of Fed purchases than the "stock" of Fed holdings; this implies that very long yields should rise when the purchases stop.




Q: So how will they ease?



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A: This is much more uncertain. However, our baseline remains a return to balance sheet expansion, with purchases of mortgage-backed securities (MBS) and Treasuries. There are three reasons why we believe MBS purchases would feature prominently. First, these may be more powerful than Treasury purchases in boosting economic activity on a dollar-for-dollar basis, as MBS yields are not nearly as close to the zero bound as Treasury yields. Second, Fed officials have repeatedly mentioned housing as a key headwind to a stronger recovery, so a policy that directly targets housing would make sense. Third, there may be more support among the public for MBS purchases because of the implied support for US homeowners as opposed to government deficits.



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That said, some Treasury purchases would probably be included as well; after all, the stock of Treasuries is rising much more quickly than that of MBS, and Fed officials may therefore want to provide some additional support for this asset class.


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Q: How large will the program be?



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A: If it is specified as a "stock" of purchases, we would expect a similar size as in past programs, i.e. $400bn-$600bn over 6-9 months. However, it is also possible that the program would be specified as a "flow" of purchases of perhaps $50bn-$75bn per month. Although there has been little talk about the latter option, it enables the committee to respond more flexibly to changing economic conditions and may be optically more attractive if the committee is worried about a political backlash domestically or abroad against further balance sheet expansion. Economically, the effects of the two options are likely to be quite similar because financial markets are forward-looking; for example, if markets believe that a purchase flow of $60bn per month will be sustained over 8 months, this would be equivalent to a $480bn stock announcement.

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Q: Will the purchases be sterilized?



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A: This is a tough call, but on balance we think yes. The argument in favor of expecting sterilization--which involves financing a Fed balance sheet increase via term deposits and/or reverse repurchase agreements as opposed to yet more excess bank reserves--is that the cost-benefit analysis looks quite promising. Economically, we believe the choice whether to finance a balance sheet increase via overnight liabilities (bank reserves) or 1-week/4-week liabilities (reverse repos/term deposits) matters very little. However, there is a belief among some investors and commentators that increases in the monetary base are more inflationary than increases in other types of Fed liabilities; if so, sterilization may be a low-cost way of reducing the risk of a rise in inflation expectations or a political backlash against "printing money."



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The substantive argument against sterilization is that it would put upward pressure on interest rates at the very short end of the yield curve (because the Fed would borrow additional funds at a 1-4 week maturity). Moreover, there has been relatively little talk about it since a Wall Street Journal article in March that floated the idea, so it is possible that the idea has fallen out of favor.





Q: Are they also likely to extend the forward guidance from the current "late 2014" to "mid-2015"?



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A: This is not quite our baseline but very possible, especially if the committee decides against renewed balance sheet expansion (see below). After all, such a shift would roughly restore the forward guidance to the same three-year horizon as at the January FOMC meeting, when the "late 2014" formulation was first adopted. At a minimum, we think that the funds rate forecasts from individual FOMC participants in the SEP are likely to move toward a later exit date (see Exhibits 2).


Exhibit 2: …and the Timing of the First Rate Hike



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Q: What if they decide against expanding the balance sheet?



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A: The leading alternative to balance sheet expansion is a small extension of Operation Twist, i.e. a sale of the remaining $200 billion or so of Treasury securities with a remaining maturity of 3 years or less, and a corresponding purchase of longer-term Treasuries and/or mortgage-backed securities.


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If the committee decides to confine itself to an extension of Operation Twist, this would further increase the probability of a lengthening of the forward guidance from the current "late 2014" formulation to "mid-2015" in order to reduce the risk of doing too little and also to mitigate any upward pressure on short-term rates that might otherwise result from selling yet more short-term Treasuries.



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Even so, we believe that an extension of Operation Twist could well be insufficient on its own and could thus be followed by additional easing action before long. Recall from the discussion above that the "decay" of unconventional policy could boost 10-year yields by 30 basis points over the next 18 months. Using standard estimates, a further $200bn twist combined with a lengthening of the guidance would offset only about half of this impact. More than this is likely to be needed eventually.


.Q: Could the committee make an extension of Operation Twist more powerful by selling intermediate-maturity Treasuries (e.g. 4-years)?


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A: In principle yes, but we do not find strategy very attractive. The main reason is the risk of putting upward pressure on intermediate yields and thereby sending very mixed signals about monetary policy. If the committee wants to do significantly more than implied by a further $200bn twist alone, balance sheet expansion is likely to be needed.


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Q: Do you expect a cut in the interest rate on excess reserves (IOER)?



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A: No. We believe that the committee views the forward guidance as a better way of mitigating upward pressure on short-term rates than a cut in the IOER because it seems less likely to interfere with money market functioning.

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Q: Do you expect additional Fed easing to be effective?



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A: Only moderately. While we believe that a sufficiently large program focused on the mortgage market would help, it is unlikely to be very powerful. That doesn't mean Fed officials shouldn't do it, since we view the costs of additional easing as low. The risk of inflation is remote, and even when it becomes less remote Fed officials should be easily able to tighten policy sufficiently.



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But it does mean that it makes sense to think about other forms of policy easing. Obvious candidates would be fiscal policy or purchases of non-government guaranteed assets, but these require the cooperation of Congress and are therefore probably not feasible. Instead, a move in the direction of "unconventional unconventional" options holds more promise. These include the Evans proposal of promising not to raise rates until the unemployment rate has fallen to a specific level and a nominal GDP level target. We do not expect these to be adopted in the short term, but they could be more effective than balance sheet action and date-based forward guidance on their own. They may therefore represent the next frontier for Fed policy should the recovery continue to disappoint.



REVIEW & OUTLOOK

June 18, 2012, 7:46 p.m. ET

A Leaderless World

Signs of disorder grow as American influence recedes.

  AFP Photo/HO/Shaam News Network/Getty Images
An image released by the Syrian opposition's Shaam News Network showing a road blocked with burning tires in Damascus on Sunday 

Not so long ago much of the world griped about an America that was too assertive, a "hyperpower" that attempted to lead with too little deference to the desires of those attending the G-20 meeting today in Mexico. Well, congratulations. A world without U.S. leadership is arriving faster than even the French hoped. How do you like it?




In Syria, a populist revolt against a dictator threatens to become a civil war as Russia and Iran back their client in Damascus and the West defaults to a useless United Nations. The conflict threatens to spill into neighboring countries.

 

Iran continues its march toward a nuclear weapon despite more than three years of Western pleading and (until recently) weak sanctions. Israel may conclude it must strike Iran first to defend itself, despite the military risks, because it lacks confidence about America's will to act. If Iran does succeed, a nuclear proliferation breakout throughout the Middle East is likely.




Again President of Russia, Vladimir Putin snubbed President Obama's invitation to the G-8 summit at Camp David and is complicating U.S. diplomacy at every turn. He is sending arms and antiaircraft missiles to Syria, blocking sanctions at the U.N. and reasserting Russian influence in Eastern Europe and Central Asia. Mr. Obama's "reset" in relations has little to show for it.





In Egypt, the military and Muslim Brotherhood vie for power after the Arab spring—with the U.S. largely a bystander. The democrats don't trust an America that helped them too little in the Mubarak days, while the military doesn't trust a U.S. Administration that abandoned Mubarak at the end. Egypt is increasingly unwilling to police its own border with Israel or the flow of arms into Gaza.




The countries of the euro zone stumble from one failed bailout to the next, jeopardizing a still-fragile global economy. The world's most impressive current leader, Germany's Angela Merkel, rejected Mr. Obama's advice to blow out her country's balance sheet with stimulus spending in 2009 and is thankful she did. Her economy is stronger for it.



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The Obama Administration has since played the role mainly of Keynesian kibitzer, privately taking the side of Europe's debtors in urging Germany to write bigger checks and ease monetary policy.



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Treasury Secretary Timothy Geithner elbowed his way into a euro-zone finance ministers meeting last September and then criticized European policies, and lately Messrs. Obama and Geithner have been blaming Europe for America's economic problems. No wonder Frau Merkel doesn't much care what the U.S. thinks.




The countries of South Asia are recalculating their interests as the U.S. heads for the exits in Afghanistan. Pakistan demands the extortion of $5,000 a truck to carry supplies to U.S. forces, while continuing to provide sanctuary for Taliban leaders. Iran extends its own influence in Western Afghanistan, while the Taliban resist U.S. entreaties to negotiate a cease-fire, figuring they can wait out the departure.
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For the Putins of the world and many American liberals, these signs of fading U.S. influence are welcome. They have finally tied down the American Gulliver. The era of "collective security" through the U.N. has arrived, and, whatever the future difficulties, at least there will be no more Iraqs.

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But note well that the substitute for U.S. leadership is not a new era of U.N.-administered peace. It is often a vacuum filled by the world's nastiest actors. That is nowhere clearer than in Syria, where Russia and Iran have a free run to fortify the Assad dictatorship. The price is high in human slaughter, but it may be higher still in showing other dictators that it hardly matters anymore if an American President declares that you "must go." What matters is if you have patrons in Moscow, Beijing or Tehran.




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The other claim, especially popular in Europe and China, is that this American retreat is inevitable because the U.S. is weaker economically. There's no doubt the recession and tepid recovery have sapped U.S. resources and confidence, but economic decline is not inevitable. It is, as Charles Krauthammer put it in 2009, "a choice."



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America can choose to stay on its current path toward a slow-growth entitlement society that spends its patrimony on domestic handouts, or it can resolve to once again be a dynamic, risk-taking society that grows at 3% or more a year.



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What the U.S. can't do is expect to grow at the 2% annual rate of the Obama era and somehow finance both ObamaCare and the current American military. On present trend, America's defense budget will inevitably shrink as Europe's military spending has to 3%, then 2% or less, of GDP.


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There are always limits to U.S. power, and American leadership does not mean intervening willy-nilly or militarily. It does require, however, that an American President believe that U.S. pre-eminence is desirable and a source for good, and that sometimes this means leading forcefully from the front even if others object.



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Without that American leadership, the increasing signs of world disorder will be portents of much worse to come.


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