The New Drivers of Europe's Geopolitics

By George Friedman

January 27, 2015 | 02:00 GMT

For the past two weeks, I have focused on the growing fragmentation of Europe. Two weeks ago, the murders in Paris prompted me to write about the fault line between Europe and the Islamic world.

Last week, I wrote about the nationalism that is rising in individual European countries after the European Central Bank was forced to allow national banks to participate in quantitative easing so European nations wouldn't be forced to bear the debt of other nations. I am focusing on fragmentation partly because it is happening before our eyes, partly because Stratfor has been forecasting this for a long time and partly because my new book on the fragmentation of Europe — Flashpoints: The Emerging Crisis in Europe — is being released today.

This is the week to speak of the political and social fragmentation within European nations and its impact on Europe as a whole. The coalition of the Radical Left party, known as Syriza, has scored a major victory in Greece. Now the party is forming a ruling coalition and overwhelming the traditional mainstream parties. It is drawing along other left-wing and right-wing parties that are united only in their resistance to the EU's insistence that austerity is the solution to the ongoing economic crisis that began in 2008.

Two Versions of the Same Tale

The story is well known. The financial crisis of 2008, which began as a mortgage default issue in the United States, created a sovereign debt crisis in Europe. Some European countries were unable to make payment on bonds, and this threatened the European banking system. There had to be some sort of state intervention, but there was a fundamental disagreement about what problem had to be solved. Broadly speaking, there were two narratives.

The German version, and the one that became the conventional view in Europe, is that the sovereign debt crisis is the result of irresponsible social policies in Greece, the country with the greatest debt problem. These troublesome policies included early retirement for government workers, excessive unemployment benefits and so on. Politicians had bought votes by squandering resources on social programs the country couldn't afford, did not rigorously collect taxes and failed to promote hard work and industriousness. Therefore, the crisis that was threatening the banking system was rooted in the irresponsibility of the debtors.

Another version, hardly heard in the early days but far more credible today, is that the crisis is the result of Germany's irresponsibility. Germany, the fourth-largest economy in the world, exports the equivalent of about 50 percent of its gross domestic product because German consumers cannot support its oversized industrial output. The result is that Germany survives on an export surge. For Germany, the European Union — with its free-trade zone, the euro and regulations in Brussels — is a means for maintaining exports. The loans German banks made to countries such as Greece after 2009 were designed to maintain demand for its exports. The Germans knew the debts could not be repaid, but they wanted to kick the can down the road and avoid dealing with the fact that their export addiction could not be maintained.

If you accept the German narrative, then the policies that must be followed are the ones that would force Greece to clean up its act. That means continuing to impose austerity on the Greeks. If the Greek narrative is correct, than the problem is with Germany. To end the crisis, Germany would have to curb its appetite for exports and shift Europe's rules on trade, the valuation of the euro and regulation from Brussels while living within its means. This would mean reducing its exports to the free-trade zone that has an industry incapable of competing with Germany's.

The German narrative has been overwhelmingly accepted, and the Greek version has hardly been heard. I describe what happened when austerity was imposed in Flashpoints:
But the impact on Greece of government cuts was far greater than expected. Like many European countries, the Greeks ran many economic activities, including medicine and other essential services, through the state, making physicians and other health care professionals government employees. When cuts were made in public sector pay and employment, it deeply affected the professional and middle classes. 
Over the course of several years, unemployment in Greece rose to over 25 percent.  
This was higher than unemployment in the United States during the Depression. Some said that Greece's black economy was making up the difference and things weren't that bad. That was true to some extent but not nearly as much as people thought, since the black economy was simply an extension of the rest of the economy, and business was bad everywhere. In fact the situation was worse than it appeared to be, since there were many government workers who were still employed but had had their wages cut drastically, many by as much as two-thirds. 
The Greek story was repeated in Spain and, to a somewhat lesser extent, in Portugal, southern France and southern Italy. Mediterranean Europe had entered the European Union with the expectation that membership would raise its living standards to the level of northern Europe. The sovereign debt crisis hit them particularly hard because in the free trade zone, this region had found it difficult to develop its economies, as it would have normally. Therefore the first economic crisis devastated them.
Regardless of which version you believe to be true, there is one thing that is certain: Greece was put in an impossible position when it agreed to a debt repayment plan that its economy could not support. These plans plunged it into a depression it still has not recovered from — and the problems have spread to other parts of Europe.

Seeds of Discontent

There was a deep belief in the European Union and beyond that the nations adhering to Europe's rules would, in due course, recover. Europe's mainstream political parties supported the European Union and its policies, and they were elected and re-elected. There was a general feeling that economic dysfunction would pass. But it is 2015 now, the situation has not gotten better and there are growing movements in many countries that are opposed to continuing with austerity. The sense that Europe is shifting was visible in the European Central Bank's decision last week to ease austerity by increasing liquidity in the system. In my view, this is too little too late; although quantitative easing might work for a recession, Southern Europe is in a depression. This is not merely a word. It means that the infrastructure of businesses that are able to utilize the money has been smashed, and therefore, quantitative easing's impact on unemployment will be limited. It takes a generation to recover from a depression. Interestingly, the European Central Bank excluded Greece from the quantitative easing program, saying the country is far too exposed to debt to allow the risk of its central bank lending.

Virtually every European country has developed growing movements that oppose the European Union and its policies. Most of these are on the right of the political spectrum. This means that in addition to their economic grievances, they want to regain control of their borders to limit immigration. Opposition movements have also emerged from the left — Podemos in Spain, for instance, and of course, Syriza in Greece. The left has the same grievances as the right, save for the racial overtones. But what is important is this: Greece has been seen as the outlier, but it is in fact the leading edge of the European crisis. It was the first to face default, the first to impose austerity, the first to experience the brutal weight that resulted and now it is the first to elect a government that pledges to end austerity. Left or right, these parties are threatening Europe's traditional parties, which the middle and lower class see as being complicit with Germany in creating the austerity regime.

Syriza has moderated its position on the European Union, as parties are wont to moderate during an election. But its position is that it will negotiate a new program of Greek debt repayments to its European lenders, one that will relieve the burden on the Greeks. There is reason to believe that it might succeed. The Germans don't care if Greece pulls out of the euro.

Germany is, however, terrified that the political movements that are afoot will end or inhibit Europe's free-trade zone.

Right-wing parties' goal of limiting the cross-border movement of workers already represents an open demand for an end to the free-trade zone for labor. But Germany, the export addict, needs the free-trade zone badly.

This is one of the points that people miss. They are concerned that countries will withdraw from the euro. As Hungary showed when the forint's decline put its citizens in danger of defaulting on mortgages, a nation-state has the power to protect its citizens from debt if it wishes to do so. The Greeks, inside or outside the eurozone, can also exercise this power. In addition to being unable to repay their debt structurally, they cannot afford to repay it politically. The parties that supported austerity in Greece were crushed. The mainstream parties in other European countries saw what happened in Greece and are aware of the rising force of Euroskepticism in their own countries. The ability of these parties to comply with these burdens is dependent on the voters, and their political base is dissolving. Rational politicians are not dismissing Syriza as an outrider.

The issue then is not the euro. Instead, the first real issue is the effect of structured or unstructured defaults on the European banking system and how the European Central Bank, committed to not making Germany liable for the debts of other countries, will handle that. The second, and more important, issue is now the future of the free-trade zone. Having open borders seemed like a good idea during prosperous times, but the fear of Islamist terrorism and the fear of Italians competing with Bulgarians for scarce jobs make those open borders less and less likely to endure. And if nations can erect walls for people, then why not erect walls for goods to protect their own industries and jobs? In the long run, protectionism hurts the economy, but Europe is dealing with many people who don't have a long run, have fallen from the professional classes and now worry about how they will feed their families.

For Germany, which depends on free access to Europe's markets to help prop up its export-dependent economy, the loss of the euro would be the loss of a tool for managing trade within and outside the eurozone. But the rise of protectionism in Europe would be a calamity. The German economy would stagger without those exports.

From my point of view, the argument about austerity is over. The European Central Bank ended the austerity regime half-heartedly last week, and the Syriza victory sent an earthquake through Europe's political system, although the Eurocratic elite will dismiss it as an outlier. If Europe's defaults — structured or unstructured — surge as a result, the question of the euro becomes an interesting but non-critical issue. What will become the issue, and what is already becoming the issue, is free trade. That is the core of the European concept, and that is the next issue on the agenda as the German narrative loses credibility and the Greek narrative replaces it as the conventional wisdom.

It is not hard to imagine the disaster that would ensue if the United States were to export 50 percent of its GDP, and half of it went to Canada and Mexico. A free-trade zone in which the giant pivot is not a net importer can't work. And that is exactly the situation in Europe. Its pivot is Germany, but rather than serving as the engine of growth by being an importer, it became the world's fourth-largest national economy by exporting half its GDP. That can't possibly be sustainable.

Possible Seismic Changes Ahead

There are then three drivers in Europe now. One is the desire to control borders — nominally to control Islamist terrorists but truthfully to limit the movement of all labor, Muslims included. Second, there is the empowerment of the nation-states in Europe by the European Central Bank, which is making its quantitative easing program run through national banks, which may only buy their own nation's debt. Third, there is the political base, which is dissolving under Europe's feet.

The question about Europe now is not whether it can retain its current form, but how radically that form will change. And the most daunting question is whether Europe, unable to maintain its union, will see a return of nationalism and its possible consequences. As I put it in Flashpoints:
The most important question in the world is whether conflict and war have actually been banished or whether this is merely an interlude, a seductive illusion. Europe is the single most prosperous region in the world. Its collective GDP is greater than that of the United States. It touches Asia, the Middle East and Africa. Another series of wars would change not only Europe, but the entire world. 

To even speak of war in Europe would have been preposterous a few years ago, and to many, it is preposterous today. But Ukraine is very much a part of Europe, as was Yugoslavia.

Europeans' confidence that all this is behind them, the sense of European exceptionalism, may well be correct.

But as Europe's institutions disintegrate, it is not too early to ask what comes next. History rarely provides the answer you expect — and certainly not the answer you hope for.

How Global Interest Rates Deceive Markets

By John Mauldin

Jan 26, 2015

“You keep on using that word. I do not think it means what you think it means.”

– Inigo Montoya, The Princess Bride

“In the economic sphere an act, a habit, an institution, a law produces not only one effect, but a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge only subsequently; they are not seen; we are fortunate if we foresee them.

“There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.

“Yet this difference is tremendous; for it almost always happens that when the immediate consequence is favorable, the later consequences are disastrous, and vice versa. Whence it follows that the bad economist pursues a small present good that will be followed by a great evil to come, while the good economist pursues a great good to come, at the risk of a small present evil.”

– From an 1850 essay by Frédéric Bastiat, “That Which Is Seen and That Which Is Unseen”

All right class, it’s time for an open book test. I’m going to give you a list of yields on various 10-year bonds, and I want to you to tell me what it means.

United States: 1.80%

Germany: 0.36%

France: 0.54%

Italy: 1.56%

UK: 1.48%

Canada: 1.365%

Australia: 2.63%

Japan: 0.22%

I see that hand up in the back. Yes, the list does appear to tell us what interest rates the market is willing to take in order to hold money in a particular country’s currency for 10 years. It may or may not tell us about the creditworthiness of the country, but it does tell us something about the expectations that investors have about potential returns on other possible investments. The more astute among you will notice that French bonds have dropped from 2.38% exactly one year ago to today’s rather astonishing low of 0.54%.

Likewise, Germany has seen its 10-year Bund rates drop from 1.66% to a shockingly low 0.36%. What does it mean that European interest rates simply fell out of bed this week? Has the opportunity set in Europe diminished? Are the French really that much better a credit risk than the United States is? If not, what is that number, 0.54%, telling us? What in the wide, wide world of fixed-income investing is going on?

Quick segue – but hopefully a little fun. One of the pleasures of having children is that you get to watch the classic movie The Princess Bride over and over. (If you haven’t appreciated it, go borrow a few kids for the weekend and watch it.) There is a classic line in the movie that is indelibly imprinted on my mind.

In the middle of the film, a villainous but supposedly genius Sicilian named Vizzini keeps using the word “inconceivable” to describe certain events. A mysterious ship is following the group at sea? “Inconceivable!” The ship’s captain starts climbing the bad guys’ rope up the Cliffs of Insanity and even starts to gain on them? “Inconceivable!” The villain doesn’t fall from said cliff after Vizzini cuts the rope that all of them were climbing? “Inconceivable!” Finally, master swordsman – and my favorite character in the movie – Inigo, famous for this and other awesome catchphrases, comments on Vizzini’s use of this word inconceivable:

“You keep on using that word. I do not think it means what you think it means.”

(You can see all the uses of Vizzini’s use of the word inconceivable and hear Inigo’s classic retort here.)

When it comes to interpreting what current interest rates are telling us about the markets in various countries, I have to say that I do not think they mean what the market seems to think they mean. In fact, buried in that list of bond yields is “false information” – information so distorted and yet so readily misunderstood that it leads to wrong conclusions and decisions – and to bad investments. In today’s letter we are going to look at what interest rates actually mean in the modern-day context of currency wars and interest-rate manipulation by central banks. I think you will come to agree with me that an interest rate may not mean what the market thinks it means.

Let me begin by briefly summarizing what I want to demonstrate in this letter. First, I think Japanese interest rates not only contain no information but also that markets are misreading this non-information as meaningful because they are interpreting the data as if it were normal market information in a familiar market environment, when the truth is that we sailed beyond the boundaries of the known economic world some time ago. The old maps are no longer reliable. Secondly, Europe is making the decision to go down the same path as the Japanese have done; and contrary to the expectations of European central bankers, the potential to end up with the same results as Japan is rather high.

The false information paradox is highlighted by the recent Swiss National Bank decision. Couple that with the surprise decisions by Canada and Denmark to cut rates, the complete retracement of the euro against the yen over the past few weeks, and Bank of Japan Governor Kuroda’s telling the World Economic Forum in Davos that he is prepared to do more (shades of “whatever it takes”) to create inflation, and you have the opening salvos of the next skirmish in the ongoing currency wars I predicted a few years ago in Code Red. All of this means that capital is going to be misallocated and that the current efforts to create jobs and growth and inflation are insufficient. Indeed, I think those efforts might very well produce a net negative effect.

Now let’s consider what today’s interest rates do and do not mean as we navigate uncharted waters.

Are We All Turning Japanese?

Japan is an interesting case study. It’s a highly developed nation with a very sophisticated culture, increasingly productive in dollar terms (although in yen terms nominal GDP has not moved all that much), and carrying an unbelievable 250% debt-to-GDP burden, but with a 10-year bond rate of 0.22%, which in theory could eventually mean that the total interest expenses of Japan would be less than those of the US on 5-6 times the amount of debt. Japan has an aging population and a savings rate that has plunged in recent years. The country has been saddled with either low inflation or deflation for most of the past 25 years. At the same time, it is an export power, with some of the world’s most competitive companies in automobiles, electronics, robotics, automation, machine tools, etc. The Japanese have a large national balance sheet from decades of running trade surpluses. If nothing else, they have given the world sushi, for which I will always hold them in high regard.

We talk about Japan’s “lost decades” during which growth has been muted at best. They are just coming out of a triple-dip recession after a disastrous downturn during the Great Recession. And through it all, for decades, there is been a widening government deficit. The chart below shows the yawning gap between Japanese government expenditures and revenues.

This next chart, from a Societe Generale report, seems to show that the Japanese are financing 40% of their budget. I say “seems” because there is a quirk in the way the Japanese do their fiscal accounting. Pay attention, class. This is important to understand. If you do not grasp this, you will not understand Japanese budgets and how they deal with their debt.

Under a Japanese law called the “60-year redemption rule,” the government is required to retire its bonds in cash over a period of 60 years, irrespective of bond duration. In the case of 10-year bonds, this would mean that one-sixth of all 10-year bonds would have to be redeemed every 10 years for cash.

In the US and Europe (and to my knowledge everywhere else in the world), we simply roll those bonds over, and they are not part of the budget. When we adjust the Japanese budget for this redemption expenditure, we find that the primary expense (the proportion of the budget that is not interest expense and deficit financing) is “only” 87.8% for the 2015 budget. Given that the current budget estimates a 1.8% 10-year bond yield and that the government is rolling over those bonds at 0.22%, interest-rate expenses are likely to fall over the coming years. That is especially true when a significant portion of those rollover bonds will show up on the balance sheet of the Bank of Japan, which will remit the interest charges back to the government. Nice work if you can get it.

This table is important. The Bank of Japan is now totally financing the government deficit, but this has not always been the case. Until the last few years, Japanese government debt was almost totally underwritten by Japanese savers. For many decades after World War II, the Japanese saved a high percentage of their earnings. And they tended to put their savings into various funds and pension plans that utilized high percentages of Japanese government bonds in their portfolios.

However, one of the things we know about savings rates is that they fall as a country’s population gets older because retirees must draw on their savings. The problem is compounded when the ratio of workers to retirees begins to fall, which it is doing rather precipitously in Japan. A few years ago I began writing about Japan and the consequences of a negative savings rate. This was a new phenomenon at the time. I pointed out that either the Bank of Japan would have to undertake large amounts of quantitative easing, or the government would have to run surpluses, or interest rates would have to rise. But if interest rates were to rise, that would make the deficit worse and could precipitate a deflationary spiral. On the other hand, monetizing the debt would cause the currency to devalue. And then, suddenly running a government surplus could trigger a recession.

Japan had to choose among disastrous scenarios. They chose to monetize and thus allow their currency to fall – that was the easiest and best of the disastrous choices.

The time for good choices came and went long ago, when they could have decided not to run such huge deficits.

Japan has had a “triple-dip” recession, partially self-inflicted. The government raised taxes (a lot) last spring, which immediately plunged the Japanese economy back into recession.

The recent QE binge did indeed help to raise inflation in Japan, although inflation is now falling again. The Bank of Japan is projecting close to 2% growth and 1% inflation for 2015 and hopes to see inflation rise to 2% by 2016. For Abenomics to work as planned, the Japanese need 4% nominal GDP growth. Four percent nominal growth can be produced by 2% real productivity growth plus 2% inflation. That growth, combined with the central bank’s retiring large amounts of government debt, would help reduce the debt-to-GDP burden – if it happens.

The False Information Conundrum

Now we come to the problem of what information Japanese interest rates really offer.

First, remember that on days when the Bank of Japan withdraws from trading 10-year Japanese bonds, there simply is no trading. For all intents and purposes, the Bank of Japan is the bond market at the longer end.

Given that reality, what information can the market derive from the interest rate on the ten-year Japanese bond? As it happens, not much at all. If the Bank of Japan is both the price maker and the price taker – if there is no real two-way market – then the only thing we know from the yield on the Japanese bond is that it is what the central bank wants it to be. The yield doesn’t tell us anything about underlying economic conditions in Japan, which, given their history, are not all that bad, relatively speaking (as we will see in a moment).

As noted above, the government is required to retire all of its 10-year bonds every 60 years. That stipulation has some very interesting consequences. If long-term bond rates stay at the level they are today, the Bank of Japan can replace a significant amount of the long-term bonds in the Japanese portfolio at interest rates between the current 0% for the 5-year bond and 0.22% for 10-year bond – that is if rates don’t go even lower because the Bank of Japan pushes them lower. Think about that for a moment. Today Japan is paying about 1/8 the interest-rate cost that the United States is paying for a new 10-year bond. That means Japan can have eight times the amount of debt at the same interest-rate cost. The irony is that, under the current replacement regime, the interest-rate cost for the government is likely to go down even as the quantity of bonds goes up – unless interest rates go up. Now then, precisely what information does this set of dynamics signal to the markets? More on this question in a few paragraphs.

Japanese pension funds, insurance companies, and other investors are all moving into Japanese and foreign equities. They are doing so because low interest rates and massive quantitative easing mean that the yen is likely to fall. The only rational response is to move into equities and, even better, into equities denominated in a foreign currency. So, when these investors sell their long-term bonds back to the Bank of Japan, they are doing so at a considerable profit. (Remember, lower yields raise the actual physical sales value of bonds.) The Bank of Japan has essentially engineered profits for not only its government-sponsored pension funds but for all pension funds and insurance companies that sell those bonds. Another way to look at the arrangement is that you have to be paid to give up your higher-yielding asset when anything you roll over on the shorter end is going to pay you almost nothing.

Sidebar: There is a somewhat public rift between the new chief investment officer of the largest Japanese government pension fund and the Bank of Japan. The CIO apparently wants to go faster in switching over to non-Japanese bond assets. Since he is a leading figure in the pension world, his actions have consequences. What happens if he and a number of his cohorts all decide to “hit the bid” at a much faster rate than the Bank of Japan is supplying buying power? In a normal world that would mean either that the Bank of Japan must increase its quantitative easing or that interest rates would rise, as other buyers must be brought into the market. This little side tempest has the potential to become rather important. We will be paying attention.

Now, back to our story. In a rather perverse way, the Bank of Japan has to lower rates in order to encourage 10-year bonds to come out of the market. Otherwise, a pension fund just sells its lower-yield debt that is rolling over. (I can find no data on what bond duration is moving out of pension funds. If someone knows where to find this, please shoot me a note. I am quite curious. Maybe all this means nothing. Or maybe it is very important.)

Prime Minister Abe has told us that he intends to balance the budget in about five years, that is, by 2020. If the Bank of Japan moves a significant chunk of total debt onto its own books and the rest of that outstanding debt is at de minimus interest rates – assuming the government actually manages to run a surplus – it can retire debt and hold interest rates down a great deal longer.

The fly in the ointment, at least from the consumer’s perspective, is that the value of the yen will continue to fall, which means that the food Japan imports (some 60% of its supply) will continue to rise in cost. On the other hand, oil at $50 and below is a huge boost to the Japanese economy. The bear market in iron ore, copper, and other industrial metals is also softening the impact of a falling yen.

The Halloween Surprise last October, when the Japanese launched their latest massive round of QE, forced the yen significantly lower against the euro. The number-one competitor of Japan and most of her industrial products (think machine tools, etc.) is Germany. The latest campaign by Draghi, et al., at the ECB has completely erased any gains made by the euro; and in fact the yen was lower than the euro over the last 12 months. But for those keeping score, the euro has now fallen 10% against the yen in less than two months. Which is why Kuroda hinted at further QE in Davos. Yes, I know he was referring to his inflation target, but it would be naïve to think that he is not also paying attention to exchange rates, given the chart below (euro-yen in red).

I know that many people seem to feel I am negative on Japan. That is far from the truth. There is a lot of opportunity in Japan, and the current government is having some successes in spite of the country’s massive debt problems and demographic headwinds. So in the interest of being “fair and balanced,” let’s look at the following note from Peter Tasker, who offers some fascinating, if sometimes irreverent, commentary on Japanese economics and culture. He is thoughtful and well-written, which you might expect from a man who has written more fiction works based on Japanese culture than he has economic books, although he is essentially a man of the investment world.

He has a different take on the success of Abenomics. The facts on the ground suggest that Japan is in many ways improving, despite horrible demographics and lack of reform. (The Japanese are making remarkable strides in creating a hydrogen-based economy, which is something few people outside of Japan, and perhaps even many in Japan, understand the implications of. The “fire ice” deposits near Japan could be as big a game changer as shale gas is for the United States. And mining them is closer to reality than you think.)

Tasker uses a Monty Python skit to give us some insight on Abe’s success:

Much of the media commentary, both domestic and overseas, has been relentlessly critical, almost as if people have a deep emotional need for Abenomics to fall apart and the Japanese economy to slide back into the doldrums.

In an attempt to provide some balance, we enlist the help of the Monty Python team. “What have the Romans ever done for us?” is a comedy routine from the classic Life of Brian film. In it a resistance leader, played by John Cleese, gives a barnstorming anti-Roman speech, only to be reminded of the various blessings the occupiers have brought – aqueducts, sanitation, wine, public order, etc. [You can see the hilarious skit here.]

A contemporary Japanese version might go something like this:

John Cleese – What has Abenomics ever given us? Absolutely nothing!

Voice from back – How about full employment?

Cleese – What?

Voice – Full employment. With the job-offer-to-applicants ratio at a twenty-two-year high, everyone who wants a job can get one. Isn’t that pretty remarkable in today’s world? 

Cleese – Alright, alright. I’ll grant you full employment, but apart from that what has Abenomics done for us? Nothing!

Second voice – Stock prices have doubled in two years. That must be good, no? It was the collapse in asset prices that set off the balance sheet recession that’s been going on for ages.

Cleese – Well, obviously stock prices. That goes without saying, doesn’t it? So apart from doubling stock prices and achieving full employment, what has Abenomics done for us? Absolutely nothing!

Third voice – And real estate prices. They’re rising all over the country now, even in regional cities. Homeowners are going to feel better about that.

Cleese – Okay then. Apart from achieving full employment, doubling stock prices and getting real estate prices moving…

Fourth voice – And corporate profits are through the roof too.

Fifth voice – Female labour force participation is at an all-time high.

Sixth voice – Didn’t you say the bond market was going to collapse and interest rates would soar? Well, rates have gone down, not up!

Seventh voice – Tourists are flooding into the country

Eighth voice – And exports seem to be taking off at last.

Ninth voice – From next April wages will be rising faster than consumer prices.

Tenth voice – And companies are revising up capital investment plans.

Eleventh voice – The corporate governance reforms are having a visible effect. 60% of companies in the MSCI Index now have two or more outside directors and share buyback announcements are up 60% year-on-year.

Cleese – Alright, alright. Apart from full employment, higher asset prices, lower interest rates, record-high profit margins, better corporate governance, a tourism boom, more working women, exports and capex, what has Abenomics ever given us?

Twelfth voice – Nominal GDP growth?

Cleese – Growth! Oh, SHUT UP! 

(With apologies, love and respect to Monty Python.)

That positive news aside, my biggest personal investment success over the past two years has been shorting the yen. And I fully intend to maintain that posture. Positive economic news will not soon remove the necessity of the Bank of Japan monetizing debt.

The Common Denominator between the Swiss and
Japanese Central Banks

As everyone is aware, the Swiss took off their peg to the euro last week, and the Swiss franc promptly climbed 15%. If you look at the data for the past three years on the euro-Swiss franc currency cross, there is no information about the value of the Swiss franc relative to the euro contained in that data. If a central bank decides to control exchange rates or interest rates, then the information that the market should be taking from those rates is nullified.

Once the Swiss National Bank removed the peg, the market immediately gleaned the information that this was a franc worth 15% more. (I bet the Swiss National Bank was surprised at the violence of the move.) If the Japanese were to remove their support and involvement in the long-term Japanese bond market, interest rates would react far more violently than they did in the case of the Swiss franc-euro currency cross. Who in their right mind would want to buy a Japanese 10-year bond at 0.22%? Or even 1% (or 2% or 3% or 5%) if they were not convinced that the central bank would eventually bail them out?

In my opinion, the European Central Bank is getting ready to further remove true information from the European bond market. Interest rates normally reflect the market telling bond sellers about the value of their debt. If the ECB drives down longer-term rates, sundering them from normal market actions, it sends false information to the various governments about the value of their bonds; and it allows politicians to avoid making the real reforms that are necessary to get Europe growing again. Now, in fairness, the ECB is trying to give Eurozone governments time to make those reforms, but the track record so far suggests that politicians will not press forward with reforms if they are not faced with the necessity of doing so – and it typically takes a crisis to provoke them to action.

Draghi addressed the issue of whether the ECB would be removing real information from the European bond market with its latest QE announcement. He was asked the question directly:

Question: You said that you’ll keep buying bonds until inflation is back on track. So basically, you have an open-ended programme. Do you see anything in terms of the percentage of outstanding debt that you can buy before you start overly influencing price formation on the secondary market, as the European Court of Justice suggested that you should avoid?

Draghi: The answer to the first question, yes, we will buy government debt up to the percentage that will allow a proper market price formation. Therefore, we have two limits. The first one is an issuer limit, which is 33%, and another one is an issue limit, which is 25%. In other words, we won’t buy more than 25% of each issue, and not more than 33% of each issuer’s debt. The 25% limit, by the way, is the one foreseen in order not to be a blocking minority in the collective action clause assemblies, basically, bond holders’ assemblies, and it’s the basis for us to be able to say, there is going to be pari passu.

I’m sure the ECB can produce a stack of academic studies that confirm that limiting their buying to 33% of the total outstanding government debt of a particular country will allow proper market price formation. I think this is one of those moments when, although in theory there is no difference between theory and practice, in practice there will be. If market participants expect that they can buy a high-yielding sovereign bond and that the ECB will eventually take them out, given that European banks have no essential limits on how much sovereign debt they can put on their balance sheets, the ECB is taking the risk out of holding Portuguese and Italian debt, both of which pay higher rates. Doing this is going to bring down the yield of lower-grade European sovereign debt far more than it will that of higher-grade bonds. Greece is its own special case, because it clearly needs some type of debt forgiveness or additional restructuring.

George Magnus (based in London) offers us this commentary on Europe and the ECB:

Given the dire state of the Eurozone economy, QE is unlikely to push inflation markedly higher, especially in the periphery countries such as Greece, Spain, Italy and Portugal. Under these circumstances, it is inconceivable that others, such as Germany, would be willing to experience significantly higher inflation to compensate. In fact, there probably is no successful QE policy that, in addition to longer-term labor and product market reforms for debtor and creditor nations, does not also rely on comprehensive debt restructuring and relief, properly recapitalized banks, and greater fiscal activism by countries and institutions that are able to implement it. If Europe is to experience a sustainable rise in demand, investment, jobs and productivity, these policies must accompany QE – but no one expects the prevailing policy stance to change so much.

 This is not to criticize QE as such, but to lament the absence of complementary policy measures, and point to the risk of a political backlash among creditors and among voters generally against the single-minded emphasis on the ECB.

Time to Watch Greece Again (Sigh)

This weekend we are greeted with elections in Greece. It now appears that Syriza will be able to control the new parliament. They want to see a restructuring of Greek debt, which frankly is the only way possible for Greece to get out of its current long-lasting depression. A 175% debt-to-GDP ratio at rates far higher than Japan’s (see below), without a central bank willing to purchase all that debt, simply does not qualify as a working business model. In the background is the collapsing Greek economy, which has shrunk by 25% in the past five years, while youth unemployment hovers at a staggering 50%. Prescription drug prices have gone up 30%; unemployment benefits end at 12 months; and the long-term unemployed lose access to state health care. The yield on the 10-year bond has dropped since the ECB’s QE action, but it is still hovering above 8%. That is a far cry from the 0.22% Japan enjoys. Already, Greek taxpayers are delaying payments in anticipation of Syriza’s promised abolition of property taxes.

The populist proposals made by Syriza will not fix any of the underlying structural problems and will likely make them even worse. There is simply not the money to do what they want. Undoing economic and labor reforms will put any future growth, which is the most important need, even further out of reach.

As an aside, if I were the young Mr. Tsipras, who will be the new leader of Greece, I would argue for a deal similar to what Ireland got for the bank debt they assumed. Ireland essentially turned their short-term debt into 40-year bonds with very small payments for the next few decades, and it’s debt that can be rolled over when the time comes. There are very few politicians who are going to be worried about what will happen in 40 years. Such a program would buy time, keep Greece in the euro, and allow them to more or less stay in compliance so that the ECB could purchase 33% of their outstanding debt.

If no agreement is reached (and the deadline is approaching), Greece will face a cash crunch within months. The spectacle of a high-income economy running out of money has not been seen since the 1930s. The only way to cover the shortfall would be for Greece to quit the Eurozone and start printing its own currency again.

I actually think (based on reports today) that the Greek problem will be solved in the context of a crisis. It would be interesting if the Eurozone could allow Greece to leave without its having to leave the European Union. Such a formula certainly sparked both reforms and growth in Asia (hat tip Peter Tasker). Which brings us to the far more important point that the recent ECB action is likely to defer the day of reckoning that Europe needs to face, as well as the impetus for reform, further into the future. This is just another example of Eurozone management significantly lengthening the road down which the can will be kicked.

The ECB’s QE also means that corporations all over the world are going to be able to borrow money at lower rates. This is going to mean more share buybacks and financial engineering, mergers and acquisitions, and private equity and less true new-business activity.

It is time to hit the send button. They are calling my flight back to Dallas, where I will visit my mom and then head on to the gym before dinner with the guys. Have a great week.

Your thinking about monster smoked beef ribs analyst,
John Mauldin
John Mauldin

Germany's top institutes push 'Grexit' plans as showdown escalates

Germany’s Wolfgang Schäuble is 'relaxed' about Greek exit from the euro

By Ambrose Evans-Pritchard

8:31PM GMT 27 Jan 2015

The ancient Greek Parthenon temple, atop the Acropolis hill overlooking Athens, is framed by a lightning bolt during a thunderstorm that broke out in the Greek capital

The likelihood of “'Grexit' has risen to 35pc, according to Holger Schmieding at Berenberg Bank Photo: AFP
A top German body has called for a clear mechanism to force Greece out of the euro if the left-wing Syriza government repudiates the terms of the country’s €245bn rescue. 
“Financial support must be cut off if Greece does not comply with its reform commitments,” said the Institute of German Economic Research (IW). "If Greece is going to take a tough line, then Europe will take a tough line as well."
IW is the second German institute in two days to issue a blunt warning to the new Greek premier, Alexis Tsipras, who has vowed to halt debt payments and reverse austerity measures imposed by the EU-IMF Troika.
The ZEW research group said on Tuesday that the EU authorities should order an immediate stress test of banks linked to Greece, and drive home the threat that they are willing to let a Greek default run its course rather than cave to pressure. “Europe should clearly signal that it is not susceptible to blackmail,” it said.
Germany’s finance minister, Wolfgang Schäuble, said in Brussels that debt forgiveness for Greece is out of the question. “Anybody discussing a haircut just shows they don’t know what they are talking about.”

Mr Schäuble said he was sick of having to justify his rescue strategy. “We have given exceptional help to Greece. I must say emphatically that German taxpayers have handed over a great deal,” he said.
In a clear warning, he said the eurozone is now strong enough to withstand a major shock. “In contrast to 2010, the financial markets have faith in the eurozone. We face no risk of contagion, so nobody should think we can be put under pressure easily. We are relaxed,” he said.
Officials in Berlin are irritated that Mr Tsipras has gone into coalition with the Independent Greeks, a viscerally anti-German party that seems to be spoiling for a cathartic showdown over Greece’s debt. “This increases the risk of a head-on collision with the international creditors,” said Holger Schmieding, from Berenberg Bank.
Mr Schmieding said the likelihood of “Grexit” has risen to 35pc. He warned that Mr Tsipras could be in for a reality shock after making “three impossible promises to his country in one campaign”. The risk is that he will end up “ruining his country” like Argentina’s Peronist leader Cristina Kirchner. “Vicious circles can start fast,” he said.
Sources close to Mr Tsipras say he is convinced that German leaders are bluffing and will ultimately yield rather than admit to their own people that the whole EMU crisis strategy has been a failure. Markets do not agree. Credit default swaps measuring bankruptcy risk in Greece rocketed on Tuesday by 248 points to 1,654, but those for Portugal, Italy and Spain barely moved.
Jürgen Matthes, IW’s international director, said Europe must be ready to punish violators in order to uphold the eurozone’s austerity strategy and avert a collapse of discipline. “We have set up a crisis prevention strategy that relies on conditionality. If this is not enforced in the Greek case, everybody will say they want the same thing,” he said.
“Syriza succeeded in selling an illusion that Greece can end the reforms and stop paying the debt, and still stay in the euro. This is impossible. If they do that the European Central Bank cannot accept collateral guaranteed by the Greek government,” he said.
“This will force the Greeks to return to the drachma and that will cause massive disruption. There will a government default, corporate defaults and bank defaults. The financial system will simply break down,” he said.
Mr Matthes said a deal may be possible that extends the maturity yet further on Greek debt but argued that the effective interest rate being paid is already 2pc, far lower than the headline average of 4.2pc.
The new Greek finance minister, Yanis Varoufakis, told The Telegraph that Syriza wants the target for the country’s primary budget to be cut from 4.5pc to 1pc of GDP, freeing enough for the new government to fund its social programme of free electricity and school lunches for the poor, and tax relief for low-earners.
The IW said a range of 3pc to 4pc is the best that Athens can hope for, and only if it also delivers on an overhaul of the tax system and a raft of reforms.
Mr Matthes warned that Syriza cannot hope for softer terms from Italy, Spain and France, since the taxpayers of these countries have lent almost as much to Greece per capita as have the Germans.

“There is not going to be flexibility in the Eurogroup, nor any coalition of southern states. There is real money at stake,” he said.

Germans in shock as new Greek leader starts with a bang

By Noah Barkin and Andreas Rinke

BERLIN Wed Jan 28, 2015 1:29pm EST

Newly appointed Greek Prime Minister and winner of the Greek parliamentary elections, Alexis Tsipras (2nd L), walks with members of his cabinet in Athens, January 27, 2015.  REUTERS/Marko Djurica

Newly appointed Greek Prime Minister and winner of the Greek parliamentary elections, Alexis Tsipras (2nd L), walks with members of his cabinet in Athens, January 27, 2015.
Credit: Reuters/Marko Djurica
(Reuters) - In his first act as prime minister on Monday, Alexis Tsipras visited the war memorial in Kaisariani where 200 Greek resistance fighters were slaughtered by the Nazis in 1944.
The move did not go unnoticed in Berlin. Nor did Tsipras's decision hours later to receive the Russian ambassador before meeting any other foreign official.

Then came the announcement that radical academic Yanis Varoufakis, who once likened German austerity policies to "fiscal waterboarding", would be taking over as Greek finance minister. A short while later, Tsipras delivered another blow, criticising an EU statement that warned Moscow of new sanctions.

The assumption in German Chancellor Angela Merkel's entourage before Sunday's Greek election was that Tsipras, the charismatic leader of the far-left Syriza party, would eke out a narrow victory, struggle to form a coalition, and if he managed to do so, shift quickly from confrontation to compromise mode.

Instead, after cruising to victory and clinching a fast-track coalition deal with the right-wing Independent Greeks party, he has signalled in his first days in office that he has no intention of backing down, unsettling officials in Berlin, some of whom admit to shock at the 40-year-old's fiery start.

"No doubt about it, we were surprised by the size of the Syriza victory and the speed with which Tsipras clinched a coalition," said one senior German official, who requested anonymity because of the sensitivity of the issue.

Another said Tsipras's choice of coalition partner and finance minister were "not good signs", while a third admitted to being "stunned" by the Greek leader's first days in office.

Officials close to Merkel say they still believe Tsipras will ultimately change course, dropping his more radical election pledges and signing up to the economic reforms that Berlin and its European partners have insisted on as a condition for handing over more aid that Athens desperately needs by next month to service its debt.

But the past days have sown doubts about this hypothesis.


Even as Greek stocks plunged and bond yields soared on Wednesday, Tsipras continued to promise "radical" change.

Over the past 24 hours, his government has put two big privatisations, of Piraeus port and Greece's biggest utility, on ice, and his ministers have pledged to raise pensions and rehire fired public sector workers.

In response, German economy minister and deputy chancellor Sigmar Gabriel criticised Athens on Wednesday in unusually stark terms for halting the privatisations without consulting, and he issued a warning to Tsipras that the euro zone could survive without Greece.

"We no longer have to worry like we did back then," Gabriel said, when asked about contagion if Greece were to exit the single currency bloc.

Marcel Fratzscher, head of the DIW economic institute in Berlin and a former official at the European Central Bank, said Tsipras was playing a "very dangerous game" by coming out with all guns blazing.

"If people start to believe that he is really serious, you could have massive capital flight and a bank run," Fratzscher said. "You are quickly at a point where a euro exit becomes more possible."
Officials point to a Brussels summit of European Union leaders on Feb. 12-13 as a first key test of Tsipras.


The other major area of concern for Germany is a new Greek government's stance on Russia.

Tsipras's meeting on Monday with the Russian ambassador, who handed over a personal letter of congratulations from Vladimir Putin, and the new Greek leader's howls of protest at the EU statement on Ukraine, have raised questions about whether the bloc's fragile consensus towards Moscow can hold.

Even before Tsipras took power, officials in Berlin were worried about keeping countries like Italy on board for Russia sanctions, which must be renewed in mid-2015.

Now the fear is that Tsipras, Italian Prime Minister Matteo Renzi and sceptical eastern European countries like Slovakia and Hungary, could band together against an extension, and a ratcheting up of sanctions in response to a new advance by pro-Russian rebels on the strategic Ukrainian port of Mariupol.

Prying Tsipras away from his European partners on the Ukraine issue would be a coup for Putin. Some officials fear the Russian president could go so far as to offer Greece the financial support it needs to meet its debt obligations as a carrot.

One senior German official described Tsipras as part of a brash new generation of European leaders, including Italy's Renzi, who weren't afraid to stand up to Merkel and challenge the assumptions that have shaped policy in the euro zone and Ukraine crises in recent years.

"He doesn't come from the establishment, he's unvarnished, confident and capable of rallying the public behind his course," the official said. "It clearly not going to be easy with him."
No one can say the signs weren't there in the run-up to the election.

Only days before the vote, Tsipras told thousands of people at a campaign rally in Athens: "On Monday, our national humiliation will be over. We will finish with orders from abroad."

In the background loudspeakers blared lyrics from the Leonard Cohen song "First we take Manhattan, then we take Berlin".

‘Empire of Chaos’ in the House

Pepe Escobar

January 27, 2015 15:45                       

U.S. President Barack Obama meets with Saudi Arabia's King Salman (R) at Erga Palace in Riyadh, January 27, 2015 (Reuters / Jim Bourg)

U.S. President Barack Obama meets with Saudi Arabia's King Salman (R) at Erga Palace in Riyadh, January 27, 2015 (Reuters / Jim Bourg)

No one in Western corporate media will tell you why US President Barack Obama is hitting Riyadh with a high-powered delegation to “pay his respects” to the new House of Saud potentate, King Salman.

Talk about a who’s who – including CIA head John Brennan; General Lloyd Austin, head of US Centcom; Secretary of State John Kerry; leading House Democrat Nancy Pelosi; and even senile Senator John “Bomb Iran” McCain.

It must have been heart wrenching for most in this crowd to skip a visit to the Taj Mahal in India so they would be part of the last-minute, “unscheduled” stop in Riyadh.

This is how the astonishing mediocrity that doubles as US Deputy National Security Adviser Ben Rhodes, spun it; “Principally, I think this is to mark this transition in leadership and to pay respects to the family and to the people of Saudi Arabia, but I’m sure that while we’re there they’ll touch on some of the leading issues where we cooperate very closely with Saudi Arabia.”

The White House and the Pentagon did not bother to “pay their respects” in person to the people of France after the Charlie Hebdo massacre. The House of Saud – “our” top bastards in the Persian Gulf – is of course much more valuable.

And yet, Air Force One, we got a problem. High-level US financial sources assure this correspondent the trip is all about Obama shoring up the new King’s support for their financial/economic war on Russia as the House of Saud is starting to have second thoughts. The Saudi role in this war has been to come up with the oil price shock – which is hurting not only Russia but also Iran and Venezuela, among others. Besides, the US puppet theoretically in charge in Ukraine, Petro Poroshenko, has just visited Saudi Arabia.

Russia is not Iran – with all due respect to Iran. If the House of Saud really believes they are talking to the head of a superpower rather than a ventriloquist’s puppet – which is Obama’s role – they are effectively doomed. Nothing Obama says means a thing. The real ‘Masters of the Universe’ who run the ‘Empire of Chaos’ want the House of Saud to do most of their dirty work against Russia; and in a later stage they will take care of the “towel heads” - as the saying goes in Washington - over their development of nuclear missiles with Pakistan. And especially because the Saudi-launched oil price war is bound to destroy the US oil industry - against US national interests.

The House of Saud has absolutely nothing to gain from this undeclared financial/economic war on Russia. The Saudis have already “lost” Yemen and Iraq. Bahrain is held by mercenary troops containing the alienation of the Shia majority. They are freaking out with the possibility of ultimate “enemy” Iran reaching a nuclear deal with His Master’s Voice. They are desperate that “Assad won’t go”. They want every Muslim Brotherhood in sight – or the vicinity – jailed or beheaded. They fear any Arab Spring-style stirrings as worse than the plague. And then there’s the fake Caliphate of ISIS/ISIL/Daesh threatening to go all the way to Mecca and Medina. The House of Saud is effectively surrounded.

U.S. President Barack Obama receives members of the Saudi Royal family, government officials and guests as first lady Michelle Obama and Saudi Arabia's King Salman (R) look on at Erga Palace in Riyadh, January 27, 2015 (Reuters / Jim Bourg)
U.S. President Barack Obama receives members of the Saudi Royal family, government officials and guests as first lady Michelle Obama and Saudi Arabia's King Salman (R) look on at Erga Palace in Riyadh, January 27, 2015 (Reuters / Jim Bourg)
The suicide roadmap
Meanwhile, as the tempest approaches, all is smiles – amid a silent family bloodbath. The powerful Sudairi clan has exacted their “revenge” as King Abdullah’s corpse was still warm.

King Salman, almost 80, and with Alzheimer’s about to turn him into mush, took no time to appoint his nephew Mohammed bin Naif as deputy crown prince. And just in case nepotism was not evident enough, he also appointed his son Prince Mohammed bin Salman as defense minister. Mohammed bin Naif is a Pentagon/CIA darling; the House of Saud’s head of counterterrorism.

So yes, this is a desert version of Giuseppe di Lampedusa’s classic The Leopard; Se vogliamo che tutto rimanga com'è bisogna che tutto cambi (“things must change, in order that they can stay the same”.) But the juicier bit is that this seems to apply much more to the House of Saud nowadays than to the ‘Empire of Chaos’.

Apparently, the game of thrones at “our” bastard’s abode leads to everything staying the same; they remain “our” privileged bastard. The Pentagon even came up with the lovely idea of having the Chairman of the Joint Chiefs of Staff sponsor an essay competition to honor late King Abdullah.

So shell out your essays lavishing the King for the no holds barred repression of the Shia minority in oil-rich eastern Saudi Arabia. Praise him for the sentencing of Sheikh Nimr Baqir al-Nimr - a popular Shia cleric and outspoken political dissident; he should be beheaded, Daesh-style, just because he led a non-violent movement committed to promoting Shia rights, women’s rights, and democratic reform in Saudi Arabia (even Human Rights Watch has admitted that Saudi Arabian Shias “face systematic discrimination in religion, education, justice, and employment.”)

Honor the late King for the thousands of political prisoners; “terrorism” charges against women who dare to drive; the 25 percent of the population living under the poverty line; and last but not least, for facilitating the expansion of al-Qaeda in Iraq, who turned into ISIS. The Pentagon will love you for that.

All that desert storm of Saudi cash spent on global Wahhabi proselytizing and indoctrinating – and I’ve seen this from the Maghreb to Java – has been such a powerful legacy; a medieval, toxic “religion” (nothing to do with legitimate Islam) that will keep destroying lives and communities and breeding fanatics till Kingdom Come. Hail the King for that – on behalf of the Pentagon. And forget about reading any of this on Arab corporate media – which is totally controlled by the House of Saud.

The House of Saud “reforming”? Away from that nefarious, barbarian Salafi religious establishment? That’s the joke of the millennium. Everything will stay the same.

But playing the ‘Empire of Chaos’ game – financial/economic war on Russia - is a game-changer, as in playing with fire. US/EU sanctions, attacks on the oil price and the ruble by giant derivative players as agents, are something way above the Saudi pay grade. The House of Saud swore that they didn’t change their production quota during 2014. But there was an excess supply – and it was brought into the market to help cause the oil price crash, alongside the manipulation by derivatives speculators.

Scores of oil analysts still can’t figure out why the House of Saud went after Russia; all reasons are political, not economical (Russian support for Syria and Iran, the Americans agreeing with the strategy, etc.). The fact is Moscow did perceive it as a declaration of economic war by Saudi Arabia. Petroleum Intelligence Weekly, cautiously, has already hinted it may get much worse, as in “potential for disruption in Mideast Gulf monarchies.”

Beware of an Emperor bearing gifts – or mourning a late King. The ‘Empire of Chaos’ is essentially asking the House of Saud to keep going kamikaze all the way against Russia. Sooner or later someone in Riyadh will realize this is the roadmap to House suicide.

Pepe Escobar’s latest book is Empire of Chaos. Follow him on Facebook.

Heard on the Street

European Banks Weigh-Up Government Bond Problem

Rule-makers Have Slammed Europe’s Implementation of Basel Capital Rules

By Paul J. Davies

Jan. 27, 2015 9:06 a.m. ET

The headquarters of the European Central Bank in Frankfurt, Germany, in December last year. With the ECB now wading into the market for government bonds, Europe’s banks have a big, willing buyer. Photo: Getty Images

The Basel Committee has been checking Europe’s homework and it isn’t pleased. It has told the Continent its banks need more capital to back sovereign risks, just as Europe is writing to its banks to say they need more capital for other risks.

The group that makes bank-capital rules has found a string of problems in the European Union’s writing of new Basel III standards into regulations. The biggest issue lies in the risk-free treatment of the near €2.5 trillion ($2.8 trillion) of government bonds and loans that eurozone banks own. This means they hold zero capital against them.

The realization that the debts of Western governments present a risk of market- and even default-related losses became undeniable during the eurozone crisis of 2011-12. So banks should assign sovereign debts a risk-weighting, which determines how much capital must be held against the assets.

Any debt-related fight between the EU and Greece following its parliamentary election could resurrect fears about sovereign-credit risks.

The U.K., which is in the EU but not the eurozone, already tackled this by requiring banks to hold extra capital against sovereign exposures. Last week it launched a consultation to formalize that.

Elsewhere in the EU, though, banks have more freedom to exclude sovereign debt from internal models that would assign it a risk weighting and capital charge. Assessors from Basel slammed that approach in a report on New Year’s Eve, saying the banks were being given too much freedom in this regard. And this, the Basel team found, resulted in a “material overstatement” of banks’ core capital.

The upshot is the rules will have to be changed. That could saddle eurozone banks with extra capital demands not long after an aggregate €40 billion of equity was raised in 2014 to bolster the sector ahead of stress tests last October.

Eurozone banks hold more than €1 trillion in loans to governments and almost €1.5 trillion in government bonds. Sovereign exposures make up about 9% of all bank assets. Germany’s banks are in line with that average, while Greece’s are below. But in Spain and Italy, sovereign debts make up 13% and 18% of assets respectively.

Banks have enjoyed strong gains on their bond holdings as yields have fallen since 2012.

German bunds saw total returns of more than 10% across all maturities in 2014 alone and Spanish ones saw gains of almost 17%, for example.

Banks might be tempted to sell some of these holdings, sidestepping requirements for additional capital while also crystallizing gains that would add to core equity capital.

If banks keep the bonds, it is difficult to predict exactly what future capital the holdings will require. In the U.K., the highest quality sovereign debt attracts an average 7.4% risk weighting.

So, if all the Eurozone exposure was of the safest sort, it would add €185 billion to banks’ risk weighted assets—leading to the need for almost €20 billion in additional capital.

For Spanish, Italian and Greek banks, their local sovereign debt will attract a much higher capital charge because it is riskier.

Whatever the number, Europe’s banks will want to reshuffle their holdings before the rules change.

And with the European Central Bank now wading into the market for government bonds, they will have a big, willing buyer.