Euro Toast, Anyone?

(Cross posted from EconoMonitor)

Greece’s Finance Minister reportedly said that his nation cannot continue to service its debt and hinted that a fifty percent write-down is likely. Greece’s sovereign debt is 350 billion euros—so losses to holders would be 175 billion euros. That would just be the beginning, however.

Nouriel Roubini has argued that the crisis will spread from Greece and increase the possibility that both Italy and Spain could be forced out unless European leaders greatly increase the funds available for bail-outs. The Sunday Telegraph has suggested that as much as 1.75 trillion sterling could be required. To put that in perspective, the US bailout of its financial system after 2008 came to $29 trillion. The 1.75 trillion figure will almost certainly prove to be wishful thinking if sovereign debt goes bad, because that will make the US subprime crisis look like a nursery school dispute. All the major European banks will go down—and so will the $3 trillion US money market mutual funds. (That probably explains why the US has suddenly taken a keen interest in Euroland, with the Fed ramping up lending to what Americans had formerly seen as “Eurotrash” financial institutions.)

It is becoming increasingly clear that authorities are merely trying to buy time to figure out how they can save the core French and German banks against a cascade of likely sovereign defaults. Meanwhile, they keep a stiff upper lip and demand more blood in the form of periphery austerity. They know this will do no good at all–indeed, it will increase the eventual costs of the bail-out while stoking North-South hostility. Presumably leaders like Chancellor Merkel are throwing red meat to their base for purely domestic political reasons.  If the EMU is eventually saved, however, the rancor will make it very difficult to mend fences.

There is no alternative to debt relief for Greek and other periphery nations.  But, they are not likely to get it, at least on the scale needed. Certainly not before a lot more pain is inflicted, and a lot more grovelling shown to Europe’s masters.

Indeed, the picture of the debtors that the Germans, especially, want to paint is one of profligate consumption fueled by runaway government spending by Mediterraneans. The only solution is to tighten the screws. As Finance Minister Wolfgang Schäuble put it: “The main reason for the lack of demand is the lack of confidence; the main reason for the lack of confidence is the deficits and public debts which are seen as unsustainable…We won’t come to grips with economies deleveraging by having governments and central banks throwing – literally – even more money at the problem. You simply cannot fight fire with fire.” You’ve got to fight the headwinds with more glacial ice.

While the story of fiscal excess is a stretch even in the case of the Greeks, it certainly cannot apply to Ireland and Iceland—or even to Spain. In the former cases, these nations adopted the neoliberal attitude toward banks that was pushed by policymakers in Europe and America, with disastrous results. The banks blew up in a speculative fever and then expected their governments to absorb all the losses. Further, as Ambrose Evans-Pritchard argues, even Greece’s total outstanding debt (private plus sovereign) is not high: 250% of GDP (versus nearly 500% in the US); Spain’s government debt ratio is just 65% of GDP. And while it is true that Italy’s government debt ratio is high, its household debt ratio is very low by global standards.

But it is not at all clear that the nuclear option—dissolution–will be avoided. Even Very Serious People are providing analyses of a Euroland divorce—with resolution ranging from a complete break-up to a split between a Teutonic Union embracing fiscal rectitude with an overvalued currency and a Latin Union with a greatly devalued currency.

A recent report from Credit Suisse dares to ask “What if?” there is a disorderly break-up of the EMU, with the narrowly defined PIGS (Portugal, Ireland, Greece and Spain) abandoning the euro and each adopting its own currency. The report paints a bleak picture because the currencies on the periphery would depreciate, raising the cost of servicing euro debt and leading to a snowball of sovereign defaults across highly indebted euro nations.

The report assumes Italy does not default—if it did, losses on sovereign debt would be very much higher.  With the assumption that Italy remains on the euro and manages to avoid default, total losses to the core European banks would be 300 billion euros and 630 billion euros for the periphery nations’ banks (excluding Italy), while the ECB’s losses would be 150 billion. (Note that gets very close to the rumored bailout costs of 1.75 trillion euros—without including any knock-on costs.)

Looking to previous “orderly” defaults, GDP would fall by 9%. With the weaker nations gone, the euro used by the stronger nations would appreciate, hurting their export sectors. That would increase the pressures for trade wars—and for a Great Depression 2.0. The report puts this probability at an optimistic 10%.

In his interesting piece, Ambrose Evans-Pritchard comes very close to getting it right—in my view. The problem, he asserts, is not “sovereign” euro debt, but rather is “the euro itself”, a “machine for perpetual destruction.” He rightly points to a competitive gap between the North and South, and argues that the euro is overvalued in the South and undervalued for Germany. He also points to the German delusion that its trade surpluses are “good” but the South’s trade deficits are “bad” balances. But obviously, they are nothing but the flip side of one another. He also discounts scare talk about the catastrophic costs of a breakup, and argues that the benefits of a North-South split could be significant. If the “Latin tier” could reboot with a significantly devalued (new) currency, it could become competitive. While my take is slightly different, I believe Evans-Pritchard is certainly on the right track, and his criticism of the German center of Europe is on-target.

An entirely different solution is offered by Jacques Delpla and Jakob von Weizsacker, “The Blue Bond Proposal,” published in May by bruegelpolicybrief. This would instead retain the union but pool a portion of each member’s government debt—equal to a Maastricht criteria 60% of GDP. This would be allocated to a “blue bond” classification, with any debt above that classified as “red bond.” The idea is that the blue bonds would be low risk, with holders serviced first; holders of red bonds would only be paid once the blue bonds are serviced. About half the current EMU members would have quite small issues of red bonds; about a quarter would not even be close to their limit on blue bond issues at current debt ratios. The proposal draws on the US experiment with “tranching” of mortgages to produce “safe” triple-A mortgage backed securities protected by “overcollateralization,” since the lower-grade securities took all the risks. Well, that did not turn out so well! The idea is that markets will discipline debt issues since blue bonds will enjoy low interest rates and red bonds will pay higher rates. Again, the US experience proves that markets are far too clever for that—if anything market discipline did precisely the opposite.

Still, I am not completely against the proposal. If the full faith and credit of the entire EMU (including most importantly that of the ECB) were put behind the blue bonds, and substantial nonmarket discipline were put on the red bonds, the scheme has some potential. More importantly, it directs us toward a real solution.

The problem with the set-up of the EMU was the separation of nations and their currencies—as I have argued since at least 1994. It was a system designed to fail. It would be like a USA with no Washington—with each state fully responsible not only for state spending, but also for social security, health care, natural disasters, and bail-outs of financial institutions within its borders. What a stupid idea. In the US, all of those responsibilities fall under the purview of the issuers of the national currency—the Fed and the Treasury. In truth, the Fed must play a subsidiary role because like the ECB it is prohibited from directly buying Treasury debt. It can only lend to financial institutions, and purchase government debt in the open market. It can help to stabilize the financial system, but can only lend, not spend, dollars into existence. The Treasury spends them into existence. When Congress is not preoccupied with Kindergarten-level spats that works almost tolerably well—a hurricane in the gulf leads to Treasury spending to relieve the pain. A national economic disaster generates a Federal budget deficit of 5 or 10 percent of GDP to relieve pain.

That cannot happen in Euroland, where the Euro Parliament’s budget is less than one percent of GDP. As I argued a decade and a half ago, the first serious Euro-wide financial crisis would expose the flaws. And it did.

And things are made much worse because Euroland can neither turn to its center for help, nor can it any longer rely on the rest of the world. The economies of the West (at least) are stumbling. In addition to the residual (and growing) problems in US real estate, the commodities speculative bubble appears to have been pricked. Since fools rush in on the belief they can take advantage of sales prices, the air will not rush out quickly. But with prices at 2, 3, and even 4 standard deviations away from the mean, the general trend will be down. That leads to vicious cycle margin calls, which will have knock-on effects as those with long positions in commodities have to sell out other asset classes. The stock market will be next—and there is plenty of reason to sell bank stocks, anyway.

And US and European banks are already insolvent. When Greece defaults and the crisis spreads to the periphery that will become more obvious. US money market mutual funds will break the buck—again—and this time they will not be rescued (Dodd-Frank makes that difficult). Further, US banks are beginning to lose civil lawsuits on their rampant fraud—securities fraud, mortgage lending fraud, foreclosure fraud, insider trading fraud. Fraud is essentially the only business that big US banks know—the only thing keeping them in business. If that line of business is taken away, they are toast. In GFC 1.0 it took $29 trillion to prop up Wall Street’s banksters. They are not going to get a second chance.

And now even China wants to slow. The Euro toast is cooked. The question now is what Euroland will do about it, and whether the US, UK and other countries with the ability to avoid a toasting will choose a tastier outcome.