Calm Before the Storm?

A relatively calm start to the week.  Can it last?  Almost certainly not.  It will get worse before it gets better.

A few themes popped since last Friday that are worth considering.  First is that some calmer voices have come to the forefront, arguing that a Greek exit is not really all that likely.  See Brad Plummer at Ezra Klein’s blog or Kate MacKenzie at FT Alphaville.  The general point:  Breaking up is hard to do.  No argument here – a Greek exit would be ugly for Greece, and the rest of Europe as well.  And, by all accounts, the Greek people don’t want that outcome.  The problem, however, is that the alternative, unending austerity to induce a substantial internal devaluation, is not really a solution either.

Indeed, it seems to me that on the current path, the cost of austerity will soon outweigh the cost of exit.  And we are running out of time to change that trajectory.  As I noted in my last post, it looks like the Greece fiscal situation is quickly deteriorating.  And it looks like a collapsing tourism industry will only worsen the economy, thereby putting additional pressure on deficit to GDP targets.  From FT Alphaville:

 Greece received a boost last year as the unrest in the Middle East made countries such as Egypt unattractive destinations. But it looks like German tourists won’t be propping up the Greek economy so much this summer…

…When you think of the tax revenue that might be lost from this drop in activity, it’s possibly another sign that the bailout programme may be so far off course since the elections that it could have to be renegotiated anyway.

The last bailout is quickly being overtaken taken overtaken by events.  What will be the demands of any new bailout?  If history is any guide, more austerity – and with it a higher probability of exit.

This seems to be exactly the story that Syriza party leader Alexis Tsipras is trying to sell in Germany.  To be sure, this is politically motivated, as he seeks to convince Greeks that voting for his party does not ensure an exit.  Indeed, he is pushing the opposite story – that only by tearing up the bailout agreement can Greece stay in the Euro.  From Bloomberg:

“Until when should German taxpayers pay into a bottomless pit?” Tsipras said to reporters in Berlin today after he held talks with leaders of Germany’s anti-capitalist Left Party. “It apparently flows to the Greek economy, but in reality only the banks and bankers are being financed.”…

…For Greeks, voting for Syriza “doesn’t mean that we’ll be kicked out of the euro,” he said. “It will mean a great opportunity for us to save the euro.”

A victory for Syriza would mean stability for Greece, whereas insisting on a continuation of the “catastrophic” austerity measures means a return to the drachma, Tsipras said.

I think he is right – except that to the Germans, tearing up the bailout is the same thing as exiting the Euro.  Both sides have their hands on the buttons that ensure mutually assured financial destruction, and each austerity package forces Greece closer to pushing that button.

Another theme is one I find particularly intriguing – the idea that Greece will establish an internal currency that trades side-by-side with the Euro.  FT Alphaville explains a version of this plan by Deutsche Bank’s Thomas Mayer.  The basic idea is that the government will need to turn to issuing some kind of IUO’s in the weeks ahead due to its deteriorating fiscal situation.  The new currency would trade internally and need to be exchanged for Euros to pay for imports. The exchange rate would not be one to one, of course, and internal prices would be devalued against the Euro.  To prevent the banking system from collapsing, it would need to be pulled into European supervision that guarantees Euro denominated accounts – thereby alleviating the fear of depositors that their Euro accounts would be replaced with a New Drachma, thus preventing a massive bank run.  This is only a half exit, and the goal would be to stabilize the budget to the point where the government could cease printing the New Drachmas and eventually return to the Euro.

I am not confident this would work – and particularly not confident that the Greek government could wisely use its new-found power of the printing press.  But it is a possible third way out, and this is a situation that desperately needs a third way.

Finally, Eurobonds are back on the table.  Sort of.  From the Wall Street Journal:

But next month’s elections in Greece could dramatically change the euro zone’s political calculus, analysts say. A victory by parties opposed to the bailout negotiated with the euro zone and the International Monetary Fund would sharply raise the risk of Greece leaving the currency area, and possibly prompt policy makers to adopt more far-reaching measures to contain the turmoil arising from such a threat.

These bolder policies include the creation of “euro bonds,” or debt jointly guaranteed by the euro zone that would allow weaker countries such as Spain to borrow at interest rates partly subsidized by Germany. Berlin remains staunchly opposed, though new French President François Hollande is expected to raise the topic during informal discussions at the summit.

Edward Harrison argues that Germany is not entirely opposed to the idea and see a path – an austerity-laden path – to Eurobonds. (Other views on the role of Eurobonds can be found at the NYT’s Room for Debate). The challenge, however, is that Europe doesn’t have time to wait.  Nor does it have time to wait for the other institutional plumbing, such a mechanism for Eurozone bank recapitalization under a full banking union.

Lacking a path to a real fiscal and economic union, the outcome of tomorrow’s EU meeting is likely to disappoint.  Back to the Wall Street Journal:

Without agreement on these major steps, the leaders will in the meantime back three relatively minor policy initiatives. The first is a proposal to increase the capital of the European Investment Bank, the bloc’s long-term lending arm, by €10 billion. The second proposal would ease requirements for troubled governments to use funds due to them from the EU budget.

The third is a plan to borrow money against the EU budget that would be dedicated to infrastructure-investment projects. The plan would create a pilot project using €230 million in EU budget money that could leverage funds of up to €4.6 billion. After two years, the program will be reviewed and possibly increased.

Analysts say none of these ideas is enough to have a significant, near-term macroeconomic effect in the bloc’s troubled economies.

“These ideas don’t materially improve trend growth prospects in the euro zone,” said Mujtaba Rahman, an analyst at the Eurasia Group, a political risk consulting firm. “It’s a lot of rhetoric and not a lot substance.”

Enough to look like policymakers are doing something, but a far cry from the steps needed to bring the crisis under control.  In other words, more of the same.

This post originally appeared at Tim Duy’s Fed Watch and is posted with permission.

3 Responses to "Calm Before the Storm?"

  1. barf   May 23, 2012 at 8:22 pm

    i think you should begin with what is being/has been done to combat the catastrophe to date and proceed from there. Who replaces Mario Draghi for example given what has occurred? Obviously "the answer" being given is dollarization. That would be by the markets. Perhaps you have heard of such a thing…

  2. Amar   May 23, 2012 at 9:37 pm

    Greece exit: imminent now?

    With the latest news that is coming in around Greece, it now seems that Greece’s exit from the European Monetary Union (EMU) is imminent.

    CNBC quoting Reuters, reports that: Euro Zone Officials Agree to Prepare for Greek Exit Scenario.

    “Each euro zone country will have to prepare a contingency plan for the eventuality of Greece leaving the single currency, three euro zone sources said on Wednesday, citing an agreement reached by officials. The consensus was reached on Monday afternoon during an hour-long teleconference of the Eurogroup Working Group (EWG). As well as confirmation from three euro zone officials, Reuters has seen a memo drawn up by one member state detailing some of the elements that euro zone countries should consider.”

    This is in line with my argument a few days back that the latest runs on banks in Greece might very well be the beginning of the end.

    So what are the bond markets saying? It almost seems as if the bond markets are ready for a Greece exit and might even be hoping that it happens! Spanish and Italian yields have been going up the past few days but are still much lower than the highs made a few months back. Of course the yields are going to rise but the fact that they have not even crossed the highs made a few months back shows that bond markets are not too worried.

    It seems that Nouriel Roubini, who predicted the 2008 crisis right down to some uncanny details, seems to be getting this one right too. Roubini has been predicting a Greece exit and an eventual meltdown of EMU for a long time now. In fact, his recommendation for a long time has been that Greece Should Default and Quit the Euro.

    "The recent debt exchange deal Europe offered Greece was a rip-off,"

    "If you take into account the large sweeteners the plan gave to creditors, the true debt relief is close to zero."

    "A return to a national currency and a sharp depreciation would quickly restore growth and competitiveness, as it did in Argentina and many other emerging markets that abandoned their currency pegs," he said.

    As recent as a few months back, Roubini’s view was that Situation in Europe is a ‘Slow Motion Train Wreck’.

    With the Greece re-election dates just a few weeks away, the economic and political dynamics surrounding the Eurozone are evolving at a very fast pace.

    Greece has dug itself into a hole from which it is nearly impossible to emerge without a severe battering. With debt at 160% of GDP, an economy in severe recession and a quarter of the population unemployed, an exit from EMU is starting to look more and more like the best option.

    Amar Harolikar
    Unknown Insights

  3. Amar   May 23, 2012 at 9:41 pm

    Can Greece take down the world?

    All of the current discussion about Greece causing a Doomsday is starting to sound more and more ridiculous (which is the funny part). Nonetheless, the underlying factors could be a far more serious issue. Here's why:

    Funny aspect # 1

    The country of Greece is comprised of less than 0.5% of Global GDP! It is pretty understandable that when the U.S. sneezes, the world catches a cold- after all, the U.S. is nearly 30% of the world’s GDP. But can Greece cause a global slowdown – I really doubt so.

    Funny aspect # 2

    There is a report from the IIF that was prepared to scare some of the hesitant lenders into signing off on the country’s bailout package. Through a series of 'well reasoned' arguments, the report discusses a global slowdown due to Greece’s default. Now, how all of this would be achieved by such a minuscule economy like Greece – which is less than 0.5% of the global GDP- has truly made the IIF report a hilarious read.

    Funny aspect # 3

    In the debt deal of February 2012, private creditors were quoted to have forgiven more than half of the Euro 200 Bn of outstanding. If forgiving more than 50% of a loan is a 'deal', then what in the world does a default mean?

    Funny aspect # 4

    Which brings us to the next aspect of our humorous stroll- If this 50% 'forgiveness' didn't cause any real blip on the global economy, will the default of remaining 50% cause a global slowdown?

    Of course, if this were to really happen, then the economists would surely begin to discuss CDO losses and the contagion effect. This leads us onto the following serious issues:

    Serious issue # 1

    Several banks and institutions will certainly go down, and countless jobs will be lost. What will become of the bankers who are going to be held responsible for writing those CDO's on Greece? More importantly, what about the politicians who are going to lose power? Let’s think of them for a moment. I would think that in such a scenario, countless big-wigs in banking & finance industry would no doubt be joining the hall of shame along with Alan Greenspan, Dick Fuld and many others. Some of these people could likely get prosecuted, and possibly even join Maddoff’s ranks as well.

    Serious issue # 2

    Every economic crisis, including the most recent one beginning in 2008, clearly portrayed the lack of integrity and competency in the so called business leaders who are supposed to be examples of these very qualities. Furthermore, after every crisis, skeletons started to tumble out of the closet.

    In conclusion, the question to ask is- can a minuscule economy with less than 0.5% of the global GDP cause a Doomsday effect, or are the business and political leaders really afraid of something else?

    Amar Harolikar
    Unknown Insights