by Doug Noland
It would be reasonable - and it sure is tempting - to dedicate this week's bulletin to a skeptical look at Europe's latest plan for credit crisis resolution. I would not be without plenty of company. So I'll instead go in a different direction. This week I found my thoughts returning back about 12 years to my earliest bulletins. Inspired by the great Austrian economist Ludwig von Mises, my introductory article discussed the need for a contemporary theory of money and credit. Not only was modern economics devoid of monetary analysis, there were critical changes unfolding within US credit that were going completely unappreciated.
Importantly, credit creation was gravitating outside of traditional
bank lending channels and liability creation. The system of government-sponsored enterprises (GSEs), such as Fannie Mae and Freddie Mac and the Federal Home Loan Bank, had evolved into major risk intermediaries and credit creators. I began by arguing against the conventional view that "only banks create credit". Securitization markets were exploding in volumes, both in mortgage and asset backed securities.
I was focused on the lack of constraints on this new credit mechanism that operated outside of traditional bank capital and reserve requirements. In contrast to the antiquated bank deposit "multiplier effect" explained in economic texts, I referred to this powerful new dynamic as an "infinite multiplier effect". Borrowing from Murray Rothbard, new credit was created "out of thin air".
The more I studied monetary history, the more I appreciated the importance of both money and credit theory. It became clear to me that money had for centuries played such a profound role in economic cycles (and monetary fiascos). Yet this type of analysis was extinct. Even within the economics community, there was not even a consensus view as to a definition of "money".
There had been decades of bickering about what monetary aggregate to use in econometric models (M1, M2 or the newer M3), along with what measure of "money" supply should be monitored and managed by the Federal Reserve. Especially in light of all the financial innovation and new financial instruments, the economics profession and the Fed punted on monetary analysis. Out of sight and out of mind.
Even if one was focused on the issue, the importance of traditional monetary analysis was lost in myriad new complexities. Yet my study of monetary history and research of contemporary credit convinced me that the analysis of "money" likely had never been more critical to the understanding of (extraordinary) market and economic behavior.
I was intrigued by Mises' work on "fiduciary media", the financial claims that had the economic functionality of traditional (narrow) money. I began to view contemporary "money" as "money is as money does". I was especially struck by monetary analysis from the late American economist Allyn Abbott Young. Young wrote brilliantly about the historical "preciousness" of money.
The more I studied, contemplated and pieced together analysis from scores of monetary thinkers, the more it became clear to me that "money" was critically important because of its special attributes. In particular, money created unusual demand dynamics: essentially, economic agents always wanted more of it and this insatiable demand dynamic created a powerful proclivity to issue it in excess quantities. Keep in mind that a boom financed by junk bonds will pose much less risk (its shorter lifespan will impart less structural damage) than a protracted bubble financed by "AAA" agency securities and Treasury debt.
Centuries of monetary fiascos made it clear that money had better be backed by something of value and of limited supply (ie gold standard) to ensure that politicians and bankers did not fall prey to the same inflationary traps that had repeatedly destroyed currencies and economies across the globe.
While it became fanciful to speak of "new eras" and "new paradigms", I saw a world uniquely devoid of a monetary anchor. There was no gold standard and no Bretton Woods monetary regime. I saw an ad hoc dollar reserve standard, one that was for awhile somewhat restraining global credit, begin to disintegrate from the poison of runaway US credit excess and intransigent current account deficits.
Marketable debt accounted for the majority of new credit creation, and these new financial sector liabilities were enjoying extraordinary demand in the marketplace. This marketable debt could also be readily leveraged (at typically inexpensive rates "pegged" by the New Age Federal Reserve) by a mushrooming leveraged speculating community, adding only greater firepower to the credit boom. Over time, the US credit system exported its bubble to the rest of the world.
From my perspective, contemporary "money" was just a special - the most "precious" - type of credit. "Money" had become nothing more than a financial claim that was trusted for its "moneyness" attributes: chiefly, a highly liquid store of nominal value. This new "money" was electronic and incredibly easy to issue in unfathomable quantities.
The vast majority of this credit was created in the process of asset-based lending (real estate and securities finance), and the more that was issued, the greater the demand for these "money-like" financial claims. The world had never experienced "money" like this before, and I suspected that the world would never be the same.
In this brave new financial world dominated by one incredible global electronic general ledger of debit and credit journal entries, "moneyness" became little more than a market perception. If the market perceived a new financial claim was liquid and "AAA", then there essentially became unlimited demand for this "money."
Not unexpectedly in such circumstances, this "money" was issued in gross excess. Most of it was created in the process of financing the real estate and securities markets. At the late stage of the boom, a hugely distorted marketplace saw trillions of risky subprime mortgages sliced and diced into mostly "AAA" "money"-like credit instruments. Importantly, a distorted marketplace believed that Washington would back GSE obligations and that the Treasury and Fed would ensure the stability of mortgage and housing markets.
The 2008 crisis was really the result of Wall Street risk intermediation and structured finance losing its "moneyness." When the mortgage finance bubble burst, the market quickly questioned the creditworthiness and liquidity profile of trillions of debt instruments. As finance abruptly tightened, asset-market bubbles popped and maladjusted economies faltered. The "moneyness" phenomenon came back to haunt financial and economic systems.
Not only had years of monetary inflation impaired underlying economic structures, a huge gulf had developed between the markets' perception of the "moneyness" of the debt instruments and the bubble state of the asset markets underpinning an acutely fragile (Hyman Minsky) "Ponzi Finance" credit structure.
I have posited that the policy response to the 2008 crisis - monetary and fiscal, at home and abroad - unleashed the "global government finance bubble." Essentially, massive government debt issuance, guarantees and central bank monetization restored "moneyness" to US and global credit. I have argued that this course of policymaking risked impairing the creditworthiness - the "moneyness" - of government debt markets, the core of contemporary monetary systems.
At its heart, the European crisis is about the escalating risk that the region's debt could lose its "moneyness". Starting with the introduction of the euro, the market perceived that even Greek debt was money-like. Despite massive deficits, a distorted marketplace had an insatiable appetite for Greek, Irish, Portuguese, Spanish and Italian debt. Importantly, the markets believed that European governments and the European Central Bank (ECB) would, in the end, back individual government and banking system obligations.
US Treasury and Federal Reserve backing restored "moneyness" to trillions of suspect financial claims back in 2008 - and since then massive federal debt issuance and Federal Reserve monetization have reflated asset markets and sustained the maladjusted US economic structure. The markets enjoyed an incredible windfall, and many these days expect European politicians and central bankers to similarly reflate eurozone credit and economies.
I believe strongly that the credit recovery and tepid US economic recovery came at an extremely high price: dynamics that ensure the eventual loss of "moneyness" for US government credit, the heart of our monetary system.
Many expect Germany to use the "moneyness" of their credit to ensure the ongoing "moneyness" for European debt more generally. The conventional view is that, at the end of the day, German politicians will do a cost versus benefit analysis and realize it will cost them less to backstop the region's debt than to risk a collapse of European monetary integration.
The Germans, however, appreciate like few other societies the critical role that stable money and credit play in all things economic and social. The Germans have refused the type of open-ended commitments necessary for the marketplace to begin to trust the credit issued by the profligate European borrowers (and an incredibly bloated banking system).
European politicians have been desperately seeking some type of structure that would ring-fence the sovereign crisis to protect the "moneyness" of, in particular, Italian and Spanish borrowings. Increasingly, the consequences of a loss of "moneyness" at the periphery were weighing heavily upon the European banking system, with heightened risk of impairing "moneyness" at the core. This was critically important, as it was quickly limiting the options available for monetary crisis management.
For example, faltering confidence in Italian debt and what an Italian debt crisis would mean to European and French banks was impacting market confidence in French sovereign credit. So any crisis resolution structure that placed significant additional demands on French sovereign debt risked impairing the "moneyness" of French credit at the core of the European debt structure. Understandably, the markets feared the crisis was spiraling out of control.
Last week's grand plan was to bring in parties from outside the region - to use "money" from the International Monetary Fund, the Chinese, other BRIC (Brazil, Russia, India, China) nations, Japan, global sovereign wealth funds and such to backstop the "moneyness" of European debt. With their support, the European Financial Stability Facility will have the capacity to leverage to, it's said, $1.4 trillion - providing the bazooka backstop that will ensure market confidence in European credit generally.
Will it work? I highly doubt it, but it does buy some time - and the markets were content. It appeared to take near-term implosion risk off the table, which set the stage for a huge short squeeze and destabilizing unwind of hedges across virtually all markets.
I assume the Chinese will move cautiously and, as always, work only in their self-interest. China will want assurances their European investments are safe, which means they will want to avoid exposure to periphery and Italian credit just like everyone else. I suspect that European Financial Stability Facility debt will struggle to retain "moneyness", as markets fret over ongoing European credit deterioration and the future of the euro currency.
There may be grand plans and grand designs for a credible "ring-fence", but the critical issue of how to ensure ongoing Italian debt "moneyness" continues to prove elusive. Global risk markets were in virtual melt-up mode last week, yet Italian 10-year yields jumped 13 basis points (bps) to 6.01%.
Henry C.K. Liu
Part I: A Currency Union Not Backed by Political Union
The Eurozone sovereign debt crisis is rooted in the dysfunction of a monetary union without political union. The fundamental cause for the crisis lies in the arrangement under which the euro is legal tender for all member states in the eurozone, yet monetary policy for the eurozone is the exclusive responsibility of the European Central Bank, for which common representation of all member states, governance and fiscal policy union in support of currency union does not formally exist. This essentially makes sovereign debt of eurozone member states denominated in euro foreign currency debts. Since individual eurozone member states do not have sovereign authority over their common currency, they are deprived of the option of solving their sovereign debt problem with monetary measures, such as devaluing their common currency or lowering interest rates.
The eurozone, also known as euro area (EA17), is an economic and monetary union (EMU) of 17 out of the 27 member states of European Union (EU27) that have adopted the euro (€) as their common currency and sole legal tender that is freely convertible at market exchange rates. The euro is also legal tender in a five other non-EMU European political entities (Montenegro, Andorra, Monaco, San Marino and Vatican City) and the disputed territory of Kosovo.
The euro is the common currency used daily by some 332 million Europeans and their separate governments. Additionally, over 175 million people worldwide use currencies which are pegged to the euro, including more than 150 million people in Africa.
A Political Crisis with Financial Dimensions
The European sovereign debt crisis is at its base a intergovernmental political crisis in the eurozone-17 with financial and economic dimensions that reaches beyond the eurozone to all its trading partner regions as well as financial and trading markets in the entire world. The crisis is centered around the difficulty in achieving policy consensus among all eurozone member states and the inability of any eurozone member state under financial distress from sovereign debt difficulties to employ monetary measures individually, such a currency devaluation or interest rate measures, to solve its euro denominated sovereign debt problems, since no member state has individual authority to set or revise monetary policy or exchange rate value for the euro to address its public finance problems. Furthermore, the economic and public finance problems of eurozone member states are not congruent, thus giving rise to varying and often contradicting political incentives in different member states, pitting the political dynamics of richer economies against those of poorer economies.
Debt Crisis of a Rich Economy
On many levels, the eurozone (EA17) is a very rich economy. It has a population of 320 million with a 2010 GDP of €9.2 trillion ($12.2 trillion), albeit with an wide range of per capita GDP, ranging from €30,600 in Austria to €19,700 in Romania. Little Luxembourg's per capita GDP was €70,000 in 2010. Despite of the fact that eurozone membership involves only 17 of the 27 member state of the EU27, the eurozone is essentially the economic and financial core of the EU, which has the highest GDP ($16.2 trillion in 2010) in the world, larger that the US GDP ($14.7 trillion). A sovereign default in any eurozone member state will put in doubt the continuance of the euro as a common currency in the eurozone and as prime reserve currency for international trade.
Collapse of Aggregate Demand
The reason why a rich economy like that of the eurozone suffers such a sudden collapses in aggregate demand caused by a banking sector and sovereign debt crisis around a common currency lies squarely on a breakdown of political consensus among eurozone member state governments. The sovereign debt crisis in the eurozone began with the global economic recession that began in mid 2007 in New York, caused by a massive meltdown in electronically linked credit markets in all major open economies due to excessive private and public debts to compensated for decades of low wages.
This global recession has thus far stubbornly resisted all coordinated efforts by governments and central banks of trading economies around the world to stimulate a quick economic recovery through the injection of liquidity via aggressive central bank interest rate policy and massive quantitative easing. The penalty for direct government bailout of too-big-to-fail financial entities to defuse a market meltdown will be a decade of slow growth for the world economy, because the debt crisis that had been caused by low wages is being solved with government austerity measures that will push wages further down. Slow economic growth is highly problematic for countries with high levels of sovereign debt. And for any country whose sovereign debt is denominated in currency not subject to the monetary authority of its central bank, the problem can be fatal.
The reason for the long and weak recovery in global economy is that the excessive debt in the global economy has not been extinguished by government bailouts. The debt has only been shifted from the private sector to the public sector, from the balance sheets of distressed commercial and investment banks to the balance sheets of central banks. The penalty for this liquidity play on the part of central banks to save insolvent financial institutions from collapse will be an extended anemic global economy in which banks, companies and households are all trying to deleverage from undistinguished debt with the new liquidity of no economic substance released by central bank quantitative easing. Also, government austerity programs needed to secure more debt will further reduce wage income and exacerbate further fall in aggregate demand in a downward vicious cycle.
ECB Quantitative Easing
A look at the way the Federal Reserve has dealt with the debt propelled recession since mid 2007 is instructive on what the ECB will likely also do to deal with the European sovereign debt crisis of 2011.
Central bank monetary policy ammunition of low interest rate has long been exhausted ever since the Federal Reserve lowered the target for the short-term Fed funds rate to between 0% and 0.25% on December 16, 2008, and keeping it there open-ended, by now for almost three years, and possibly has to for another year or two more. When central bank inflation targeting is finally put in place, the Fed funds rate will go negative.
In the accompanying statement on the zero interest rate move on December 16, 2008, already a year and a half into the recession, the Fed said:
“The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.
“The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level.
“As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities.
“Early next year (2009), the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility (TALF) to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.”
Term Asset-Backed Securities Loan Facility (TALF)
On November 25, 2008, not waiting until 2009 as announced, The Fed launched TALF “to support the issuance of asset-backed securities (ABS) collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration (SBA).” The on-going record of the ineffectiveness of TALF will give some idea of what the ECB swill face since it is now being pushed to take similar measures by US Treasury Secretary Geithner, even though TALF was designed to deal with commercial and consumer debt while the ECB is facing a crisis of sovereign debt.
The Fed said in 2008 that under TALF, the Federal Reserve Bank of New York (NY Fed) would lent up to $1 trillion (originally planned to be $200 billion) on a non recourse basis to holders of certain AAA-rated ABS backed by newly and recently originated consumer and small business loans. As TALF money did not originate from the Treasury, the program did not require congressional approval to disburse funds, but a new act of Congress forced the Fed to reveal how it actually spent the money.
The Fed explained the reasoning behind the TALF as follows:
“New issuance of ABS declined precipitously in September and came to a halt in October. At the same time, interest rate spreads on AAA-rated tranches of ABS soared to levels well outside the range of historical experience, reflecting unusually high risk premiums. The ABS markets historically have funded a substantial share of consumer credit and SBA-guaranteed small business loans. Continued disruption of these markets could significantly limit the availability of credit to households and small businesses and thereby contribute to further weakening of U.S. economic activity. The TALF is designed to increase credit availability and support economic activity by facilitating renewed issuance of consumer and small business ABS at more normal interest rate spreads”
According to the plan, the NY Fed would spend up to $200 billion in loans to spur the market in securities backed by payments from loans to small business and consumers. Yet, the program closed after only funding the purchase of $43 billion in distress loans.
Under TALF, the Fed lent $1 trillion to banks and hedge funds at nearly interest-free rates. Because the money came from the Fed and not the Treasury, there was no congressional oversight of how the funds were disbursed, until an act of Congress forced the Fed to open its books. Congressional staffers then examined more than 21,000 transactions. One study estimated that the subsidy rate on the TALF’s $12.1 billion of loans to buy Commercial Mortgage-Backed Securities (CMBS) was 34 percent.
Special Purpose Vehicle – Financial Neutron Bomb
TALF money was designed not to go directly to targeted small businesses and consumers, but to the institutional issuers of asset-backed securities (ABS). The NY Fed would take the securities as collateral for more loans to the issuers of ABS. To manage the TALF loans, the NY Fed created a Special Purpose Vehicle (SPV) that would buy the assets securing the TALF loans. The function of a SPV is to isolate risk from the creator, in this case the NY Fed, as a device to hide debt from the balance sheet of the creator. In the case of TALF, the SPV creator is ultimately the NY Fed's parent, the Federal Reserve, the nation’s lender of last resort to banks.
SPVs are financial neutron bombs, used in war to kill enemy population without causing damage to physical assets, thus saving reconstruction time and cost in captured enemy territories. A neutron bomb is a fission-fusion thermonuclear weapon (hydrogen bomb) in which the burst of neutrons generated by a fusion reaction is intentionally allowed to escape from the weapon, rather than being absorbed by its containing components. The weapon’s X-ray mirrors and radiation case, normally made of uranium or lead in a standard bomb, are instead made of chromium or nickel so that the neutrons can escape to kill enemy troops and civilians, leaving empty undamaged cities for occupation by the winner in a battle.
SPV to Skirt Basel II Capital Requirements
In a May 14, 2002 AToL article: The BIS vs National Banks, I warned about Special Purpose Vehicles (SPV) five years before the credit crisis broke out in July 2007:
“Aggregate regulatory capital thus ends up being lower than the economic risks require; and although regulatory capital ratios rise, they are in effect merely meaningless statistical artifacts. Risks never disappear; they are always passed on. LCBOs in effect pass their unaccounted-for risks onto the global financial system. Thus the fierce opponents of socialism have become the deft operators in the socialization of risk while retaining profits from such risk socialization in private hands.
“Set for 2004, implementation of the new Basel II Capital Accord is meant to respond to such regulatory erosion by LCBOs. “Synthetic securitization” refers to structured transactions in which banks use credit derivatives to transfer the credit risk of a specified pool of assets to third parties, such as insurance companies, other banks, and unregulated entities, known as Special Purpose Vehicles (SPV), used widely by the likes of Enron and GE. The transfer may be either funded, for example, by issuing credit-linked securities in tranches with various seniorities (collateralized loan obligations or CLOs) or unfunded, for example, using credit default swaps. Synthetic securitization can replicate the economic risk transfer characteristics of securitization without removing assets from the originating bank’s balance sheet or recorded banking book exposures.
“Synthetic securitization may also be used more flexibly than traditional securitization. For example, to transfer the junior (first and second loss) element of credit risk and retain a senior tranche; to embed extra features such as leverage or foreign currency payouts; and to package for sale the credit risk of a portfolio (or reference portfolio) not originated by the bank. Banks may also exchange the credit risk on parts of their portfolios bilaterally without any issuance of rated notes to the market.”
Central Bank uses SPV to Hide Expansion of Balance Sheet
The Treasury's Troubled Assets Relief Program (TARP) of the Emergency Economic Stabilization Act of 2008 would finance the first $20 billion of troubles assets purchases by buying distressed debt in the NY Fed’s SPV. If more than $20 billion in assets are bought by the SPV through TALF, the NY Fed will lend the additional money to the SPV. Since a loan is treated in accounting as an asset, the NY Fed, by providing the funds to buy distress debt, actually expands it balance sheet positively while its SPV assumes more liability.
Troubled Assets Relief Program (TARP)
TARP allows the US Treasury to purchase or insure up to $700 billion of “troubled assets”, defined as:
A) residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages, that in each case was originated or issued on or before March 14, 2008, the purchase of which the Secretary determines promotes financial market stability; and
B) any other financial instrument that the Secretary, after consultation with the Chairman of the Board of Governors of the Federal Reserve System, determines the purchase of which is necessary to promote financial market stability, but only upon transmittal of such determination, in writing, to the appropriate committees of Congress.”
TARP allows the Treasury to purchase illiquid, difficult-to-value assets at full face value from banks and other financial institutions. The targeted assets can be collateralized debt obligations (CDO), which were sold in a booming market until July 2007, when they were hit by widespread foreclosures on the underlying loans.
TARP is intended to restore liquidity of these assets in a failed market with no other buyers, by purchasing them using secondary market mechanisms, thus allowing participating institutions to stabilize their balance sheets and avoid further losses.
TARP does not allow banks to recoup losses already incurred on troubled assets, but Treasury officials expect that once trading of these assets resumes, their prices will stabilize and ultimately increase in value, resulting in gains to both participating banks and the Treasury itself. The concept of future gains from troubled assets comes from the hypothesis in the financial industry that these assets are oversold, as only a small percentage of all mortgages are in default, while the relative fall in prices represents losses from a much higher default rate. Yet the low default rate was not produced by economic conditions, but by the Fed’s financial manipulation. Thus the banks are saved, but not the economy as a whole, which ultimately still has to pay off the undistinguished debt.
The Emergency Economic Stabilization Act of 2008 (EESA) requires financial institutions selling assets to TARP to issue equity warrants (a type of security that entitles, but without the obligation, its holder to purchase shares in the company issuing the security for a specific price), or equity or senior debt securities (for non-publicly listed companies) to the Treasury. In the case of warrants, the Treasury will only receive warrants for non-voting shares, or will agree not to vote the stock.
This measure is supposedly designed to protect taxpayers by giving the Treasury the possibility of profiting through its new ownership stakes in these institutions. Ideally, if the financial institutions benefit from government assistance and recover their former strength, the government will also be able to profit from their recovery.
Another important goal of TARP is to encourage banks to resume lending again at levels seen before the crisis, both to each other and to consumers and businesses. If TARP can stabilize bank capital ratios, it should theoretically allow them to increase lending instead of hoarding cash to cushion against future unforeseen losses from troubled assets.
The Fed argues that increased lending equates to “loosening” of credit, which the government hopes will restore order to the financial markets and improve investor confidence in financial institutions and the markets. As banks gain increased lending confidence, the interbank lending interest rates (the rates at which the banks lend to each other on a short term basis) should decrease, further facilitating lending. So far, this goal has not been achieved as bank merely used TARP money to deleverage rather than increase lending.
TARP will operate as a “revolving purchase facility”. The Treasury will have a set spending limit, $250 billion at the start of the program, with which it will purchase the assets and then either sell them or hold the assets and collect the “coupons”. The money received from sales and coupons will go back into the pool, facilitating the purchase of more assets.
The initial $250 billion can be increased to $350 billion upon the president's certification to Congress that such an increase is necessary. The remaining $350 billion may be released to the Treasury upon a written report to Congress from the Treasury with details of its plan for the money. Congress then has 15 days to vote to disapprove the increase before the money will be automatically released. The first $350 billion was released on October 3, 2008, and Congress voted to approve the release of the second $350 billion on January 15, 2009.
One way that TARP money is being spent is to support the “Making Homes Affordable” plan, which was implemented on March 4, 2009, using TARP money by the Treasury. Because “at risk” mortgages are defined as “troubled assets” under TARP, the Treasury has the power to implement the plan. Generally, it provides refinancing for mortgages held by Fannie Mae or Freddie Mac. Privately held mortgages will be eligible for other incentives, including a favorable loan modification for five years.
The authority of the Treasury to establish and manage TARP under a newly created Office of Financial Stability (OFS) became law October 3, 2008, the result of an initial proposal that ultimately was passed by Congress as H.R. 1424, enacting the Emergency Economic Stabilization Act of 2008 and several other related acts.
Collateral assets accepted by TARP include dollar-denominated cash ABS with a long-term credit rating in the highest investment-grade rating category from two or more major “nationally recognized statistical rating organizations (NRSROs)” and do not have a long-term credit rating below the highest investment-grade rating category from a major NRSRO. Synthetic ABS (credit-default swaps on ABS) do not qualify as eligible collateral. The program was launched on March 3, 2009.
Zero Interest Rate and Quantitative Easing
As interest rates cannot go below zero, central banks are forced to resort to quantitative easing to inject money into the financial system which allows insolvent financial institutions to deny the disastrous reality of insolvency from the collapse of the market value of collaterals to pretend that the global financial market is merely facing a temporary liquidity problem and that massive liquidity injection from the central bank would allow an orderly restructuring of the massive overhanging distressed private debt by shifting it to the public sector with no borrower defaults and therefore no “haircuts” for exposed creditors.
The price for this strategy of short-term crisis resolution of excessive private sector debt by increasing public sector debt is the long-term stagnation of the global economy. This is because private sector deleveraging with public sector money drains economic vitality that will take a long time to work through.
The Cure Worse than the Disease
It is now becoming clear that notwithstanding the Fed’s assertion that its bailouts prevented a systemic melt down of global financial markets, the cure of saving the banking sector at the expense of the economy is looking more like a cure worse than the disease. A faster recovery might have been the net bonus if the banks were left to go belly up on their own.
As it happened, the panic rescue by central banks left the global economy a fate of a lost decade. This is critical because economic recovery and the existing international financial architecture depends on a high rate of growth. And three years after the outbreak of the global financial crisis that began in mid July 2007, the global economy is still plagued by high unemployment and stagnation despite massive amount of liquidity injection by center banks.
Sovereign Debt Denominated in Foreign Currency
To make matters worse, all trading economies, particularly the exporting emerging market economies, that denominate their debts in one of the two prime reserve currencies for international trade, such as the dollar and the euro, will find critically needed counter cyclical monetary measures unavailable to their governments because their central banks cannot issue dollars or euros, thus have to earn more dollars or euros from the global trading system at a time when the global economy has been condemned to suffer demand deficit with a decade of economic decline engineered by central bank monetary measures to save the banking sector in the advanced economies. These emerging economies also cannot borrow more dollars or euros from global capital and debt markets because their credit ratings are being cut by suddenly less-permissive credit rating agencies. They invariably become financial wards of the stronger economies and prisoners of the International Monetary Fund (IMF) conditionalities.
A Complex Rescue Plan for Europe with a Special Purpose Vehicle
A European official told CNBC on the sideline of the IMF meeting in Washington on Saturday, September 17, 2011 that the EU is working on a detailed plan aimed at shoring up the stability of European banks.
The plan appears to involve a complex flow of funds. It would involve money from the European Financial Stability Facility (EFSF), a bailout vehicle created in 2010 to alleviate the sovereign debt crisis in Europe, to capitalize a special purpose vehicle (SPV) that would be created by the European Investment Bank (EIB), the European Union’s finance institution. EFSF shareholders are the 27 member states of the EU, which have jointly subscribed its capital. The Board of Governors of the EIB is composed of the finance ministers of these 27 member states.
The role of the EIB in this plan is to provide long-term financing in support of investment projects. The SPV serves the purpose of isolating the parent (EIB) from financial risk of the plan, a device commonly used in complex financing to separate different layers of equity infusion.
The EIB’s SPV would issue bonds to investors and use the proceeds to purchase sovereign debt of distressed eurozone member states from their state central banks. The hope is that this would alleviate the pressure on the financially distressed member states and on the eurozone banks (primarily French and German banks) that hold a lot of the distressed sovereign debt. The bonds issued by EIB’s SPV could then be used by the EIB as collateral for borrowing from the European Central Bank (ECB), allowing the member state central banks to make loans to commercial banks faced with liquidity shortages.
Banks loaded down with distressed eurozone sovereign debt would be able to sell the debt to the EIB’s SPV financed by the ECB with the distressed sovereign debts as collaterals at full face value so that eurozone commercial banks can access the liquidity facilities of the ECB.
Although the structure is complex, the underlying objective is relatively simple. Banks would essentially be allowed to exchange their distressed sovereign debt at face value for debt issued by a special purpose vehicle created by the EIB capitalized with funds from the EFSF.
In some ways, this resembles the original plan for the Troubled Asset Relief Program (TARP) used by the Federal Reserve on 2008. As originally conceived, the TARP would have purchased “toxic securities” from banks. (This plan was abandoned when U.S. regulators concluded that it was too difficult to price the securities and that the plan would take too long to implement.) In the European case, the “toxic securities” would be distressed sovereign debt rather than securitized mortgage bonds.
Plan to Stabilize Banks Holding Eurozone Sovereign Debt
Over the weekend of September 17, finance leaders from around the world met in the annual IFM/World Bank conference in Washington to discuss the global economic state of affairs. At this meeting European finance ministers said that they would take bolder steps to fight the sovereign debt crisis, which is plaguing recovery of the global economy.
A focal point for the European officials is the stabilization European commercial banks, which have been under a heavy market pressure. European commercial banks, particularly French and German banks, hold significant amounts of sovereign debt from the peripheral eurozone member states, know as PIIGS (Portugal, Italy, Ireland, Greece and Spain). Concern over Greek sovereign default is threatening a European banking crisis.
Suggestions have surface for Europe to deal with this possible banking crisis by creating a plan similar to that of the US TARP program of 2008, following the collapse of the US housing market and the bankruptcy of Lehman Brothers, “Troubled Asset Relief Program” (TARP) was created by the US government to strengthen financial institutions. Under TARP $700 billion of capital was injected into US banks.
For a EuroTARP, it is estimated that at least $202 billion of capital will need to be injected into the European Financial Stability Facility (EFSF) to purchase distressed sovereign debt from the European commercial banks. The hope is that this would alleviate the pressure on the peripheral European member states and on the European commercial banks.
Ambereen Choudhury, an analyst at JP Morgan Cazenove, a leading investment bank focused on mergers & acquisitions, debt and equity placements and equity research and distribution based in the UK, wrote in a report issued on September 26, 2011 that eurozone banks need at least €150 billion ($202 billion) of capital provided through a Europe wide Troubled Asset Relief Program akin to the U.S. plan.
“We assume Euro-Tarp rather than specific support only for the most distressed institutions, as we believe a general solution is required to restore general confidence and reopen the funding markets for all institutions,” Choudhury said in the report. Goodman Sates president Gary Con said that modeling a European financial rescue on TARP “would be a good solution.”
Higher Leverage as Cure for High Leverage
One question is what the JP Morgan Cazenove approach would mean for the balance sheet of the EFSF, which already carries committed emergency loans to Ireland, Portugal and Greece. It is expected to provide over €100 billion ($134.9 billion) in additional funding for a Greek bailout. After committed loans, the Fed’s war chest will be down to about €298 billion ($402 billion). German Finance Minister Wolfing Schaeuble said on Monday, September 19, that there is no plan to expand the EFSF.
This plan will catapult the EFSF into the category of a highly leveraged fund, which borrows more than its equity capital provided by EU member governments. No official plans have been released. Details of the structure will change as European policymakers fight over the best course of action from the perspective of their different national interest.
Many of the proposed options to expand further the €440 billion ($596 billion) European Financial Stability Facility (EFSF) have problems, including opposition from countries like Germany, which fears a replay of its disastrous inflationary monetary policies of the 1920s during the Weimar Republic.
Meanwhile, euro zone officials played down rumor on Monday, September 19, of emerging plans to cut by half Greece’s sovereign debts and to recapitalize European banks to cope with the fallout, stressing that no such scheme is on the table yet.
Rough calculations suggest the EFSF, which borrows its funds from credit markets backed by guarantees from eurozone member states, might cope with a bailout of Spain but that it would not have enough financial power if Italy needed help.
The EFSF is already committed to providing €17.7 billion ($24 billion) in emergency loans to Ireland and €26 billion ($35.3 billion) to Portugal.
In addition, the EFSF takes over the remainder of Europe’s contribution to an initial bailout of Greece, which is likely to require around €25 billion ($34 billion), and is expected to provide two-thirds of a €109 billion ($147.7 billion) second bailout of Greece.
Taken together, the EFSF’s current commitments total at least €142 billion ($193 billion), leaving it €298 billion ($405 billion). A package for Spain might top €290 billion ($395 billion), while a rescue bill for Italy could total almost €490 billion ($666 billion).
If Greece defaults on its sovereign debt, contagion will spread to cause sovereign defaults by all the other PIIGS governments and a massive failure in financial markets world wide.
Some suggest doubling the funding of EFSF, while others talk of boosting it to “several trillion”. But the way to restore confidence, which will be determined by the reaction of already stressed markets, goes beyond simple mathematics.
Greece only a Detonator of European Sovereign Debt Bomb
The sovereign debt default haunting Europe has its detonator in Greece, one of the smallest yet most heavily indebted economies in Europe. Greece, while not a poor country, desperately needs a next aid payment of $11 billion to avoid running out of cash within weeks, but negotiations between the Greek government and the “troika” of the European Union, European Central Bank, and International Monetary Fund have stalled. The problem is no one believes that the next payment of $11 billion will by itself solve Greece’s sovereign debt problem. Considered unthinkable not too long ago, a Greek default now seems imminent — a subsequent exit from the eurozone no longer improbable.
Orderly Default Option
Talks of a potential “orderly default” of Greek sovereign debt have emerged, even suggestions of a Greek exit from the eurozone as a possible scenario. Time is running out for continuing indecision and denial. In the end, the governments of the stronger economies, such as Germany and France, will have to step up to the plate, as their economies had the most to lose from a wave of falling dominos of sovereign debt default in the eurozone.
French and German Responsibility
In many ways, France and Germany were responsible for the sad state of affair facing eurozone governments today. Financial stability in the eurozone had been guaranteed by the euro convergence criteria as spelled out in the Stability and Growth Pact (SGP) are:
1. Inflation rates:
No more than 1.5 percentage points higher than the average of the three best performing (lowest inflation) member states of the EU.
2. Government finance:
Annual government fiscal deficit:
The ratio of the annual government fiscal deficit to GDP must not exceed 3% at the end of the preceding fiscal year. If not, it is at least required to reach a level close to 3%. Only exceptional and temporary excesses would be granted for exceptional cases.
The ratio of gross government debt to GDP must not exceed 60% at the end of the preceding fiscal year. Even if the target cannot be achieved due to the specific conditions, the ratio must have sufficiently diminished and must be approaching the reference value at a satisfactory pace.
3. Exchange rate:
Applicant countries should have joined the exchange rate mechanism (ERM II) under the European Monetary System (EMS) for two consecutive years and should not have devaluated its currency during the period.
4. Long-term interest rates:
The nominal long-term interest rate must not be more than 2 percentage points higher than in the three lowest inflation member states.
Had these criteria set by the Stability and Growth Pact (SGP) been observed, it is unlikely that eurozone governments would face any sovereign debt crisis today. Ironically, the watering down of the SGP, which led to the current sovereign debt crisis in the eurozone, had been at the request of Germany and France, two of the strongest of the then 16 eurozone member states. Eurozone financial markets had been imitating the rush to phantom wealth creation through synthetic structured finance and debt securitization invented by fearless young traders in New York and London working with money provided by loose monetary measures of all central banks led the Federal Reserve.
In March 2005, the EU’s Economic and Financial Affairs Council (ECOFIN), under the pressure of France and Germany, relaxed SPG rules to respond to criticisms of insufficient flexibility and to make the pact more enforceable. Permissiveness infested the European theoretical regulatory framework, following the US example.
ECOFIN, one of the oldest configurations of the Council of the European Union, is composed of the Economic and Finance Ministers of the 27 European Union member states, as well as Fiscal Budget Ministers when budgetary issues are discussed.
The EU Council covers a number of EU policy areas, such as economic policy coordination, economic surveillance, monitoring of member state budgetary policies and public finances, the shape of the euro (legal, practical and international aspects), financial markets and capital movements and economic relations with third countries. It also prepares and adopts every year, together with the European Parliament, the budget of the European Union which is about €100 billion ($136 billion).
The Council meets once a month and makes decisions mainly by qualified majority, in consultation or co-decision with the European Parliament, with the exception of fiscal matters which are decided by unanimity. When the ECOFIN examines dossiers related to the euro and EMU, the representatives of the member states whose currency is not the euro do not take part in the vote of the Council.
At the urging of Germany and France, the ECONFIN agreed on a reform of the SGP. The ceilings of 3% for budget deficit and 60% for public debt were maintained, but the decision to declare a country in excessive deficit can now rely on certain new parameters: the behavior of the cyclically adjusted budget, the level of debt, the duration of the slow growth period and the possibility that the deficit is related to productivity-enhancing procedures. The pact is part of a set of Council Regulations, decided upon the European Council Summit 22-23 March 2005.
Greece a Victim of Structured Finance
Greece fell into the euro debt trap by yielding to the temptation of structured finance, the instruments of which were first developed in the US and adopted by US transnational financial institutions such as Goldman Sachs, Citibank, JPMorgan Chase and Bank of America to generate phenomenal profit for them in deregulated global markets fueled by floods of dollar-denominated liquidity release by the Federal Reserve, the US central bank, through the virtual transaction of synthetic derivatives known as synthetic collateralized debt obligations (CDO).
This new game of phantom wealth creation was soon joined by copycats in Europe such as Barclay, Société Générale, Deutsche Bank and ING. Such synthetic instruments were designed to, among other things, help banks hide their liabilities by pushing them off their balance sheets and thus lowering their capital requirement to increase profit from expanded loan-making to yield higher return on capital. (Please see my May 9, 2007 AToL article: Liquidity Boom and Looming Crisis, written and published two months before the credit crisis first imploded in New York in July 2007.)
Later, expanding from the private sector, such schemes were sold to EMU member governments to help them mask their true public debt levels to skirt strict EMU rules, in order to engage in permanent monetary easing. Across the eurozone, in obscure and opaque over-the-counter (OTC) derivative deals that traded directly between counterparties off exchanges between “special purpose vehicles” (SPV), and designed to help governments legally skirt EMU criteria, transnational banks provided Eurozone governments with cash upfront in return for future payments by government. Such payments would reduce government fiscal revenue since the revenue from collateral assets has been pledged to investors of CDOs. The liabilities were taken off their national balance sheets to present a healthy picture of national finance, until the government is forced to make up the revenue shortfall in a recession.
Thus it is hypocrisy of the extreme for Germany to hold Greece hostage with demand of severe fiscal austerity that will lead to socio-political instability, by asserting disingenuously that Germans work harder than Greeks, and that the German government is fiscally more responsible than the Greek government, and that Greece cannot expect German taxpayers to bail out Greece from a decade of poor public finance, made possible by German influence on diluting the criteria of the SPG.
Goldman Doing God’s Work Again
Wall Street is directly responsible for Greece’s public finance predicament. In 2005, Goldman Sachs, doing what its chairman told Congress as “God’s work”, sold interest rate swaps it created to the National Bank of Greece (NBG), the country’s largest bank. In 2008, Goldman Sachs helped NGB put the swap denominated in euros into a legal special purpose vehicle (SPV) called Titlos. National then retained the bonds that Titlos issued as collateral to borrow even more euros from the European Central Bank (ECB) and in turn from international banks. The swap will be costly and unprofitable for the Greek government through its long contract term, while Goodman profited handsome in fees up front.
Appropriately, in Greek manuscripts, the titlo was often used to mark the place where a scribe accidentally skipped the letter, if there was no space to draw the missed letter above. SPV Titlos performed the special purpose of skipping the sovereign liability Greece had assumed in order to get more loans from the ECB and international banks than was permitted under SPG criteria. Such SPV deals were not made public even though Titlos obligations are among the weak links in Greek public finance in 2010. Information on them finally trickled out only through government investigations and media investigative reporting.
Der Spiegel reported in early January 2010 that Goldman Sachs two years earlier had helped the government of Greece cover up part of its huge fiscal deficit via a currency swap deal name Titlos, which used artificially high exchange rates. A report commissioned by the Greek Finance Ministry released on February 1, 2010, revealed that Greece had used swaps to defer interest repayments by several years.
On February 15, 2010, Bloomberg reported a Greek government inquiry uncovered a series of swaps agreements with securities firms that allowed it to mask its growing public debts. The document did not identify the securities firms Greece used. But the former head of Greece’s Public Debt Management Agency told Bloomberg that the government turned to Goldman Sachs in 2002 to obtain $1 billion through a swap agreement.
(Please see my AToL series on GLOBAL POST-CRISIS ECONOMIC OUTLOOK:
Part XII: Financial Globalization and Recurring Financial Crises
Part XI: Comparing Eurozone Membership to Dollarization of Argentina
Part X: The Trillion Dollar Failure
Part IX: Effect of the Greek Crisis on German Domestic Politics
Part VIII: Greek Tragedy
Part VII: Global Sovereign Debt Crisis
Part VI: Public Debt and Other Issues
Part V: Public Debt, Fiscal Deficit and Sovereign Insolvency
In these articles, I warned against the danger of SPVs that would eventual put Greece into a disastrous sovereign debt crisis.)
The fundamental decisions over the future of the European monetary union will be politically difficult, and they will be costly for the richer economies. The costs of not acting decisively now, however, are going to be even higher. The urgency in bailing out Greece is the contagion on Spain and Italy should Greece defaults, and through these economies to the US and Asia.
This fact is validated by the blunt warning from US Treasury Secretary Timothy Geithner on Friday, September 16 to eurozone finance ministers at a closed meeting of in Wroclaw, Poland. Geithner told the Europeans to stop political bickering and take control of the financial aspects of the debt crisis that has brought “catastrophic risk” to global financial markets.
Geithner Warns Europe
Mr. Geithner reportedly said on the sideline of the ministerial meeting: “What’s very damaging is not just seeing the divisiveness in the debate over strategy in Europe but the ongoing conflict between countries and the [European] central bank”, adding that “governments and central banks need to take out the catastrophic risk to markets.”
Geithner’s presence at the meeting of EU financial ministers underlined the concerned of the US government about the danger of financial contagion from the eurozone sovereign debt and banking crisis and its negative effect on the fragile economic recovery in the US and other parts of the world, including Asia.
In a blunt warning that reflected Washington’s growing concern, Secretary Geithner urged European leaders to halt a months-long clash with the European Central Bank and argued that the EU’s growing reliance on foreign lenders would imperil the zone’s ability to control its own destiny.
“What is very damaging [in Europe] from the outside is not the divisiveness about the broader debate, about strategy, but about the ongoing conflict between governments and the central bank, and you need both to work together to do what is essential to the resolution of any crisis,” Mr Geithner said on the sidelines of a meeting of eurozone finance ministers in Wroclaw, Poland on Friday, September 16.
“Governments and central banks have to take out the catastrophic risk from markets… [and avoid] loose talk about dismantling the institutions of the euro,” he added.
Mr Geithner’s comments came as the Europe’s finance ministers agreed to withhold an €8 billion loan payment to Greece, a move that could leave Athens scrambling to satisfy its lenders before it runs out of cash.
George Osborns, UK chancellor, echoed Mr Geithner’s comments, telling Sky news on Saturday, September 18, that “people know that time is running out, that the eurozone needs to show it can get a grip on the situation.”
However, some eurozone finance ministers hit back at Mr Geithner’s comments, questioning the usefulness of his visit. “I found it peculiar that even though the Americans have significantly worse fundamental data than the eurozone, that they tell us what we should do and when we make a suggestion ... that they say no straight away,” said Maria Fekter, Austria’s finance minister.
Sweden’s Anders Borg said: “we need to make progress, but it’s quite clear the US has a big debt problem and the situation would be better if the US could show a sustainable way forward.”
The eurozone’s more fiscally prudent governments – particularly Germany and the Netherlands - are keen to prove to their voters that they were forcing Greece to comply with the deep fiscal budget cuts and other reforms it promised when it accepted a €109 billion rescue package last year.
Several eurozone ministers also dismissed a US suggestion to give additional flexibility to the eurozone’s €440 billion rescue fund, re-opening trans-Atlantic fissures over fiscal and economic policy.
Markets Respond Negatively to EU Postponement on Decision
Finance ministers of the EU extended the time frame to approve a revamp of the €440 billion rescue fund that was agreed by heads of member state in July. After predicting that all 17 governments of eurozone member states would ratify the changes by the end of this September, they are now expecting the process to drag on until mid-October.
Some eurozone ministers expressed unhappiness with Mr Geithner’s comments about Europe ending divisions as such comments actually opened up new divisions.
Austria's Finance Minister Maria Fekter, one eurozone politician at the meeting who voiced her objection to Mr Geithner's comments, said: “I found it peculiar that even though the Americans have significantly worse fundamental [economic] data than the eurozone, that they tell us what we should do.” She was referring to US high national debt and the recurring trade and fiscal deficits, not mentioning the political standoff in Congress over the increase of the national debt ceiling.
Joe Quinlan & Peter Sparding in Real Clear World gave the following analysis on Impact of a Eurozone Default on the Transatlantic Economy. Joe Quinlan is a Transatlantic Fellow at the German Marshall Fund. Peter Sparding is a Program Officer with the Economic Policy Program of the German Marshall Fund in Washington.Yet the September 17 weekend meeting of the 17 eurozone finance ministers in Poland, instead of calming markets, only increased market concerns. The meeting produced little in the way of concrete proposals to deal with Greece’s acute funding issues and the risks of financial contagion.
Too Little, Too Late
Only two months after a second bailout was agreed to by European leaders, and amid new data indicating that the Greek economy is shrinking at a faster rate than expected, the size of rescue packages currency being discussed already seems to be inadequate. Furthermore, a number of indicators suggest the markets have already begun to discount a default — yields on Greek bonds have soared to record highs, while the price for credit-default swaps to insure Greek debt has rocketed. Many hedge funds are poised to make a killing on a Greek sovereign default.
Despite these punishing moves by investors who react with incomplete and unsubstantiated information, markets may still be under-pricing the total cost of a Greek default. A default on this scale is unprecedented, and its potentially widespread ramifications are unknown. Markets can limit some of their risk, but it is far from certain that an actual default would not lead to further panic and turmoil.
Life After Default
Scenarios for a Greek default could include a run on banks in Greece and in the rest of the world. Capital, people, goods, and other transportable assets would likely leave Greece and the eurozone. Hoarding of physical cash and delays in payments among international banks and multinational corporations could be expected.
A Greek exit from the monetary zone might become an unavoidable next step. The risk of redenomination of government debt and currency depreciation would then result in higher borrowing costs or even being frozen out of debt and capital market. With the cost of capital very high over the medium term, or capital and credit unavailable at any price, the new/old currency likely being extremely weak and thus highly inflationary, a painful and prolonged period of no or negative economic growth for Greece and the eurozone seems unavoidable.
The pain would also be felt elsewhere in the eurozone as suspicion and mistrust on credit worthiness among banks would curtail lending. Other perceived weak economies, such as Portugal, Ireland, or even Spain and Italy would swiftly be “tested” by financial markets. Despite what some in the creditor countries might hope for, Greece’s default and/or exit from the common currency would thus not signal the end of the crisis, but instead would add even more pressure on stronger countries to come up with a “Big Bang” solution.
Impact on the US
For the US, developments in Europe should be reason for serious concern. While not as heavily invested in Greek debt, US banks are somewhat more exposed in Ireland and Spain. The US would have to try to insulate its financial system from shocks in Europe in order to protect its own already battered banking sector and its economy. To avoid a potential default-induced financial crisis, the Federal Reserve has already expanded its swap operations with the European Central Bank, and it may have to do more. (end of analysis)
On September 18, 2011, the Federal Open Market Committee (FOMC) authorized a $180 billion expansion of its temporary reciprocal currency arrangements (swap lines).
According to the Fed’s press release, the changes allow for “increases in the existing swap lines with the ECB and the Swiss National Bank” and for “new swap facilities…with the Bank of Japan, the Bank of England, and the Bank of Canada.” These measures “…are designed to improve the liquidity conditions in global financial markets,” the release said.
An underlying aspect of a currency swap is that banks (and businesses) around the world have assets and liabilities not only in their home currency, but also in dollars. Thus, banks in eurozone need funding in dollars as well as in euros. However, Europeans banks recently have been reluctant to lend to one another. Some observers believe this reluctance relates to uncertainty about the assets that other banks have on their balance sheets or because a bank might be uncertain about its own short-term cash needs. Whatever the cause, this reluctance in the interbank market has pushed up the premium for short-term dollar funding and has been evident in a sharp escalation in LIBOR rates.
The currency swap lines were designed to inject liquidity, which can help bring rates down. The bottom line is that the Fed, by exchanging dollars for foreign currency, has helped to provide liquidity to banks around the world. This effort can help to bring interbank rates back down at a time when restrictively high rates can choke off access to financing that European banks and other businesses need to operate. The swap might also be needed to provide Federal Reserve dollars for US branches of European banks and jawbone US banks and money market funds to not withdraw their funds from Europe.
However, even if the U.S. financial sector somehow managed to insulate itself from the risk of financial contagion, the impact on corporate America would be severe. Europe accounts for over one-fifth of world GDP and one-quarter of global personal consumption. Just over half of corporate America’s non-US revenue comes from Europe.
Geithner Warns Europe
Against this backdrop, it is no wonder that U.S. Treasury Secretary Timothy Geithner warned this weekend of “catastrophic risks” if Europe failed to rise to this challenge. Indeed, the time to find a “good” outcome for Europe’s crisis has passed. It is time to acknowledge that any solution now will be costly. In the short term, this includes strengthening European banks and extending further support to distressed countries.
Another failure to act decisively contains unforeseeable risk and is likely to come at a much higher price — and not only for Europe. Secretary Geithner did not mince words. The fallout from a Greek default, the risks of the eurozone disintegrating, the systemic risks of a European banking crisis, the aftershocks to the U.S. economy — any or all of these events could ultimately prove catastrophic for an already fragile transatlantic economy and transatlantic partnership.
Turning EFSF into a Bank
The Centre for European Policy Studies, a think tank in Brussels, proposed increasing EFSF’s funding by is to turn it into a bank. This means the Luxembourg-based entity could lend money to financially distressed eurozone member with loans from the ECB to refinance such loans rather than having to rely solely on its limited capital base.
As a bank, the EFSF could lend up to ten times its capital even in this difficult market, which would mean the €440 billion of capital in the facility could in theory be transformed into more than €4 trillion of bailout funds.
But the reality is more complex. The EFSF would raise funds from the ECB relative to the quality of the collateral it puts up. Such collateral financial instruments are distressed government bonds that have low ratings because of high risk of default. This means that by definition, the EFSF can never raise sufficient bail out funds based on the distressed sovereign debts without a market discount plus a haircut imposed by the ECB. An under-funded EFSF that cannot buy distressed debt as face value cannot perform its role as a restorer of market confidence.
But it is political opposition rather than financial obstacles that poses the biggest and perhaps insurmountable difficulty. German Bundesbank chief Jens Weidmann has expressed his concern that the ECB itself may already be overextending.
The eurozone’s central banks and the ECB have a combined capital base of €82 billion. It has already lent €535 billion to banks and bought a further €150 billion of government bonds to prop up the depressed market.
Opposition from Germany and ECB
So far, Germany, the euro zone’s deep pocket funding source, and the ECB, the lender of last resort, are both opposed to the idea of turning the EFSF into a bank, suggesting the idea has little chance of becoming reality.
By Sunday, September 25, German finance minister Wolfgang Schaeuble said he was looking into alternatives to the EFSF-bank option. One alternative would be to use the EFSF to insure investors against losses from buying Italian or Spanish banks. The EFSF would issue “credit enhancements” for new bonds that could cover potential losses, cutting the risk for bondholders.
EFSF as Insurer
Such a scheme would not help Greece, said Sony Kapoor, a financial expert who advocated the model, but would set up a contagion “firewall” for Italy and Spain that would allow them tap money markets even if Greece were to default.
“This could take the form of the EFSF offering insurance against, say, the first 20 percent of any losses on these ... and would enable the EFSF to bring down the borrowing costs for Italy and Spain for the next 3 years or more,” Kapoor, the managing director of think tank Re-Define told CNBC. “Lowering the borrowing costs for Italy and Spain is a necessary step before any restructuring of Greek debt can be seriously contemplated, said Kapoor, “The options being discussed are primarily about policymakers, who believe that Italy and Spain are fundamentally solvent, calling the markets’ bluff that they are not.”
Unlike the EFSF as it is currently constituted, the European Stability Mechanism (ESM) is permanent and has a pool of capital of €80 billion ($108.8 billion), paid in by countries in the same way as they do with the ECB.
Starting the ESM in July 2012, rather than July 2013 as planned, could reassure investors because it provides a second lever to support markets alongside the ECB. However, German chancellor Angela Merkel and other leaders have to convince eurozone member state legislators to back their pledge to allow the EFSF to extend loans to eurozone member state whose sovereign bonds faces default or to buy sovereign bonds to prop up struggling eurozone member states.
Merkel’s Domestic Political Problem
German Chancellor Angela Merkel said on Sunday (September 18): “Allowing Greece to default on its debt now would destroy investor confidence in the euro zone and might spark contagion like that experienced after the bankruptcy of Lehman Brothers in 2008. We need to take steps we can control,” Merkel said, drawing a parallel between the Greek situation and that of Lehman, whose bankruptcy helped trigger the global financial crisis, “What we can’t do is destroy the confidence of all investors mid-course and get a situation where they say that if we’ve done it for Greece, we will also do it for Spain, for Belgium, or any other country. Then not a single person would put their money in Europe anymore.”
In a one-hour interview on the euro zone crisis with popular German talk show host Guenther Jauch, Merkel said she relied on the view of the International Monetary Fund when assessing how to handle Greece. “As long as the IMF was convinced Greece’s debt was sustainable, then she supported that position,” she said.
Merkel also made clear that she did not view a parliamentary vote in Germany on Thursday (September 15) on the euro zone’s rescue mechanism as “make-or-brake” for her government. Because opposition parties support giving new powers to the European Financial Stability Facility (EFSF), passage is not in question.
But some German politicians have suggested that if Merkel fails to win a majority with the conservative parties in her coalition — known in Germany as a “chancellor majority” — she should dissolve parliament and call new elections.
"We are talking about a law here, a completely normal law. The government needs a majority. The chancellor majority is what you need when you are voted in as chancellor, or in other special personnel cases,” Merkel said. "I want my own majority and I will fight for this.” She also said she was “appalled” at a lack of progress from the Group of 20 countries in forging a consensus on regulating banks and dealing with the "too big to fail" problem.
Christian Wulff, who owes his job as Germany’s president to Mrs Merkel, complained that the financial markets are pushing governments around. Politics must “regain its ability to act,” he demanded.
The euro crisis is Merkel’s trial by ordeal. She has tried to help indebted euro members states while refusing to write blank cheques on German tax money. But the markets have repeatedly tested that approach, requiring ever larger and more elaborate bail-outs. Now, Germany’s increasingly skeptical Bundestag (lower house of parliament) is about to weigh in. This month (September) it will consider legislation to approve expanded powers for the European Financial Stability Facility (EFSF), a temporary fund for helping the indebted euro countries. After that it will vote on a second bail-out of Greece, worth about €109 billion ($157 billion), and then on a permanent successor to the EFSF.
Resistance, much of it from Mrs Merkel’s coalition, is stiffening. Dissenters have two main worries. The first is that the Bundestag will be stripped of its right to determine how taxpayers’ money is spent. They expect encouragement on September 7th from a ruling by the constitutional court on the legality of the first Greek bail-out and the EFSF. The court is not expected to overturn the measures, but may reinforce the Bundestag’s authority over budgetary matters. The trick will be to do that without paralyzing the institutions being set up to deal with euro crises.
The second fear is that Germany will end up pouring even more money into countries that are unwilling or unable to solve their own fiscal problems. The rescue measures “will certainly buy time,” says Wolfgang Bosbach, a CDU leader in the Bundestag who is normally loyal to Mrs Merkel. “But I fear they won’t solve the problem permanently, so there will have to be more aid.” Greece’s problem is not lack of credit; it is lack of competitiveness, he believes.
There are enough pro-rescue votes in the Bundestag to pass the legislation (the main opposition parties favour even more generous measures, such as issuing Eurobonds jointly guaranteed by euro-zone governments). The question is whether the “chancellor majority” will suffice to enact the package without opposition votes. If the majority buckles, Mrs Merkel would be weakened, perhaps fatally. The government could collapse, two years before elections are scheduled. But this seems unlikely. None of the coalition parties is keen to face elections now. The FDP, which harbors some vocal skeptics, might not even re-enter the Bundestag. Mr Bosbach expects the chancellor’s majority to hold up, though he does not plan to join it.
Belatedly, Mrs Merkel is starting to counter the threat. She will try to placate the CDU’s base in a series of regional meetings and has set up a commission to fashion a party consensus on the euro. Her rhetoric now sometimes throbs with un-Merkel-like fervor. “Europe is the most important thing we have,” she says (though not in Schwerin). Other CDU leaders are sounding Europhile notes not heard for some time (without providing much detail or any timetable). Ursula von der Leyen, the labor minister, calls for a “United States of Europe”.
Mrs Merkel may recover from her mid-term slump. Though CDU traditionalists grumble about her leadership, they have no one capable of challenging her. Rising stars like Mrs von der Leyen are modernisers like the chancellor herself. “There is no alternative centre of power” within the party, says Gerd Langguth of the University of Bonn. With luck, Mrs Merkel will have two years to persuade voters, also, to see the brighter side of things.
Geithner Pushed Europe Again
Treasury Secretary Timothy Geithner told European government officials bluntly on Saturday, September 24, 2011, to eliminate the threat of a catastrophic financial crisis by teaming up with the European Central bank to boost the continent’s bailout capacity.
Geithner, in his most explicit language to date, said fiscal authorities should work more closely with the ECB to ensure that euro-area governments with sound policies have access to affordable financing and to ensure that European banks have adequate capital and liquidity to weather the crisis.
"The threat of cascading default, bank runs, and catastrophic risk must be taken off the table, as otherwise it will undermine all other efforts, both within Europe and globally. Decisions as to how to conclusively address the region's problems cannot wait until the crisis gets more severe," Geithner said.
Geithner has been lobbying for weeks for European officials to leverage their €440 billion ($603 billion) European Financial Stability Fund through the ECB to increase its capacity. His statement suggests that he wants Europe to employ the ECB's balance sheet in the same manner as the Federal Reserve did with Treasury capital during the 2008-09 financial crisis.
The Treasury in 2008 pledged $20 billion in capital to allow the Federal Reserve to lend $200 billion to restart credit markets frozen by the financial crisis.
Geithner said that because inflation risks were largely less acute, some central banks had room to further ease policy, keep rates lower longer and slow the pace of expected tightening.
He and Federal Reserve Chairman Ben Bernanke met on Friday, September 16, in Washington with top officials from the European Central Bank and some national central banks from Europe, in part to discuss international financial regulatory reform.
Geithner said US growth needed additional support from the Obama administration's $447 billion tax-cut and spending package to boost jobs growth. Without this, fiscal policy would shrink too quickly and likely cause U.S. growth to be below potential in 2012.
“Fiscal policy everywhere has to be guided by the imperatives of growth," he said. Geithner also said that the IMF is still falling short in assessing exchange rate policies and should itself be subject to more scrutiny.
“The Fund's surveillance would benefit from the publication of an External Stability Report that provides a frank assessment of exchange rate misalignment and excessive reserves accumulation and progress being made in reducing global imbalances," Geithner said. "We call on the IMF to set forth a strong and comprehensive set of proposals to address these deficiencies.”
On September 29, 2011, the German Parliament approved the expansion of the bailout fund for heavily indebted European countries, the most important step in a tortuous process that has rattled markets and raised doubts about the ability of governments to react to the expanding debt crisis.