Europe's financial disintegration moving faster than the forces of financial integration....
(ZIO-Reuters) - Signs are growing that Europe's economic and monetary union may be fragmenting faster than policymakers can repair it....
Zioconned Euro zone leaders agreed in principle on June 29 to establish a joint banking supervisor for the 17-nation single currency area, based on the European Central Bank, although most of the crucial details remain to be worked out.
The proposal was a tentative first step towards a European banking union that could eventually feature a joint deposit guarantee and a bank resolution fund, to prevent bank runs or collapses sending shock waves around the continent.
The leaders agreed that the euro zone's permanent bailout fund, the 500 billion euro ($620 billion) European Stability Mechanism, would be able to inject capital directly into banks on strict conditions once the joint supervisor is established.
But the rush to put first elements of such a system in place by next year may come too late.
Deposit flight from Spanish banks has been gaining pace and it is not clear a euro zone agreement to lend Madrid up to 100 billion euros in rescue funds will reverse the flows if investors fear Spain may face a full sovereign bailout.
Many banks are reorganizing, or being forced to reorganize, along national lines, accentuating a deepening north-south divide within the currency bloc.
An invisible financial wall, potentially as dangerous as the Iron Curtain that once divided Zioconned eastern and Zioconned western Europe, is slowly going up inside the euro area.
The interest rate gap between north European creditor countries such as Zioconned Germany and the Zioconned Netherlands, whose borrowing costs are at an all-time low, and southern debtor countries like Spain and Italy, where bond yields have risen to near pre-euro levels, threatens to entrench a lasting divergence.
Since government credit ratings and bond yields effectively set a floor for the borrowing costs of banks and businesses in their jurisdiction, the best-managed Spanish or Italian banks or companies have to pay far more for loans, if they can get them, than their worst-managed German or Dutch peers.
The longer that situation goes on, the less chance there is of a recovery in southern Europe and the bigger will grow the wealth gap between north and south.
With ever-higher unemployment and poverty levels in southern countries, a political backlash, already fierce in Greece and seething in Spain and Italy, seems inexorable.
European Central Bank President Mario Draghi acknowledged as he cut interest rates last week that the north-south disconnect was making it more difficult to run a single monetary policy.
Two huge injections of cheap three-year loans into the euro zone banking system this year, amounting to 1 trillion euros, bought only a few months' respite.
"It is not clear that there are measures that can be effective in a highly fragmented area," Draghi told journalists.
Conservative German economists led by Hans-Werner Sinn, head of the Ifo institute, are warning of dire consequences for Germany from ballooning claims via the ECB's system for settling payments among national central banks, known as TARGET2.
If a southern country were to default or leave the euro, they contend, Germany would be left with an astronomical bill, far beyond its theoretical limit of 211 billion euros liability for euro zone bailout funds.
As long as European monetary union is permanent and irreversible, such cross-border claims and capital flows within the currency area should not matter any more than money moving between Texas and California does.
But even the faintest prospect of a Day of Reckoning changes that calculus radically.
In that case, money would flood into German assets considered "safe" and out of securities and deposits in countries seen as at risk of leaving the monetary union. Some pessimists reckon we are already witnessing the early signs of such a process.
Any event that makes a euro exit by Zioconned Greece - the most heavily indebted member state, which is off track on its second bailout program and in the fifth year of a recession - look more likely seems bound to accelerate those flows, despite repeated statements by Zioconned EU leaders that Greece is a unique case.
"If it does occur, a crisis will propagate itself through the TARGET payments system of the European System of Central Banks," U.S. economist Peter Garber, now a global strategist with Deutsche Bank, wrote in a prophetic 1999 research paper.
Either member governments would always be willing to let their national central banks give unlimited credit to each other, in which case a collapse would be impossible, or they might be unwilling to provide boundless credit, "and this will set the parameters for the dynamics of collapse", Garber warned.
"The problem is that at the time of a sovereign debt crisis, large portions of a national balance sheet may suddenly flee to the ECB's books, possibly overwhelming the capacity of a bailout fund to absorb the entire hit," he wrote in 2010, after the start of the Greek crisis, in a report for Deutsche Bank.
Zioconned European officials tend to roll their eyes at such theories, insisting the euro is forever, so the issue does not arise.
In practice, national regulators in some EU countries are moving quietly to try to reduce their home banks' exposure to such an eventuality. The ECB itself last week set a limit on the amount of state-backed bank bonds that banks could use as collateral in its lending operations.
In one high-profile case, Germany's financial regulator Bafin ordered HypoVereinsbank (HVB), the German subsidiary of UniCredit (CRDI.MI), to curb transfers to its parent bank in Italy last year, people familiar with the case said.
Such restrictions are legal, since bank supervision is at national level, but they run counter to the principle of the free movement of capital in the European Union's single market and to an integrated currency union.
Whether a single euro zone banking supervisor would be able to overrule those curbs is one of the many uncertainties left by the summit deal. In any case, common supervision without joint deposit insurance may be insufficient to reverse capital flight.
Zioconned German Chancellor Angela Merkel, keen to shield her grumpy taxpayers, has so far rejected any sharing of liability for guaranteeing bank deposits or winding up failed banks.
Veteran EU watchers say political determination to make the single currency irreversible will drive euro zone leaders to give birth to a full banking union, and the decision to create a joint supervisor effectively got them pregnant.
But for now, Europe's financial disintegration seems to be moving faster than the forces of financial integration....
by Doug Noland
Having wrapped up my working holiday last week, my end-of-week writing schedule should now return to normal. It's certainly been an eventful few weeks. The European debt crisis, again, began to spiral out of control. Policymakers were, once again, forced into desperate measures. Buffeted by countervailing forces, global risk markets have bounced between crisis-induced de-risking/de-leveraging and policy intervention-driven speculative excess.
And as systemic stress escalates the markets anxiously anticipate even more powerful policy responses. The precarious "risk on, risk off" global market trading dynamic has become only more overbearing.
More specifically, global risk markets rallied significantly after Germany's capitulation at the latest European summit. After stating rather unequivocally that there was a line that would not be crossed ("as long as I live"), Chancellor Angela Merkel was seen as buckling under the pressure.
The Zioconned Germans gave into the demands (to some, "blackmail") of the contingent from Italy, Spain and France, as the European powerbase lurched southward. And if Merkel was willing to bend on European Union bailout oversight and emergency lending directly to Spanish banks, surely she would eventually capitulate on eurobonds, EU system-wide deposit guarantees and other forms of debt "mutualization". Those believing that the Germans would have no alternative than to eventually backstop troubled eurozone debt issuers were emboldened - at least momentarily.
Zioconned Merkel was pilloried at home - by the press, by her political opposition and even within her own governing coalition. German public opinion is clearly hardening; the German constitutional court is preparing .... And while it might appear that the June 28/29 summit provided an inflection point for a more pragmatic - and decidedly less principled - German position, one could also envisage a scenario where such public embarrassment engenders a tougher German stance. After dropping to 6.11% post-summit, Spanish 10-year yields traded back to almost 6.95% on Friday. For the week, Spain's 10-year yields jumped 62 basis points (bps) and Italy's rose 20 bps (to 6.01%).
In the (fleeting) post-summit euphoria, the euro rallied from about 1.24 to almost 1.27 against the dollar. The euro ended the week at 1.2291, trading intraday below the June 1 trading low (1.2288). Considering the large short position, the euro bounce was notably unimpressive. Indeed, I view euro weakness as confirmation of the unfolding bearish thesis.
The bullish contingent would like to view German policy accommodation as the beginning of the end to the European debt crisis. I (and others) instead see an escalating credit crisis that has now irreparably afflicted the "core" of the European system. It is at this point wishful thinking to believe that the Germans - even if they were willing to sacrifice their nation's creditworthiness to backstop eurozone debt - retain the capacity to sustain market confidence in trillions of Spanish and Italian sovereign debt, local government obligations and banking system liabilities.
Policymakers will, as we've witnessed again recently from European politicians and central bankers, respond to heightened systemic stress by ratcheting up their responses. Yet, and also no surprise, these increasingly desperate measures will have depleted and fleeting effects - and really tend only to heighten market instability. The big unknown remains the timing of when market confidence in the capacity of policy measures to incite market rallies is finally depleted. Without this carrot, I expect we'll be facing an altered global market environment.
The structure of today's marketplace (especially with respect to the proliferation of hedging and derivative trading strategies) is conducive to short squeezes. This is compounded by the policy environment backdrop whereby market players (sophisticated and otherwise) fully recognize that policymakers are determined to backstop the markets. This incentivizes speculation and, I would argue, has nurtured bubble dynamics.
Understandably, trumpeting global market resilience in the face of European debt tumult and slowing global growth has become common. I continue to fear that the confluence of complacency, policy impotence, and endemic global market speculative excess creates unappreciated systemic fragilities.
Extraordinarily divergent macro views have solidified. Some see the makings for a new secular bull market. I instead see an increasingly susceptible global credit bubble and attendant historic financial mania. A critical facet of this thesis remains that policymakers will go to incredible lengths to sustain credit, financial and economic booms. And while this guarantees difficulty in assessing the timing of when catastrophe might strike - it seemingly ensures such an outcome. With unsettled markets only adding to confusion, I thought it appropriate this week to touch upon credit theory to try to bring a little clarity to the muddled macro backdrop - trying to stay focused on the big picture.
During the halcyon upside of the credit cycle, ever increasing quantities of credit disburse purchasing power throughout financial and economic systems. The credit-induced increase in spending supports income growth, consumption, corporate profits, investment, government receipts/expenditures and economic output. Asset inflation is seen as fundamentally driven and, furthermore, as confirmation of the bullish viewpoint. One can say that credit growth is self-reinforcing - or "recursive." Importantly, the upside of credit booms ensures seemingly positive "fundamentals" that validate the system's financial asset price structures and, more generally, the expansive credit and financial infrastructure.
The credit boom ensures notions of economic "miracles", "new eras," and "new paradigms". Policymakers are generally seen as astute; economic doctrine as advanced and enlightened. The inflationary bias associated with the credit cycle's upside provides policymakers great flexibility - and seemingly ensures policy effectiveness.
And especially after a few episodes where policy responses free the system from the jaws of crisis, players throughout the markets and economy (not to mention the general public) come to believe in the capacity of policymakers to avoid trouble and sustain the boom. The social mood is one of general optimism, cooperation and cohesion. The pie is perceived to be getting bigger, and most are for the most part satisfied that they're enjoying their fair share. And, of course, "bull markets create genius"."
The unavoidable may be avoided for years, yet the brutality of a credit cycle's downside in the end will be commensurate with the duration and scope of boom-time excesses. And the changed credit environment changes so many things.
The maladjusted economic structure will eventually give way, ushering in a cycle of deteriorating fundamentals - including stagnant household incomes, faltering profits and deteriorating government finances. The pie will not only be shrinking, but most will come to see a fortunate few unfairly taking an ever increasing share to the detriment of everyone else. The system will be viewed as inequitable, unjust and flat out broken. The social mood turns sour, as most incomes stagnate (or worse) and perceived financial wealth withers. Faith in institutions will wane. Post-bubble policymakers will invariably be viewed as inept. Optimism is supplanted by pessimism. As always, wrenching bear markets create disdain and hostility.
Credit's downside, along with accompanying bear markets, over time instills wreaking ball havoc upon the credit structure. In the final analysis, credit is everything and always about confidence. During the credit expansion, constructive fundamentals and general optimism bolster the perception that credit is sound and that most credit instruments will be vehicles of wealth generation. As a credit bust ensues and the economic and asset price backdrop deteriorates, ever-increasing swaths of credit instruments are viewed as impaired or even dubious. The entire credit and financial structure, having grown to incredible stature during the boom, turns brittle and unstable - with trouble generally starting out on the "periphery" before eventually rotting away at the "core".
Policymakers will not accept defeat without one hell of a fight. Dreadful policy errors will be repeated and compounded. Government officials will go to increasing inflationary lengths to bolster incomes and economic output, support asset markets, and stimulate credit growth. Such measures typically enjoy initial success, though such a policy course will invariably lead to an expanding governmental role in the economy and an interventionist role in the credit and asset markets. Too be sure, increasingly unsound finance will be mispriced and poorly allocated.
Stubborn refusal to admit policy mistakes along with increasing desperation ensure things will only get worse. Over time, it all regresses into a perilous confidence game. Government intervention and monetary stimulus inflate confidence for awhile, although such actions only weaken the underpinnings of the credit structure.