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"Dreams Versus Reality" - Former IMF Chief Economist On Europe's Last Stand

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Successive plans to restore confidence in the euro area have failed. Proposals currently on the table also seem likely to fail. The market cost of borrowing is at unsustainable levels for many banks and a significant number of governments that share the euro. In three short sentences, the Peterson Institute for International Economics' (PIIE) Simon Johnson introduces the clear and present danger that Europe has become in a comprehensive article on the deepening European crisis. The circular nature of the realization of sovereign credit risk realities and the subsequent effective insolvency of banks exacerbates a credit crunch and exaggerates problems in the real economy - most specifically in the periphery. Johnson outlines five measures that are needed to enable the euro area to survive but the big bazooka of up to EUR5tn just for the PIIGS is what the PIIE senior fellow fears as the ECB is pushed down a dangerous path. The coordination of 17 disaparate nations leaves the former IMF man greatly concerned as the unique nature of this crisis leaves "four economic, social, and political events as possible causes of systemic collapse with each at risk of occurring in the next weeks, months, or years and these risks will not disappear quickly." As European sovereign bonds are now deeply subordinated claims on recessionary economies, it is no surprise that Johnson ends by noting that Europe's economy remains in a dangerous state.

 

The European Crisis Deepens

Peter Boone and Simon Johnson, Peterson Institute for International Economics

Summary

 Successive plans to restore confidence in the euro area have failed. Proposals currently on the table also seem likely to fail. The market cost of borrowing is at unsustainable levels for many banks and a significant number of governments that share the euro.

 

Two major problems loom over the euro area. First, the introduction of sovereign credit risk has made nations and subsequently banks effectively insolvent unless they receive large-scale bailouts. Second, the ensuing credit crunch has exacerbated difficulties in the real economy, causing Europe’s periphery to plunge into recession. This has increased the financing needs of troubled nations well into the future.

 

With governments reaching their presumed debt limits, some commentators are calling on the European Central Bank (ECB) to bear the costs of additional bailouts. The ECB is now treading a dangerous path. It feels compelled to provide adequate “liquidity” to avert systemic financial collapse, yet must presumably limit its activities in order to prevent a loss of confidence in the euro—i.e., a change in market and political sentiment that could lead to a rapid breakup of the euro area.

 

Five measures are needed to enable the euro area to survive: (1) an immediate program to deal with excessive sovereign debt, (2) far more aggressive plans to reduce budget deficits and make peripheral nations hypercompetitive” in the near future, (3) supportive monetary policy from the ECB, (4) the introduction of mechanisms that credibly achieve long-term fiscal sustainability, and (5) institutional change that reduces the scope for excessive leverage and consequent instability in the financial sector.

 

Europe’s leaders have mainly focused on a potential longterm fiscal agreement, and the ECB under Mario Draghi is setting a more relaxed credit policy; however, the other elements are essentially ignored.

 

This crisis is unique due to its size and the need to coordinate 17 disparate nations (see chart below). We give four examples of economic, social, and political events that could lead to more sovereign defaults and serious danger of systemic collapse. Each trigger has some risk of occurring in the next weeks, months, or years, and these risks will not disappear quickly.

 

Key Systemic Problems In The Euro Area

Within the complex sphere of Europe’s crisis, if we had to pick one issue that turns this crisis from a tough economic adjustment into a potentially calamitous collapse, we would argue it is the transformation of Europe’s sovereign debt market.

 

European Sovereign Bonds Are Now Deeply Subordinated Claims on Recessionary Economies

 

Once risk premiums are incorporated in debt, Greece, Ireland, Portugal, and Italy do not appear solvent. For example, with a debt/GDP ratio of 120 percent and a 500-basis-point risk premium, Italy would need to maintain a 6 percent of GDP larger primary surplus to keep its debt stock stable relative to the size of its economy. This is unlikely to be politically sustainable.

 

Crisis Spreads into Europe’s Core Banks and Incites Capital Flight from the Periphery

 

Europe’s peripheral banks are suffering large deposit losses as capital moves to safer nations. The chart above shows the enormous capital flight that is occurring through the banking sector across the euro area. These Target2 balances show a cumulative transfer of €440 billion from peripheral nations to Germany from early 2009 to October 2011. Were it not for these implicit bailouts through the payments system, the euro area would have already collapsed.

 

Macroeconomic Programs: Too Timid to Restore Confidence or Growth

 

The strong core is becoming stronger, while Greece, Ireland, Portugal, and Spain have high unemployment. Italy’s troubles are recent, so with a sharp recession beginning, we anticipate Italian unemployment will soon rise sharply too.

Dreams versus Reality

There is no doubt that European political leaders are highly committed to keeping the euro area together, and so far, there is widespread support from business leaders and the population to maintain it. There is also, rightly, great fear that disorderly collapse of the euro area would impose untold costs on the global economy. All these factors suggest the euro area will hold together.

 

However, many financial collapses started this way. A far more dramatic creation and collapse was the downfall of the ruble zone when the Soviet Union collapsed in 1991.

 

Argentina’s attempt to peg its currency to the dollar in the 1990s was initially highly successful but ended when its politicians and society could not make the adjustments needed to hold the structure together. The Baltic nations—Estonia, Latvia, and Lithuania—have managed to maintain their pegs but only after dramatic wage adjustments and recessions.

 

More relevant, the various exchange rate arrangements that Europe created prior to the euro all failed. With the creation of the euro, Europe’s leaders raised the stakes by ensuring the costs of a new round of failures would be far greater than those of the past, but otherwise arguably little has changed to make this attempt more likely to succeed than the previous one. Small probabilities of very negative events can be destabilizing. A lot of things can go wrong at the level of individual countries within the euro area—and one country’s debacle can easily spill over to affect default risk and interest rates in the other 16 countries.

 

The euro swap market is based, in part, on interest rates charged by 44 banks in a range of countries; about half of these banks may be considered to be located in troubled or potentially troubled countries. If the euro swap market comes under pressure or ceases to function, this would have major implications for the funding of all European sovereigns—including those that are a relatively good credit risk.

 

At the least, we expect several more sovereign defaults and multiple further crises to plague Europe in the next several years. There is simply too much debt, and adjustment programs are too slow to prevent it. But this prediction implies that the long-term social costs, including unemployment and recessions rather than growth, attributable to this currency union are serious. Sometimes it is easier to make these adjustments through flexible exchange rates, and we certainly would have seen more rapid recovery if peripheral nations had the leeway to use exchange rates.

 

When we combine multiple years of stagnation with leveraged financial institutions and nervous financial markets, a rapid shift from low-level crisis to collapse is very plausible.

 

European leaders could take measures to reduce this risk (through further actions on sovereign debt restructurings, more aggressive economic adjustment, and increased bailout funds). However, so far, there is little political will to take these necessary measures. Europe’s economy remains, therefore, in a dangerous state.

 

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Tue, 01/24/2012 - 13:09 | 2092933 Mr Lennon Hendrix
Mr Lennon Hendrix's picture

Europe as Custer-Brilliant.

Tue, 01/24/2012 - 13:14 | 2092960 Chief KnocAHoma
Chief KnocAHoma's picture

Lagarde - (As she holds a gun to the head of Greece) I am telling all the citizens of the EU I am gona pull the trigger and you will all be wiped out.... unless... you all support the ESM which was passed secretly last nite... oh.... and you have to get those Huns to allow the EU to print, print, print....or I'll pull the trigger.... I mean it... I will do it this time...I'm not kidding...

Tue, 01/24/2012 - 13:28 | 2093021 Mr Lennon Hendrix
Mr Lennon Hendrix's picture

And Bernanke is telling the Fed Board to, "Shoot the hostage!"

Tue, 01/24/2012 - 18:16 | 2094242 Babushka
Babushka's picture

Five measures are needed to enable the euro area to survive: (1) an immediate program to deal with excessive sovereign debt, (2) far more aggressive plans to reduce budget deficits and make peripheral nations hypercompetitive” in the near future, (3) supportive monetary policy from the ECB, (4) the introduction of mechanisms that credibly achieve long-term fiscal sustainability, and (5) institutional change that reduces the scope for excessive leverage and consequent instability in the financial sector.

What a load of bollocks!

1)How the hell someone could immediately deal with a sovereign debt except to default on it or to inflate out of it which is a bit longer than immediately if one doesn't want to venture in hyperinflation mode..

2)The far more aggressive plans to reduce budget deficits (my ass), considering that the bailing out our credit/financial/banking system by sovereign states/nations means that the money provided to above mentioned institutions or let call it exposure to blackmailing is carried over to sovereign budget deficits as the expenditure was never planned before and was adapted on basis pay as you go. The two ways to cut it down is to reduce social expenses, which we do see already happening all over the gaff or to break the big banks and take over all usable assets as productive industry and business and refinance it through the budgetary means/direct- all other stinking assets let go to open market to re-establish mark to market value, accordingly to achieved results prosecute the bad boys-bankers and hell with that - confiscate they assets and the property to recompensate those who was misdealt or right out skinned and stuffed.

3)supportive monetary policy from the ECB - I understand it means give the banks as much as they want and take all possible stinking shit as collateral? So they can engineer new financial gimmicks to sell it back to ECB and  book  the profits,  instead of investing the money in real economy...?

4) the introduction of mechanisms that credibly achieve long-term fiscal sustainability. I would love the author to elaborate a bit on this one? Does he mean zero inflation, national referendums to cough up on some big projects demanding extra effort of nation, gold standard,...or just let paper it all over it worked so well last 20 times in history?

5) institutional change that reduces the scope for excessive leverage and consequent instability in the financial sector.

I wonder if author means the Basel Accords the milestone of financial industry ?

The principal uniform weighting of assets:
- zero weight for OECD government debt and all other government debt with less than one year maturity;
- 20 percent weight for debt of OECD banks;
- 50 percent weight for mortgage debt

Hell with that lets go full tilt and have a 100% all way down, so nobody could loan out the money if one doesn't have it. Plus personal liability of the bankers would do the wunders or wouldn't it

The banks are paid by clients/investors/borrowers for only one thing and only - risk assessment (both ways), and those which are not good at it, to slow, to heavy. to picky, to relaying on rating agencys - shell go out of business and the sooner  the cheaper it for everybody.

Wed, 01/25/2012 - 03:15 | 2095619 piceridu
piceridu's picture

For some reason, the image of Cleavon Little in Blazing Saddles comes to mind...

Tue, 01/24/2012 - 13:14 | 2092955 francis_sawyer
Tue, 01/24/2012 - 13:16 | 2092966 Temporalist
Temporalist's picture

"A lot of this action in gold is linked to QE.  The ECB is printing money now by lending, banks in Europe, massive amounts of money.  They lent, just before Christmas, 500 billion euros and they are continuing to lend major amounts.

Without this lending the banks will not survive, especially the French and the Spanish banks.  Just last week they had about 15 billion from the ECB.  So, the ECB lends them money and this is a different form of QE.

By lending the banks money, what do the banks do with the money?  Well, they borrow the money for nothing or at 1% and give the ECB toxic debt, in return, as security.  Then they buy government bonds for the money they get.  So the ECB gets the money back again.  It’s just incredible, it’s a form of a Ponzi Scheme, combined with money printing."

-Egon von Greyerz

http://kingworldnews.com/kingworldnews/KWN_DailyWeb/Entries/2012/1/23_Vo...

Tue, 01/24/2012 - 13:34 | 2093036 Chief KnocAHoma
Chief KnocAHoma's picture

So let me get this straight, and please correct me if I am wrong: The EU passed the ESM to allow the ECB to QE. Now the CB will use a ZIRP to increase M2 hoping to save the PIIGS by printing and loaning money to banks to increase MZM just as the US did. So far they haven't even slowed down long enough to kiss us or say FU.

Tue, 01/24/2012 - 16:33 | 2093800 RSDallas
RSDallas's picture

Who's on freaking first base?

Tue, 01/24/2012 - 20:18 | 2094609 Buck Johnson
Buck Johnson's picture

That is why this game won't continue to infinity, it's designed to fail.  No culture has ever inflated their currency and devalued it and came out a working plan, it doesn't work.   The insidiousness of the print (money/debt same thing) technique is that you can't do it in the first place.  Once you start doing it from day one your hooked and you go down a path of insolvency and currency implosion.  It's like a drug addict saying he can handle his drugs but he's out stealing from his mother and friends.  The trap is doing it in the first place.

Tue, 01/24/2012 - 13:19 | 2092984 GeneMarchbanks
GeneMarchbanks's picture

'Five measures are needed to enable the euro area to survive: (1) an immediate program to deal with excessive sovereign debt, (2) far more aggressive plans to reduce budget deficits and make peripheral nations hypercompetitive” in the near future, (3) supportive monetary policy from the ECB, (4) the introduction of mechanisms that credibly achieve long-term fiscal sustainability, and (5) institutional change that reduces the scope for excessive leverage and consequent instability in the financial sector.'

I need some more clarity. Can someone please explain i) how this is somehow especially applicable to the euro and not other currencies/nations? and ii) why do I need a Harvard economist to understand that Europe is in a "dangerous state?"

Tue, 01/24/2012 - 13:48 | 2093094 Dick Darlington
Dick Darlington's picture

why do I need a Harvard economist to understand that Europe is in a "dangerous state?

Because we mortals, esp the ones who don't have PhD in eCONomics, are too dumb to understand the complex nature of modern economies and high finance. Without the precious PhD's guiding us through the valley of darkness we mortals would be lost forever. Look how good things are. The PhD's have brought us so far and things are great! Now that we have this shallow and transitory blip in the neo classical path of eternal growth, we NEED the same PhD's to walk us through the fog and back to the said path.

Tue, 01/24/2012 - 13:56 | 2093121 s2man
s2man's picture

Anyone who frequents ZH knows those measures need to be taken, "economist" needed.  Good luck implementing them, anywhere, you economist.

Tue, 01/24/2012 - 13:26 | 2093012 jomama
jomama's picture

counter party risk, bitchez.

Tue, 01/24/2012 - 13:31 | 2093029 Bullwinkle Moose
Bullwinkle Moose's picture

What we are witnessing is going to be in history books for the next 1000 years.

Tue, 01/24/2012 - 13:41 | 2093049 Long-John-Silver
Long-John-Silver's picture

Longer than 1,000 yrs. We still remember the fall of Rome. This FAIL will be even larger.

Wed, 01/25/2012 - 03:46 | 2095645 lewy14
lewy14's picture

We remember - but I wonder if contemporaneous "Romans" thought much of it.

Rome had squandered much of its legitimacy in the eyes of its citizens after the crisis of the third century and the confiscatory "tax reforms" of Diocletian. Romans who were free citizens effectively became tax serfs as the currency became worthless and tax was levied "in kind".

Roman Emperor vs Goth King: a distinction without a difference to many by the fifth century.

Tue, 01/24/2012 - 13:48 | 2093087 mayhem_korner
mayhem_korner's picture

What we are witnessing is going to be in history books for the next 1000 years.

 

What's the likelihood that those future generations will heed the lessons (if they're around)?  .01%?

Tue, 01/24/2012 - 14:28 | 2093253 Spacemoose
Spacemoose's picture

1000 years from now they'll say "it's different this time..."

Tue, 01/24/2012 - 14:38 | 2093286 Bullwinkle Moose
Bullwinkle Moose's picture

They will read but not understand.

Tue, 01/24/2012 - 13:36 | 2093039 Long-John-Silver
Tue, 01/24/2012 - 13:47 | 2093080 Sandmann
Sandmann's picture

Funny how overcapacity in I-Banking cut away margins and they went public to raise more capital to throw at low margins in the hope of staying ahead of their bonus obligations. The continual sourcing of global pools of capital for speculation immunised in bond portfolios with sovereign bonds and synthetics like CMOs to make the punter feel he had a blue-chip gambler with an inside angle on the roulette wheel. The gaming strategy being that insiders had to rig the market to keep so many players afloat, constantly ratcheting up the game with intellectually-deficient strategies like LTCM and half-witted notions like CDS to keep marketing the pitch to capital pools looking for a yield.

Once sovereign wealth funds became too small it needed sovereign states to offer cash, bonds,, IOUs and finally Indentured Servitude for their Populations as yet Unborn.

It must be drugs - that great unexplored topic of Narcotics on the Trading Floor and Dope in the Boardroom - noone sane could have pyramided this system to Complete Collapse, but it is clearly unavoidable and as Voltaire said of Candide - we must go and cultivate our garden - and opt out

 

 

Tue, 01/24/2012 - 13:53 | 2093107 GeneMarchbanks
GeneMarchbanks's picture

Berlusconi said it. Traders and their coke.

Tue, 01/24/2012 - 13:48 | 2093083 Bartanist
Bartanist's picture

This is all well and good. However, the bankers have the power to create as much money as they want and distribute it any way they want. They could solve the problems tomorrow if they wanted, simply by changing the rules of the game. (they do not want to solve the problems) And, what they do not have is the power to get people to do exactly what they tell them to do... especially after they take away hope and substitute fear.

Hope rallies people willingly toward a goal. Fear makes unwilling slaves who are always trying to shake themselves of the fear and will do anything, sacrifice anything to remove the fear. It is not a good long-term solution.

Tue, 01/24/2012 - 13:56 | 2093126 s2man
s2man's picture

Sounds like he's been reading Talib (sp?).  Can you say Systemic Instablity?

Tue, 01/24/2012 - 14:00 | 2093143 Peter K
Peter K's picture

Exactly Correct. Euro zone = USSR rouble zone:)

No getting around it.

Tue, 01/24/2012 - 14:08 | 2093174 TK7936
TK7936's picture

"Successive plans to restore confidence in the euro area have failed"

Dont care about your confidence, really i dont.

Tue, 01/24/2012 - 14:19 | 2093217 NEOSERF
NEOSERF's picture

You know all those German GDP trade "profits" they made in the last 15 years benefiting from free trade and open borders....they are going to have to relinquish every bit of it and more in the coming 4 years...If Germany was Hank Paulson, they'd be cashing out now and letting the rest of the world take it in the rear..

Tue, 01/24/2012 - 15:17 | 2093494 Sandmann
Sandmann's picture

Those German trade surpluses are funding the EU oil deficits....without them the EuroZone will be crushed by oil import costs

Tue, 01/24/2012 - 14:56 | 2093379 plantigrade
plantigrade's picture

"make peripheral nations hypercompetitive" :D

that was rich

Tue, 01/24/2012 - 15:40 | 2093600 ajk24455
ajk24455's picture

A list of necessary steps is published by someone different 4 times a day everyday.  Some have 3 steps or 4 or more etc...

Not once has one of the steps included something about the realization that the solution, whatever it is, will be painful to some degree whatsoever. 

Seriously, in all these lists step one should be something along the lines of:  This will be a painful process, we will probably lose a few banks, definitely go into recession, and write off a shitload of bad debt so some of your investments might have to be marked to market.

Until the political elite figure this out and are willing to tell the people what we already know, nothing will change.  There is no pain-free solution! 

Tue, 01/24/2012 - 17:24 | 2093988 mrsuther
mrsuther's picture

The elephant in the room is the fact that all of these economies are socialist and some of them have been maintaining their governments by borrowing from their socialist neighbors.  Can you say none of these very small men and women have any idea how to function in a system that requires value for performance and the fools that have continued to give them money (prop up the bad banks/soverigns=etc.) are now blking at giving them more money and they have found out that there is no way out, no way to avoid a collapse.  I believe that the Euro Zone will either collape of partially collapse and reform with us (USA) watching and waiting ou turn.

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