Explanation of Europes Mess and What needs to be Done to Solve It

From Paul Krugman in his blog. 

Paul Krugman has a great way of explaining some complicated issues in pretty simple terms.  In his blog post "Hard Hearts, Soft Heads," Professor Krugman explains what needs to be done in Europe and the mess that the region is in.  He says:

Let’s think about the current problems of the euro are in terms of perfectly ordinary, textbook macroeconomics.

First, take the aggregate view. The euro area as a whole has record high unemployment and record low inflation. By any normal standards, this says that monetary policy is too tight. Yes, there’s a problem getting traction, because the ECB is close to the zero lower bound — but that’s a problem of implementation. On what possible grounds could you argue that printing money is not at least a partial solution to the crisis?

Next, look at the internal adjustment problem. The big capital flows from north to south during europhoria have left Spain etc. overvalued , and in need of “internal devaluation”. But there is now completely overwhelming evidence for downward nominal wage rigidity: it’s much easier to get Spanish wages relative to German wages in line through rising German wages than falling Spanish wages. Germany’s own internal devaluation from 2001 to 2007 was accomplished through inflation abroad, not deflation at home. But a too-low overall euro inflation rate pushes the burden onto deflation in debtor countries. Again, on what possible grounds could you argue that a somewhat higher inflation rate — remember, it’s now running at just 0.8 percent — would do nothing to help solve the crisis?

Finally, to the extent that debt levels are a problem, low inflation makes this problem much worse, for all the usual reasons.

The whole blog entry is worth a read as it explains why Europe is such a mess and why it will remain a mess due to their policies and the German frame of mind.

Will ECB Go to Negative on Deposit Rate to Spur Lending

From Bloomberg:

Policy makers hope that the measure, obliging banks to pay to hold a liquidity cushion, would prompt them to lend cash to companies and households instead, the people said. At the same time, a negative deposit rate also risks curbing banks’ profit as loan rates fall while the institutions may be unable to pass negative rates onto depositors.

 By cutting by less than a quarter-point, the central bank could test the policy while minimizing disruption to the financial system, one of the people said. The ECB’s next interest-rate decision will be announced on Dec. 5. Denmark currently has a deposit rate of minus 0.1 percent.

It's interesting that Europe is considering this out of the box maneuver.  Could it mean that deflation is much more of a problem in Europe than we already think?

Greece to Troika: No more austerity

From CNBC.  According to Finance Minister Yannis Stournaras:

No austerity measures are needed. They are dangerous; we should let the automatic stabilizers work. We are willing to take structural measures with a fiscal impact, but not austerity measures.

Another quote:

 Greece has achieved tremendous progress up to now, people have made huge sacrifices, so we have to be very careful now what kind of measures we implement to close the fiscal gap, if any.

 I can't disagree with the guy.  The average Greek has made a huge sacrifice over the last 5 years with little or no progress made as Germany refuses to allow a little more inflation within it's boards to compensate for the deflation that is occurring with the countries around the Mediterranean. 

Is Brussels Ready to Get Tough With Germany

Germany is running a huge current account surplus which is second in the world next to China as a % of GDP.  As the leader of the European Union this is not a good thing and does not help it's partners with their dilemma.  With Germany running a trade balance surplus this means that they are exporting more than they are importing.  With it's neighbors struggling it needs to do just the opposite.  Instead of saving it needs to spend.Germany needs to accept higher inflation within it's boarders in order to allow the periphery to get out of their mess.  Without higher inflation in Germany, the periphery countries need to undergo a massive amount of deflation in order to right their ships.  This is not without precedence.  In the late 1990's the shoe was on the other foot and the German economy was hurting and it was the periphery that was willing to take in all of the excess liquidity that was required for Germany to export it's way out of it's financial mess.

Paul Krugman explains it better than I do in this piece:

The creation of the euro was followed by the emergence of huge imbalances, with vast amounts of capital flowing from the core to the periphery. Then came a “sudden stop” of private capital flows, forcing the peripheral nations to eliminate their current account deficits, albeit with the process slowed by the provision of official loans, mainly through loans among central banks. The really bad news for the periphery is that so far the adjustment has taken place mainly through depressed economies rather than regained competitiveness; so the counterpart of that “improvement” for Spain is 25 percent unemployment.
Normally you would and should expect the adjustment to be more or less symmetrical, with surplus countries reducing their surpluses as deficit countries reduced their deficits. But that hasn’t happened. Germany hasn’t adjusted at all; all of the rise in peripheral European current accounts has taken place at the expense of the rest of the world.
And that’s a very bad thing. We are still in a world ruled by inadequate demand, and very much subject to the paradox of thrift. By running inappropriate large surpluses, Germany is hurting growth and employment in the world at large. Germans may find this incomprehensible, but it’s just macroeconomics 101.
You might argue that it’s not the German government’s fault that it runs surpluses — but you’d be wrong. (I’ve fallen into this trap, but acknowledged the error.) For one thing, Germany has pursued fiscal austerity despite its creditor status, contributing to an overall tightening of policy in the eurozone. And one way to think about Germany’s role within the euro is that it is in effect engaging in huge foreign exchange intervention via Target 2, which holds down the “shadow Deutche Mark”:

Article in Reuters about European Commission putting pressure on Germany here.

ECB Cuts Rates

The ECB cut rates today in an effort to fight against worryingly low inflation.

According to the WSJ:

The Frankfurt-based central bank cut the main interest rate at which it lends to banks to 0.25% from 0.5%, and slashed its emergency lending facility by 0.25 percentage point to 0.75%, the ECB said Thursday. The governing council decided to keep the deposit rate on bank funds parked at the ECB unchanged at zero.

In another excerpt:

The ECB had kept the main interest rate unchanged since May, preferring instead to rely on the forward guidance it issued in July to keep interest rates at current or lower levels for "an extended period of time." But a worryingly low inflation reading for October, reported last week, caught investors and government officials off guard and may have put pressure on the ECB to take action sooner rather than later to shore up its guidance. The vast majority of economists had expected the ECB to stand pat Thursday.

The ECB has come a long way since the days of Jean-Claude Trichet.  

Is Europe Heading for Deflation?

Chart below from WSJ seems to indicate yes.  Link to article here.

With inflation declining and unemployment soaring is Europe going to follow the lead of the US and japan and try to pump liquidity into the market through innovative approaches?

Edit:  Another article on the topic.  This one is from Reuters.  Looks like the Euro is taking  dive on fears that the ECB will have to lower rates to combat a lack of inflation.

Another Unispiring Response From the ECB

Nice move by the ECB who again decided to sit on their hands.

Let me see.  Periphery countries are falling apart, there is a run on banks belonging to these weaker countries, unemployment is going through the roof, and economic growth is non existent but the ECB still refuses to drop rates further. 

Frankly, the lack of action by the people that count in Europe has been disturbing from the very beginning.  It's almost as if they are a deer in the headlights and can't do anything.  They hope that by doing a little bit at a time they can buy the time they need for all of this to go away.  This won't go away anytime soon and it won't go away without a serious cost to all countries and citizens involved and all of this because the people that run the joint worry about inflation which hasn't and will not exist in Europe at any time in the near future.

A Bio on Alexis Tsipras of Syriza

As per the BBC.  Interesting read on who might soon be the most powerful man in Greece.

ECB Backdoor Purchases of Sovereign Bonds

Mario Draghi may know what he's doing after all.  After months of leading the markets to believe that he would follow in his predecessors footsteps and do nothing close to resembling serving as a lender of last resort, Mr. Draghi has opened the window for European banks to borrow money at the official rate of one percent for three years.  The collateral being accepted for these loans could be as poor as lowly rated subprime paper.

So far the interest in the program has been incredible with the ECB loaning out close to 500B euros with another program due to take place in February.

The hope with this program is that the borrowing banks will use this money to buy the sovereign debt of their respective countries with anything left over being loaned for investments in the economies of the various countries in the euro zone.

The only remaining question that is left is "Is this enough?"  It definitely is better than nothing.  It actually is a lot better.  Rates in government paper has dropped significantly.  As Floyd Norris states in an article he wrote:

On Tuesday, the same day the banks were putting in their requests for loans, Spain held an auction of Treasury bills. A month earlier, it had to pay an annual rate of 5.1 percent on three-month bills and 5.2 percent on six-month securities. This time the rates were 1.7 percent and 2.4 percent. Credit that plunge to Mr. Draghi.

Rates have also fallen significantly on government debt out to three years, but the declines in longer term rates have been smaller. 

Rates on longer term paper have not shown the same results and chances are that they may have little affect on them overall simply because of the length of the loan from the ECB.  The hopes are that by giving banks the nice spread between the loan rate and the treasury rates banks will continue to buy bonds bring down costs of sovereign debt but also giving the banks a chance to make some money and help them recapitalize.  With a healthy banking system, hopefully the economies of the European union can bounce back.

Lets hope that this helps solve the Euro crisis and helps alleviate the pain many citizens of the zone are experiencing due to misguided austerity being forced upon them by the Germans.

One final note:  Ireland may not necessarily be getting better.  Austerity has taken a huge chunk out of the Irish economy and nobody knows how long it will take to get back to prior levels after this mess is over.

Latest Euro Decision

So the European Union members decided to give up sovereignty when it comes to regulating budget deficits in the future.  To me that seems to be tying hands when problems arise.  Kind of like having austerity take place when an economic downturn occurs (oh wait?!?!).  This also in no way solves the problem that is currently affecting Europe.  It's like the leaders of the union said that we will work on what we can do to prevent this from happening next time while ignoring the dire problems which currently face the Euro zone.  You can't deflate your way to prosperity.

Once again it will all depend on the ECB and whether it will buy the bonds needed to support these countries in order to get them out of this mess.

What Will the ECB Do Tomorrow?

Hopefully cut rates by more than 25 basis points.

The New Euro Solution?

The new be all end all solution to the euro crisis from Merkel and Sarkozy involves tighter rules on budget rule violators but is this enough?  What this means is that countries who are experiencing a slow down to their economy will automatically have to cut spending at a time when tax receipts are slowing thus magnifying the slow down?

What do these countries get in return for their sacrifice?  Does this mean that Germany will allow the ECB the flexibility it needs to combat future problems within the Euro zone?  Does this mean that there will be one common voice on fiscal policy thus taking away the necessary consensus of 17 parliaments that you currently need within the euro zone to get anything done during a time of crisis?  The answer is no to all questions.  Once again Germany is leading everyone to believe that this crisis was generated because of profligate spending by the trouble economies of Europe.  With the exception of Greece such was not the case.  The problem stems from a current account deficit generated by the countries of the southern region of Europe when Germany made an effort to get themselves out of their own mess 10 years ago.  Germany's surplus is the rest of the Euro zone's deficit.  This in combination with an ECB that caters to Germany and the lack of courage by anyone in the Euro zone to make the tough decisions and push for the necessary reforms have created a perfect storm.

What do I expect from the Euro zone summit at the end of this week?  A lot of promises, a grand announcement (there's even talk of two highly leveraged bailout funds) and a market rally afterwards to run out the rest of the year.  However, unless the ECB decides to make some tough choices for all (including Germany) then this mess will only be resolved after a nasty undressing of what was once know as the Euro.

International Scorecard

Below are a few things going on around the world whcih can easily affect stock prices.

1. The situation in Europe.
2. Protests against the results in Russia.
3. Pakistani President has heart condition which has forced him to leave country for treatment.
4. Tensions with Iraq.
5. Change of rule occurring in the middle east.
6. Growth in Brazil slows to a crawl.

Euro Yields Rise

Looks like the panic that is Europe is continuing to spread.  Today the spreads between French, Spanish, and Belgian bonds vs. the German equivalent rose.  It looks as if Spain is approaching the dangerous 7% threshold that stirred things up in Italy last week.  Yet the ECB is still on record as saying that it will not serve as the lender of last resort.  Looks like this crisis is going to get a lot worse before it gets better.

What Would Happen if Greece Defaulted?

A couple of reads that are well worth considering when wondering what will happen if Greece decides to default?

1. Nouriel Roubini-Full Analysis: Greece Should Default and Abandon the Euro
2. Stergios Skaperdas-NYT: How to Leave the Euro 

Why is Italy and Spain Worse Off Than the US

Good Op Ed by Paul Krugman.  I especially liked his summary on why countries like Italy and spain are having problems in spite of the fact that their economies aren't necessarily worse off than coutnries like the US, Great Britain, and Japan.  According to Krugman:

What has happened, it turns out, is that by going on the euro, Spain and Italy in effect reduced themselves to the status of third-world countries that have to borrow in someone else’s currency, with all the loss of flexibility that implies. In particular, since euro-area countries can’t print money even in an emergency, they’re subject to funding disruptions in a way that nations that kept their own currencies aren’t — and the result is what you see right now. America, which borrows in dollars, doesn’t have that problem.

The whole article is a good read.  It turns out that many countries that became members of the EU have become Germany's bitches and know that they need massive help Germany and it's puppet (ECB) are turning their backs on them.

Europe Still Doesn't Get It.

An excerpt from a recent wsj.com article.

New ECB President Mario Draghi said last week that the bank won't act as a lender of last resort to euro-zone governments, affirming the bank's stance that its mandate under the European Union treaty is limited to fighting inflation.

Europe still doesn't get it.  Greece is small potatoes.  Italy, on the other hand, is not.

In a nutshell:

1. Investors are no longer interested in buying Italian bonds as evidenced by the rising interest rates on these bonds (rates would be much higher if the ECB had not bought many of these bonds).
2. EFSF is nowhere near big enough to backstop Italy.
3. The biggest shareholders in the IMF (US) refuse to bailout another country.

At this point the ECB needs to throw out its ill planned mantra of price stability only and assume the additional role of lender of last resort before the EU goes down the crapper and takes the rest of the world economy with it.

The irony of this is that the fear of a replay of the unrest that the Germans remember during the 30's may end up being the downfall of their great European experiment.  It is this fear of inflation which could introduce a new round of chaos in Europe this time due to economic depression and collapse.

ECB Cuts Rates!!!

In his first meeting in charge Mario Draghi and the ECB lowered rates by 25 basis points to 1.25%.  the move was a surprise to many economists.  That was the good news.  The bad news was the statement the Draghi said in his post meeting press conference.

“What makes you think that becoming the lender of last resort for governments is what you need to keep the euro region together?”

and

“ That is not really in the remit of the ECB. The remit of the ECB is maintaining price stability in the medium term.”

So the ECB still seems to miss the point.  They are the lender of last resort.  History has shown that central banks that don't take their role as lenders of last resort seriously have failed miserably.  Yet the ECB is still worried about price stability which is not an issue at this point.  As a matter of fact a little inflation would probably help things in Europe a bit.

Link to Bloomberg article here.

IIF on European Bank Recapitalization

Charles Dallara who is Managing Director of the International Institute of Finance said the following in a letter he submitted to G20 leaders before the start of the meetings in Cannes tomorrow and Friday.

“It is essential for the official sector to begin viewing the banking system as an indispensible partner in fostering recovery, rather than an adversary on which it is necessary to impose ever more punitive measures.” 

Interesting how the banks who are again on the brink of failure again are going against an increase in capital requirements which will help keep banks solvent and depositors safe.

Read Bloomberg story here.

The Mess Called Europe

That lasted long.  The markets are now on day 3 of a continued downtrend after the latest agreement came out of Europe early last Thursday morning.  With many i's not dotted and many more t's not crossed there is a ton of uncertainty surrounding the latest deal from Europe.  This has been witnessed by the rising spread between Italian bonds and their German counterparts since the announcement.

Now to add another wrench into the spoke, the Greeks are going to referendum on the latest European proposals.  With the ruling PASOK party's approval at lows and the unpopularity surrounding the forced austerity measures that have increased taxes and unemployment, while cutting pensions and wages the prevailing belief in the market is that the Greek nation will vote down the latest moves.  This will probably force new elections which will cause further instability.  It will also force the EU into making the difficult choices that it has not been able to make in the last 21 months.  Europe will need to step up and backstop it's banks as Greece will probably default outright.  The ECB will need to step up and purchase bonds of the weakening member states aggressively and it will need to issue a statement telling the world that it will continue to do so until things stabilize.  It will also need to drop rates.  It's time the ECB grows a sack.  Everyone can appreciate the fact that the big fear in Europe is hyperinflation, but as the central bank of the largest union in the world, it needs to balance that concern with the pressing needs that surround it currently.

Since the crisis started it has become more and more evident that the measures that Europe has implemented to address the issues at hand are not sufficient.  The austerity measures that have been put in place have done nothing but increase the deficits and put handcuffs on the economies affected.  Without the ECB accepting it's role as lender of last resort this issue will not be resolved.  It's time to flood the market with euros' in order to help prop up the struggling EU economy and address the increasing likelihood that this contagion has the ability to swallow up all of Europe and thus destroy the great European experiment.