Streetwise Professor

December 4, 2011

When, Not If

Filed under: Economics,Financial Crisis II,Politics — The Professor @ 9:15 am

The coordinated intervention of central banks calmed the European situation in the runup to 9 December EU summit, but the fundamentals of the situation have not really changed.  To get a handle on how things might play out, it’s worthwhile to lay out the basic facts.

  1. Some countries on the Euro will never be able to pay back what they owe.  Greece is clearly at the top of the list, but Portugal is likely in the same boat.
  2. Other countries, notably Italy and Spain, are not clearly insolvent, but they are in a sufficiently parlous fiscal condition, and have enough short term debt that must be rolled over, to make them vulnerable to speculative attacks that make these rollovers impossible.  In the event, this would result in default.  Put differently, these countries are sufficiently dodgy fiscally that they are at serious risk of a shift from a rollover equilibrium to a run equilibrium.
  3. The European Central Bank is not supposed to print.
  4. The ECB is not supposed to serve as a lender of last resort (LOLR).
  5. In terms of the insolvent countries, default would be very costly not just for the debtors, but the creditors.  Some highly leveraged European banks with huge balance sheets would likely become insolvent, likely requiring government bailouts.
  6. Given the price stability mandate of the ECB, the debts of Greece, etc., can’t be inflated away.  Even if the ECB mandate was abandoned, inflating away the problems of the Greeks, etc., would have huge distributive effects in a single currency. The real value of all Euro-denominated sovereign debts would decline.  (As would the real value of Euro-denominated private debt.)   This would lead to huge transfers of wealth across the Eurozone and worldwide.  It could cause S&L-like problems with European banks, as the real value of their long term assets would decline more than the value of their shorter term liabilities, making them insolvent on a mark-to-market basis.  German fear of inflation is not just a Weimar neurosis.
  7. There are various means of allocating losses as a way of avoiding default.  Some of the obligations of the insolvent countries could be assumed effectively by richer countries through Eurobonds, for example.  Some of the obligations could be written off “voluntarily” by holders of the debt of insolvent countries.
  8. The liquidity problems of Italy could potentially be addressed by allowing the ECB to act as LOLR, but this exposes the ECB to substantial credit risk.  Realization of credit losses could result in inflation (with the implications discussed in 6) or the recapitalization of the ECB, with the cost paid by the taxpayers of the more fiscally solid countries.
  9. Any mechanism (e.g., Eurobonds, closer fiscal union) to address the debt problems of insolvent or illiquid nations will likely create substantial moral hazards.
  10. The bargaining problem is a multi-lateral one.  Moreover, the bargainers (heads of government) are agents for disparate interests that will be impacted very differently by alternative outcomes.
  11. Multiple issues/alternatives are up for negotiation.
  12. There are serious problems with enforcing any deal that is negotiated.  For instance, if Germany prevails in its insistence that any fiscal transfer mechanism be accompanied by fiscal reforms in the debtor countries, its ability to enforce this agreement is highly limited.
  13. Germany and the other relatively fiscally sound states could afford to bail out Greece, and maybe Greece plus Portugal.  Those plus Italy, or Spain, or Spain and Italy–no.
  14. A deal extended to any state (e.g., a substantial writedown of Greek debt) becomes a precedent (or focal point) in negotiations with any other state.

In other words: a fine mess.

The costs of default or inflating away debts are large for the creditor countries.  This gives the big debtors substantial leverage in negotiations: it is well know that it corporate bankruptcies, equity can often extract substantial amounts from creditors, and something analogous is true with spades here.

Also, these costs give rise to a huge bargaining range, which in turn encourages all sorts of opportunism and gamesmanship, and which can result in failures to come to agreement.  EU political mechanisms, and the large number of parties involved, increase the likelihood of such a bargaining failure.

It’s hard to see this ending well.  If I had to guess, I’d say it will go something like the following.  The costs of default, or of inflating away insolvent countries’ debts, are so large that the debtors will have substantial bargaining power. Germany et al will have to find some way of writing off or absorbing a big chunk of these debts, but will demand in return some mechanism to ensure that the debtors adhere to fiscal discipline, to which the debtors will grudgingly promise to implement.  Given such a deal, the ECB will find its way to serve as an LOLR, mitigating the liquidity problem for Italy.

But the debtors’ promises to get their fiscal houses in order will not be credible, and will not be enforceable.  So even if the Euros successfully escape their immediate predicament, it will return with a vengeance before too long.

And even this not-so-rosy-rosy-scenario (in which reckoning is merely postponed for a bit, rather than banished for all time) is not a sure thing.  The bargaining problems–huge bargaining range; the massive distributive effects of any deal, and the fact that different deals could have very different distributive effects; large numbers of participants in the negotiation, with the negotiators being subject to conflicting demands from their diverse domestic constituencies; the difficulty of enforcing any deal–are ugly individually, and arguably intractable collectively.  Failure is a very real option.

And in the event of failure, the various amputation options become much more likely.

I could perhaps see some kind of relatively stable, long-term deal coming out of this process if there was a robust enforcement mechanism, and if political commitments made today were credible and binding on future politicians.  But there isn’t, and they aren’t.  From which I conclude that the ultimate demise of the Euro is a matter of when, not if.

Print Friendly, PDF & Email


  1. I would logically agree with your analysis. But history has shown that lot of funding issues can remain in limbo for a prolonged time – Japanese banks for instance. China has successfully papered over bad loan problems for around 15 years now. So, in theory the zombie bank situation could exist in the Eurozone for a decade as well…Given that Italy is supposedly running a small budget surplus and has promised a more fiscally responsible path, things “might” work out in a few years.

    Comment by Surya — December 4, 2011 @ 9:55 am

  2. I agree with Surya as regards the fiction, but with several caveats: China, and to a lesser extent Japan are single entities that have had a culture of command economies – directly in the case of China and under “guidance” in the case of Japan. They also had lenders of last resort and a strong savings culture. Here we are dealing with multiple entities (nations) and multiple parties within these entities (parties)with very different financial cultures and profiles. That make keeping everyone on the script nearly impossible over the long haul. There is a much larger chance of direct conflict, or more probably someone makes a mistake.

    As regards the ECB – don’t discount the idea that they will lie: what have their bond purchases been but market support operations, and can’t the dollar Swaps be viewed as another way of expanding the monetary base on the sly? when putsch (sic) comes to shove don’t count on anyone following orders!

    The key short term indicator to look at is the overnight swap basis, the rule of thumb being anything below -50bp indicates real trouble for banks in terms of 1. Liquidity, 2. Holding their dollar assets at least at break even. In other words, a liquidity problem becomes a direct and apparent solvency problem. I believe on Thursday, it got well below -150 before rallying on the ECB’s non intervention intervention. Actually, given the poor liquidity in a number of the ABS markets, any serious liquidations of securities would probably put the Banks down 2-6 points on their security holdings.

    Longer term what we have is a solvency problem across multiple borders being managed by a group of players who have proven themselves inept in all the arts except denial, delay and fudge – they seem now to be moving towards a kind of political coup d”etat in terms of stripping sovereignty from members without any means of enforcing it. I include our President in this group. Its success will be a function of how the political class sticks together. In the case of Greece, the class has been completely co-opted. I do not know whether anyone will step up and say no elsewhere.

    Comment by Sotos — December 4, 2011 @ 10:54 am

  3. @Surya & @Sotos–Yes, these things can be fudged for a long time. I would add the S&L situation in the US as another example. But Sotos, you hit on what I believe is the key point, and which I try to emphasize in the post. It is the negotiation issue, and the difficulty of enforcing any bargain. Both Japan and China are societies that value consensus and uniformity highly. Even Japan has effectively been a one party state for a large portion of the Zombie Years. It has been able to get the markets to fund it, meaning that it hasn’t faced the existential moment that precipitates crisis. Trying to negotiate among 17 (or 27) states, when any deal–or non-deal–will affect the distribution of huge amounts of wealth, and when there is no real credible enforcement mechanism makes the Euro problem orders of magnitude more fraught than the Japanese or Chinese.

    WRT ECB, I really doubt that they could get away with lying re monetization, or at least in a big way. The Germans would freak and put a stop to that.

    And the more that I think of it, the more that I am convinced that inflating to save Greece and/or Portugal, and even Italy, would be catastrophic. It would be using an atom bomb to deal with a problem more suited for a JDAM. The collateral damage would be immense. If you inflated enough to reduce the real value of Greek debts by 25 or 30 percent, you’d reduce the real value of the much larger totals of German, French, Dutch, etc., debt by the same amount in a single currency zone. That would lead to huge wealth transfers that would be massively politically destabilizing. And who’s to say that they could really stop at 25 or 30 percent? These things have a way of spinning out of control. I don’t think that it is credible to say “we’ll monetize this much and no more.”

    Re China. I think their time is coming, and sooner rather than later. There is of course the interplay with Europe, but their papering over is becoming increasing untenable. I hope to blog on this later today.

    Thanks for the comments, guys. I claim no prescience in how this will play out. But the Euros will have to draw several consecutive inside straights for it to end well.

    The ProfessorComment by The Professor — December 4, 2011 @ 11:27 am

  4. So, Professor, toca teca as thay say in Spain (which AIUI means, roughly, ‘let’s see the colour of your money’): who do you reckon will be the first country out of the Euro?

    I am increasingly thinking it will be several all in one clip. I wish I knew how to place a bet on this.

    Very helpfully clear analysis by the way. Over the weekend, one of the architects of the Euro, Delors, was bleating about how it all failed because they did it wrong in the first place. Well, he would say that, wouldn’t he? Actually he wasn’t really an architect, he was more General Groves than Robert Oppenheimer. Or perhaps a Nedelin.

    Comment by Green as Grass — December 5, 2011 @ 4:33 am

  5. Almost, prof, but not quite. Let me editorialize:

    1. Yep.
    2. Pretty much, although I think that they could be pulled back from the brink reasonably easily.
    3., 4 and 5. Yep.
    6. That depends. You can make funding cheap enough that the banks will muddle though, especially on an accural accounted basis. A default postponed is a default that does not cause losses this year. I don’t suggest this is a good idea, just that (as in Japan) you can do it.
    7. Yep.
    8. If the intervention works the credit risk is not substantial. Arguably the ECB already owns (or at least has as collateral) enough Italian debt that going further is sensible.
    9. Yep. That’s intervention for you.
    10. Yes, and that is the hardest part of the problem. Moreover Angela not only has to please herself, but also crucially make sure the CDU is not out of power for a generation.
    11. I’m not sure what you mean by that.
    12. Yep.
    13. No, I disagree, especially as a big dose of liquidity will help rebuild capital for many of the eurozone banks that are most vulnerable. Italy while highly endebted as a state has relatively low total endebtedness thanks to low private sector debt. Italy with better tax collection and labour market reform is saveable. Spain is more delicate as total endebtedness is higher and it is hard to see where the growth is going to come from, plus there aren’t the same easy wins for enhancing growth that there are in Italy.
    14. Indeed. That is why it will be a treaty renegotiation for all 17 (or even 27) rather than a bilateral deal. For which, see 10., I agree.

    In other words, don’t bet on it ending badly in the near future. It might well… but it _could_ still be fixed, and the incentive to do that is pretty high.

    Comment by David — December 5, 2011 @ 9:34 am

  6. David–

    Don’t necessarily disagree with you. Re 7–your statement is a conditional one: “if the intervention works.” But that’s where the risk comes in. This is a coordination game, with multiple equilibria. The risk is a jump from an “it works” equilibrium to an “it doesn’t work anymore” equilibrium. That can’t be ruled out, especially given all the enforcement/credibility issues. Indeed, once a lot of the risk lives at the ECB, the Italians, etc., have it and the Germans etc. by the short ones. There is asynchronous performance here under the intervention scenario. The ECB intervenes based on Italian, etc., promises to be good boys and girls in the future.

    Re 11–multiple issues inc. Eurobonds, fiscal union, or something weaker; LOLR/changes in ECB powers; how to divide up the (sunk) cost of Greece, etc. And there are more. Have to deal with all of them. That makes negotiation much more difficult and complicated.

    Re 13–I again view your disagreement as being conditional on the intervention working. My statement was that if they all went Humpty Dumpty Germany etc. couldn’t afford to put them back together.

    Predicting timing is always very hard, particularly when you are talking about coordination games. Milton Friedman once said he was very good at predicting what would happen, but awful at predicting when it would happen. I confess to something similar. Which is why I don’t trade, as there timing is everything. Being right eventually is no help if you go bust in the meantime.

    There are so many moving parts here, and multiple measures have to be coordinated for things to work out well. The endogeneity (“reflexivity”) that arises from the coordination game means that things can muddle along for a while, and then collapse suddenly. In my view, this could be worked out except for one big problem: the lack of credibility and enforcement of asynchronous performance. The problem is ultimately a political one, and given the political realities I can’t see it ending well, although per the above when the bad end will come is difficult to predict.

    You mention the “incentive to do that [fix the problem] is pretty high.” I agree. The benefits of a deal that would fix things would have a big payoff. In a Coasean zero transaction cost world that deal would get done. But the (political) transactions costs are so acute here that I have serious doubts that an enduring deal will get done.

    The ProfessorComment by The Professor — December 5, 2011 @ 12:11 pm

  7. David–Also, re 6. Your comment seems to be that funding/liquidity injection can allow muddling through, and that it won’t lead to inflation. That’s a little different than the point I was making. I was focusing on a somewhat different scenario, namely, that inflation is a feature not a bug–a stealth way of reducing the real cost of Greek debt, i.e., a stealth default. My point is that that is a very costly alternative b/c w/single currency, you can’t default via inflation selectively. Given that, the inflation option–which is one some are advocating–is likely to be extremely unpalatable.

    The liquidity issue I think is most germane for Italy and Spain (my group 2 countries). It isn’t for Greece, and arguably Portugal, Ireland. That is why I distinguished between groups of countries. Allocating the losses on Greek, Portuguese, and Irish debt has to be done in some way. Uncontrolled default. Negotiated default. Default that isn’t called default (eg “voluntary” haircuts). Inflation. My argument is that the inflation alternative is not realistic.

    The ProfessorComment by The Professor — December 5, 2011 @ 3:34 pm

  8. David–I think there is a significant difference between being a LOLR to banks, and a LOLR to sovereigns. The Bagheot rule–lend at a penalty rate against good collateral–won’t work for sovs. Sov won’t and can’t pledge collateral in anywhere near the amount necessary. The debt purchased by the ECB is backed by nothing but political promises. Those promises are not credible, and once the debt is purchased by the ECB, it is at the mercy of the issuing sovereign.

    There’s a pretty big literature on sovereign debt. The lack of credibility/enforcement mechanisms makes it difficult to envision LOLR for a sovereign.

    The ProfessorComment by The Professor — December 5, 2011 @ 3:49 pm

  9. Thank you, as always, for most insightful comments.

    Re liquidity, you say ‘Your comment seems to be that funding/liquidity injection can allow muddling through, and that it won’t lead to inflation. That’s a little different than the point I was making. I was focusing on a somewhat different scenario, namely, that inflation is a feature not a bug–a stealth way of reducing the real cost of Greek debt, i.e., a stealth default. My point is that that is a very costly alternative b/c w/single currency, you can’t default via inflation selectively. Given that, the inflation option–which is one some are advocating–is likely to be extremely unpalatable.’ I agree that Eurozone inflation creation isn’t an answer; the Germans won’t tolerate it, and it won’t act quickly enough for the Italians, given the difficulty of creating enough of it. So, no, that isn’t the answer.

    What may be the answer, I think, is collectivisation of (much of) the debt. The eurozone as a whole can (probably) afford the eurozone’s debt. This is a form of LOLR, then, but one whose price is considerable loss of sovereignty. (A penalty rate indeed, although not in the conventional sense.) The issue is persuading the Germans to stomach it. What Merkozy seems to have got to today is an agreement sufficiently tough that Angela thinks she can sell it at home; whether she can, and whether it is enough to calm the markets, remains to be seen.

    Comment by David — December 5, 2011 @ 5:36 pm

  10. Thanks, David–likewise. Back in the summer I wrote that Europe could socialize or monetize the debt. By “monetize” I meant inflate it away, which in a way is a form of socializing (by taxing the real balances of all Euro holders). I think inflating it away won’t work–and you agree, I believe. The problem is that any mechanism involving the ECB entails the risk of inflation, with its attendant costs. Thus, it is likely that any socialization/collectivization mechanism has to involve German, Dutch, etc. assuming responsibility for others’ debt, via a Eurobond mechanism or something similar. The price that Germany will demand is the debtors’ sovereignty. But I still am hung up about the mechanism for enforcing any such “tough” agreement.

    The ProfessorComment by The Professor — December 5, 2011 @ 7:20 pm

  11. Very interesting post and set of comments. What I’m struck with is precisely the game-theoretic stuff you develop here, Prof. The PIIGS know they already are zombies. If they fully implement austerity programs being demanded by the Germans and the northern European economies to reduce their debt burdens in exchange for mutualization of existing debt, all they get out of the deal is continued austerity and an economy that’s not going to recover in any meaningful way for decades, and, most likely, episodes of greater or lesser social unrest that most likely will result in widespread violence (c.f., the years of lead during the Brigate Rosse/Baader-Meinhoff period). If they don’t agree to the demands, and don’t implement the austerity programs being demanded, they’re still zombies — all they get out of the deal is continued austerity and an economy that’s not going to recover in any meaningful way for decades, and, most likely, episodes of greater or lesser social unrest that most likely will result in widespread violence (c.f., the years of lead and the Brigate Rosse/Baader-Meinhoff period). It’s not like we haven’t seen this reel before.

    The true leverage of the zombie PIIGS lies in the fact that if they just say no to all the demands being made by the northern economies with the money, the asset bases of the banks in the northern economies (along with the banks domiciled in the PIIGS economies) — i.e., the bonds issued by those zombies — go to zero quicker than they would have if some way was found to draw out the inevitable default on these bonds. If that default is sudden, the euro banks holding those zombie sovereign debt will be vaporized (not unlike the former investment banks were here in the U.S. when LEH became a zombie). Now ask yourself: Who’s got the stronger bargaining position?

    These zombie PIIGS know this. That gives them a powerful negotiating position. They literally have nothing more to lose.

    Comment by markets.aurelius — December 6, 2011 @ 4:42 pm

  12. Sheila Bair, former FDIC head, is making a lot of sense here:

    “If there is any question as to why we need strongly capitalized banks, one need look no further than Europe where lax capital regulation has resulted in a highly leveraged banking system that is poorly positioned to absorb losses associated with its sovereign debt crisis. I know some American bank CEOs have complained about the higher capital standards we have in the US – and they are right – in part. Capital regulation is much tougher here and I hope it’s going to get even tougher.

    “But do we want the European banking system? That system is now so fragile it is doubtful that even the strongest banks could raise significant new capital from non-government sources. The choices in Europe are not pretty. They can let a good portion of their banking system fail or they can commit to massive financial assistance through a combination of ECB bond buying and loans and guarantees from the IMF and stronger Eurozone countries. Frankly, I don’t know which is worse.”

    Those are her prepared remarks for today’s Senate Committee on Banking, Housing and Urban Affairs, Financial Institutions and Consumer Protection Subcommittee. See

    Comment by markets.aurelius — December 7, 2011 @ 6:14 am

  13. Felix Salmon had a nice write-up on this report:

    Cutting right to the chase: “… the German Bundesbank is about to exhaust its capacity to lend more funds to strapped governments.”

    Comment by markets.aurelius — December 7, 2011 @ 1:21 pm

RSS feed for comments on this post. TrackBack URI

Leave a comment

Powered by WordPress