Tag Archives: Wolfgang Munchau

Global Economy On Fast Track To Disaster

In the last couple of days several prominent economic experts have concluded that the global debt crisis – currently ravaging Europe – is more or less unstoppable, and that recent events has been a major turn in the wrong direction. They are angry, frustrated and puts most of the blame on the German government.

“How bad will it be? Will it really be 1937 all over again? I don’t know. What I do know is that economic policy around the world has taken a major wrong turn, and that the odds of a prolonged slump are rising by the day. “

Paul Krugman


“Whatever the Europeans try to do to alleviate the crisis, it does not work: A blanket bank rescue, a €440bn special purpose vehicle to provide a protective shield, and one austerity package after another. Bond spreads and credit default swap indices continue to rise, and the money market is once again freezing up.”

That’s how associate editor and columnist for the Financial Times, Wolfgang Münchau, describes the situation.

And he points out the this is something that has never happened before to European politicians, who in the past were able to get away with a lot less effort. A statement was usually sufficient to placate the markets.

What Is Going On?

“For a start, there is no speculative attack, convenient as such an explanation may be,” Münchau writes, and put up the ugly picture that many politicians (and economists) still refuses to see:

“What has happened is that global investors have realized a deep underling truth about our European sovereign debt crisis – that at its core, it is not a sovereign debt crisis at all – but a highly interconnected banking crisis about to blow up.”

“There is a dynamic at work that the macroeconomic data does not convey – and that the political response to the crisis does not address,” he adds.

Those inter-connections are even bigger than previously thought – but it should not be surprising given the massive current account imbalances in the euro zone.

In its latest Quarterly Review, the Bank for International Settlements came out with some shocking figures:

* German banks have a $200bn exposure to Spain, $175bn to Ireland, and $50bn, respectively, to Greece and Portugal, making a total exposure to the four countries of almost $500bn, more than 20% of German GDP.

* French banks have an exposure of $250bn to Spain, $80bn to Ireland, $100bn to Greece, and $50bn to Portugal, also almost $500bn in exposures, but more than 25% of French GDP.

* Total foreign bank exposures are well over $1100bn to Spain and $800bn to Ireland.  Add the four countries together, and you are arrive at more than $2 trillion.

(Here’s the BIS report)

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Wolfgang Münchau

Wolfgang Münchau

“Now, I am not saying that there is $2 trillion of bad debt. I have no idea how big the portion of genuinely bad debt is. The problem is that no one else knows it either, and that includes the banks, which are now refusing to lend in the inter-banking market,” Münchau writes.

As pointed out here at the Econotwist’s Blog several times since 2008 – there are a lot of parallels to the subprime crisis – including the scale, the inter-connectedness, and the information asymmetries.

In the presence of such factors, investors start to panic. The reason they are panicking despite the bank guarantees is that the markets no longer trust the government that have issued the guarantee. The spreads go up, thus reinforcing the crisis.

“A vicious circle is already well underway,” Wolfgang Münchau says.

The vicious cycle has now engulfed Spain. The Spanish private sector is now effectively cut off from global capital markets.

Fighting Derivatives – With Derivatives

The European Central Bank is now the lender of both first and last resort to the Spanish banks.

Spain’s share in ECB lending is already twice its share in the ECB, and rising.

The ECB is desperate for the Special Purpose Vehicle (SPV) to be in place by the summer. But while this would get the ECB off the hook, it does not solve the problem.

Münchau: “I would expect that early bond purchases by the SPV would trigger a generalized attack on southern European bond markets, France probably included. Having ignored sovereign default risk completely, the markets now regard everything as extremely risky that is not Germany. No matter what happens to the euro zone, Germany can always be relied upon to be a safe bet. If the euro zone ever were to split, there is much less certainty about which side of the euro zone fault line Italy and France would end up.”

The reason for this complete mess is – as usual when it comes to severe economic crisis – political.

So far, all those guarantees have not cost us a cent. No taxes have been raised, no expenditure has been cut.

But this will be different when the SPV’s are in place, and starts pay actual money.

These so-called Special Purpose Vehicles were originally invented by the engineers in the financial sector as a way to finance risky project without having to disclose them in their balance sheet – also called off-balance products.

But the thing is; governments can’t hide losses on SPV’s off-balance sheet in their national accounts.

“Though they will probably try,” Münchau writes. “In the end, money will flow – a lot of money.”

Germany’s To Blame

It’s unlikely that the Germany government has the stomach to bail everybody out – like the US administration and  Federal Reserve has done in America – even if such action probably is the best long term solution, also for  Germany.

In a recent column an angry professor Paul Krugman writes:

Paul Krugman

Paul Krugman

“German deficit hawkery has nothing to do with fiscal realism. Instead, it’s about moralizing and posturing. Germans tend to think of running deficits as being morally wrong, while balancing budgets is considered virtuous, never mind the circumstances or economic logic,” he proclaims.

Adding: “There will, of course, be a price for this posturing. Only part of that price will fall on Germany: German austerity will worsen the crisis in the euro area, making it that much harder for Spain and other troubled economies to recover. Europe’s troubles are also leading to a weak euro, which perversely helps German manufacturing, but also exports the consequences of German austerity to the rest of the world, including the United States.”

At the moment it would be no surprise if the Germans decides not to participate in any future bailouts.

Since each bailout requires unanimity, Germany could block any decision.

Germany, along with a small number of other EU countries, could unilaterally withdraw from the euro zone.

It’s Getting Dangerous

What can turns this into a dangerous crisis is not the absolute level of debt, but the intra-euro zone financial flows.

These are a mirror-image of the internal economic imbalances.

Germany’s massive current account surplus is per definition a surplus of domestic savings over domestic investment, and these savings are channeled towards economies with large current account deficits, like Spain, Portugal, Greece and Ireland.

Germany is now effectively being asked to bail out its customers. That would require a fiscal union, which Germany is not prepared to consider.

The reason the crisis is getting worse again is because investors cannot see how this conflagration can be untangled.

“German politicians seem determined to prove their strength by imposing suffering — and politicians around the world are following their lead,” Krugman writes.

“How bad will it be? Will it really be 1937 all over again? I don’t know. What I do know is that economic policy around the world has taken a major wrong turn, and that the odds of a prolonged slump are rising by the day. “

We’re In Desperate Need of….Something Big! 

Even “Ol’man” Greenspan is getting nervous.

Alan Greenspan

Alan Greenspan

I an article in The Wall Street Journal, Friday, the former FED chairman writes tht said the U.S. may soon face higher borrowing costs on its swelling debt.

“Perceptions of a large U.S. borrowing capacity are misleading, and current long-term bond yields are masking America’s debt challenge,” Greenspan says.

Greenspan rebutted “misplaced” concern that reducing the deficit would put the economic recovery in danger.

“The United States, and most of the rest of the developed world, is in need of a tectonic shift in fiscal policy,” according to Greenspan (84), adding that; “Incremental change will not be adequate.”

Whatever Mr. Greenspan means by “tectonic” isn’t quite clear.

However, it’s obviously something big and fundamental.

“The federal government is currently saddled with commitments for the next three decades that it will be unable to meet in real terms. The very severity of the pending crisis and growing analogies to Greece set the stage for a serious response.”

“Our economy cannot afford a major mistake in underestimating the corrosive momentum of this fiscal crisis. Our policy focus must therefore err significantly on the side of restraint,” Greenspan writes.

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European Banks: “Leman Times Ten”

Albert Edwards: Europe On The Edge Of A Deflationary Precipice

Gerald Celente: “The Great Crash Has Occurred”

“We Stand At The Brink Of The Next Great Crisis”

Germany In Favour Of Creating European Army

2010 Analysis: “11 Black Swans”

2010 Analysis: Warns Against Social Unrest

2010 Analysis: Collapse of Credit

2010 Analysis: The Road to Disaster

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Why Optimists Are Wrong About The Euro Zone

I don’t there’s much disagreement on that the euro zone needs is a consolidation strategy based on growth, a credible fiscal adjustment plan and and a new and functioning system of economic governance. In face of the worst economic crisis in Europe since WW II, the most optimistic politicians believe that austerity programmes coupled with a weak euro will solve the problems. Well, they’re wrong.

“The Europeans are choking off the recovery before it has even started.

Wolfgang Münchau

The consensus argument among European leaders at the moment is that fiscal indiscipline has caused the crisis. Austerity must therefore solve it. A weak euro and a global recovery would cushion the impact of austerity. In addition, the financial guarantees and the bans on short sales would see off the speculators. Voila! End of crisis.

Sounds pretty straight forward, right? Almost too good to be true.

And it probably is.

The optimists have not had a good crisis so far. According to Financial Times commentator, Wolfgang Münchau, this will not change.

Here’s why:

“First, fiscal adjustment programmes will be necessary eventually but European governments are currently repeating their age-old mistake of cutting spending and raising taxes well before the economy has recovered. In the US there is a debate about another stimulus package to ensure the recovery does not prematurely run of out steam. The Europeans are choking off the recovery before it has even started. The premature austerity programmes will ultimately impede debt reduction, as nominal growth remains very weak,” Münchau points out.

Furthermore, Italy and Spain will both need to accompany fiscal adjustment with structural reforms.

There are no such reforms on the horizon in Italy. Spain is about to decide a labor reform package.

But it will almost certainly not deal with the fundamental problem of a divided and extremely inflexible labor market.

Even in Germany, where domestic spending remains anemic, the government coalition is discussing a tax increase.

How Low Can You Go?

“Second, the euro’s exchange rate has indeed weakened, and may weaken further. But it will probably not do so sufficiently to solve southern Europe’s competitiveness problems. In Greece, for example, tourism is the main export industry. A slump of the euro against the dollar is not going to change the country’s relative competitive position against the euro zone nations of the Mediterranean Sea. It could improve competitiveness against Turkey and Croatia, for example, but only to the extent that the lira and kuna also revalue. For the euro exchange rate alone to do the heavy lifting in restoring southern European competitiveness, it would take a massive further depreciation – to about 60 or 80 US cents to the euro,” the FT Deutschland commentator writes.

Assume this were to happen, and then consider the overall effects:

The Organisation for Economic Co-operation and Development last week forecast that Germany’s current account surplus, which fell to 5 per cent of gross domestic product in 2009, would rise again to 7.2 per cent in 2011.

That forecast is based on current exchange rates. An extreme further fall in the euro would have two effects: it would increase Germany’s surplus even further, probably to well over 10 per cent of GDP, and thus increase internal imbalances within the euro zone.

It would also contribute to a deterioration of global imbalances, as the euro zone as a whole would turn a small current account deficit into a large surplus. Relying on the exchange rate would be the ultimate beggar-thy-neighbor policy.

Rescue Package Might Be Illegal

“Third, lingering doubts remain about the €750bn financial rescue package to help weaker euro zone countries. The German constitutional court has still to rule on the package and, while its rulings are difficult to predict, there are some legitimate reasons for concern,” Münchau says.

The Council invoked Article 122 of the treaty on the functioning of the European Union, under which financial assistance is allowed “where a Member State is in difficulties or is seriously threatened with severe difficulties caused by natural disasters or exceptional occurrences beyond its control.”

But it is not sure the court will accept the force majeure argument invoked by the European Council in deciding to permit the rescue package.

“I think there are legitimate doubts about whether the multiple policy failures that led to this crisis constitute an event beyond one’s control. I also fear the German justices will express misgivings about the European Central Bank’s decision this month to buy bonds,” Münchau writes.

Chasing Ghosts

“Fourth, the assumption that the crisis was caused, or triggered, by speculation, is not just legally dubious. It may also deflect from the overriding need to reform the euro zone governance framework. If you blame speculators, it may be an obvious policy response to ban short sales and penalize hedge funds rather than reform the framework. I therefore expect little substantive reform. At most there will be a souped-up stability pact, to be announced in another pompous press conference at the next European summit in June. Governments are already watering down the European Commission’s sensible, though not very ambitious, proposals. This means European governments are very likely to miss the opportunity to fix the problems in the long run,” Wolfgang Münchau concludes.

What the euro zone really needs is a consolidation strategy based on growth and a credible fiscal adjustment plan.

It needs to encourage domestic demand in northern Europe to facilitate the adjustment in the south. And it needs a new and functioning system of economic governance.

But instead, governments have chosen to chase speculators and to impress each other with austerity packages. They are thus contributing further to the euro zone’s increasingly probable though still distant disintegration.

Related by the Econotwist:

Bundesbank Suspects A French Conspiracy

Goodbye Keynes – Hello Ricardo!

Transantlantic Bailout Buddys Agree To Disagree

Proposal For New Single European Bond

Albert Edwards: Europe On The Edge Of A Deflationary Precipice

Merkel: The Euro Is At Risk, Could Have Global Consequences

E.U. Prepared To Set Up Own Rating Agency

Europe To Fight Speculators With “Secret Plan”

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"Greece Will Default"

But not this year, Financial Times columnist Wolfgang Münchau writes in an article, published Sunday. According to Münchau there is five things that can resolve the situation, but default is the only option that is consistent with what we know at the moment. Here’s a full transcript of the article.

Greece will not only have to make an extremely large public sector deficit reduction effort but it will also have to do this under a condition of disinfaction, and possibly deflation, which would push its nominal growth rate to negative.”

Wolfgang Münchau

Wolfgang Münchau

I am willing to risk two predictions: The first is that Greece will not default this year. The second is that Greece will default. The Greek government has demonstrated that it can still borrow at a rate of about 6 per cent but if you do the maths on the public debt dynamics, as I did recently, it would be hard to arrive at any other scenario than an eventual default.

The adjustment effort needed to prevent a debt explosion is extremely large.

The Nordic countries achieved adjustment on a similar scale during the 1980s and 1990s, but they had two advantages over Greece. They did it in a different global environment; but more crucially they were, in part, able to devalue and improve their competitiveness.

As a member of a large monetary union Greece can improve its competitiveness only through relative disinflation against the euro zone average, which in effect means through deflation. But as the French economist Jacques Delpla has pointed out, this will invariably produce a debt-deflation dynamic in the Greek private sector of the kind described by the economist Irving Fisher during the 1930s.

So Greece will not only have to make an extremely large public sector deficit reduction effort but it will also have to do this under a condition of disinflation, and possibly deflation, which would push its nominal growth rate to negative levels during the adjustment period. That, in turn, would jeopardize the debt reduction programs of both the public and private sectors.

Under those circumstances, there is no way that Greece could ever stabilize its debt-to-gross domestic product ratio, no matter how hard the government of George Papandreou tries.

To get out of this mess, one of five things will have to happen.

The first, and most optimistic, solution would be a significant fall in the euro’s exchange rate, say to parity with the US dollar, coupled with a strong recovery in the euro zone. This might just do the trick to sustain Greek growth as it adjusts.

The second is that Greece gets access to low-interest rate loans from the European Union and the International Monetary Fund.

The third would be a private sector debt restructuring to prevent a Fisher-style debt-deflation dynamic.

The fourth is that Greece leaves the euro zone.

The fifth is default.

If you go through the options one by one, you realize that the first is improbable. The EU has in effect ruled out the second. The third would require an unlikely additional bail-out of the European banks.

While option four would be most convenient for the Germans, the Greeks are not so stupid as to leave the euro zone. That leaves them with option five: to default inside the euro zone. It is the only option that is consistent with what we know.

But it would throw the euro zone into a potentially terminal crisis. Spain and Portugal have problems of a different kind but of a similar dimension.

Spain will have to go through a disinflation/deflation period that will produce a formidable private sector debt-deflation spiral. Without devaluation, or the possibility of a sustained fiscal boost, the Spanish depression could last forever, or at least for as long as the country stays in the monetary union. Portugal, like Greece, suffers from a combined public and private sector debt problem.

When a country such as Greece pays 300 basis points over the yield of a supposed risk-free bond, this means, mathematically, that investors see a probability of around 17 per cent that they will lose 17 per cent of their investment.

So in other words, a spread of 300 basis points is a valuation in which default is still considered improbable.

If those perceptions changed from improbable to, say, moderately probable, the yield spreads between southern European countries and Germany would explode.

For the time being, Greece can get by because of its excellent debt management, which is why I am confident that Greece is not going to need an immediate bail-out.

But given the political economy of the EU, this might turn out to be a disadvantage. Europe’s complacent leaders will only step in if a crisis is both imminent and visible.

The really treacherous aspect about the Greek crisis is that the country’s liquidity position is better than its solvency position. Insolvency is a gradual, invisible process. The negative effects of debt-deflation dynamics have not yet begun, but will become inevitable as the Greek public and private sectors go through a simultaneous debt reduction process. In such an environment my assumption of a 2 per cent rate of nominal growth might be far too optimistic.

And even with such an unrealistically optimistic assumption, default would be hard to avoid.

There have only ever been two intellectually honest views about economic and monetary union.

The first is that it could not work, as it would eventually produce a situation in which a country’s national interest conflicts with the interest of the monetary union at large.

The second is that it could work, but only for as long as member states are ready to co-ordinate economic policy in the short run, and move towards a minimally sufficient fiscal union in the long run.

The message from the EU, and from Germany in particular, is that the latter has now been ruled out.

By Wolfgang Münchau

Related by the Econotwist:

Greek Debt Crisis Become Critical (Again)

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Fitch Expects More European Sovereign Downgrades

Greek Bailout “Backstop” Confidence Trick Already Backfiring

Markets To Test Greece

Greece Wants E.U. To Use Old Latvia Fund For Bailout



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