Saturday, January 8, 2011

Timing, Generals, and the Euro

At the beginning of the new year, thoughts return to time. We think of what has passed over the last year and look to the year ahead.

But what is more intriguing than time is timing. Why does a crisis erupt when it does and not sooner or later? Why do the successive stages of a speculative attack on the euro take place when they do?

They say many things about fighting a war. One of them is that it is hard to wait and not know when the next battle will be or from what direction it will come. Some insight can be gained by considering the following factors.

First, an awful lot of money is required to wage a successful speculative attack on a large country in the euro zone. Since financial speculators are dispersed, they require a means of deciding whether and when to place their resources on  a particular country, a direction, and an outcome. Just as in the horse races, the better your prediction, the better the payoff. Unlike the horse races, the target a speculator is trying to hit is determined not only by the target country but by the market as a whole. This is not an entirely anonymous and invisible market, but one that is dominated by a variety of financial institutions looking for opportunities for profit, and hoping that other market participants will prove them right.

That means that there must be a tipping point at which some trigger leads the first of the speculators to stick their necks out and the rest of them to follow until the rush becomes unstoppable. The question is, what is that tipping point? One thing that has emerged from the history of the financial crisis to date is that quarterly company reports are windows of time during which financial markets pay close attention to the way the wind is blowing. This makes sense from their perspective. When businesses slump, so do government finances, either because public finances will remain generally weak, or because catastrophic failures, which means the failure of a key company with knock-on effects for the rest of the economy may tempt the government to respond with costly, debt-fuelled state intervention that the market will eventually flee from.

The ebb and flow of reporting season, four times per year, is therefore central to whether investors are presented with a focal point that can lead to crisis. The full-blown financial crisis was triggered by quarterly reports on financial institutions. Attention has spread to the wider economy as well, in search of signs from strategic economic sectors.

What we need to watch and understand better is when and under what conditions the markets actually turn, when and how they can be held at bay, and what that deterrence is likely to cost (and what form it can take) if it is to be effective. Deterrence is a notoriously difficult thing to observe. If it works correctly, there is no battle.

However, it is possible to detect how public authorities marshall resources and how they position them. The EU heads of government are currently debating treaty changes that will allow the long-term establishment of the EFSF, and possibly bonds that use the EFSF as collateral to leverage even further funds. This is a risky move that I will return to in another post.

For the moment, it should suffice to say that using the funds available to the EU through the EFSF will not be enough. The EU will have to deploy those funds strategically when the time is right and where they are needed. That requires clear political authority that can be exercised within hours, if not minutes. Currently this authority is lacking in Europe. The Heads of Government must convene to fight whilst the enemy is overrunning them. There are no generals in command.

If Europe wants to defend the euro, that will have to change.

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