Monday, April 18, 2011

Finland gives the finger to Portugal

Finland's elections yesterday have generated a right-wing government that has promised to block Finish money going into the fund that will be used to help countries like Greece, Ireland and Portugal. Portugal is up for emergency funding now.


There is no immediate clue that Finland will oppose the others moving forward. Nevertheless, it makes it harder to argue that everyone should be involved in the rescue.

Wednesday, April 13, 2011

American investments and European problems

It's possible that America is headed for a patch of economic trouble. If that happens and further American investments are liquidated in Europe to shore up the books on the left side of the Atlantic, that will spell further trouble for the entire EU, not just the euro zone.

The IMF yesterday warned that public finances in the United States are spinning out of control--specifically, that the deficit is growing whilst the economy is not declining. Financial papers and pundits are all over it, from the mildly crazy to the staid and respected. There is therefore a convergence of attention and assessment. Public debt levels are at 100% of GDP. It is not too late to recover. Belgium and Italy both came back from debt levels exceeding 130% of GDP, but that road was hard.

The problem for Europe is this. Once the US government starts reducing borrowing and spending, the economy will shrink, and with it, corporate profits and investment positions. The likely impact will be large enough to incite companies and other investors to sell off some of what they have abroad to make up at least some of the difference. This means redemptions (investors cashing in their positions and repatriating the funds) from investment houses in Europe, reflected in reduced volumes of cash in European financial markets.

We saw what happened last time this occurred in 2008/2009. The dollar started out low in 2008 and then rose in value in 2009 as American redemptions meant selling euros and converting them into dollars. This means that they value of the euro will be pulled in two ways that may cancel each other out initially, but drag Europe down in the medium term. There will be a push upward on the euro for a short time, but those redemptions will lead to stock market declines that may very well spill into the real economy.

Ultimately, Europe will have to start thinking about how it will deal with American decline. When a key global institution joins the chorus of critics who demand you live more modestly, change will eventually happen. What we don't know is what exactly the timing will be or what event will start the rush toward the fire exits. There are no elections this year which serve as a defining moment of political clarity. But the current American showdown between Republicans and Democrats over the national budget will probably play the biggest role of all. 

Monday, April 11, 2011

The Coming Earthquake: Spain and EMU

Spain is already in denial mode: that it won't be the next target in the war to collapse the euro zone. Public finances are suffering due to the general economic downturn. This has to be bitter. It has managed its public finances as well as can be expected, and better than most northern EMU members expected. And as I've said before, Spain has the political wherewithal to make cuts when they're needed. But they also have to be possible.

And yet, none of the political austerity may matter in the end, which would deal a crushing blow to those who argue that public austerity is a public virtue. The problem is Spanish banks. They are enormous, and they are not only exposed to Portugal to the tune of 100 billion euros , but we don't know what toxic assets of their own they have. That makes them (potential) zombie banks. If one or more of them were to fail, the pressure on the Spanish governmment to cover the losses will be enormous. If there is any doubt about that, look toward Iceland, which Britain and the Netherlands are now suing because the Icelandic public rejected a taxpayer-funded bailout of Dutch and British depositors.

It will be interesting to see how the European Banking Authority deals with the stress testing of these banks, in addition to how they deal with stress testing more generally. Will they choose the harsh reality or to assuage public fears about the state the banks are in?

But...if there is some sort of catastrophe, it would be wise for the Spanish government and the Spanish electorate to allow some bank failure if it is required, rather than write a blank check. The government have managed their finances relatively well. If banks fail, it will not be the Spanish government's fault. Other countries (particularly Germany) will say it is, but Madrid should ignore them. The choice between a sharp, deep cut into the economy from which the country can recover quickly and decades of indentured servitude of the Spanish taxpayer to nothern creditors is pretty clear when you look at it in those terms.

When the rage in Spain comes, it should be properly directed at bank practices that have not yet been sufficiently targeted. Yes, the state allowed and encouraged these things and should be critiqued for that, but it is not the same. The corporate governance of banks is still insufficient, and therefore consequences have not been drawn for the causes of the crisis. A good collapse may be just what Europe needs to expose the rot where it really is, in the private sector. Ireland failed to do that. Iceland did do it, but the message hasn't gotten across to the Dutch and the Brits and the Germans. And until it does, the regulatory measures to prevent another crisis won't be forthcoming.

Friday, April 8, 2011

Stress testing for the weak

The European Banking Authority is responsible for so-called stress testing. What happens if the economy shrinks, the stock markets plunge and so on? It announced today that roughly 90 banks will soon be subject to the latest round of stress testing.

Six things should worry us, however.

First, the assumptions the regulators are making need to be more dramatic. The entire point of a stress test is not to see how you will withstand a mild cold. You want to know whether you'll survive the flu. Crises are like that. The hit hard and fast.

Regulators will look at what would happen if the European economy were to shrink by 0.5% of GDP and if the stock market would decline by 15%. Any noticeable recession takes a couple percentage points off the economy, and the collapse of any large institution certainly would set off a chain of events

Second, the only major shock that the regulators are accepting is a reduction in stock markets. What about the bond markets? What about derivatives markets? These two dwarf anything that the stock market has to offer, and banks are major players. This thinking is far too optimistic.

Third, what about the linkages between other financial market participants and banks? It's a complex financial world out there, with cross-holdings and ownerships and investment positions across banks, insurance companies, unit trusts, hedge funds and other investment houses.

Fourth, everyone is wondering now what the terms of a bailout in Portugal will be, and what the consequences of a debt default in Greece would be. If those positions fail, then there will be major knock-on effects for the banks of countries throughout the EU. Refusing to stress test this is reckless endangerment of the European banking system.

Fifth, the banks still don't like it. Not surprising.
Finally, banks have been making announcements recently that they will raise new capital on markets to ensure that their vaults are sufficiently stocked to get a good review. But if they were doing the right thing in the first place, why would they need to? Banks don't like sitting on their cash. And raising new capital may mean borrowing briefly from other banks, only to pay it back once the inspectors are gone.

Stress testing in the EU has a long way to go before it does more than assuage public fears about banking solvency and liquidity. It needs more robust models and reporting between tests at a minimum.

Thursday, April 7, 2011

Missing the connection

Electric car makers in Europe were asked to agree on a single plug by 31 March of this year. They have failed. Germany insisted on its design, France and Italy opposed it, with the consumer once again nowhere in sight. It's clear that if a single plug were developed for cars, that it would eventually spread to other electric equipment, at least on the rest of the continent. Except perhaps for Britain which always does its own thing and doesn't care what everyone else is up to.

Europeans know it well, as do visitors conducting a multi-country tour. In many cases, switching countries requires switching plugs. It's an unbelievable pain in the neck if you're a consumer. And while the consumer suffers, governments are insisting that it's their way or no way.

In economics class, we teach that this is a case of transaction costs...that the cost to consumers of switching from one plug to another prohibits switching. But this latest episode shows that's just nonsense. It's comparative advantage for companies and the national governments putting politics in front of better, simpler life.

But just imagine...Europe could use an economic stimulus along with that better, simpler life. What better way than giving people an incentive to upgrade their electric sockets?

Wednesday, April 6, 2011

Portugal breaks

Today, the caretaker government of Portugal asked for help from its European neighbours. Interest rates on the markets to fund even more debt hit new highs this week, and the ECB has publicly shown its weariness of purchasing those bonds when no one else would.

Portugal will become the next aid recipient of the EFSF--the European Financial Stability Facility. The German government has underlined that other options are off the table. It's what the EFSF was created for. And now that the German government has paid the price by losing yet another regional election to voter backlash (a revolutionary labour-green government in the conservative south-west province of Baden-Wuerttemberg), it might as well accept the mantle of organising the control of Europe's finances.

Friday, April 1, 2011

Goldman Sachs Targets France

Goldman Sachs has confirmed what I've been saying all along. The big targets in this war of the financial institutions against the states of Europe are not the small countries onthe euro zone periphery. They're the big countries. That's where they'll make a killing, where they will really get what they want: to make a fortune betting on the collapse of entire countries. It's what they've done until now, except it was with  countries that could be more easily blamed for getting into the mess themselves.

Jim O'Niell of GS announced yesterday that he was going straight past the next possible front line of this war, Spain, and directly to the core of what he wants. Whilst everyone speculated that GS would raise the battle cry to attack Spain next, O'Niell made it clear that France is his target. He sees the country's finances as far worse than its southern neighbour's. At first glance he's right. But France also has a greater capacity to put its economy right than Spain does. And neither country has the problems of Greece and Portugal. Painting them with the same brush makes the justification easier, but the facts remain the same.

This doesn't mean that GS won't lead an attack on Madrid. It eventually will. But it wants to keep folks guessing about where the next invasion will land.  After Portugal, of course. Silently, everyone has written that country off.

European leaders should consider one consequence of how the financial crisis was managed, and how it is hurting them now. Goldman Sachs is alive today because the U.S. Government kept it alive with TARP money. It paid the government back fairly quickly. But now Europe is going to pay the real price.