Banking and the Euro Zone Crisis: the next phase

As an ongoing symptom of the interconnectedness of private finance, public finance, and the lack of infrastructure in the euro zone, the IMF has warned that banks are expected to withdraw 1.2 trillion dollars of credit from the euro zone economy over the next 18 months. That's 10 percent of the EU economy, and even more of the euro zone economy.

The IMF, which views this contraction as the natural consequence of deleveraging (destroying reliance of the financial sector on credit to the same degree as before the crisis started), suggests that the only way to avert an even greater disaster is to accept a milder one--in which banks are closed, merged and restructured across national boundaries to reflect the lower amount of money in the economy.

That, in itself, may make sense. But will national governments in the EU break from their existing pattern of saving national banks to allow such restructuring?

That would indeed be a revolution in thinking, and it's just possible that national governments haven't hit bottom yet. I'm not putting any money it.

INET talks about the crisis

The Institute for New Economic Thinking, INET, is meeting in Berlin today until Sunday to discuss the current crisis, and the state of economics and economic policy: (Paradigm Lost: Rethinking Economics and Politics). This is important and worth watching. Check out the information on the website, and most importantly, comments from folks tweeting at the conference. Just search for #inetberlin  on your twitter feed.

Early messages:

Classical economists are trying to grapple with the new recognition (new for them anyway), that human behaviour is not as rational and predictable as their theories to date would have us believe. (See @LynnParramore)

Re-working the basics of economic policy to let up on austerity measures.

And my favourite quote so far, tweeted by Megan Greene (@economistmeg)

'Gurria: Markets are like heat-seeking missiles. They go after your weaknesses, not your strengths.' #inetberlin

Externally-Imposed Adjustment and Contraction in Greece

10 days ago, the Greek government successfully arranged a reduction of its outstanding debt with private creditors.This was a requirement of the EU and the IMF approving the next bailout of Greece.

Adjustment means contraction, both for Greeks and for investors. A 20% reduction of the minimum wage and broad budget reductions in advance of the deal followed a 7.5% contraction of the Greek economy in the last quarter of 2011.

In the debt swap deal, private holders of Greek debt, many of them pension funds and other investment funds, were paid 15% of face value in cash and 31% of face value in longer-term, lower-interest bonds. Those that did not accept were forced to accept the terms by collective action clauses that the Greek government recently legislated. Note that Greek pension funds were badly hurt by this restructuring, which means that Greek pension will have to be massively cut. That battle is yet to come.

After that deal was sealed, attention then turned to the private body that decides what happens to credit default swaps when something like this happens. The ISDA, or International Swaps and Derivatives Association, determined that a so-called credit event had occurred, but that it was not that large. Current estimates are that payouts from CDS contracts will cost European banks around 3 billion euros.

This means that for the moment, if you look at it from the perspective of those trying to make the deal, that the cost has been low and catastrophe has been avoided. Catastrophe means a disorderly default, in which investors lose everything and CDS payments become enormous.

Although those who promoted the deal argue that catastrophe has been averted, they are wrong. It has merely been delayed and been made more costly. As the head of the private bank Berenberg says, there is no prospect of growth with which Greece could pay back the rest of the debt it owes. An ever-shrinking economy means ever-growing incapacity to repay. The latest IMF Report on Greece has come up with new figures today on how the current bailout will be insufficient, and how another 21 billion might be required until 2016. Given the recent bailout, and the current trends of the Greek economy, which is deliberately designed by the IMF to focus on 'internal devaluation' (falling prices and wages, despite rising taxes) (see executive summary of the report), which cost the IMF 28 billion euros until 2014, that seems rather hopeful.

What is striking in the IMF report is the clear expectation that Greeks will choose, if given a choice, not to fully implement the deals they've signed on to. Which is why foreign administration is the governance of the future.

Welcome to the new face of the euro.

Greek Default and the Euro Zone Crisis

Standard and Poors downgraded Greece today to Selective Default status. The International Swaps and Derivatives Association is now debating whether this means that credit default swaps are due to be paid as a result. It will decide by the 29th. If it argues that they are due to be paid, then a great many contracts will have to paid out, some banks won't be able to fulfil their obligations.

This is an excellent time for national governments in the EU to consider whether the core business of retail banking ought to be connected to the world of financial derivatives, investment banking and international finance. It still is, and perhaps should not be.

Europe's autocratic politics of debt

Two things have come across the news this week, neither of which bodes well for the EU.

First, the EU Commission and Council, following up on agreements made with the Troika, insisted on written statements by both major political parties in Greece that they would be denied a bailout unless they both declared in writing that they would accept the ultimatum that the Troika had imposed on the current government. Elections are coming up soon, and the EU's creditor states are intent on ensuring that choice is off the table. Of course, Greece could chose to fold and walk away from both the euro and the aid, but neither Commission nor Council are saying that. (Though one politician is now talking openly about Greek exit.)That should again give everyone pause about what the EU stands for.

In the absence of agreement, a Council meeting scheduled for tomorrow has been cancelled.

Second, the Commission is busy preparing to punish Spain, which has been ahead of the curve and the Commission in dealing with the crisis, by charging the government money for not moving any further. I don't know what the responsibles in Brussels are thinking, but whipping the most compliant is not going to further their cause. If anything, it reeks of desperation, to show that the excessive deficit procedure is relevant, somewhere, somehow. That's no way to run the EU.

Once upon a time, the EU stood for democracy. It brought both of these countries into the Union to bolster democratic movements and to prevent a return to dictatorship. And now, it views democracy as the greatest threat to the Union.

Ironic, isn't it?

This is a bad move on the part of the EU

Who Pays Attention to ECOFIN?

Southern Europe, that's who. Log onto Twitter, search ECOFIN (the EU's Council of Economics and Finance Ministers, responsible for decisions on the euro zone), and you'll get mostly posts from southern Europe. Type in a country name, like Portugal or Greece, and the sources become more varied.

It says something about how the power relationships are currently felt in euro zone politics.

What impact they have remains to be seen. ECOFIN meets tomorrow to discuss public policy progress and debt restructuring for Greece. One demand has already been made clear: aid is conditional on all main political parties accepting it.

A Europe of the States or a European Union?

It's been a while since I last wrote. Things got busy.

In the meantime, Europe's leaders have announced a fiscal pact that will institutionalise EU control of member state finances, which will mean the most for countries that lose control and need outside aid to stay in the euro zone. This isn't a fiscal union, involving real transfers, and it reinforces the responsibility of the member states of the euro zone to get their own houses in order. It's more a Europe of the Member States rather than a European Union per se. If that is what they really want, then fine, but beyond the question of who 'they' are, and I think it means creditor states, supported grudgingly by debtor states for fear of hurting at the hands of financial markets even more than they do today, but it means that periodic crises are likely to happen from time to time in the euro zone.

It's not the only economic policy area related to the financial crisis in which the EU has effectively pushed the member states to the fore and demanded more of them--institutionally, financially, and in terms of pre-determined policy. I'm currently attending a workshop on banking in the EU and the impacts of the financial crisis that the University of Denver and the University of Colorado at Boulder are so kind to organise and support. I'm learning a lot from my esteemed colleagues. What interests me is how national financial stability measures remain in Europe, despite claims by some to the contrary. I'll follow up on that in a subsequent post.

What does this mean? Europe remains fragile and vulnerable. Strength requires more.