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.

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?

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.

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.

The Noose Tightens on Southern Europe

We've been waiting a long time to see when interest rates would rise in Europe. The ECB has been giving signals for the last month that it will raise them at its next board meeting in early April.

The ECB is concerned about inflation, so rates will rise. That means the euro zone's countries with deficit problems are about to see them get worse.

Greece's search for the exit

Greece's Finance Minister, Giorgos Papakonstantinou, has started to look for the exit. Emerging from a cabinet meeting today, he declared that Greece's economy is on the road to recovery, that tax cuts will be introduced on fuel, and that privatisations should not be pursued rashly, lest the country lose control of the foundations of controlling its destiny.


This comes just days after the EU Heads of Government committed fresh new funds to the European Financial Stability Facility under the Euro Plus Pact. That pact provides funds, but increases the likelihood that countries who let the finances spin out of control will face financial penalties, and eventually be left on their own.


The ink on that agreement is hardly dry and the Greek government does not look impressed. It claims that economic growth rates between 30 and 40 per cent are removing the necessity to make hard choices.  How convenient.


Assuming Greece's financial statistics are as poor as they ever were, Europe now faces a choice. It can drive a sword through its freshly-minted Pact (and indeed, there might be good reasons for never having agreed to this pact). Or it can turn the sword on Athens. You can imagine which option Berlin would prefer.


This should be interesting. The Greek governmnent sees itself not as Persephone, but more like  Asterix and Obelix. Whose view will turn out to be right?


Popcorn, anyone?

Portugal's next

It's been clear for some time that Portugal would be the next target, but the timing was an open question. This week, however, interest rates for Portuguese bonds have held above 8 per cent, and a political crisis has followed, which is likely to collapse the Portuguese government. 

The Prime Minister's office will now reap what it sowed when it acquiesced to tighter fiscal constraints on national governments that Germany and a few other creditor countries have demanded in return for institutionalising financial aid to the euro zone's debtor countries. That deal has been cemented just recently. It remained silent, hoping that financial markets would believe they had reason to be confident they wouldn't be next in line. 

But this is folly. Bluffing doesn't work when the situation is entirely clear to everyone. Portugal has never had anything resembling control of its public finances. Yes, it has had devastating natural disasters that have hurt the economy and the government's tax revenue for which it can do nothing, but Portugal also has no discipline. This is key in assessing its capacity to reform its finances. There is no evidence that successive Portuguese governments every intended to restrain the country's finances. They got a free ride during the euro's early years, as Germany and France were breaking the rules, but the free ride is over.

There are three ways to interpret the behaviour of the Portuguese government with regard to the austerity measures demanded by Europe's creditors. The first is that they realised they were in grave financial danger, and were willing to reform, but simply hoped that signalling strength would reassure markets not to flee the country. The second, is again that Portuguese parties are willing to exercise discipline, but no one wants to be first and reap the political backlash that ensues. The third possibility, and the one I fear is most likely, is that Portugal is in the grip of a Greek-style delusion that they can go on living as they have, because someone will bail them out. 

They're in for a rude awakening.