Duncan’s Economic Blog

The Euro Crisis: How to Stop It

Posted in Uncategorized by duncanseconomicblog on November 26, 2010

I said on Monday that the bailout of Ireland would not work. I was talking in terms of Ireland itself and the future of its economy. I stand by that.

But I also asked:

what happens after this? Assuming the EU manages to come up with enough cash to keep the economy liquid, what happens next? Do the bond markets now turn on Portugal? And if the EFSF (European Financial Stability Facility) is then used to bailout Lisbon, what if they turn on Spain? The EFSF couldn’t cope with that. What long term planning is being done to come up with a long term, Europe-wide solution? It’s taken a week of leaks and denials to get to this point with Ireland, this bailout has been incredibly badly managed – I doubt much long term planning has been carried out.

It turns out I was right to be worried.

Back in May, the bailing out of Greece was met by an immediate (although now unwound) “relief rally” in Greek bonds, peripherial country spreads and the Euro.

This is not happening now.

Instead we are stepping closer to crisis.

Irish, Portuguese, Spanish, Greek and (very alarmingly) Italian spreads over German bunds are still rising.

Even more alarmingly, looking beyond the spreads – the actual yields on German bunds have headed higher too. As have German CDS spreads (from a low base).

The Irish bailout is now expected to be agreed by Sunday – after inept management for two weeks. But both Labour Party and FG are saying they will want to renegotiate it.

The Irish budget, set for 7th Dec, may not pass.

Either way, Portugal will need support with in days now. And after Portugal and Ireland, there is no cash left in EFSF.

There is an urgent need to stop the crisis before it hits Spain properly.

I’d suggest three immediate steps, I’m not sure that it would work, but I think the chances of success are higher than what is currently “planned”.

 (i)                  The ECB should announce it is prepared to offer as much liquidity support as is needed to periphery banks if deposits continue to flee. An emergency from of QE, but one that might help stem the flight of deposits.

(ii)                We need “proper” stress tests of all euroarea banks (not just the periphery). Not the confidence building exercises of a few months ago, but severe scenarios (taking into account step three below). This should be immediately followed by a full recapitalisation of those banks that fail. Give the banks 20 days or so to try and raise that capital in the private markets, if they can’t then forcibly inject it and be prepared to severely hit (or even wipe out) equity holders.  In an ideal world the EFSF would be used to fund the new equity, creating a string of banks with large stakes held by the Euroland governments in common.

By these two steps the Euroland governments and the ECB can settle liquidity and solvency issues in the banks. It should hopefully lead to banks better equipped to lend to fund a recovery.

Ideally the ECB should fund this through QE rather than placing more pressure on government deficits.

 (iii)               Sovereign restructuring in the periphery with hair cuts around the 20-30% on government bonds. The recapitalised banks should be able to take the strain. Pension funds will be hit (on the other hand, it will lead to less taxation in the medium term, the net effect on pensioners is hard to determine).

This might or might not work. It is a medium term fix. The longer term requires greater rebalancing in the Euroland economies and a reordering of the ECB. But I suspect it is better than relying on austerity.

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20 Responses

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  1. Luis Enrique said, on November 26, 2010 at 10:48 am

    sensible stuff I think – have you read Simon Johnston??

    http://baselinescenario.com/2010/11/25/will-ireland-default-ask-belgium/

    if the end game is ECB printing money to ensure nominal debts are repaid (after whatever haircuts is imposed) and (potentially) imposing real losses via inflation, then Euro devaluation will see Germany boom even more, so talking of imbalances, it would be nice to see either Germany transfer some of the consequent surplus into the Euro pot, or some mechanism to try to smooth out trade surpluses over the Euro area. If that last thing makes sense, which I’m not sure it does.

    • duncanseconomicblog said, on November 26, 2010 at 11:21 am

      Johnston is v interesting.

      I agree on the German surplus, maybe some European version of the Bretton Woods system originally devised by Keynes?

      • Luis Enrique said, on November 26, 2010 at 11:35 am

        (let’s make that bet – if UK tax revenues as % of GDP decrease over next 3 years, to some degree with both agree fits with spirit of what you meant when you wrote we are now on path to lower tax revenues, I’ll buy you a slap up meal at TGI Friday’s*, if not vice versa).

        * only kidding. somewhere of your choosing.

        • duncanseconomicblog said, on November 26, 2010 at 11:43 am

          How about real income tax revenue is lower in 2012/13 than 2010/11?

          • Luis Enrique said, on November 26, 2010 at 1:26 pm

            I don’t think you were originally talking about just income taxes were you? context was whether cuts will increase deficit or not, so total tax take is what matters. Real total tax revenue lower in 2012/2 than 10/11 and you’re on.

            (I’m hoping incomes taxes might be lower because bankers are earning less. chance would be a fine thing)

            • duncanseconomicblog said, on November 26, 2010 at 1:47 pm

              Happy to take that subject to the caveat that we exclude any further increases in VAT? (Other than the announced move to 20%)

              • Luis Enrique said, on November 26, 2010 at 3:01 pm

                ok, but I’ll leave it to you to make the necessary adjustments should they raise VAT again.

                well, one way or another, I look forward to supper some time in 2013

  2. Neil Wilson said, on November 26, 2010 at 10:53 am

    If a bank is licensed to operate a fractional reserve, then the licenser has to have enough Euros to fully fund the deposits the bank has created. Otherwise the bank will fail due to lack of cashflow if it gets into trouble.

    For me using that facility should only be available once the bank has gone into administration and been nationalised or euroised (whatever the mechanism is).

    So who was regulating these banks, and why haven’t they got enough Euros to fund the inevitable bank run?

    • duncanseconomicblog said, on November 26, 2010 at 11:22 am

      Fair points Neil.

      European financial institutions require European, not national, regulators – and in terms of funding – many of these “national” banks are European.

  3. CharlieMcMenamin said, on November 26, 2010 at 11:31 am

    Maybe. Maybe it might work.

    Or maybe not, as you yourself implicitly acknowledge.

    I lack the technical economic background to engage too far in detailed assessments of these suggestions (mind you, I note that even an expert commentator like Paul Mason has been reduced to drawing cartoons to get the seriousness of the issue across).

    But I there is one political thought I’d like to share after reading your post.

    For all Newsnight et al talking up the possibility of the ‘two tier Eurozone’ as a fall back position should the current attempt at stabilisation fail I can’t really imagine anyone having the foresight to put together such a deal in the continent wide chaos and unrest that might accompany the collapse of the Euro as we currently have it. Perhaps some very clever German bankers are secretly working on how to do it now? But the formal leaders are investing all their time and emotional energy in propping up what we’ve got now. What I am saying is, I suppose, not merely is there no obvious Plan B, but also that the more energy that goes into proposals like yours to somehow keep the Euro afloat the less energy and time there will be available to organise a retreat from it.There comes a point where one has to read the writing on the wall. I don’t known if Ireland’s impossible circumstance (there is no political possibility of that budget getting through I suspect) is that point because I know too little of the technicalities. But there must be a point when it starts making sense to start asking when will the Euro collapse, not if. When might that point be?

    • duncanseconomicblog said, on November 26, 2010 at 11:47 am

      I think for the moment, the imperative is to try and save the Euro. I agree planning needs to be happening on how exactly it could break up.

      It needs major reform, as does economic governance in the EU as a whole.

      As for leaving – It can be done but would be very tricky. And I worry that it would simply lead to a round of competetive devaulation in no bodies interest.

  4. Left Outside said, on November 26, 2010 at 11:54 am

    ” (iii) Sovereign restructuring in the periphery with hair cuts around the 20-30% on government bonds. The recapitalised banks should be able to take the strain. Pension funds will be hit (on the other hand, it will lead to less taxation in the medium term, the net effect on pensioners is hard to determine).”

    Good idea, but what’s periphery?

    Greece and Ireland certainly, Portugal too, but although Spain has been harried it remains a large robustish economy compared to the others. If the creditors of those four take a haircut then Italy may begin to look peripheral and if UK banks have are more exposed than we realise we may end up on the periphery (although I doubt it). Getting all this coordinated would be difficult enough, but it is hard to know who has to be coordinated.

    • duncanseconomicblog said, on November 26, 2010 at 12:43 pm

      Good question!

      Sequencing here matters, we need to stress test and re-cap the banks before we get into haircuts. And pre-announce all of this soon.

      Greece, Ireland and Portugal are certain. Spain possible. I think Italy would be ok after that. (Although in absence of co-ordinated response, Italy follows Spain as bond market target).

  5. World Spinner said, on November 26, 2010 at 12:30 pm

    The Euro Crisis: How to Stop It « Duncan's Economic Blog…

    Here at World Spinner we are debating the same thing……

  6. [...] This post was mentioned on Twitter by Adam Lent and Duncan Weldon, Duncan Weldon. Duncan Weldon said: Post: The Euro crisis and how to stop it. http://wp.me/pt0AC-jm [...]

  7. crossland said, on November 26, 2010 at 3:18 pm

    Paul Mason provides a bit more on the mystery behind why the UK bilateral deal may be needed
    http://www.bbc.co.uk/blogs/newsnight/paulmason/
    So our legal system can be used to force a haircut on the bondholders apparantly.

    lots of other developments also.

  8. vimothy said, on November 26, 2010 at 8:21 pm

    Duncan,

    I don’t see any good options here. A money financed bailout of the banks by the ECB is not something I feel particularly eager to see, although it may well be better than continent-wide conflagration.

    Related question: Who recapitalises the ECB when it takes a capital loss on its assets? How will this work?

    • duncanseconomicblog said, on November 26, 2010 at 9:11 pm

      Vimothy,

      There aren’t any good options. I feel the above is a better option than what they are currently doing.

      On the related Q, another difficult one. If it comes to that, it’ll have to be the IMF I suspect, doubt governments would be in any shape to help.

      • vimothy said, on November 27, 2010 at 1:04 pm

        Wow, this is a really bad situation. Mind boggling, really.

        A big problem for the ECB is that without risk free assets to buy, QE becomes fiscal policy (potentially at least). Could it refuse to buy govt bonds from at risk states?

        Fiscal policy from within the EU is just a redistribution of fragilities, which is something, I suppose, but still, even if they recapitalise the banks, the sovereign debt issue remains.

  9. [...] I’ve long favoured proper stress tests and re-capitalisation of the at-risk-banks before a managed default of debt by heavily indebted governments. [...]


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