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Euro-TARP: The Euphoria Didn’t Last

By: Francis Cianfrocca (Diary)  |  May 11th, 2010 at 08:14 AM  | 

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As I wrote here yesterday, we ‘ve just seen the remarkable spectacle of more than a dozen fractious finance ministers come together to puncture the risk of a Lehman-style market debacle. Taking a page out of Ben Bernanke’s playbook, they cobbled together and announced a package of 750 billion euros (nearly a trillion dollars) in liquidity guarantees.

Think about that number. It’s twice the size of Greece’s economy.  This wasn’t targeted at Greece. It was targeted at last week’s quickening alarm over the possibility of an interbank liquidity crisis.

I call this the Bernanke Doctrine. You respond to disordered credit markets by making short-term liquidity available in essentially unlimited size, as soon as you sense the beginning of the disorder. Although Bernanke got the idea from his studies of the dynamics of the banking crises that preceded the Great Depression, it makes all the more sense in an intensely interconnected world that trades at the speed of light.

How did it work? Well, you saw a nearly 8 percent relief rally in European stocks yesterday, after about 4 percent in Asia. US stocks rose about 4 percent. Interest rates on notes and bonds rocketed skyward yesterday, the euro briefly traded stronger than $1.30, and corporate debt spreads tightened.

So as of early yesterday, this looked like a brilliant performance for Euro-TARP.

As I pointed out here , however, the US rally had a somewhat heavy feel to it. This morning, stocks are lower in Europe by nearly 3 percent, and will probably fall in New York. Midcurve rates have resumed their downward march, with the 10-year US Treasury note yielding 3.47% (it was 3.60% yesterday), and the euro has retreated to below $1.27.

But look a little closer. The indicators of health in European interbank credit markets are basically unchanged from yesterday, and a little wider than last week. That does NOT look like progress.

What Euro-TARP did was to remove the risk of an acute credit crunch, which could possibly have bloomed into a systemic crash. What Euro-TARP did NOT do, is to improve the underlying dynamics that created the risk of an extreme event. Greece is still indebted far beyond any plausible ability to repay its creditors (including some major French and German banks). Several other sovereigns are in almost as deep as Greece. And there’s no end to the problem in sight.

What appears to be happening now is what several people have been predicting for more than a year: we’re seeing a “reset” in the market value of the debt of overextended states. The parents have finally taken away the credit card.

What this means for states like Greece going forward is unclear, but the most likely path is this: the EU, its member states, and the IMF will continue to provide low-cost loans to Greece (and probably some other states). This ought to reduce the threat of a Greek default (which is where the threat of systemic disorder comes from).

In return, Greece will have to keep promising to impose austerity on its people, but the pressure to actually do so will be balanced by the fact that it’s in no one’s interest (least of all Germany’s export businesses) to see widespread social unrest and deep recession on Europe’s southern flank. By the time the weather starts cooling this fall, the riots in Greece will be over.

And the value of the euro will need to fall, in order to reflect the misallocation of capital represented by a probably-permanent extension of low-rate loans to Greece and other states. When a kid gets into trouble with her new credit card, sometimes it makes the most sense for her parents to dig deep into their savings and pay off her debt. That’s basically what’s happening here.

And we learned something new about the management of systemic financial crisis. (Well, policymakers learned something new. The markets which imparted the lesson already knew it.) The lesson is that we can quell “long-tail” events, the acute panics that seem to be part of the DNA of financial markets. But doing so in a particular case does NOT mean that the underlying problems which led to the panic have been solved. That’s a separate effort. Euro-TARP bought some time, and not much more.

And finally, the status of US sovereign debt as the world’s safe-haven in times of disorder was emphatically proven yet again. Like morphine, this has an extremely dangerous effect on US policymakers and Congresspeople: it anesthetizes them into thinking that they have time to reduce our own fiscal overextension, which isn’t as bad as Greece’s but rapidly getting worse.
It defies all logic to assume, as our current fiscal policy tacitly does, that the US government will always be able to fund arbitrarily-sized deficits at low interest rates.  Someday, as with Greece, that will stop being true.

This story first appeared at The New Ledger.

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  • http://thesandsinstitute.org Vassar Bushmills

    VB

  • Tbone

    what happens then?

    Answer correctly and win $100 trillion ZWD.

    • Bill S

      And as you imply, the answer is quite unknown.

      I suspect the answer is that eventually the interest rates skyrocket, inflation takes off, and we’re all %&@*ed.

    • Francis Cianfrocca

      Yesterday, there was very little information on what EuroTARP actually is. Today, some reports have it that it’s a little like a private equity fund. The general partners committed to make up to 750 bn euros available as needed for making low-rate loans to sovereigns. And when the capital calls come, they’re supposed to go out and borrow the needed funds.

      Combine that with Trichet’s recent statements that, contrary to weeks of denials, the ECB actually will be willing to buy some sovereign debt. That suggests that EuroTARP will get the money it needs through monetization.

      That’s directly inflationary. And it’s the reason why I’m suggesting that the euro will lose value.

      Another point: it seems like the basic strategy for dealing with this fiscal problem is to substitute the credit quality of France and Germany for that of the heavily-indebted states. In the US, we did something economically equivalent, by simultaneously deleveraging the private sector while pumping up govt borrowing to hitherto-incredible levels.

      To continue the credit-card analogy, it’s like you got your parents to cosign, so you get a lower interest rate and a slightly higher borrowing limit. This actually does work, SO LONG AS you cut down on the overborrowing that created the original problem. But that’s the problem: neither we nor the Greeks are doing anything to solve it. All we’ve done is postpone the problem.

  • http://jhpruitt.blogtownhall.com/ kipling

    The next step for Greece is a loss of national sovereignty or at least a part of it. The Greek government will take no steps to rein in rabid spending because the Greeks themselves are unwilling to part with their entitlements. In the old days the Greeks would be left to their fates and either live in squalar or be conquered. Today the EU will step in and provide the funding and fiscal discipline needed. The EU does not have to worry much about what the Greek people want as the Greeks have little say in the non-democratic EU system.

    • IJB

      I don’t think the EU could do a thing to stop it either.

      If I was Turkey, I’d start ramping up military spending – the entire eastern end of the Mediterranean is theirs for the taking, if they want it!

      • afterseven

        Don’t forget the Greek Resistance not only overthrew their Italian occupiers, they tied up numerous Nazi Divisions between 1941 – 1944 that were badly needed elsewhere.

        The notion that Turkey will be taking Greek Mainlands or Islands as suggested above is a pure fantasy.

        Although austerity measures will be imposed on Greece, ceding sovereignty is a separate issue, and its not in Greek nature to do so.

        Austerity measures will be imposed on the USA eventually, whether self imposed or imposed by our foreign sovereign creditors is of little matter. There is no reason to believe that sovereignty is lost in such an arrangement…unless we are to start playing at semantics.

        If Greece is said to lose sovereignty, it was lost the day they entered the EU….which is why the USA should not enter into binding international agreements.

  • Francis Cianfrocca

    If I read you correctly, at some level, you’re talking about reducing Greece to a colony of France and/or Germany, or maybe the Brussels EU directorate. I’m not sure how else to read “loss of sovereignty.”

    I think it’s a lot more likely that everyone will grumble a lot, the strong states will pay up, Greece will impose some mild austerity, and that will be the end of it. The economics of the euro depend on Germany being able to expand eurozone exports, which in turn depends on states like Greece retaining their ability to pay for imports,

    Even if that ability to pay for imports is fictional. The Germans don’t want to upset this applecart.

  • dt

    Francis,

    Thanks again as always for your interesting market analysis. To think through your final paragraph a bit, I have a couple of questions. First, if one were to accept (and I fully recognize that most here would not) a Keynesian approach to macro-economics, couldn’t one argue that deficit spending of this type is sustainable, even in the long run, so long as the deficit directly expands the economy at a rate as fast as or faster than the increase in deficit and debt? Second, even if one did not accept a Keynesian view, would not the result of a “reset” mean a devaluation of the dollar relative to other currencies, which, in turn, would go a long way to inflating away the value of the debt the United States would have built up over that time. Finally, and perhaps most importantly, I am inferring from your last paragraph that you believe that when the United States reaches that day of reckoning where the dollar is no longer the worlds store of value, that the ramifications of that day would come on as quickly as did the Greek debt crisis. But isn’t it just as possible that we’ll see a gradual reset/releveraging of the value of the dollar as the United States increases its debt such that we will be able to continue to service the debt at lower cost on a gradual basis (thereby avoiding market turmoil)?

    Thanks!

  • dt

    Francis,

    Thanks again as always for your interesting market analysis. To think through your final paragraph a bit, I have a couple of questions. First, if one were to accept (and I fully recognize that most here would not) a Keynesian approach to macro-economics, couldn’t one argue that deficit spending of this type is sustainable, even in the long run, so long as the deficit directly expands the economy at a rate as fast as or faster than the increase in deficit and debt? Second, even if one did not accept a Keynesian view, would not the result of a “reset” mean a devaluation of the dollar relative to other currencies, which, in turn, would go a long way to inflating away the value of the debt the United States would have built up over that time. Finally, and perhaps most importantly, I am inferring from your last paragraph that you believe that when the United States reaches that day of reckoning where the dollar is no longer the worlds store of value, that the ramifications of that day would come on as quickly as did the Greek debt crisis. But isn’t it just as possible that we’ll see a gradual reset/releveraging of the value of the dollar as the United States increases its debt such that we will be able to continue to service the debt at lower cost on a gradual basis (thereby avoiding market turmoil)?

    Thanks!

    • Francis Cianfrocca

      I really can’t answer all of that in a short reply.

      You’re absolutely right: the way that the US will deal with a fiscal crisis (assuming nothing changes politically here) is going to be very different from what happened in Greece. The most important reason why is that the US has about $50 trillion in real and financial capital. That capital will slowly burn down and become impaired, possibly over two decades, as the US deals with our unfunded social commitments. Think of it as slowly draining your rainy-day fund.

      I’m a supply-sider, not a Keynesian, so I don’t believe that economic output is stimulated by demand. I believe that output is stimulated by attractive risk-adjusted rates of return on capital. The true effect of Keynesian stimulus (whether pursued as countercyclical policy, or as a long-term de facto response to unfunded social commitments), is to forcibly convert savings into investment and/or consumption. That’s why there are limits to how effective it can be.

      And of course the most important limit on that process is the long-term interest rate. The fact that rates are low in both the US and Japan is why the fiscal crisis doesn’t seem as urgent to policymakers as it really is.

      But what if you’re the US president and you’re saying “thank goodness rates are low so I don’t really have to cut spending or raise taxes”? What you’re really doing is saying “I hope no one decides they have better things to do with their money than lend it to me.”

      In other words, we no longer control our own destiny. And that’s a direct parallel to Greece.

      Did I answer most of your questions?

      • dt

        Yes you did, thanks. The interesting, and somewhat sad thing that I think follows from what you’re saying is that policymakers might actually be making the informed choice to mortgage our collective destiny (if I can borrow and slightly modify your phrase) because it is the best of several terrible alternatives.

        On the one hand, they could allow financial collapse, or at the very least, horrific financial consequences (i.e. pain now). On the other they could postpone that day of reckoning and hope to manage it into a softer landing in the future (i.e. pay later).

        Faced with such unpalatable alternatives, I’m not sure I’d make a different choice, particularly if I thought I’d have a decent chance to manage the soft landing in the future. The danger, of course is that I might be spectacularly wrong about my ability to do so, and Friedman, I think, would teach that it would folly to try.

        These types of alternatives must have been what Bernanke, Paulson, Geithner, etc. were weighing when they decided on TARP. Ditto for the EU here. Doesn’t give me a whole lot of comfort, but then again, I’m not sure much comfort was to be found.

        I think you’d agree with the above based on what you’ve written on TARP, but please feel to correct my impression if I’m wrong.

        DT

        • Francis Cianfrocca

          Forgive me for shouting, but you hit the nail on the head. It’s politically rational, and therefore expedient, for US policymakers to keep hoping that interest rates stay low. They’re making a bet that they never really will have to cut spending, raise taxes, or both.

          They’re also assuming that the US economy will return to growth strong enough to generate new revenue and thus reduce deficits automatically. But Obama and the Democratic Congress cling to this vain hope (which is on full display in Orszag’s 10-year budget projection), even as they continue to raise business taxes and regulations, which will ENSURE that we DON’T get a return to strong growth!

          But as I’ve said on other occasions, the government has a split personality on this issue. It actually makes some sense for them to prevent a strong economic recovery, because that will keep interest rates low.

          To your point about TARP: I have it on quite good authority that Bernanke and Paulson were not thinking about the economic consequences when they put TARP on the table. (It was a “break-glass” plan that Paulson had requested that his staff write several months earlier just in case it was needed.)

          All they were thinking about was getting the financial markets stabilized. At that point (September 2008), it was not at all clear that a huge economic decline was about to occur, although Bernanke made it very clear in closed-door Congressional testimony that he expected that outcome if TARP was not passed.

          • http://impudent.blognation.us/blog kyle8

            They don’t have the slightest clue what grows an economy, (and yes I am talking about those members of his council of economic advisers who have PHD by their name).

            They actually believe that enough spending will jump-start the economy, and that inflation will not happen because the markets are still depressed.

            They either never learned, or forgot all of the lessons of the ’70′s and ’80′s.

  • glorybee

    “Greece will have to keep promising to impose austerity on its people, but the pressure to actually do so will be balanced by the fact that it?s in no one?s interest (least of all Germany?s export businesses) to see widespread social unrest and deep recession on Europe?s southern flank. By the time the weather starts cooling this fall, the riots in Greece will be over.”
    What event in reality leads to the acceptance of this blithe assumption? Riots resulting in death & destruction took place before ANY “austerity” measures were even imposed. It wasn’t fiscal stability that was bailed out, it was a profligate lifestyle dependent upon the stupidity – and cash – of strangers. This won’t last a year before more cash is demanded. Like the physical laws of gravity, the fiscal laws of debt will not be denied. Weimar-like inflation, massive unrest, plunging standards of living lurk behind every cumulative TARP.

    • Francis Cianfrocca

      I’m making a prediction, based on analysis, that the EU will not insist that the Greek government impose the kind of austerity that will produce a debilitating recession and social unrest.

      The Greeks will indeed pledge to impose full austerity, but they won’t actually go all the way.

      And so the Germans will chicken out and pay up. They’ll grumble, but they won’t insist. Why? Because they have as much to lose as the Greeks do if the latter hit the wall.

      Lots of people, particularly right-leaning people, believe that we should let the failures fail, and everyone else can just learn their lesson. That’s simply not realistic. The right thing to do is to prevent the excesses from happening in the first place. And that indeed will happen, which is the point of resetting sovereign interest rates higher.

      But the mess that Europe has now, they’re stuck with.

      • IJB

        …I wouldn’t make that assumption at all.

        I think we are likely heading into a period of markedly increased political instability in Europe.

        I think about the least-bad result of this will be the massive shrinking of the Euro-zone. But there are much worse scenarios possible, and I don’t see the German electorate staving them off anymore…

        • Francis Cianfrocca

          …it’s that they do as they’re told. ‘Nuff said.

          • Scope

            Obama nudges Merkel or some such thing. Obama called Merkel and forcefully asked her to go along with the bailout plan. Supposedly he told her that he had to make some of those same kind of hard decisions, and as uncomfortable as it was, he manned up to the task. Hahahaha, sorry, I had to let that one out.

            From what I have been reading around the web, as to Merkel and Germany, including some comments sections at Der Spiegel, there are some that are angered that Merkel took so long to back the bailout, and appeared very indecisive and weak, and therefore made Germany appear weak. Germany believes that it has the strongest face and voice in the EU, as they are the strongest economy and as I read elsewhere, have the “fattest wallet.”

            On the other hand, and probably in larger numbers, I am reading that Merkel’s party lost their majority in the weekend elections because of Merkel’s backing of the bailout. Not many don’t believe that the German’s are a frugal people, and deplore other states/countries that are big spenders and money wasters. The Germans are furious that Greece was allowed into the EU by deceit. They lied about their debts in order to gain admittance. Don’t lie to the Germans. Many see what they have accumulated, as being now given away to the Greeks because of the Greeks stupidity. Germany all along was the biggest and strongest voice in the severe austerity measures, if they committed to the bailouts. I don’t know anything about German politics, or their representative parties in the parliament, but, it seems that it was Merkel’s party that approved the bailouts on Friday. The opposition seems to be furious for more than one reason.

            It appears that Germany had held alot of Greek debt, and that that may have led to Merkel’s decision. I haven’t seen what those debt figures were, but, with the reality that Greece will soon enough be back for more bailout money, and the German’s have to pony up the biggest portion, would it not have been better to have lost on the original debt, rather than to keep propping up what many believe will be an ongoing, long range problem with Greece? What happens if Spain and Portugal and possibly other EU countries starat looking at the bailout trough? How many times will Germany come to the rescue, and keep committing their funds?

            I’ve read, more than once, that the EU members who haven’t destroyed their economies, will start pealing away from the Euro at least, if not from the EU. I would bet if that does happen, Germany will be first to go back to the deutchmark (sp). Doesn’t seem like Merkel will have much future say in the decision.

          • Scope

            exports to Greece matter when they won’t be able to pay for those imports?

      • glorybee

        do not impose full austerity, what has changed other than even more debt? You talk about future excesses but even with this latest infusion, the current excesses have not stopped accumulating. If there are no consequences for profligate living what prevents excesses? Higher interest rates? We’re not talking about a couple of basis points, but rather spectacular inflationary devastation. I agree with most of your commentary but I am vastly more pessimistic about the future.

      • Spiral

        Lots of people, particularly right-leaning people, believe that we should let the failures fail, and everyone else can just learn their lesson. That?s simply not realistic.

        When you say, “That’s simply not realistic,” are you saying it’s not politically realistic? Or not realistic in terms of how it would impact the economy?

        Aren’t there some benefits to playing hardball with creditors, instead of bailing them out in order to smooth things over and avoid instability?

        Here are a few benefits of letting creditors take their “haircuts” that I can think of:

        [1] Justice. The taxpayer, who didn’t decide to invest in Greek debt or in AIG, Bear Stearns or Lehman, doesn’t have to take a loss for an investment he or she did not make. The creditor who did make such an investment must suffer the consequences.

        [2] Other creditors might be paying attention. Remember how the Primary Reserve Fund “broke the buck” after Lehman was, unexpectedly, not bailed out? A few more failures like that and not only would the taxpayer be able to take a day off from working to pay for all of these bailouts, some people might realize that a money market fund shouldn’t be investing in highly leveraged investment banks like Lehman. Ya think?

        I’m just saying that as we keep hearing that allowing the regular bankruptcy process work, allowing insolvent banks to be shut down, well, that is just a recipe for 30 percent unemployment and forcing everyone to pick lettuce for a living, we are forgetting some basics about costs, morality/justice and incentives.

        I’m just asking the question because these days if you are a business person and you can’t pay your creditors, both you and your creditors are going to try to hit up the US taxpayer for some help. At some point, if we want our economy to grow, we are going to have to stop transferring so many resources to people, banks and businesses that can’t convince people to voluntarily invest in their enterprises.

        • Common_Cents

          If they are in the club and politically connected, they can pull the too big to fail card. If they are not they’ll get a haircut like The bible toting gun clinging average Joe GM bond holders.

          No wonder the IMF can act with confidence around the world, they get payment preference over everyone.

          • Spiral

            Well, many economists and some “moderate-conservatives” are saying, “If we had not passed the TARP unemployment would be 30 percent right now instead of the current 9.9 percent.”

            Now, there is no way to prove or disprove this statement. But many people, including Steve Forbes and Rich Lowry and Charles Krauthammer, people who I respect, have said things like this.

            I still think that they are wrong, however. If allowing the bankruptcy process to go forward is so damaging to the economy, why not revised backruptcy law?

            But perhaps a more fundamental question is simply, are we afraid of letting the free market work, which includes letting businesses fail?

  • afterseven

    My read on the lack of enthusiasm in the last 24 hours for a $1 Trillion dollar TARP style Euro bailout stems from my perception that we are witnessing a real Push Back from either specific capitalists or from the unconscious collective mechanisms of capitalism itself. A

    Markets, Private Lenders and Banks across the globe are collectively saying NO to Socialism as an economic model. We are witnessing it minute by minute. Maybe caused by Obama’s year long siege on banks? and on Goldman Sachs specifically… Maybe caused as a response to Greek anarchy as a predictable byproduct of unsustainable bloated Government Socialist Spending? Maybe caused by overly cautious Bond rating entities still smarting from Lehman Bros.? Maybe caused by a collective realization, that capital markets can no longer support infinite Socialist largess and that prospective Sovereign default is too close to becoming an acceptable norm? Whatever the case…we are witnessing a fiscal smackdown of Global Historical significance.

  • Common_Cents

    “Damages to tourism mean damages to the Greek economy as a whole, since about 17 per cent of the country?s GDP is generated by the tourist industry and about one in five jobs is in the sphere.”

    I read tourism bookings were already down 8-10% before the televised riots. 17% of GDP and 1 in 5 jobs in tourism. Ouch.