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Monday, May 10, 2010

A Crumble

Looking at Treasuries, and the yen, the Euro and all that jazz, it is clear that no amount of rhetoric is going to convince private parties that those bonds are going to be paid in full.

The Euro gave up most of its gains.

The problem here is that the ECB needs to tell everyone exactly what it is going to do and how much before confidence can be restored (if it can be restored). And that would have to include something about how the bonds will be written down. Otherwise, the losses are still there, and if the ECB plans to overwhelm the losses with money, it is certainly an inflationary event. If the losses are going to be quietly filtered through to other countries, it will drive up their bond rates. If no one knows what's really going to be done, I guess we all just sit in a state of free-floating anxiety and wariness.

The worst part about this is that every Euro authority is hammering the line that this is speculation, when a blind, deal and mute carpenter can tell that it isn't. The worries over repayment are well-founded.

I was going to translate this Spiegel article for you, because the English articles are not nearly so frank. But I have got a bad case of the jitters - this post is really just an anxiety dump.

Some of my anxiety is very well-founded. For instance, what happens to Italy? It's not like Italy can really stand much higher rates, but Italy also has a very high public debt. To control its debt levels, Italy has to grow faster than the interest rates it pays (because its public debt is higher than its GDP). That does not appear possible for the next few years, which means its debt levels will keep growing in relation to GDP, and if Italy's bonds are really a bad investment, then what was this exercise for? And G_d forbid Italy now guarantees Greece's bad debts. Would that make anyone more willing to buy Italian bonds?

And what's the purpose of dumping debt on say, Germany and the Netherlands? Countries that have already imposed relatively austere regimens may be the only ones that can bail the Euro out, but that means they will essentially be taking higher debt margins, and their positions will be worsened.

Now, if the debt were just written down, it is true that some countries would be hit hard, but anyway Spain, Portugal and Greece will be hit hard, and obviously Italy must correct itself. France has been trying to reform anyway. But if this crisis were confronted more honestly, then perhaps the Euro would drop, but some European countries would profit from the drop (it would, for example, make Germany's manufacturers more competitive), and at least the healthier countries could continue on their paths, and hopefully generate some real growth that would help the less fiscally stable countries.

The eerie prospect of getting countries like the Netherlands and Germany loaded down with this stuff isn't really going to be reassuring, is it? The worst of it is that countries which are now stronger don't have the relatively easy options to cut social programs. Thus they don't have the range of options that France and Italy have. If they get too weighed down, their future growth will really suffer. So is the intent here to sacrifice the good to the bad?

The next part of my anxiety (which I worked out for myself over the woodpile) is that this level of delusive rhetoric is something that has always been associated with disaster in my banking experience. The path to correction always involves recognizing your bad debts and writing them down or off, recovering what you can and then putting what's left out in real assets (good loans) that will pay you. The alternative - rolling over bad debts and letting them grow - just magnifies your losses. So if Europe were a bank, right now I'd be getting my money out.

When people don't know how bad debt will be handled, they account for all the possibilities, which almost inevitably means that the effect of the bad debt is magnified.

As for the yen rise, a big hunk of the USD carry trade is busted, isn't it? However a larger split between the Euro and the yen is not good for Japanese manufacturers.

Excellent post Mama!

...countries which are now stronger don't have the relatively easy options to cut social programs....So is the intent here to sacrifice the good to the bad?

This is the clearest statement of the problem I've seen yet. The bad debt must be repudiated, the over-generous pensions must be reduced or eliminated, and the goldbricking bureaucracies must be cut down to size. Whole governments have to be put through bankruptcy so as to save the valuable pieces, and regulatory regimes had darn well better worry more about providing value than about increasing next year's budget.

This applies to EU, U.S., the states, everybody. Anybody who values a strong national government (which I do) had better demand less of it, or lose the whole thing.
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