Jim Walker on Euro and Yuan

Past Debt Crises Offer Lessons for Euro Zone

http://online.wsj.com/article/SB10001424052748704638304575636830900220828.html

For almost 30 years, I have been covering sovereign debt crises.

I was working in the New York bureau of Reuters in August 1982 when Mexico announced it couldn't meet its debts. I followed Latin America's debt travails through the 1980s and Mexico's in 1994-95. I was on hand for the Asian crisis of the late 1990s and the subsequent rescue packages for Brazil and Argentina.

These experiences have led me to the following profound conclusion: Like Tolstoy's happy families, debt crises are all alike. On the other hand, like his unhappy families, they are also all different.

Many of these crises ended in default; some didn't. The difference between the two largely hung on whether an economy could grow out of its troubles. If Greece's rescue and Ireland's impending bailout aren't being greeted with relief by financial markets, that is almost certainly because of worries about low growth, which are heightened by austerity policies.

South Korea and the other Asian economies grew after their crises, so injections of emergency funding through financial rescues led by the International Monetary Fund were generally enough to tide them over and avoid default.

By contrast, the 1980s debt troubles of Latin American countries condemned them to slow growth. That initially forced rescheduling of their debts, stretching out maturities initially a year at a time and later over multiple years.

Bolder action was prevented by the weakness of Western banks whose balance sheets weren't strong enough to confront the reality that these governments were never going to pay their debts in full.

Rescheduling reduced the net present value of the debts, but not by enough to allow the governments to escape their debt traps. In a parallel with the euro zone's current predicament, governments could only reduce debt burdens significantly once the banks had had time to boost their capital cushions and recognize the losses. In retrospect, Asia suffered a liquidity crisis; Latin America a crisis of solvency.

But the lesson from both crises was: Don't borrow from banks at floating interest rates and don't borrow in somebody else's currency. Borrowing in your own currency at fixed interest rates was supposed to be the answer. That way interest rate spikes wouldn't create an unpayable interest bill across your entire debt. Neither would you suffer the ballooning of dollar debts that followed, for example, the sharp devaluation of the 1994 Mexican crisis.

Another lesson from past crises, such as the depression that followed Chiles's banking collapse in 1981, is that private debt matters. In a crisis, excess private-sector debts will almost inevitably become public debts as they did in the U.S., U.K. and with devastating effect in Ireland.

Euro-zone governments didn't borrow at floating rates but many are now realizing that they didn't borrow in their own currency either. The peripheral countries of the euro zone borrowed in a currency that belonged mainly to Germany and the other core countries of the euro zone. As a number of correspondents have suggested to me, this isn't a true sovereign debt crisis because the countries involved don't have sovereign control over their monetary and exchange-rate policies.

But the euro did allow governments such as in Greece and Portugal to pile on debts that otherwise would have been recognized as unsustainable. When governments in what used to be called the third world defaulted, they often did so with those debts at between 40% and 60% of GDP.

Bond investors and bankers would quickly become nervous of high debts and deficits. In the mid-1990s, most Latin American countries, based on their debts and deficits, would have qualified under the euro zone's membership criteria.

By contrast, euro-zone governments were able to pile on debts for a decade way beyond what would have been tolerated of Latin America.

This has prompted another marked difference with past sovereign debt crises: the size of the debts relative to the size of the economies concerned. Ireland's probable bailout will approach 50% of gross domestic product. Spain's financing needs over 2011-13 to cover its budget deficits and its debt maturities are estimated at €350 billion ($467 billion).

European politicians are going through what all politicians do in such crises, phases of denial, shock and finally acceptance.

National governments struggle in such circumstances so it is small wonder that a loose economic confederation of states united by not much more than their common currency presents a spectacle of confusion.

As euro-zone members fashion a rescue plan for Ireland, with little sign that it has prevented contagion to other peripheral states in the currency area, I am reminded by what a senior U.S. policy maker told me in the late 1990s after he had backed a bailout plan for Brazil: "There is one thing worse than failure," he said, "and that's failure that takes a lot of your money and credibility with it."

The End of the Euro

How the crisis in Greece could lead to the demise of Europe’s most ambitious project.

by Niall FergusonMay 07, 2010

http://www.newsweek.com/2010/05/07/the-end-of-the-euro.html

Crisis—from the Greek “krisis,” for a turning point in a disease—is one of many English words we owe to the ancient Athenians. Now their modern descendants are reminding us what it really means.

Just when it seemed safe to start using the word “recovery,” a Greek crisis is threatening the world economy, and the very existence of the world’s second-biggest currency.

The euro seemed like such a good idea just 10 years ago. Europe had already achieved remarkable levels of integration as a trading bloc, to say nothing of its consolidation as a legal community. Monetary union offered all kinds of alluring benefits. It would end forever the exchange-rate volatility that had bedeviled the continent since the breakdown of the Bretton Woods system of fixed rates in the 1970s. No more annoying and costly currency conversions for travelers and businesses. And greater price transparency would improve the flow of intra-European trade.

A single European currency also seemed to offer a sweet trade. European countries with problems of excessive public debt would get German-style low inflation and interest rates. And the Germans could quietly hope that the euro would be a little weaker than their own super-strong Deutsche mark.

Monetary union had geopolitical appeal, too. In the wake of German reunification, the French worried that Europe was heading for a new kind of domination by its biggest member state. Getting the Germans to pool monetary sovereignty would increase the power of the other members over a potential Fourth Reich. And, best of all, it would create an alternative reserve currency to challenge the mighty U.S. dollar.

Still, when European Commission president Jacques Delors first proposed monetary union, it seemed a wildly ambitious project. Even when it was formally adopted as the third pillar of the European Union in the Maastricht Treaty of 1992, many economists—myself included—remained skeptical.

It was far from clear that the 11 countries that initially joined up constituted an “optimal currency area.” A single monetary policy would likely amplify, rather than diminish, the fundamental differentials between highly productive Germany and the less efficient periphery.

But the worst defect in the design of the EMU, we argued, was that it was uniting Europe’s currencies but leaving its fiscal policies completely uncoordinated. There were, to be sure, “convergence criteria,” which specified that a country could join only if its deficit was less than 3 percent of gross domestic product and its public debt was less than 60 percent. But even when these were turned into a permanent set of fiscal rules in the Stability and Growth Pact, there was no obvious way they could be enforced.

The design of the EMU illustrates a profoundly important truth about human institutions. Just because you don’t create a formal procedure for something you would rather didn’t happen, that doesn’t mean it won’t happen. This was one of the reasons Britain decided not to join the single currency. A confidential Bank of England paper circulated in 1998 speculated about what would happen if a country—referred to only as “Country I”—ran much larger deficits than were allowed. The result, the bank warned, would be a colossal mess.

Why? Because the new European Central Bank (ECB) was prohibited from bailing out a country with such an excess deficit by lending money directly to the government. Yet, at the same time, there was no mechanism for Country I to exit the monetary union. This rigidity was one reason Harvard economist Martin Feldstein foresaw the single currency leading not to greater harmony in Europe, but to conflict.

Make that “Country G.”

For nearly nine years after Greece became the 12th EMU member on Jan. 1, 2001, the Cassandras appeared to have gotten it wrong. The euro was a triumphant success. Long-term interest rates converged. True, the fiscal rules were not tightly enforced—indeed, none of the member states really satisfied the convergence criteria when the euro was launched in 1999—but the trends were healthy. Deficits shrank. And although there was less convergence of inflation rates and economic performance than had been hoped for, there seemed little cause for concern. Not only Europeans but the whole world took to the euro. Between 1999 and 2003, international banks issued more bonds priced in euros than in dollars. The countries that had stayed out began to wonder if they’d missed not just the bus but a luxury coach.

Then, in October 2009, a newly elected Greek government fessed up. Greece’s budget deficit was in fact a whopping 12.7 percent of GDP, as opposed to the 6 percent reported by the old government, and more than three times the 3.7 percent promised to the European Commission at the beginning of 2009. It also turned out that the ECB was indirectly funding more than a third of Greek government borrowing via its emergency lending to Greek banks (giving the lie to the supposed “no bailouts” rule). The news set off precisely the kind of chain reaction the Euro-skeptics had always feared. Lenders had always charged higher interest on Greek bonds than German bonds, even in the euro’s golden years, but that spread suddenly blew out from about 1 percent to above 5, and then 10. The country went into a fiscal death spiral as rising interest rates made the deficit even larger (it’s now up to 13.6 percent) by increasing the costs of debt service. In desperation, the Greeks turned to their fellow Europeans for assistance. That might have been relatively cheap back in January, but the German government hesitated. In the midst of a global financial crisis and a German recession, and with regional elections fast approaching, German voters were in no mood to bail out foreigners who had been fiddling with their fiscal figures. But the longer the Germans dithered, the higher the cost of a Greek bailout rose.

Finally, at the end of April, a deal was hammered out whereby the Greeks received €110 billion, of which €30 billion came from the International Monetary Fund, and the rest from the other euro-zone countries. In return, the government in Athens committed to strict fiscal retrenchment, pledging to reduce the deficit to 3 percent by 2014 with a mixture of spending cuts and tax hikes.

Problem solved? Unfortunately not. This Greek tragedy has several more acts to come.

The first will be a Greek default. It’s simply not credible that the government will be able to deliver such severe fiscal tightening at a time of deep recession. Even if everything were to go according to plan, the debt would peak at 150 percent of GDP, with a crippling 7.5 percent of GDP going on interest payments. Greece manifestly lacks the political will to do this. Prediction: the government of George Papandreou will fall and its successor will inflict a 30 percent “haircut” on holders of Greek bonds.

The next act will be even more dramatic. For what makes the crisis in tiny Greece so serious is the contagion effect—the realization among investors that if this can happen to Greek bonds, it can happen to other bonds, too. A scan of the data reveals two other euro-zone countries with bloated debts (Italy and Belgium) and another two with Greek-style overreliance on foreign lending (Portugal and Spain).

Last week the rating agency Moody’s placed Portugal’s long-term government bond Aa2 rating on review for a possible downgrade. And as Spain sold five-year bonds paying 3.5 percent—compared with a yield of 2.8 percent two months ago—rumors swirled that Madrid was seeking a bailout even bigger than Greece’s.

Nor is this the only way the Greek crisis can spread like a virus throughout the European economy. Their balance sheets stuffed full of dodgy government bonds, the Greek banks are heading into Lehman Brothers territory. For neighboring countries like Bulgaria and Romania, which rely heavily on Greek banks for funding, that spells a credit crunch.

Even more alarming is the exposure of other EU banks to Greek debt, which totals $193 billion, according to the Bank for International Settlements. Factor in the risk of copycat crises in Portugal and Spain, and you begin to see the outlines of a disastrous Europewide banking crisis. The only way out of that will be further compromises by the ECB about the paper it accepts as collateral. Already last week it waived its rules, continuing to hold Greek bonds, despite their junk status. If this continues, there is only one way for the euro to go, and that’s down.

Keep this in perspective. When the euro was launched back in January 1999, it was worth less than $1.20, and for most of its first three years it was down below parity with the dollar. So its recent slide from close to $1.60 before the global financial crisis to $1.27 last week is far from unprecedented. But the way this crisis is unfolding, further declines seem likely. It will surely be at least a year before investors wake up to the fact that the fiscal predicament of the United States is actually worse than that of the euro zone.

The difference is, of course, that the United States has a federal system, while the euro zone does not. In America, Texas automatically bails out Michigan via the redistribution of income and corporation tax receipts. What the Greek crisis has belatedly revealed is that such fiscal centralization is the necessary corollary of a monetary union.

Europe now faces a much bigger decision than whether to bail out Greece. The real choice is between becoming a fully fledged United States of Europe, or remaining little more than a modern-day Holy Roman Empire, a gimcrack hodgepodge of “variable geometry” that will sooner or later fall apart.

Ferguson is Laurence A. Tisch professor of history at Harvard University and William Ziegler professor at Harvard Business School. He is the author of The Ascent of Money: A Financial History of the World (Penguin Press).

World Collapse Explained in 3 Minutes

Europe’s Debt Crisis Is Casting a Shadow Over China

From: http://www.cnbc.com/id/37189729

The pain of the European debt crisis is spreading, with the plummeting euro making Chinese companies less competitive in Europe, their largest market, and complicating any move to break the Chinese currency’s peg to the dollar.

Chinese policy makers reached a consensus last month about breaking the dollar peg. But allowing the renminbi, which is also known as the yuan, to rise against the dollar now would mean a further increase in the renminbi’s level against the euro, creating even more problems for Chinese exporters to Europe.

The euro has plunged against the renminbi in recent weeks, at one point Monday reaching its lowest level since late 2002.

The steep rise of the renminbi prompted a Commerce Ministry official in Beijing to warn Monday that China’s exports could be threatened. The official’s comments, the most explicit yet on the implications for China of Europe’s recent financial difficulties, suggest that even the world's fastest-growing major economy, and increasingly the engine of global growth, is not immune to the crisis that started in Greece and threatens to spread across much of Europe.

“The yuan has risen about 14.5 percent against the euro during the past four months, which will increase cost pressure for Chinese exporters and also have a negative impact on China’s exports to European countries,” Yao Jian, the ministry’s spokesman, said at a news conference in Beijing, according to news services.

Some economists warn that there may be much worse to come. The biggest reason why Chinese exports plunged early last year was not weakening demand in industrialized countries but a sudden, temporary disappearance of trade finance. The availability of trade finance could easily become a serious problem again soon, said Dong Tao, the chief Asia economist at Credit Suisse.

Chinese exporters rely very heavily on bank letters of credit to finance their shipments. The availability of the letters of credit is closely linked to overnight lending rates between banks. When banks have trouble borrowing money themselves, they tend to cut sharply the issuance of letters of credit for trade finance as a quick, easy way to conserve cash without violating the terms of other financial obligations, like established lines of credit for big corporations.

Interbank lending rates surged late last week and on Monday and must now come back down very quickly to persuade banks to keep issuing letters of credit, Mr. Tao said. “Without trade finance, trade won’t happen,” he said.

The Shanghai stock market plunged Monday, with the composite index falling 5.1 percent on worries about global demand as well as concerns about possible further moves in China to limit a steep rise in real estate prices this spring.

Some Chinese companies are already running into difficulty because of the euro’s fall against the renminbi.

“We have been receiving calls from some European clients who signed contracts with us earlier this month, and they all want to cancel their orders, since the depreciation of the euro has eroded all their margins and then some,” said Elvin Xu, the sales manager of Guangdong Ouyi Electrical Appliance in Zhongshan, China, which makes gas stoves, heaters and water heaters.

“They say they cannot increase the prices at their end to their customers, given intense competition in their marketplace,” Mr. Xu added.

The renminbi is rising along with the dollar against the euro. The Chinese government has continued to intervene heavily in currency markets in recent weeks to prevent the renminbi from rising against the dollar, maintaining an informal peg of 6.827 renminbi to the dollar, the level since July 2008.

Because American companies in particular compete in the Chinese market with European companies in many industries, the euro’s weakness against the renminbi is putting American companies at a disadvantage just as Gary Locke, the U.S. commerce secretary, is leading the first cabinet-level trade mission of the administration of President Barack Obama to China this week.

Mr. Locke said Monday in Hong Kong that Mr. Obama’s goal was to double American exports by 2015. Short-term currency fluctuations do not detract from that goal, he said, adding, “Who knows what the euro will be next month, six months from now or a year from now?”

Steve Jennings, one of the American executives traveling with Mr. Locke, said that the weakness of the euro would help European companies compete against U.S. companies in export markets all over the world.

“As the euro continues to decline, they’re going to have some advantages,” said Mr. Jennings, the chief marketing officer of BPL Global, a company based in Oregon that manufactures electricity monitoring equipment.

Chinese leaders reached a consensus in April to break the renminbi’s peg to the dollar, ending a dispute that spilled into public view in March when Commerce Ministry officials warned in speeches and interviews in Beijing and Washington about the dangers of any change in the renminbi’s value. The ministry halted those warnings immediately after the consensus was reached, and Chen Deming, the commerce minister, even reversed himself publicly by saying that China’s trade deficit in March was nothing to worry about.

But events since then have delayed implementation of the consensus, including public attention paid to a visit to Beijing by the U.S. Treasury secretary, Timothy F. Geithner, followed by the Qinghai earthquake and then the euro’s slide.

The euro’s difficulties have also inflicted tens of billions of dollars in losses on the value of China’s $2.4 trillion in foreign exchange reserves, according to Western economists. China had been trying to limit its dependence on U.S. Treasury securities for those reserves in recent years, fearing that the United States might someday suffer from budget problems or inflation, and did so by expanding its holdings of European government bonds.

But the State Administration of Foreign Exchange, which administers the reserves, does not have to mark them to market daily, so it is not clear what effect, if any, the losses will have on Chinese policy.

If Greece Is Bear Stearns, Will the UK Be Lehman?

http://www.cnbc.com/id/37079126

Monday’s market euphoria across the world at the terms of the European Union/International Monetary Fund rescue package for the European bond market faded Tuesday as investors sold stocks and took profits on the euro. The worry for investors is whether governments in Greece and Portugal can live up to their end of the bargain and manage to significantly cut government spending in the face of bitter opposition from voters.

Despite averting what could have very well turned into a fully-fledged liquidity crisis with Sunday’s news of a 750 billion euros ($951 billion) stabilization fund and European Central Bank assistance for the European bond market some investors remain sceptical that the worst is now behind us.

“The big question I am asking myself is whether Greece is Bear Stearns” Anthony Fry, senior managing director at Evercore Partners, said. “What I really fear is that if Greece is Bear Stearns then the UK is Lehman Brothers.” Fry worked for Lehman before its collapse.

Other analysts have told CNBC the UK is not in major trouble.

Michael Gallagher, director of research at IDEAglobal, said he believes the UK will be alright due to its ability to sell government bonds internally.

Steven Barrow, the head of G10 Research at Standard Bank agreed.

“I am confident about the prospects for the pound,” Barrow said. The difference between the UK and Greece, according to Barrow, is that Britain has more room for maneuver.

“The UK can devalue and print money, the UK will not default, the UK will not need the IMF,” he said.

But with talks over who will form the next UK government dragging on, Fry is adamant that such analysis is nonsense.

“I can’t believe (the UK) can avoid trouble," he said. "The current coalition talks are like arguing over a birthday cake. Once they decide how much of the cake they get they realize no one bothered to bake the cake.”

With a lot of money needing to be raised over the coming months and years, UK borrowing costs are going to move sharply higher, he argued.

“My big fear is that after (Chancellor of the Exchequer) Alistair Darling refused to support the EU/IMF/ECB bailout of the euro zone bond market, the euro zone may stand by and do nothing when the UK gets into trouble,” he said.

Euro Rescue Rally Fades

For the time being, the market has allowed the UK time to form a new government and unveil a credible plan to cut government spending. But the European rescue rally has faded very quickly. Fry said he remains worried about the problems facing Greece spreading to Spain and Portugal despite Sunday night’s unprecedented support.

“Today will be a correction post Monday’s huge short squeeze," Gallagher said. "The big question now is whether institutional investors will return to the European bond market.”

Pimco’s decision to stay clear of a proposed Greek dollar-denominated bond auction last month was one of the key moments leading up to Sunday’s rescue package. Over the following weeks, July will be crucial, when €227 billion redemptions come up in the euro zone and with Spain needing to refinance significantly that month, according to Gallgher.

“What we are likely to see is a two-tier Europe," he told CNBC. “A double-dip recession in Southern Europe is increasingly likely. Core Europe will slow, but do OK. The outlook to the South is far worse.”

Stephane Deo, the head of European economic research at UBS, is more upbeat on the impact of the rescue package.

"The plan is actually quite impressive," Deo said. "We only need €500 billion to guarantee borrowing for Spain and Portugal, we have €750 billion. The euro still needs to do its work of cutting deficits in countries like Greece, Portugal and Spain and have two years to do so.”

Talk of the single currency breaking up should be dismissed, he added.

“Talk of the euro breaking up is nonsense," he said. "What we will get is tighter fiscal cooperation. If Germany is lending money to Spain it will demand tough measures on spending.”

But Simon Derrick, currency strategist at Bank of New York Mellon, is not so sure this will be the case.

”The ECB has agreed to such a program on the basis that governments have assured that they will meet strict budget targets and step up consolidation efforts," he said. "Aside from the questionable politics behind smaller states being ‘inspected’ by their larger brethren, the new, improved Pact’s Achilles Heel will nonetheless remain the same: governments resisting expansionary, deficit financing once its economic fortunes begin to falter.”

So, if if Greece is Bear Stearns and the UK is Lehman, who will be AIG, Freddie or Fannie?

“No comment," Fry said.

How can Greece save itself?

[From a comment to a leader article in the economist: http://www.economist.com/opinion/displaystory.cfm?story_id=16009099]

The question that will go unanswered in the whole crisis, is what would have been different had the German government rescued Greece in a more timely fashion.

I think not all that much. The austerity measures placed on Greece are unreasonable, unjustifiable and have no way of achieving their goal of repaying the debt. Austerity measures are tantamount to collectively putting Greece into a debtor's prison. And there are rather good reasons, why we don't have any living experience of those.

Putting a debtor into prison only works, if the debtor in fact *has* the money, but refuses to pay it. But more often than not, the debtor has spend the money in one way or another and no matter how long you let him rot in prison, will not be able to pay it back. If your desire is to get your money back and not to shame the debtor, then you'd rather help him find a way to earn it back.

Placing austerity measures on a country with the hope of its debt being repaid, assumes that its expenditure is somehow so grossly in excess of its needs, that reducing expenditure alone will easily be enough to pay it back. But this is not at all the case.

Even if Greece decided to cut *all* its military expenditure in order to repay its debt, the Greek deficit would merely be diminished from its current 13% of GDP to 9%. Extravagant expenditure alone cannot account for the deficit and cutting expenditure will do nothing to effectively diminish it, not to mention do anything in the way of repaying Greek debt.

Trying to repay Greece's debt through austerity measures - increased taxes and decreased spending - is a laughable proposition. There are exactly two ways in which Greece can repay its debt.

1) Inflation. This will be impossible unless Greece gets out of the Euro area and also undesirable for all involved.

2) Economic growth. But this will require increased spending, reduced taxes and growing wages - quite the contrary of the austerity measures required from both the IMF and the EU (with Germany in the front line) and almost impossible to achieve so long as Germany follows the doctrine of keeping its real-wage growth below increases of productivity in order to dump its products on other markets - which is impoverishing its own people and those abroad.

The other options to resolve the issue are debt forgiveness, debt restructuring or default. All of which amount to the same.

European Recovery Ahead?

Rogers: Greece Should Be Allowed to Go Bankrupt

ECB heads to Athens

The German Reformation

The political history of Europe since Bismarck’s unification of Germany in 1871 has been the struggle of the European nations to contain the military, political and economic might of Germany. Germany has fought three wars in two centuries, the Franco-Prussian in 1870, and the First and Second World Wars to prevent what its leaders perceived as the dangers inherent in its central strategic position between France on the West and Russia on the East. The desperate desire of the continent's leaders to avoid a repeat of the disasters of the first half of the 20th has dictated the purpose and structure of every major European international system since 1945.

Beginning with the European Coal and Steel Pact in 1950, running through the Treaty of Rome in 1957 that created the common market, the Maastricht Treaty in 1992 which brought about the euro and European Union, and culminating with the Lisbon Treaty three years ago which binds the 27 nations of the EU into the world’s only supra-national entity, Germany has been woven ever closer into the communal life of the continent.

The European Union, even in its original incarnation of the European Economic Community in the late 1950s, was the economic side of German containment. Perhaps the purpose of the community is more generously stated by saying its goal was to align the economic interests of all of its members so that economic predation and conflict would be unthinkable.

In its goal of remaking of European politics the economic union has been completely successful. A war between the members of the EU is currently inconceivable. No one can imagine German aggression on Europe for economic or political gain. As Robert Schumann the French Foreign Minister said in 1950 in his speech which proposed the union project “any war between France and Germany” would be “not merely unthinkable but materially impossible”. The goal and process of the union was to bind Germany within strong European institutions that treated all members the same, minimizing historical grievances and eliminating the temptation for the stronger to take advantage of their superiority.

The military side of German containment was subsumed within the Cold War through NATO and the bi-polar post war political world. Even the need to defend Germany itself was under NATO command, an arrangement accepted without demur by the Germans. The front line of the confrontation between the United States and the Soviet Union between NATO and the Warsaw Pact ran through the middle of a divided Germany.

However, these strategic adaptations did not change the essential nature of Germany, the German people or its position as the largest, most productive and richest nation in Old Europe, and now in the new European Union as well. Until last month, German was the world’s first exporter by value of goods, a remarkable achievement for a nation of 82 million people. China, which surpassed it, has sixteen times its population.

The German engineering, productivity and efficiency that have made its products some of the highest value in the world are an example and a burden for its partners in the EMU. The other euro-zone members must compete with the Germans within the straightjacket of the EU and the ECB. The euro and the its single interest rate have welded all of the countries of the EMU to the economy of Germany.

The historical relationship of the past 60 years between Germany and the rest of Europe has been reversed. Instead of Germany binding itself to the political fates of its neighbors, her neighbors have bound themselves to the German economic standard.

For France, the Netherlands, Belgium, Sweden, Austria, the Czechs and others, whose economies and workers are not much less efficient than Germany, the benefits of the union in transactional efficiency and competition have probably drawn their economies closer to the German standard.

But for the southern countries, Greece Spain, Portugal and perhaps Italy the temptation of the credit provided by membership in the euro was irresistible. Combine cheap money with budgetary indiscipline and the results were predictable and unsustainable. The current fiscal deficits threaten to overthrow the discipline of the 3% and 60% deficit and debt to GDP limits of the Maastricht treaty. For these countries, with the exception of Italy, their export products do not have the high value added quality of Germany. They have traditionally resorted to currency devaluations to restore competitive productivity and export efficiency to their economies.

The currency devaluation route is closed. The European bailout route has been stopped by Angel Merkel and a German public that does not want to pay for the profligacy of their euro partners. There was no disguising the fact that an EU rescue for Greece would be paid for by German taxpayers. German resistance has forced the rest of the EMU into line with its wishes. The IMF will dictate terms to Greece.

This was not the denouement that many thought would happen when the crisis blew up last year. A few weeks of public punishment for Greece and then the EU would come to the rescue, was the common opinion on the continent at the time.

Europe cannot have the benefits of the euro and the ECB without German cooperation. In the past Germany has accepted its role as the guarantor of last resort for the European Union without public reserve. Germans were the foremost Europeans. That day has passed. German national interest is diverging from unquestioning allegiance to the European project. The economic logic of the euro and the European Union will force reformation on the union; it will be led by Germany.

Versailles on the Lethe

http://www.fxsolutions.com/learning-tools/market-directions.asp

The Europeans are determined to take care of their own; or to discipline their own, depending on your view. But the degree of pain and denial that Germany and France are demanding of Greece is of a level that neither government would inflict on their own citizens. The German Chancellor and French President would be voted out of office if they dared.

“The best solution [to the Greek situation] without any doubt is that Greece meets its obligations and that the markets believe these commitments will be implemented”, said German Chancellor Angela Merkel following the European Union (EU) summit on Thursday. The EU summiteers offered Greece solidarity but no cash and no loan guarantees.

Northern European public opinion is against funding Greek profligacy with taxpayer euros. Successive Greek governments used the low interest rates provided by the ECB and euro membership to buy an economic boom the cost of which is now due. Greece will have great difficulty rolling its debt in the spring without external guarantees or ruinous interest charges. It has not helped the Athenian position that it cheated to enter the euro in 2001 and hid the size of its deficit from its European Monetary Union (EMU) partners under the previous government.

“Greece has to help itself; we want to help Greece do it”. “That we help to convince the population [of Greece] of the necessity of solid fiscal policy”, declared German Finance Minister Wolfgang Schaueble in an interview with the German paper Frankfurter Rundschau. By help, Mr. Schaueble means that drastic spending cuts are “the logical and inevitable consequence” of the country’s financial dilemma. The Greek population is expected to understand and acquiesce.

But Greece is only the most outstanding example of a problem that is shared by several less wealthy and less prudent EMU members, including Spain, Portugal, Ireland and Italy, and is to some degree inherent in the unified currency structure.

The EMU experiment, one monetary policy and one interest rate, for sixteen capitals, with uncoordinated fiscal and tax policies and elected governments with very different financial traditions, that answer not to a federal authority but to their own voters, is wholly dependant on the prudence and financial good sense of the individual capitals. The EMU lacks any credible enforcement mechanisms for ensuring fiscal discipline from its members.

The writers of the Maastricht Treaty thought that the unified currency would be self-enforcing. They expected that fiscal congruence would evolve from the requirements of the convergence criteria that set eligibility for euro membership and that had demanded a high standard of fiscal and deficit performance of the joining countries. That has not happened. The countries which had been used to borrowing and then devaluing to maintain competitiveness, Italy, Greece, Spain and Portugal, have remained as they were. The pact has not taught fiscal prudence.

What might be said of the Greek voters’ penchant for squeezing benefits and pay from their government, may also be said, if somewhat less so, of Italy, Spain and Portugal, and in fact Germany and France themselves. Though the protests and street riots in Athens last year had little to do with finance and there have not been any related to the current crisis perhaps the voters should not be overly tried.

Yet it is not apparent that any voter in Greece, as an example or the EMU would want to return to the pre-euro world of cross borders currency wars. Whatever the volatility and disruptions from the current situation, it still compares favorably to the financial and economic turmoil that the old free floating and ERM regimes suffered. It may seem that the EMU is at risk, but it is not. It is doubtful that anyone in Europe, in government or without, would want to return to the world of competitive devaluations, currency change at every national boundary, wildly fluctuating exchange rates and defensive overnight interest rates of 50% or 100% deployed against currency speculators.

One thing that should have been learned over the past three years is the reach of unintended financial consequences. If it applies to Lehman, then surely it applies to the finances of an entire national economy. If Greece is shut out of the sovereign debt markets, what will the consequences be for the continent’s banking system, linked throughout the European Union to banks in France ($76 billion of exposure), Switzerland ($64 billion), and Germany ($43 billion)? And these are only the most direct links. The ramifications of asset downgrades can spread very quickly, from bank to bank and country to country. No political leader, especially not in the EMU could survive the consequences that would spring from the default of a euro member.

But unintended consequences can be political as well. If Germany and France insist on inflicting extended economic pain on several members of the EMU, what damage may they do to the political popularity of the entire project? Germany and France need to consider if they want to be seen as the enforcers of austerity on Greece?

Three years is a very long time in politics. Whatever solution is forthcoming from the EU, the chance that Greece will maintain its ‘rigorous fiscal discipline’ until its deficit is back to 3% is small. Or to be more generous, it remains to be proven that Greek voters will permit the Greek government to do what it has promised to do.

That Greece and the other high spenders return to the budget vicinity of the Maastricht treaty is necessary lest the euro devolve to into a club where the savers of Northern Europe subsidize the spenders of the south. That reality would not last long at the polls nor would the EMU

But is it a good idea for the future of the monetary union for Germany and France, and it will be seen primarily as German instigation and enforcement, to demand the type of financial austerity and economic pain from the population of Greece now and perhaps Spain, Portugal, Ireland and others in the future that could very easily turn the voters of these countries against the EMU and the euro?

“The responsibility for the European currency lies in the hands of the EMU. We do not want to delegate it to the IMF”, said Mr. Schaueble. Perhaps the EMU needs to consider whether enforcing its own rules is really in its own best interest?

Why Sovereign Debt Pain Has Only Just Started

Source: http://www.cnbc.com/id/35308660

Let’s play a game. I’ll remove a few words from the following piece of debt market research and you guess which country the strategist author is talking about.

“The country urgently needs a credible and enforceable austerity plan — the worry for **** investors is that, despite all the **** posturing, politicians still fail to grasp the magnitude of the problem. Repercussions could be severe — the bond vigilantes are hovering and the backdrop is ever threatening …”

Greece? Spain? Portugal?

Actually, it is the UK that Schroders’ Head of European & UK Interest Rate Strategies David Scammell is talking about. But, quite frankly, he could have been talking about any number of countries both in the European Union and beyond. And that is the problem.

We have become used to this kind of concern at the so-called ‘peripheral’ euro zone members. But maybe we need to get real, even if the politicians won’t, and realize that the pain has only just started in a host of Western countries.

Scammell was on "Squawk Box Europe" Tuesday reminding viewers that the rise in Greek yields recently is a clear warning that markets are in the mood to "punish any country that takes creditors for granted."

According to Schroders research, the UK policymakers need to be careful in how much attention they pay to bond investor concerns elsewhere. The UK needs to raise around £220 billion ($343 billion) this year and over £550 billion over the next three years, adding that “the task of the Debt Management Office is daunting.”

And without quantitative easing from the Bank of England, Scammell said the problem would have already come home to roost in 2009. Non-bank private sector investors were net sellers of around £35 billion to £40 billion last year. This was matched by buying from banks and overseas investors of a similar amount. In fact, without QE purchases in the region of £200 billion the Treasury would have had potentially an enormous 2009 funding hole.

As if the problem were not already severe enough, Scammell said the UK dilemma would worsen if the country were to suffer a downgrade from the ratings agencies. UK AAA status is now a topic of open discussion. Implications of a downgrade would include the prospect of much higher funding costs and would be bad news for gilt investors, the economy, banks and the government.

Viewers of "Squawk Box" once again voiced strong opinions Tuesday on the subject of sovereign debt.

Mike agreed that the UK faces serious headwinds:

“I think the UK will be downgraded in the future as our debts are being masked for the moment — the election — we created this global mess along with America and we have massive debt levels now. Greece, Portugal are just the start. You can’t inject massive amounts of liquidity into economies without some kind of repercussions!”

While Jean-Paul in Los Angeles draw parallels with private sector funding:

“There is so much attention on the PIGS and other countries because the private sector has completely deserted and the public sector has been overburdened.”

But Eric fells the differences between the US and Europe needs attention:

“The disconnect between continents isn't adequately appreciated. A guest fretted about the contagion effect of Greek debt concerns, spreading to places like California which is five times the economy of Greece. The US wouldn't let California default under any circumstance just as the EU wouldn't let Greece or any other member state default. While it is currently more complicated for the EU to bail out Greece, laws don't exist until they're written.”

More severe medicine though is called for from Richard:

“The EU should please find a way — quickly, and on an emergency basis — to cut Greece loose from any tie that binds them to the European Union and the euro. Regrettably, there might not be enough room in the fiscal lifeboat at this time and tough choices must be made to cut someone loose. Make no mistake; Greece is definitively the loser. Let 'em go to the IMF."

Greece remains in the eye of the storm but this cyclone has an unpredictable trajectory and we should all wake up to the fact that it is not just the "European periphery" that investors will focus on. As the ERM crisis showed us in the early 1990’s, and the East Asia crisis reminded us again a few years later, the path of international speculation rarely abates before every stone has been upturned.

The euro's troubles

http://www.economist.com/opinion/displaystory.cfm?story_id=15452803

SINCE the launch of Europe’s single currency, there have been theoretical worries about profligacy. The main fear was that free-spending countries (ie, Italy) might borrow excessively and pass either higher interest costs or the bill for a bail-out on to their sober, frugal brethren (ie, Germany). Eleven years after the euro’s birth, as Greece skids towards disaster, those vague fears have become an urgent question of policy.

The first attempt to deal with profligacy, the comically misnamed stability and growth pact, was never going to work. Neither the threat of fines on miscreants unable to afford them nor the euro area’s ban on bail-outs was credible. Yet in the past few months Greek bond yields have widened spectacularly against German ones, as lenders have rightly begun to ask what plans there are for euro-area countries in trouble—and, in the silence that followed, to fear a sovereign default.

What should be done? The aversion of most euro-area countries to a bail-out is understandable, even laudable—nothing would encourage reckless spending like the knowledge that other countries were ready to step in. Greece is especially undeserving (see article). Although some of its problems have been brought on by global recession and by speculators, almost all the blame lies at home. Blatant Greek fiddling with the national accounts to disguise government borrowing has shot to pieces the country’s credibility, both in the markets and with other euro-area members. Deep structural weaknesses in the Greek economy have been left to fester. For a decade or more Greece has lived far beyond its means. Savage austerity is now inevitable. Yet, although the newish Socialist government of George Papandreou has promised to reduce borrowing below 3% of GDP by 2012, that may prove too unpopular to carry through (see article).

A messy Greek default would harm almost everybody. As markets and governments know only too well, behind Greece stand others: Portugal, Ireland, Spain and even Italy, the world’s third-biggest sovereign debtor. Hence the selfish case for other euro-area countries to help. There is plenty of money around. The EU can advance structural-fund aid that is due to be paid in future years. The European Investment Bank can lend more. There may even be scope for a direct EU loan (but not one from the European Central Bank, which under the Maastricht treaty should not bail out euro-area governments).

Look to Washington

The harder question is how to ensure that any help does not undermine reform—that it comes with conditions that promote sound policies, including deep budget cuts and structural reforms. What Greece needs is an outside agency to urge the government on and stiffen its resolve to face down protests if necessary. The answer is to turn to the IMF.

Many in Greece (and the rest of Europe) see calling in the IMF as a humiliation, for the euro as much as for Greece. They also fear stringent IMF conditionality. Yet stringency is just what is needed. In principle the European Commission could monitor performance and impose conditions (or a new European Monetary Fund might do so). But because Greece is a full member of the EU and the euro, any European lender would find it hard to convince markets that it could hang tough against political pressure and social protests. In contrast, the IMF is independent, can afford to be unpopular and has experience of bailing out indebted governments that nobody in Brussels (or Frankfurt) shares. It is, moreover, already dealing with other EU countries such as Hungary, Latvia and Romania.

It is true that the fund’s role in a single-currency zone would be to help avert a sovereign-debt crisis, not to offer classical balance-of-payments support. But its expertise in drawing up austerity measures and reform programmes would be just as valuable. It may be embarrassing for a euro member to need the fund’s assistance, just as it was for Britain in 1976. But the Greeks should be ready to turn to the IMF before they lumber themselves with an even worse fate.

Others Will Follow Greek Tragedy: Ferguson

Greek Debt Could Be Worse than Thought

Looking Back on ECB's 10 Years

A great video on the history of the ECB and Euro: