Friday, June 15, 2012

Euro explosion

The European bank run is on, and with it the slow-motion train wreck  will move to high speed.

The Wall Street Journal reports €600 to 900 million  a day are flowing out of Greek banks, and  the outflow may rise above a billion euros per day. At the end of April there were only €166 Billion deposits to flow. Count the days.  And Greeks -- those who can't move money abroad or move themselves abroad -- are "hiding money in jars, under the bed, even burying it in the mountains."

In related news, I read last week say that payments are simply stopping in Greece. If there's a chance to pay in Drachma next month, why pay in euros now? Shipments are stopping -- if your invoice might get paid in drachma, no point in sending goods today. This is simple implosion.  Spain has already lost about € 100 billion of bank deposits and Italy is losing them quickly.
What's going on? Keynesian economists love to talk about how great leaving the euro will be, because then salaries can be cut by depreciation rather than explicitly.

But if you have a bank account, leaving the euro means that you go to bed one night with € 10,000 in your bank account. The next morning, you have 10,000 drachmas. Those drachmas are going to be swiftly devalued to about 1/3 or so of their original value. In addition, it's a good bet there will be capital controls and exchange controls, so you can't get money out of the country or buy things with euros.

People understand this. They get out now.  To an account holder, the country leaving the euro is the same as the government seizing bank accounts. Burglars at least know enough not to advertize their visits in newspapers for two years before they visit.

The run means everything will happen super fast from here on in. The time to dither around and make pronouncements is running out.


How do you stop a bank run?

1. One common prescription is for the government to guarantee deposits. But that won't work, since the whole problem is that the government is out of money and the banks are stuffed full of government debt.

Spain discovered a version of this conundrum last week. Spain borrowed € 100 billion to recapitalize  banks. The result was not only a continued run on the banks, but a sharp rise in Spanish government interest rates.

Why didn't it work? "Recapitalize" means that the Spanish government owns stock in banks. If the banks lose more money, the Spanish government loses money -- but the government still has to repay the 100 billion loan. Unfortunately, the Spanish government is broke. And what do these banks own? Spanish real estate and a lot of Spanish government debt.
...That would raise pressure on the Spanish government, which has come to rely on local banks using ECB funds to buy sovereign debt. According to the latest Spanish Treasury data, while foreign investors have reduced their holdings of Spanish bonds to 32% of the total in March from 36% in December, Spanish banks have raised their holdings to 41% of the total in March from 35% in December
2. The second run-stopping prescription is for the central bank -- the ECB in this case -- to open the spigots. They already are. Ask yourself, where are banks getting the cash to redeem all these deposits anyway? They sure aren't selling assets -- real estate loans and government bonds. The answer is, the ECB is lending them the money.

But wait, isn't the ECB only supposed to lend against collateral? Yes, and that collateral is largely government bonds.  The ECB knows it's taking junk collateral.  If the ECB doesn't stop this massive lending, it understands well that it will essentially end up monetizing all the debt of the southern tier, and a huge inflation will eventually break out. The ECB knows that too. How long will it continue to lend?

If the ECB decides to stop this massive lending, then the game is up. The banks fail, the governments guaranteeing the banks fail, and chaos erupts --whether or not the governments decide to turn the remaining euros in to monopoly money.

3. As in the US "bank holiday," governments can try to shut down the banks, impose capital controls, etc. But if it's not just very temporary illiquidity, the run starts up the moment you reopen the banks. And if you so much as breathe a word you're thinking of doing it, the run starts ahead of time. Whoops, it's too late. Continuing from the journal here
According to the senior [Greek] banker, the current rate of deposit outflows--of €1 billion or less per day–remains "manageable" since the banks keep large cash buffers on hand to deal with the withdrawals. But if those outflows were to grow four- or five-fold, Greece would be forced to impose deposit and other capital controls.
4. The last way to stop this run is to try, even at this late date, to commit fully and forecefully that no country will leave the euro.

That will be hard. Pronouncements at this date have little weight. The only way to do it is to be very clear of the awful things a government will allow rather than leave. It will default on its sovereign debt. It will cut government salaries and entitlements. It will allow bank failures, and it will allow foreign banks to come in and swoop up the assets. All of these things will be awful. But the government has to persuade voters it understands that leaving the euro will be worse.

Even that will not be enough. To a government in fiscal stress, bank accounts look like an ice cream bar to a hungry child. Greece and Italy have already passed wealth and property taxes. "Tax the rich" rhetoric is strong. People with bank accounts fear expropriation and punitive wealth taxation as much as devaluation. Somehow, the government has to persuade them their bank accounts are safe from depredation in the euro.


Why are we here?

I've been writing for two and a half years about mistakes in Europe, and won't repeat all of that now. But there are two central points to make.

1. The euro was explicitly set up as a currency union without a fiscal union. (And it turned in to one without a bank regulatory union.) That can work, a fact which practically all commentators ignore.

The central ingredient is: sovereigns who can't pay their bills default. The European central bank does not print up euros to bail out sovereign creditors, either directly or via the subterfuge of lending to banks who then buy the sovereign debt.

The euro was explicitly set up this way. The main problem is, when the crisis came, nobody bothered to read the instruction manual.

2. As many times in history, strapped governments have forced banks to take on their debts. A sovereign default is manageable. A country-wide banking crisis is much worse.

The liberal consensus wants "more regulation" to stop banks from taking risk. The regulators stuffed the banks with sovereign debts, and treated those debts as riskfree for years. They also confused "the banking system cannot fail" with "no individual bank can fail."


Paul Krugman, writing May 18, wrote a few almost-sensible paragraphs about Europe, echoing many of these points. (His article is for once about economics, not the evil character of Republican politicians, so there is some substance to talk about.) Since I agree so rarely with Krugman, I thought I'd celebrate with a few quotes, though with some quibbles and some interpretations that I'm sure he would disavow.

Mostly, I agree with his main point, that the emerging bank run means the crisis is likely going to move much more quickly now.
Right now, Greece is experiencing what’s being called a “bank jog” — a somewhat slow-motion bank run, as more and more depositors pull out their cash in anticipation of a possible Greek exit from the euro. Europe’s central bank is, in effect, financing this bank run by lending Greece the necessary euros; if and (probably) when the central bank decides it can lend no more, Greece will be forced to abandon the euro and issue its own currency again.
Comment: As above. Change "forced to" to "choose to" and I'm on board. There is an option. Sovereign default. Let banks fail -- meaning their senior debt becomes equity and they are recapitalized. Good banks buy the assets of bad banks.  But the Europeans probably won't have the stomach for it.
This demonstration that the euro is, in fact, reversible would lead, in turn, to runs on Spanish and Italian banks. Once again the European Central Bank would have to choose whether to provide open-ended financing; if it were to say no, the euro as a whole would blow up.
Comment. Right again. The only thing keeping any money in Spanish and Italian banks is the idea that leaving the euro really can't happen. Once it's clear that exit, devaluation -- along with likely currency controls, bank closures, deposit seizures, and sky-high wealth taxes -- are on the table, the run will start in earnest.
Yet financing isn’t enough. Italy and, in particular, Spain must be offered hope — an economic environment in which they have some reasonable prospect of emerging from austerity and depression. Realistically, the only way to provide such an environment would be for the central bank to drop its obsession with price stability, to accept and indeed encourage several years of 3 percent or 4 percent inflation in Europe (and more than that in Germany).
I agree with the first two sentences. But the only hope for such an economic environment is shock liberalization. (Despite Krugman's "savage cuts" these economies still spend half of GDP, with direct intervention, state industries, and other off the books interventions bringing the total even larger.)

Not only is inflation not "the only way" to provide such long-term growth, it isn't a way. When has deliberate, anticipated and announced inflation ever brought long-term prosperity? You must be kidding.

On the other hand, I agree that inflation is the most likely path that Europe will choose. Not because inflation works any Phillips curve magic, but because inflation is the "easy" way to engineer a massive default of government and bank debt.

By arithmetic, here are the options:

1) Government default. (Restructuring, really)  If done right away, this would have meant private-sector losses. Now that so much debt has been rolled in to banks, it means bank failures too.

2) The Germans pay for everything. Not happening. There is not enough taxing power in Germany to repay the entire debt of Portugal, Spain, Italy, and Greece, plus their banks losses and their ongoing deficits.

3) The ECB buys up the sovereign debt, or lends to banks on sovereign "collateral," effectively doing the same. By turning trillions of debt in to money, we get inflation. Inflation engineers the sovereign default and bank debt default implicitly.

4) Shock liberalization, privatization, freeing of markets, selling state assets. Remove the highly distorting taxes of the "austerity" plans, which said loudly "don't start businesses here, don't hire anyone here, and if you have some wealth I suggest you get it to the Bahamas ASAP." Return quickly to strong real growth. Pay back the debt. Fairly radical reform of unsustainable entitlements.

My obvious choice is number 4. The Europeans' most likely choice is number 3. It can be sold as "stimulus" and "liquidity provision," and it kicks the can down the road. The inflation won't happen for several years. Then it will be easy to blame speculators and hoarders and markets and expectations and so on.

But Krugman's wrong on the size of the inflation. Several years of 3-4 percent inflation is nowhere near enough. To write down PIGS debt by half, you have to double the price level. And you have to do it before the debt rolls over. So that means doubling the price level -- 100% inflation -- in under two years or so. If you do it over several years, the overall rise in the price level has to be even higher.

To my mind an inflation so large that it wipes out half of PIGS and bank debt is about the same result as breaking up the euro directly. And the Germans will probably leave before that happens. 
Both the central bankers and the Germans hate this idea, but it’s the only plausible way the euro might be saved. For the past two-and-a-half years, European leaders have responded to crisis with half-measures that buy time, yet they have made no use of that time. Now time has run out.
I'll go with this only because "plausible" includes the chances that European leaders will take it. I agree with the second sentence, though I suspect the "full measures" in my mind -- default, bank restructuring, commitment to euro and open markets, shock liberalization -- are different from what I presume from other writing that Krugman does -- endless stimulus financed by Germany
So will Europe finally rise to the occasion? Let’s hope so — and not just because a euro breakup would have negative ripple effects throughout the world. For the biggest costs of European policy failure would probably be political.

Think of it this way: Failure of the euro would amount to a huge defeat for the broader European project, the attempt to bring peace, prosperity and democracy to a continent with a terrible history. It would also have much the same effect that the failure of austerity is having in Greece, discrediting the political mainstream and empowering extremists.
And now in full-throated agreement. The currency union, without fiscal union, will be a horrible thing to lose.

But what's kicking off the run is that governments are being tempted to leave. I wonder whether Mr. Krugman and his colleagues have any regrets for the many elegies they have written to the wonders of separate currencies and devaluation, the prospect of which is now causing the run.


Bottom line: I'm pretty pessimistic. The run is on and will intensify.  Alternatives exist, but they are so unpalatable to standard views that I think massive intervention by the ECB as the most likely current policy.

The ECB will print euros like mad and lend them to banks, which will continue to buy government debt.  Southerners will take the ECB money and put it in Northern banks. The ECB ends up owning the debt through the banking system. The ECB understands the danger full well, but will give in.

After that, there is a sliver of hope. A shock liberalization could give a return to robust growth and sustainable government finances within a year. Then the debt would not default, and the ECB and its banks could sell back all the sovereign debt they have bought.

But unless that miracle happens, within a year or so the ECB's collateral will evaporate in the inevitable sovereign defaults, the sovereign defaults will mean bank defaults, and the euro will inflate away rather than break up. An immense, and utterly avoidable tragedy.

So, given that there's no way they'd take my radical advice, if I were in charge I would recommend changing the "austerity" conditions on bailouts and ECB financing, with their emphasis on higher distorting taxes and vague promise of structural reform sometime in the next century, to "reform" conditions demanding a tight schedule of structural reforms within months.