At last, an idea on how and when it will all end in tears

[peterbirks]

The Irish bailout, announced last night with the rider, "details to follow", finally gives us some kind of clue as to when and how the whole euro shebang will fall apart.

If we look at the numbers (which Ireland hasn't yet published and, I suspect, doesn't want to publish) we have about €90bn going into save Ireland/the Irish banks (the two are now virtually synonymous, given that Ireland has promised to back the debts of the banks).

The sources of this funding are various. Now, although we can blame Merkel for triggering this crisis, one of its fundamental causes was ECB boss Trichet going to Merkel and Sarkozy and saying: "Look, the ECB is being used by Ireland for a purpose for which the ECB was not designed. If you don't help, we will pull the plug".

So, money had to be found from somewhere else. About a third of the €90bn will come from the International Monetary Fund. The UK will pay a proportion of this. A further few billion will come from the UK and Sweden in the form of bilateral agreements. For the UK this will probably be inextricably linked to the UK loan book and the vulnerability of RBS and Lloyds TSB. Since the UK can't let RBS fail (which, should the nuclear financial scenario occur in Ireland, would be a serious threat for RBS) it's putting a few billion in now to save a few more billion later. Some of the money will come from the €60bn European Financial Stability Fund, but the majority will come from the completely different €440bn European Financial Stability Facility – put together this summer at the time of the Greek rescue and, I recall, meant to stop contagion by its very existence.

No such luck.

It's this final piece of information that tells us where, in a way when, and in a way how, the euro will cease to exist in its current form.

Greece (years of living well and not working) was first. Ireland (banks that lent long and borrowed short) was second. Portugal (cannot get the books to balance, Greece Mark II) will be next.

If the Irish bailout will cost the EFS Facility about €50bn, we have to expect the Portuguese bailout, when it comes (February 2011) to cost about the same. That will be a full €100bn of the €440bn ESF Facility. The ESF Fund (€60bn) will also be nearly broke by this time.

If Portugal is Greece Mark II, then Spain is will be Ireland Mark II, AKA "Ireland, but this time it's serious". Come next October or November, it will be clear that the Spanish property bubble has burst nearly as comprehensively as the Irish property bubble. The banks will be unable to fulfil their cash flow requirements. They will be technically insolvent and "too big to fail". The Spanish government, proportionately not quite as badly, but in absolute terms on a much larger scale, will need help from the rest of the EU. Spain's GDP this year will be about €1,000bn. The eurozone will be about €9,000bn and the EU as a whole will be €12,000bn. Ireland is about €200bn, or one fifth the size of Spain (Portugal is about €220bn, btw).

Ireland's deficit at the moment is about 12% of GDP and is expected to rise to 15% before coming back down. Portugal's is running at about 9% of GDP – but these are the official numbers. Although I don't distrust them as much as I distrusted Greece's official figures, I don't have absolute faith in them, not by a long way.

And the Spanish deficit for 2010? About 10% of GDP, or €100bn,

Now, we can slice and dice these numbers lots of ways (e.g., the Spanish deficit this year comes to more than 1% of the eurozone as a whole), but logic and rationality isn't really that important here. There was a very good article inthe FT on Saturdday on the build-up to the current crisis, where a senior German official was quoted as saying that "logically" the markets should not have reacted to Merkel's statement re bond "haircuts" in the way that it did. To which the answer is: "tough shit, welcome to the real world".

No, what's important here is what will happen when the Spain situation becomes "critical, emergency stage red". Let's pencil that in on our Outlook calendar for October 26 2011.

Spain's cap-in-hand request to the ESF Facility will be, say, four times higher than that needed by Ireland. If it turns out to three times higher or less, then we might squeak through. But at four times higher, the cupboard will be emptied. The €440bn (after Ireland and Portuugal, €340bn) chest will not be enough.

Now, there is talk of a €750bn cash reserve -- in other words, even if the ESF Facility is all used up, there's just a little bit left behind. But will the German public stand for this? Will the German leadership stand for this? What will happen to the Italian bond market if and when it does happen? And what implications does that have for France, which has about 20% of its annual GDP stored in Italian bonds?

If you think the past week has looked like a full-blown crisis (and if you allow for the fact that, in the grand scheme of the global economy, Ireland is very much a minnow) it doesn't take much of a leap of the imagination to see that a similar bailout for Spain would bring the world to realize that the euro simply isn't working. At that point the contagion becomes unstoppable. That doesn't mean that the euro would collapse v the dollar or the yen. Indeed, it might actually strengthen on the grounds that the market could see all the shit economies being thrown out. The movement of the euro would depend entirely on the level which it would be pegged to the new German Deutschmark (which will probably still be called the euro).

But for the smaller European economies, everything will be changed. On the plus side, devaluation will become an option (bad news for the UK), while on the minus side, their bonds will become piles of worthless shit (ok, I exaggerate slightly) and borrowing costs will go through the roof (good news for the UK).

So, there you have it, 2011 in a nutshell. Fun, eh?

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Comments

[(Anonymous)]

Any thoughts on this as a possible way out of the Euro mess?

http://mrzine.monthlyreview.org/2010/varoufakis051110.html

[peterbirks.livejournal.com]

The thing about reading stuff like this is that you have to spend a lot of time seeking out the logical flaws, or the non sequiturs. And these are often cleverly hidden. I'm quite used to this because you see it a lot in the witterings of poker analysts attempting to justify playing in a certain way and denigrating (often equally valid) plays in another way.

Now, in the brief reading that I gave this piece last night (I fear that no Greek or Irish academic's analysis of the situation is going to be completely value-bias-free) I was at least relieved to see that the writer admitted that his solution would not happen. That saves a lot of trouble.

The solution seems to me to be a form of the "sovereign pooling of debt". This is a bit like the "gold out of lead" alchemy, and its real basis assumption is that the strength of Germany would "pull up" the weaker economies. Notwithstanding Germany's obvious reluctance to put in with such a scheme (or rather, the reluctance of its voters), the non-sequitur arrives here. By transferring 60% of the debt to a newly invented tranche, the writer says that

This will immediately reduce borrowing costs for the most exposed member states, attract investments from the Central Banks of surplus countries (e.g. China) and from sovereign wealth funds (e.g. Norwegian, Russian, Chinese),

.
But is this necessarily so? It's a nice solution for Greece, but it doesn't address the fundamental problems. It also begins with the implicit assumption that the aim is how to save the eurozone, whereas this is not the aim of very player in this game, not by a long way. So, it's a solution that won't be implemented, and, if it was implemented, might not work, and it provides a solution that only some players in the game see as the main aim (which is a bit of the Grek value bias creeping in).

PJ

The Aardvark says...

[(Anonymous)]

(One more thing I screwed up on my way to Hackney -- and I don't want to invalidate auto-logins for when I get home.)

Indeed. I tend to the supposition that it's all a bit of a wash for the UK -- a few silly little political moans there, the odd £7 billion there. I can't see serious money men worrying about this too much, and I assume a lot of it is factored into UK gilts, and I assume the rest will simply bounce the government borrowing rate by plus-minus 0.2% or so. Pretty negligible, as long as the UK banks aren't compromised.

Mind you, having said that, they're almost last in line to be compromised. Even Germany's in a worse position, in that respect.

Well, there's been a pointless year of everybody (including international financial institutions, and even hedge funds, and journalists -- saving your good self -- and so on, telling us that the PIIGs (don't forget Italy, just because everybody else has!) will be solved if only Greece is "solved." And failing that, Ireland is "solving" itself. And, er, Portugal is only a small economy, anyhow.

We're not even at Italy yet. Your highlighting Spain is timely. A small suggestion: Spain has a very large overhang of immigrants, mostly brought in for purposes of construction in the good times. Geographically it was natural for those immigrants to come largely from Muslim regions. There are several Muslim countries with hydrocarbons, er, money to burn.

Solution!

Abu Dhabi should ditch Dubai, buy up half a million beach-front apartments in the south of Spain, and establish the Third Caliphate.

Well, of course it's a stupid idea. But is it more stupid that what the EU comes out with every second month or so?

Re: The Aardvark says...

[peterbirks.livejournal.com]

The newspapers this morning are full of "Spain will be the trigger point" stuff, with nearly all commentators stating that the euro might well not survive a Spanish bond meltdown. But the thing is, the meltdown is already happening. Spain's three-month borrowing requirements are soaring. Governments have implicitly assumed that the capital markets will always be available to them, but the capital markets aren't charities put in place solely to ensure that governments will always be able to raise cash. That lesson should have been learnt 800 years ago. The eurozone and the IMF and the markets are eventually going to stop bowing to the holy grail that no senio bondholder should suffer any loss. FFS, taxpayers and consumers are getting it up the arse -- bondholders should be told that their threats no longer hold water and they can go fuck themselves. That will happen when the euro falls apart. And the statements that this will make it impossible for the "new" economies (let's call it Ireland 2012 plc) to get funding from the markets is bollocks. However, on the downside, any credit that is provided will not be as cheap as it once was. And there's the rub. This is about governments that not only assumed that credit would always be available, but that cheap credit would always be available.

PJ

Re: The Aardvark says...

[real-aardvark.livejournal.com]

And, of course, not just governments, but also something like 500 million people in Western economies (I omit Japan, which has its own lovely little government debt crisis looming). I must admit, I spent the last ten years looking at this from the outside and thinking "you're all loonies!" But then, it's a prisoner's dilemma sort of thing, because if the regulators don't turn off the spigot, then you'd look pretty stupid as the only person in (say) the UK not taking advantage of the cheap credit ... even though it buggers up the very country you're living in.

(Incidentally, all this crowing from the right-wing press about how smart we were not to join the Euro, coz, like, we so totally kept control, is nauseating. Yes, we had fiscal and monetary freedom denied to the members of the Euro. No, we did not use that freedom wisely at the time. In fact, we fucked up just as badly, and in exactly the same ways, and we had no excuse, because we had reserved levers that we refused to pull.)

Another ludicrous thought experiment. EU GDP is comparable to that of the USA. If the US Fed can manage a couple of trillion in QE, then by inference (and ignoring tedious details like charters and legality and stuff -- let's pretend we're all French here), there's no reason the ECB couldn't do the same.

I mean, if these bozos are actually serious about saving the Euro, then this has to be the way to go.

First of all, it's such a ridiculously large amount of money that it might even keep the short-sellers quiet (on the principle that the ECB could selectively target any given market movement and, basically, bankrupt those naughty people with monopoly money).

Mainly, however, it would address the immediate structural problem that all EU periphery countries have, which is to say that there's no liquidity out there for government bonds and, even if there was, the spread is completely unaffordable ... which leads, for example, to Portugal not even being able to afford "austerity," because if you brutalise next year's GDP, you also brutalise tax receipts and therefore you brutalise your ability to pay the interest on government bonds.

You'd have to be quite selective about how to use the QE, of course. No money for stupid housing projects (a la Spain) or failed banks (a la Eire): let the speculators take a massive haircut. Only use QE to buy government bonds, and only use it to buy bonds with a short maturity (unblocking the sewer, if you don't mind that parallel), and probably insist on some sort of asset-based hypothecation as a corollary.

The point would be to drive the the bond spread over the base rate down to something that is realistically affordable in the medium term, whilst leaving the individual miscreant governments enough time to get the actual structural problems sorted out.

Yes yes, I know it's a very silly idea; but it's not obviously sillier than the €400 billion or so that they're "lending" to the PIIGs. I mean, very little of that money is ever going to come back, so the ECB is taking a massive haircut (which it won't admit to) in any case. At least, if you trade the printing presses against wonky collateral, you might get some bang for your, er euros.

Mind you, I'm not entirely sure that this isn't what the ECB fund isn't already doing ... it just seems to be doing it in a very amateurish, politically-motivated, day-to-day, and unplanned way.

And as usual, any possible monetary solution will run slap-bang up against the German phobia of hyperinflation. So, however smart the central bankers are, they're basically held at the end of a Teutonic gun-barrel, because the reality is that (pace William) the German people won't put up with this stuff, the German government won't put up with this stuff, the German constitutional court won't put up with this stuff, and all three of them are in a state of denial when it comes to the viability of the loan books of German banks.

Re: The Aardvark says...

[real-aardvark.livejournal.com]

Indeed. As ye sow, so shall ye reap. Soon, very soon, far faster than Merkel thinks (because she's loony enough to think that her government can control the agenda), bond holders are going to be forced to take a massive haircut. The first PIIG to exit the Euro (probably not Ireland -- I'd nominate Portugal, based on government debt to foreigners) will trigger utter panic, because the debts will still be euro-denominated. It may well get to the point where Portugal looks at the 1997 crisis and says "fuck it, we can't be any worse off" and does an Argentina. At that point, all other euro-denominated government debt will take a massive hit, and haircuts are the order of the day.

I can't really see any way round this. Bond trading is going to be fun over the next two years. Bond owning is not.

Re: The Aardvark says...

[peterbirks.livejournal.com]

The exit will definitely come from a greyish swan trigger point that you and I know is going to happen, but which will still catch us by surprise when it does (see the paradox "headmaster tells the school that he will be giving them a day off this month and that he will only tell them on the morning of the day off itself, and that it will be a surprise when he tells them" -- which leads one bright spark to calculate that he cannot therefore give the school a day off that month). And, yes, this will mean that senior bondholders will finally get it in the neck -- perhaps fine for equitable sharing of the pain, but also rather worrying in terms of euro-implications (which is one reason that everyone in the EU is frantically trying to stop it happening).

PJ

Re: The Aardvark says...

[real-aardvark.livejournal.com]

Yes yes I know you don't care.

The original version of the paradox was a little more gruesome. Basically, you're on death row and the prison governor walks in and tells you that you're booked to be hanged inside the next fortnight. But we're a compassionate society here, he tells you, so we won't tell you until 7 o'clock on the morning you're going to have to take the drop.

"That's wonderful news," you say.

"But you're going to die inside two weeks!" says the governor. "Why are you so happy?"

"Because ..." you say; etc etc.

Re: The Aardvark says...

[real-aardvark.livejournal.com]

There is, btw, a teeny tiny flaw in that supposed paradox. I believe it's called the fallacy of induction. Let's be absolutely honest about this -- once you're convinced you're not going to be hanged, the man with the rope might as well walk in on day one and put a rope round your neck.

Let's hope the rest of us aren't surprised in a similarly nasty way.

Re: The Aardvark says...

[peterbirks.livejournal.com]

Your "Euro QE but on an organized basis" was roughly the proposed line of rescue from the Irish academic on Wake Up To Money a few days ago, although he did not have the sense to say "but of course it isn't going to happen".

The ECB doesn't have the firepower to do it on its own (its funds are meant to solve temporary liquidity problems, not systemic disasters) and the eurozone as a whole just won't do it. The disadvantage of the euro being "the Deutschmark writ large" is now clear. Far from just getting the benefits of being a strong currency, the peripherals are getting the quid pro quo of having to act in a way that brings about a strong currency. But they can't do that from where they are starting now (as you point out) because to do so causes a short-term contraction that would make 1980-82 in the UK look like a hiccup.

One possible solution could be the "patriot bond" idea (hell, this is effectively a war that needs financing, so why not use wartime techniques). Given the low rates of interest available at the moment (and for the next few years, from the look of it), pushing bonds to retail investors at, say, 5% tax-free might actually fly.

PJ

Synchronicity

[real-aardvark.livejournal.com]

You say that the Irish banks are virtually synonymous with the Irish state, and for all the obvious reasons (idiot promise by BIFFO, market sentiment, nationalisation, etc) this is true in every practical sense.

However, it does mask an interesting underlying reality. Let's completely ignore the connections between the two (for the sake of the present discussion).

The Big Three Irish banks have X in (dubious) assets and Y in (non-transparent) balance sheets and Z in funding requirements, starting from yesterday and rolling into the foreseeable future.

The Irish state (in which I will include the 4 million poor sods who live there and are either unemployed, otherwise dependent upon state handouts, or else are mortgaged beyond the hilt) have X' in assets and Y' in balance sheets and Z' in funding requirements, likewise.

I recognise the fact that the former is essentially now merged into the latter; but what does this mean for X', Y' and Z'?

Re: Synchronicity

[peterbirks.livejournal.com]

Yes, I see what you are getting at, but I don't feel competent to answer it! One could, perhaps, point out that the situation is somewhat the same in Germany with the Landesbanken. The only difference is, germany can probably cover the Landesbanken, whereas the Irish state can't cover the Irish banks. Therefore, X', Y' and Z' in Ireland would head into negative territory if X, Y and Z went tits up. That, as far as I can see, either implies more funding from the EU -- either directly to X or indirectly to X', or a reduction in Z and Z' via the simple expediency of either default or devaluation (or both).

Er, so I guess my answer is that the implication is that money can go into Ireland either via X or X' or Z or Z', or any combination thereof, and it won't make much difference to the end result. To this extent, the statement that "Ireland" is putting some money in to rescue itself from the crisis is a bit of an accounting fiction. What it really means is that the Irish people will have to consume less, rather than the investors in the banks that have ownership of senior Irish bank debt.

PJ
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