Earlier we speculated that the European crisis might in fact be over.
The point of the post wasn't to argue that Europe had been solved; rather the point was that crises can and do end without the fundamental problems being solved. So if you're waiting around for a "solution" then you'll inevitably end up missing the turn.
The US crisis of '08-'09 demonstrates this pretty nicely.
Back in the thick of the crisis, what was everyone screaming about?
Well, there was the housing collapse obviously. This was probably the essential economic event, as it set off the wave of defaults and foreclosures hit the financial system like a bomb. Closely associated with the housing collapse was the acknowledgment that consumers had drowned themselves in debt during the boom, and that it would likely take years and years to get back to normal.
And the truth is that these issues have not gone away.
Take a look at revolving consumer credit (credit cards, basically).
While the rate of decline has improved a little bit, consumers remain in non-stop deleveraging mode.
Or consider housing.
According to the government's house price index, 2009 was not the bottom there. That index has hit its lowest level yet earlier this year, fully two years after the stock market bottomed.
While we're at it, here's a big, scary looking at household debt (outstanding) vs. GDP.
The bottom line, which you should hopefully grasp, is that there are some big, honking economic overhangs -- trends that have arguably built up for decades -- that haven't gone away or even improved over the last couple of years. We're going to be wrestling with these for awhile.
But the crisis has gone away, because despite these big issues, the market isn't worried that the whole thing is a sandcastle that's about to blow away. So even as housing market and credit trends have gotten worse, the market has had a really nice 2 or 2.5 year-run.
For what it's worth, it's this contradiction of a crisis being over against the backdrop of ongoing fundamental problems that's caused so many experts to miss the incredible comeback in the market.
So what does this mean for the Eurozone crisis? Well, it's the same: You don't actually need to fix all the fundamental problems for the crisis to end; you just need to be fairly certain that the whole thing isn't headed for total collapse.
Let's back up...
There's no doubt that the Eurozone is deeply flawed. We talk about the problems all the time here, but there are really two huge issues.
Any "fix" that you could come up with inevitably runs into the politics problem -- the fact that you have 17 sovereign Eurozone countries and none of them want to spend a dime of taxpayer money helping out their peers, especially the peers who live in nice climates on the beach.
Remember this Venn diagram?
But as we established with the American crisis of 2008-2009, you don't actually need to solve the underlying problems to end a crisis. All you need is for the markets to think that it's not all about to collapse. The solution can then be worked out over years
So what would it take to end the crisis in Europe? Basically just the assurance that there isn't going to be an imminent banking collapse and that the various governments will be able to continue financing their deficits for awhile. And through two years of crisis meetings, and ECB tinkering, it's possible that we're limping towards some point of stability.
At the last ECB meeting, Mario Draghi announced an unprecedented spate of measures designed to pump liquidity into the system. It may turn out that banks can basically pledge very piece of junk on their balance sheets, including individual loans, as collateral for fresh, badly needed cash. In short, the ECB is doing a lot to stave off a banking collapse. And it may turn out that by plying the banks with so much liquidity, governments are then able to finance their deficits -- a form of arbitrage that FT Alphaville dubs "the Sarko trade", since it was Sarkozy's suggestion that banks use cheap capital to sop up sovereign debt.
There are a lot of problems with this solution: One is that banks themselves have said they don't intend to use cheap liquidity for the purchase of buying sovereign debt, and also the potential size of this trade might not really be big enough.
But this could start to fix the plumbing. And that's key.
Ultimately, the problem in Italy (and Spain and everywhere else) is not that debts and deficits are so big. That's really not the issue.
The problem is that the plumbing is broken...
See in normal times, government deficits should be self-financing in that the government spends, the private sector gets that money, that money then eventually gets deposit into a bank, which then uses those deposits to buy government debt (presumably because it's risk-free) and the process is repeated and everything works out fine. But clearly in Europe that all broke down. Greece convinced everyone that government debt is not risk free, and money flowed from peripheral banks to German banks (and Swiss banks) depriving the government of natural debt buyers. This is why, for example, Richard Koo has proposed the radical solution of governments only being able to sell debt to their own citizens -- basically so that the plumbing remains intact and money doesn't "leak" out.
If you start to fix the plumbing, you could get to where governments can start financing their deficits at sustainable rates again. Even if deficit targets are missed it can be okay provided that spending gets plumbed back into government bonds.
This isn't a "solution" but it is how the crisis could end.
People are in a state of panic right now. This is nicely illustrated by this recent chart from Nomura, which examines cross-border equity flows: When people start freaking out they dump foreign equity assets. Right now, these flows are at a level that's only been surpassed twice in over 25 years: The crash of '87 and the collapse of Lehman.
Bottom line: It's possible that the crisis/panic we're seeing now could subside long before the core problems in Europe get fixed, a process that at best will take years.
The point of the post wasn't to argue that Europe had been solved; rather the point was that crises can and do end without the fundamental problems being solved. So if you're waiting around for a "solution" then you'll inevitably end up missing the turn.
The US crisis of '08-'09 demonstrates this pretty nicely.
Back in the thick of the crisis, what was everyone screaming about?
Well, there was the housing collapse obviously. This was probably the essential economic event, as it set off the wave of defaults and foreclosures hit the financial system like a bomb. Closely associated with the housing collapse was the acknowledgment that consumers had drowned themselves in debt during the boom, and that it would likely take years and years to get back to normal.
And the truth is that these issues have not gone away.
Take a look at revolving consumer credit (credit cards, basically).
While the rate of decline has improved a little bit, consumers remain in non-stop deleveraging mode.
Or consider housing.
According to the government's house price index, 2009 was not the bottom there. That index has hit its lowest level yet earlier this year, fully two years after the stock market bottomed.
While we're at it, here's a big, scary looking at household debt (outstanding) vs. GDP.
The bottom line, which you should hopefully grasp, is that there are some big, honking economic overhangs -- trends that have arguably built up for decades -- that haven't gone away or even improved over the last couple of years. We're going to be wrestling with these for awhile.
But the crisis has gone away, because despite these big issues, the market isn't worried that the whole thing is a sandcastle that's about to blow away. So even as housing market and credit trends have gotten worse, the market has had a really nice 2 or 2.5 year-run.
For what it's worth, it's this contradiction of a crisis being over against the backdrop of ongoing fundamental problems that's caused so many experts to miss the incredible comeback in the market.
So what does this mean for the Eurozone crisis? Well, it's the same: You don't actually need to fix all the fundamental problems for the crisis to end; you just need to be fairly certain that the whole thing isn't headed for total collapse.
Let's back up...
There's no doubt that the Eurozone is deeply flawed. We talk about the problems all the time here, but there are really two huge issues.
- The competitiveness issue: It's very difficult for less productive, peripheral economies to compete. Greece, Italy, et. al. don't have the luxury of competitive currency devaluation like they used to, and so they run ongoing trade deficits with their core neighbors (Germany, chiefly) and it's not obvious how that gets fixed. So-called "internal devaluation" via austerity hasn't really worked at all, and has produced considerable political and social discomfort (which has further exacerbated economic weakness).
- The lack of sovereign currencies issue: A big problem for Italy and others is not their high debt loads, but that they lack their own currency to print. This is crucial as it explains why the UK is a safe haven and France is not. It explains why Sweden is a safe-haven but Finland is not. It explains why Japan has a monster debt-to-GDP but borrows at rates that are the envy of the world.
Any "fix" that you could come up with inevitably runs into the politics problem -- the fact that you have 17 sovereign Eurozone countries and none of them want to spend a dime of taxpayer money helping out their peers, especially the peers who live in nice climates on the beach.
Remember this Venn diagram?
 Image: Pawelmorski |
But as we established with the American crisis of 2008-2009, you don't actually need to solve the underlying problems to end a crisis. All you need is for the markets to think that it's not all about to collapse. The solution can then be worked out over years
So what would it take to end the crisis in Europe? Basically just the assurance that there isn't going to be an imminent banking collapse and that the various governments will be able to continue financing their deficits for awhile. And through two years of crisis meetings, and ECB tinkering, it's possible that we're limping towards some point of stability.
At the last ECB meeting, Mario Draghi announced an unprecedented spate of measures designed to pump liquidity into the system. It may turn out that banks can basically pledge very piece of junk on their balance sheets, including individual loans, as collateral for fresh, badly needed cash. In short, the ECB is doing a lot to stave off a banking collapse. And it may turn out that by plying the banks with so much liquidity, governments are then able to finance their deficits -- a form of arbitrage that FT Alphaville dubs "the Sarko trade", since it was Sarkozy's suggestion that banks use cheap capital to sop up sovereign debt.
There are a lot of problems with this solution: One is that banks themselves have said they don't intend to use cheap liquidity for the purchase of buying sovereign debt, and also the potential size of this trade might not really be big enough.
But this could start to fix the plumbing. And that's key.
Ultimately, the problem in Italy (and Spain and everywhere else) is not that debts and deficits are so big. That's really not the issue.
The problem is that the plumbing is broken...
See in normal times, government deficits should be self-financing in that the government spends, the private sector gets that money, that money then eventually gets deposit into a bank, which then uses those deposits to buy government debt (presumably because it's risk-free) and the process is repeated and everything works out fine. But clearly in Europe that all broke down. Greece convinced everyone that government debt is not risk free, and money flowed from peripheral banks to German banks (and Swiss banks) depriving the government of natural debt buyers. This is why, for example, Richard Koo has proposed the radical solution of governments only being able to sell debt to their own citizens -- basically so that the plumbing remains intact and money doesn't "leak" out.
If you start to fix the plumbing, you could get to where governments can start financing their deficits at sustainable rates again. Even if deficit targets are missed it can be okay provided that spending gets plumbed back into government bonds.
This isn't a "solution" but it is how the crisis could end.
People are in a state of panic right now. This is nicely illustrated by this recent chart from Nomura, which examines cross-border equity flows: When people start freaking out they dump foreign equity assets. Right now, these flows are at a level that's only been surpassed twice in over 25 years: The crash of '87 and the collapse of Lehman.
 Image: Nomura |
Bottom line: It's possible that the crisis/panic we're seeing now could subside long before the core problems in Europe get fixed, a process that at best will take years.
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