Part 1. Will Europe face defaults?
Its official – Spain and Portugal will need to be bailed out soon. How do I know? In one of my favorite TV shows, Yes Minister, the all-knowing civil servant Sir Humphrey explains to cabinet minister Jim Hacker that you can never be certain that something will happen until the government denies it.
So check out this article in Tuesday’s Financial Times:
Spanish and Portuguese leaders, with reinforcements from Brussels, are fighting a rearguard action to convince investors that there is no need for further eurozone bail-outs after the €80bn-€90bn ($109bn-$122bn) rescue agreed for Ireland at the weekend.
“Absolutely not,” said Elena Salgado, Spanish finance minister, when asked in a radio interview on Monday whether Spain needed help from the European Union. “Spain is doing everything it has promised to do, with tangible results.”
Portugal is regarded by bond market investors and economists as next in line for a rescue after the bail-outs of Greece and Ireland. But José Sócrates, Portuguese prime minister, was adamant that there was “no connection” between the Irish rescue and Portugal’s problems. “Portugal doesn’t need anyone’s help and will solve its own problems,” he said, insisting that the country had a clear strategy to cut its yawning budget deficit.
Was Sir Humphrey exaggerating? Perhaps, but I do remember that Dublin was pretty adamant just a week or so ago that there would be no restructuring of Irish debt.
The truth is we didn’t need the denials to know what was going to happen. Everything we are seeing in Europe has a great deal of historical precedence and events are unfolding very much according to the standard script. I think it is pretty safe to make the following predictions:
- Greece will be forced to default and restructure its debt, and the restructuring will come with a significant amount of debt forgiveness. The idea that it can grow its way out of the current debt burden is a fantasy. Remember that when countries are in conditions of financial distress, they face systematic disinvestment and capital flight, and as a consequence are never able to grow at anywhere close to the necessary rates – especially since any growth they do manage to achieve generally comes from additional fiscal spending, which simply runs up debt further.
- Greece will not be the only defaulter. Spain, Portugal, Ireland, Italy, Belgium and much of Eastern Europe will also face severe financial distress and possible default. History suggests that when a country is experiencing a solvency crisis, growth comes only after debt forgiveness, and many or most of those countries will also be forced into debt forgiveness.
- Political radicalism in these countries will rise inexorably as a consequence of rising class conflict. As Keynes pointed out as far back as 1922, the process of adjusting the currency and debt will primarily be one of assigning the costs to different economic groups, and this is never an easy or conflict-free exercise. Of course the less stable a government becomes as a consequence of this adjustment, the more likely it is to prefer very short-term solutions.* This Sunday, by the way, Catalans are likely to vote in an election in which the “current Socialist-led coalition government in Spain’s northeastern region will fall, a slap in the face for Spain’s prime minister, José Luis Rodríguez Zapatero,”, according to an article in Wednesday’s New York Times. There will be a lot more of this sort of thing in the next few years.
- So why not bite the bullet and just get it over with? Because the European banking system would not survive even the best-case restructuring scenario. As a consequence we are fated to witness several years of difficult economic adjustment while everyone pretends that these countries, under the right policies, can work their way through their debt burdens. What will really be happening is that European banks will aggressively rebuild their capital bases, with the unwilling help of the poor household sector, until they are sufficiently well capitalized to begin taking the write-offs. Only then will we recognize that some countries cannot repay their debts.
- As an aside the European junk-bond market might take off. With banks crippled in their lending activities, Europe’s financial markets will probably go through a process much like that which the US experienced in the 1980s. American banks at that time were unable to fulfill their traditional lending function as they struggled to clean up their LDC and energy loan portfolios, leaving the way open for the likes of Drexel Burnham to create a massive junk bond market. This process will be helped to the extent that European policymakers try to avoid paying for the adjustment by liberalizing bank-lending practices.
- Several countries, most notably Spain, will be forced to choose between giving up sovereignty to Germany, suffering extremely high rates of unemployment for several years, or giving up the euro. They will almost certainly choose the third option. There are still a lot of people who say giving up the euro is “unimaginable”, but that just shows a weak imagination. I especially remember in 2000 Domingo Cavallo dismissing the stupidity of foreign investors who imagined Argentina might be forced to suspend payments and devalue the peso – which it did in late 2001. More recently, on April 30, Cavallo warned Greece: “Don’t even think of abandoning the euro, whether temporarily or definitively, because that will provoke a financial catastrophe in Greece and various other countries in Europe.” Now there’s some useful advice, especially when you consider the huge surge in growth and the fall in unemployment Argentina experienced after it devalued.
This has been said before, but in a way this crisis is the European equivalence of the American Civil War. Once the dust finally settles Europe will either be a unified country with fiscal sovereignty firmly established in Berlin or Brussels, or it will be fragmented with little chance of reunion.
Part 2. Will Beijing raise interest rates to combat inflation?
The big concern in China now is rising inflation. The market is obsessed with fears over what steps Beijing will or will not take to combat rising prices. Beijing has already hiked interest rates, raised reserve requirements, imposed price freezes, and is reportedly going to tough out the existing lending quotas. Beijing may even throw in the towel and declare a “new normal.” According to an article in Wednesday’s South China Morning Post:
Beijing is likely to raise next year’s official inflation target and tighten monetary policy, state media said Wednesday, amid expectations for consumer prices to continue rising.
The Central Economic Work Conference, which is expected to meet next month, will probably hike the government’s annual inflation target to 4.0 per cent from 3.0 per cent this year, the China Business News said, citing an unnamed source. The conference is the most important economic policy making event of the year and gathers top Chinese leaders, usually including President Hu Jintao and Premier Wen Jiabao.
As I mentioned in an entry last month, it was going to be very hard for the banks to stay within this year’s RMB 7.5 trillion quota, and there was a real question about whether or not the regulators were going to enforce the quota. On Tuesday evening the PBoC even announced that it was going to face challenges in controlling the lending pace for the rest of the year. Separately, Tuesday’s Bloomberg had an interesting article on the subject:
China’s biggest banks are close to reaching annual lending quotas and plan to stop expanding their loan books to avoid exceeding the limits, according to four people with knowledge of the matter. Industrial & Commercial Bank of China Ltd., Bank of China Ltd. and Agricultural Bank of China Ltd. are only extending new loans as existing ones get repaid, the people said, speaking on condition of anonymity. Lenders are also cutting holdings of discounted bills to make room for longer-term debt, they said.
Tuesday’s People’s Daily is suggesting that next year’s loan quota will be below this year’s:
Financial institutions forecast that the new bank loan scale will reach between 6 trillion yuan and 7 trillion yuan in 2011. Although the figure is lower than the 7.5 trillion yuan of new bank loans for 2010, its upper limit will possibly reach 7 trillion yuan. This is mainly associated with the loans to be allocated to reserve projects.
I am very skeptical that they will be able to reduce the loan quota next year, especially if trade tensions worsen, which I expect, but I did notice that there was sort of an “out’ in the PD article:
Furthermore, a certain amount of new loans should be extended in order to ensure continued economic growth and structural adjustments in 2011.
On the subject of interest rates there was also this article in Bloomberg about concerns that interest rates would rise:
China’s benchmark money-market rate rose to the highest level in almost seven weeks on speculation policy makers will lift borrowing costs again after raising lenders’ reserve requirements last week to tame inflation.
China’s central bank adviser Xia Bin said the nation should further tighten monetary policy next year due to the pressure of excessive liquidity at home and abroad, the Shanghai-based Oriental Morning Post newspaper reported yesterday. The People’s Bank of China said Nov. 19 it would lift the amount of cash banks must set aside as reserves by 50 basis points from Nov. 29. A press official at the central bank, who refused to be identified, declined to comment.
“Future rate hikes and inflation-curbing measures are now more adequately priced in but the bias for higher rates will remain until the next rate hike materializes,” said Delphine Arrighi, a Hong Kong-based strategist at Standard Chartered Plc. “We still see another 25 basis point interest-rate increase by the end of this year, and another three increases, all of 25 basis points, within the first half of next year,” she said.
Last month I said I doubted Beijing’s resolve to hold firm on the loan quotas, just as I doubted we would see much action on the interest-rate front, but it seems increasingly likely that the hawks are going to win this argument. So are interest rates really rising, and if so will it matter?
The answer to the first question is: No. Inflation this year is rising much faster than interest rates, which have only managed a 25 basis-point hike. It will take at least 200-300 basis points, probably a lot more, just to bring real deposit rates back to where they were earlier in the year.
As for the second question, I am not sure raising rates will reduce inflation at all. On the contrary, in China they may actually increase inflation. I know this is going to seem pretty controversial – how can raising rates make inflation worse?
Bear with me. In the US, I think, most of us agree that raising interest rates is anti-inflationary, but why? I would argue that it reduces inflationary pressures primarily through three channels. First, raising interest rates makes it more expensive for consumers to borrow money to finance purchases.
Second, because most Americans save in the form of stocks, bonds, and real estate, rather than bank deposits, higher rates are associated with declining asset prices, and so Americans feel poorer. This (the “wealth effect”) causes them to reduce their consumption. Finally, raising rates reduces investment and so raises unemployment, further reducing consumption by increasing uncertainty and lowering household income.
In other words raising interest rates in the US puts downward pressure on prices by reducing demand. But will raising interest rates reduce demand in China?
I am not at all sure it will. Take the first of the three effects. Excluding mortgages (whose pricing reflects other concerns) there is very little consumer financing in China, so increasing its cost is not likely to have much effect. You might argue that it will affect demand for automobiles, where there is some financing, but this is a small part of the consumer basket and most of the inflationary pressure is anyway on food prices.
What about the wealth effect? Here raising rates may actually be counterproductive. The vast bulk of Chinese savings is in the form of bank deposits, and China’s artificially low interest rates are effectively a major hidden tax on household income, as I have argued many times before. In this case raising the deposit rate is like reducing taxes, and this is hardly likely to reduce demand. On the contrary, by raising disposable household income it will actually raise household consumption, although this may take several months before it is significant.
Finally what about the effect on investment and employment – will raising rates cause unemployment to rise? Maybe, but with real lending rates so low, perhaps even negative, and with the credit risk on much of the lending effectively socialized, the mechanism by which interest rates regulate lending does not work in China they way it does in the US. What limits credit growth in China is primarily the new lending quota, not interest rates, and perhaps not even reserve requirements. Interest rates themselves are likely to have little impact on the amount of lending – at least in the formal banking system, but in the informal banks, where there is no financial repression, it might. Anyway I am very skeptical that the State Council will let rates rise enough to let rising unemployment bring down demand.
In a funny way, then, rising inflation creates its own resolution in a financial system that is severely repressed. As inflation rises, real interest rates decline. This reduces real household income and so reduces demand. It also reduces the real borrowing cost for manufacturers, and so supply rises. In my opinion this is the main reason why countries with severely repressed financial systems can accommodate rapid monetary growth and low inflation, as China has for most of the past two decades.
This doesn’t necessarily mean that inflation won’t be a problem in China next year. Many things affect inflation besides the monetary response. My point is not that thanks to financial repression China can never experience inflation, it is merely that raising interest rates might not be nearly as effective in combating inflation as we might otherwise think and may even be counterproductive.
My former student and Shenyin Wanguo associate, Chen Long, after he saw the early version of this piece made a strong counter-argument that one of the consequences of inflation and negative real deposit rates is that households are reducing deposits and rushing to anticipate consumption – i.e. buying stuff now that they don’t really need as a store of wealth. This drives up consumption today, albeit at the expense of consumption tomorrow, and in that sense it may add inflationary pressure. Hiking interest rates, Chen Long pointed out, may reduce the incentive to do so. He is right, of course, but it is not clear that this effect outweighs the wealth effect.
While financially repressed systems are very good at combating inflation, this comes with a cost – overinvestment and low household consumption. Already we are seeing household deposits flee the banking system and much of this money is going to end up fueling even more asset bubbles. Meanwhile the value of Chinese savings continues to drop, making Chinese fell poorer and so reducing their consumption.
In my opinion this is the real reason the PBoC wants to raise interest rates. They want to slow down the massive capital misallocation China is experiencing and they want to rebalance the economy towards consumption by increasing household wealth. But are they succeeding? Not really. It would take an awful lot of interest rate hikes just to bring real interest rates to where they were a few months ago. Chinese growth is getting more, not less unbalanced. But perhaps we won’t have to worry about inflation too much longer.
* On this topic I recommend a book I recently finished reading, Beth Simmon’s 1997 book, Who Adjusts? Domestic Sources of Foreign Economic Policy during the Interwar Years
Professor Pettis, next year will we be talking more about the failing Euro or out-of-control Chinese inflation?
BTW the last post was the best exchange btwn the readers and yourself I have read this year. Thank you for the time you devote to this blog.
Prof Pettis,
I would like to get your opinion.
What will dominate the headlines next year? Runaway Chinese inflation or the failing Euro?
Thanks
Jacob Kirkegaard has a piece on CNBC.com making a case that Spain is not in such a bad shape. Government debt is 64% of GDP and mostly domestically financed. The contingent liabilities related to the Spanish government support for the Spanish banks are only 5% of GDP compared to 176% in Ireland. The Spanish laws do not allow people to walk away from their mortgages so the Spanish banks may be shielded better from the consequences of the housing bubble bursting. On the surface, and if we believe the government stats, Spain does not look that bad.
Chen Long is right. Raising interest rates will affect the financing of production, which will affect prices. In particular, production includes farming, which finances the purchase of equipment, fertilizer, etc. Also, household consumption doesn’t raise prices. Only increases in money supply or decrease in the supply of good/services can raise prices. Lastly, interest rates have a direct impact on the cost of any lending and the benefits of saving.
This is an extremely interesting point. May I beg to differ on the political outcome of the current crisis in Europe. But, sure, you have your biases. And so have I! And it is difficult not to agree on the syndrome. The China part of your post is most stimulating as well. Reading through it, I discovered what makes current economics so strange for an old bloke such as myself – financial education before 1980 so-to-speak.
In current established economics, whether neo-con or neo-Keynesian, the discussion on economic matters tends to be extremely detailed. Well sometime getting into the boring. But one issue is generally left outside, money viewed as active capital. Tax policies have been a great subject of analys by ne-cons. Sure. But plain money trying to support itself and avoid monetary destruction via inflation has never been an issue since the beginning of the 80s.
Well, money as such is left outside. Such handled as some sort of “subjectable issue”, more of a policy matter than anything else. Money can instrumented easily via monetary policy (neo-con), tax policies (neo-keynes). And doctrinaire academia à la Bernanke sometimes. Money is certainly not the deity, the sacred cow it used to be in my young years. Both despised and adored.
Being an old boy, this idea that money can be ultimately manipulated is extremely curious. I just cannot grasp it. And i do not believe you can instrument capital markets the sovietic way they are now for a long period of time. They come back in some sort of other way. With a revenge. That is I feel indeed more comfortable with the Marxist and Austrian views of economics. Old chaps, such as your honorable reader, find it absolutely strange that, in China, the whole economic life (including food controls..) is now left in private hands whilst the monetary equilibrium is still under firm state control.
IMVHO one day – within a 1-3 years- this will freeze up. Both currency markets and money ones. Globalization as we know it will stop for a while then take another turn. IMVHO Chinese policy makers will confront some kind of “mur de l’argent” just as much as 1936 “front populaire” did confront a capital crisis. Sure no more solid prediction than forecasting communist China would become the ultimate capitalist state in 1980! But I can tell you that the massive Asian malinvestments show, even from the minuscule and remote place I stand from. They show as much our public deficits do. Public or private money lost is money money, anyway.
And that is why I find it difficult to buy into the text below:
“rising inflation creates its own resolution in a financial system that is severely repressed. As inflation rises, real interest rates decline. This reduces real household income and so reduces demand. It also reduces the real borrowing cost for manufacturers, and so supply rises. In my opinion this is the main reason why countries with severely repressed financial systems can accommodate rapid monetary growth and low inflation, as China has for most of the past two decades.”
You said the “the surplus rises”. That certainly applied to the previous era. Does it pertain to the current situation? IMVO, as I said earlier China – and the whole world by the way – will confront a global accross-the-board capital crisis pretty soon. Once that can certainly not be tackled using the current thinking frameworks. Neither on the private side of money with the jolly good follies of private banking, “capital-at-risk” and al. Nor at policy level with our great commanders in chief at the helm of central banks and the great policy papers of Bernanke in 2007 (yes I read them in due time… but I do know why i prefered this blog and a couple of others even harsher and more permissive in thinking).
The coming capital crises will not be papered over. Or should I, this crisis will indeed be papered over. And that will show! I am not calling for a full return to “old school” economics but a plain acceptance that those using the current framework plain failed. Accross the board. Just did not see the elephant in the room, the OECDE financial situation.
Daniel:
The writing above in italics, is that yours or whose, could you be more clear.
CS
RS, I can only guess but I suspect the euro will be a bigger problem for the markets than Chinese inflation.
QE3, it is always a mistake to judge one country by the problems of another. The key is figure out where its own balance sheet is vulnerable. In the case of Spain I would say that the problems are the very high and persistent unemployment that will be needed for an adjustment and the fact that the real cost of the real estate crisis for the banks hasn’t yet been absorbed. The fact that Spanish cannot walk away from their mortgages is actually, in my opinion, a huge problem. It creates a tremendous disincentive to resolve the crisis. When I first saw that point a few weeks ago I was very troubled.
Siggyboss, your arguments seem pretty self-contradictory. Why would you say that only monetary expansion, not consumer demand, can affect prices, but changes in production will affect prices?
Daniel, thanks very much for your comments. I think one of the biggest problems with economic thinking is precisely that there is a “new” economics that seems divorced from what we had spend hundreds of years learning. As for the passage you identified, I am actually working on a short piece called “Monetary expansion under financial repression” in which I argue that the logic of financial repression creates a strange bifurcation of monetary policy so that monetary expansion can be much greater on one side of the economy and much lower on another than the nominal increase suggests. There is in other words a separate set of aggregates for producers and for households that drives the imbalances. I have sent the piece around to a few monetary economists for comments, and if they don’t shoot it down completely I will publish it and discuss it. Money is such a weird thing.
CSteven, the first of the three italicized paragraphs is mine. The other two are Daniel’s.
Michael,
Heavy stuff, and maybe a bit too. The normativel problem (there are only normative problems in this case, technically this is all easy to solve once we agree how the losses will be allocated) is not Spanish citizens unwilling to undergo hardship – they had their fun a few years ago. The problem is German taxpayers wondering what is in it for them.
I like this, it sounds exactly like what people should have considered when they joined the EUR:
” Once the dust finally settles Europe will either be a unified country with fiscal sovereignty firmly established in Berlin or Brussels, or it will be fragmented with little chance of reunion”
And, why not. It took the US more than half a million lives to achieve unity. Why not try to do this in Europe peacefully?
Also, if the Berlin/Brussels solution is not achieved (it will be Brussels, in the new Capital District of the EU, located between the sovereign states of Flanders and Wallonia, both roughly the size of an average Scandinavian country), it will not mean that Germany will stand alone, just that the French will have a problem. They had dragged the southerners along (with one exception, the Germans wanted the Italians for historical reasons) in order to not have to explain to their citizens that after three wars (in the last two of which they asked the US to beat up those bullies), they still may have to eat sausage.
But if there is something like a core-euro, it will include quite a few decent economies and it may be OK for Poland and a few others to join too and at a more realistic rate than the leavers. Without the South, there should be no problem for Swedes and Danes to join, and maybe the UK would like to accept a transfer of Ireland to the Sterling Area (or the UK$?). That should still leave a few viable nation states with illusions of joint sovereignty, right?
Just to show how unserious talk about these complex issues gan get when uninformed people give it a go…
Two things:
I was surprised you did not mention that low rates favour loans for local and national government, and given the high level of debt they would lose a lot if they would raise interest rates.
The other thing is that given that a big part of the inflation is coming from food prices (which are raising everywhere), a factor you can hardly control via interest rates (I calculated the correlation between cpi YoY in China vs FAO Food price index … 0.8!), the most likely solution would be letting the RMB revaluate. This would also have a high cost for government since the PBoC would see the value of its reserves shrink at an astonihing rate, thus resulting in a really bad balance for the PBoC.
Do you think chinese government would care more about PBoC’s balance or about fighting inflation?
Michael,
At the risk of looking like an idiot, what did you mean by, “perhaps we won’t have to worry about inflation too much longer?”
I was actually going to ask you about the significance of Spain and Ireland having recourse mortgages. And my understanding is that personal bankruptcy isn’t available in Spain like it is here in the U.S. Maybe they’ll need to build debtors’ prisons?
I can see one bit of light at the end of the tunnel. Five years from now, when households in Europe, China and the U.S. will all look back on years of subsidizing the banks, overtly and otherwise, there may be a great swelling of international good-will and unity, all under the banner, “Roast the Bankers!!”
Have a great Thanksgiving!
Bob
So how does it all end? How does this play out for China in the short and long term?
Will China be forced to revalue, or will stubborn nationalism continue to force exploiting every other alternative? Is there some point where they crack, or can they continue on this path forever? If they will crack at some point, what signs can we look for as signals? Would major new US trade barriers be a sign?
I completely agree with the Euro predictions, but I’d like to see more of that for China.
M. Pettis, wrote:
In the case of Spain I would say that the problems are the very high and persistent unemployment that will be needed for an adjustment and the fact that the real cost of the real estate crisis for the banks hasn’t yet been absorbed. The fact that Spanish cannot walk away from their mortgages is actually, in my opinion, a huge problem. It creates a tremendous disincentive to resolve the crisis. When I first saw that point a few weeks ago I was very troubled.
Agreed in the first and in the second point. Nevertheless I believe that since mortgage delinquency is getting such a big problem some kind of “walk away” will be allowed. Simply because the judges will be collapsed other arrangements will be necessary. I think that banks have already absorved a big chunk of real estate losses but only a small part of the household mortgage losses. With persistent and high unemployment and a lot of subprime-like lending between 2004-2006 there are millions of losses there to be recongnized. For instance, according to Caja Sur auditors, mortgage delinquencies (10%) double the rate that the bank admited before (5%). In any case spanish banks are paying the interest of their MBSs without any delay, although some many of them already run out of their reserves long ago. The problem comes when the principal has to be payed back… AND Y THINK THAT THEY SHOULD BE REPAID TO THE EXTENT THEY WERE COLLECTED, leaving losses to the bondholders. Hey! They invested (causing the bubble) and they should bear the losses. That is the proper way to adjust debt liquidation. But well… I guess it will not occur this way.
Dear Dr. Pettis,
I just forgot to give my sincere congratulations for your great job explaining your thougths.
Best regards
Excellent analysis. I am often drawn to a quote which when tough choices lie ahead:
“people only accept change when they are faced with necessity, and only recognize necessity when a crisis is upon them” – Jean Monnet.
Clearly, on many levels, global finances are in a crisis somewhere. The crisis, however, is defined and felt differently depending on ones viewpoint. For the electorate in these heavily indebted Euro nations the crisis is being felt in the form of financial oppression that Gov’ts are now forcing down their throats;
- zero savings rates
- longer working hours (if you keep your job)
- higher unemployment
- loss of benefits
- higher taxes and loss of services
- smaller pensions
- etc, etc.
At some point the electorate is going to say no more, whether it is Irish citizens refusing to let their Govt bail out an Irish bank for the benefit of a UK bank, German citizens refusing to commit to the EFSF, or maybe even Americans refusing to raise their contribution to the IMF for the benefit of Greece. The trickle down is happening and many nations are approaching a critical political juncture because the “crisis” is is now definable in some form to many more people.
We appear to have reached a tippng point in many places and some tough decisions now have to be made on the burden sharing of this global debt overhang. Begs the question: How much sympathy does each Euro nation feel for its neighbor? I sense less and less as time pases.
if the eurozone crisis does indeed go all the way, then at some point the eu is going to have a “banquo” moment.
since the 1980s at least, the european national governments have intentionally ducked every opportunity to give voice to the european public via a european presidency with a direct democratic mandate.
the european public is asleep – so let sleeping dogs lie, they figured. european issues are technical, and best left to technocrats. in this way, the european project has been run as a cartel of the national governments, with the public not being given a look in.
but when it comes to the moment of true crisis, and the national governments are haggling over how to solve it, there will be an empty chair at the table. and the european polity – which was strangled at birth by the midwives – will come back to haunt them.
Chen Long’s point is interesting to me because I’m pretty much doing as he sez. I’m buying lots of pu’erh tea, tea that is in cake form and can be stored for long periods of time. I do so mostly because I anticipate cash being harder to come by in the future and wish to lock down hedonism points for when I’m poor and miserable. I don’t buy bonds because I don’t think that US sovereign debt crisis will be especially far in the future.
I’d be pretty shocked if this sort of thing isn’t partially the case. What I think hiking interest rates will do is largely pull money out of the constant froth of mini-bubbles, from ant farms to puerh tea to stock markets to apartment etc, etc. Smoothing out the business cycle increases people’s ability to anticipate profits and increases people’s willingness to reject unsound investment choices. So money pours out of things people buy and hold, like a second apartment in a good city area, to things people buy and *use*. This provokes consumption of peripheral items around the use. In short, you’ll have stronger inflationary pressures (after some time) just because people stop trying to hoard copper and start new family businesses (banks pay interest on savings, savings can be shown as a reason to loan, people don’t need unreliable credit services from the black market). New family businesses need rent, equipment instead of just warehouse space. So forth and so on.
What do you mean in your last sentence on Chinese inflation when you say “but perhaps we won’t have to worry about inflation too much longer”? It seems to me that the 2008-10 credit expansion is pushing too much credit into the system at a time of full employment and increasing workers’ rights. This seems to be a potentially powerful combination setting the stage for a very bad bout of inflation.
European political union is not only patently unrealistic, due to divergent values and (especially) languages, but also anachronistic. The latter deserves explanation.
The unification track (EU, eurozone, then unification) was set in motion by exhausted postwar European states, to prevent another war. Each step took decades.
Then came the information revolution and globalization. Suddenly currency exchange and political borders are trivial, as long as trade is open and currencies can float. The EU has quickly become so tightly economically integrated that intra-European war came to sound quaint.
Because of globalization, currency union has become an unnecessary step to the unnecessary goal of political union. The existing trade union achieves 95% of the original goals of integration, at 5% of the complexity and contentiousness of a political union.
The logic points to trade union. Long run, the return on investment is far higher to go back, not forward.
As a result, this is what will happen. It’s just a question of time.
This is ridiculous to suggest that countries like Spain will drop out of the Euro. What do you guys think.. that the Spanish people will go along with that?
It should be obvious that it would end up in hyperinflation..
Nice & thought provoking – lots of background in China – I will read through this a few more time & comment
I Hope the euro can survive. If it breaks up, things would get really bad. It would be a real Credit Anstalt, transforming a long recession into a real Depression.
How long can China fight the effects of its currency pegging?
It appears to me that China:
A) Decided to peg their currency in order to stimulate their economy through exporting.
This led to:
B) A rapid growth of their monetary supply and
C) Over-investment in order to produce exports.
This has led to inflation, which they have decided to combat by:
D) Raising interest rates and
E) Raising reserves.
It reminds me of that old joke where a patient goes to the doctor and says, “It hurts when I poke myself in the eye.” And the doctor responds with, “Then stop poking yourself in the eye.” Instead of using D and E to combat its inflation, China should just stop doing A, shouldn’t it? Especially since you are arguing that D & E may not even be effective.
Xav,
At last someone with a sense of reality. I have no idea why reasonably well educated people without ties to speculators engage in this kind of sensationalism. The only reason why things are difficult for Ireland right now is that its peculiar debt is bank liabilities that used to be funded in the interbank market and have migrated (with a gvt of Ireland guarantee) to the ECB balance sheet. These are liabilities of banks that have already transferred their worst assets to the NAMA There may be more to come) and hence probably have a recovery value of at least 70%. That is someting very different from accumulated budget deficits, the normal source of gvt debt.
When the ECB announced that it wanted to return to some form of normalcy (unlike its irresponsible colleagues in Washington), which would hurt the Irish banks in particular, predatory speculators started to short PIIGS debt, in the expectation that the Greece situation would repeat itself on a bigger scale and they would be able to buy it back before things started to revert to the mean (of course there are always a few who cannot find a chair when the music stops). Those who did not, are sitting on the fence to join the bonanza and go long when the market starts to believe that everything was a bit exaggerated. Why on earth do we allow, in a world full of financial regulators, fund managers to do this? Why do we allow regulated banks to provide services and financing to them?
Hello Michael
Thoughts on this please.
China’s Economic Treadmill to Hell; Shadow Over Asia; What happen WHEN China Slows?
http://globaleconomicanalysis.blogspot.com/2010/11/chinas-economic-treadmill-to-hell.html
Also can you please send me your email address?
Mish
Rien Huizer – You ask “why do we allow fund managers to do this”? The answer is simple, because we are free economies and markets and we don’t dictate how investors should handle their risk perceptions. It would be preferrable to only let them buy but not sell, but then they would not buy in the first place.
Yo Mike !
Long time no see…I was in Beijing but didn’t know you lived there…Hope to see you some day.
Soviet Sex….lol
Rien, yours is a very German view but I am not sure it is how things are seen in Spain. You say that the Spanish should pay for the adjustment since they’ve already had their fun, but Spanish unemployment was high for much of the past decade, and Spain’s “fun” consisted of an out-of-control housing bubble primed by excessively loose monetary policy generated, mainly, by Germany’s domestic monetary needs. It would have been almost impossible under the circumstances to prevent massive liquidity expansion from leading to asset bubbles and trade deficits, and we don’t even have the satisfaction of criticizing the Spanish for weak bank regulations and fiscal extravagance. Germany’s claim to virtue is not helped by the fact that thanks to the travails of southern Europe Germany now gets all the benefits of a weak currency without the cost of monetary intervention.
The bigger point is not that Germany is wrong and Spain is right. It is that while Germans may feel thoroughly justified in setting off their virtue against the vices of the deficit countries, that is a very biased view of the crisis and it is unlikely to be the same bias that deficit Europe brings to their understanding of the crisis. To say that southern Europe should simply accept the German view and get on with it strikes me as not only analytically weak but also impractical. Spanish workers will not necessarily agree that they should run many years of high unemployment simply to maintain the euro. To pretend so is just silly.
Sergio, you are right about the balance sheet impact of rising rates and in fact this is something I have discussed many times before. And I agree, it is not clear by what mechanism rising interests would alleviate rising food prices. Revaluing the currency is likely to be more effective.
Bob, I find the whole issue of inflation in China very complex because of the weird feedback effects repressed financial systems display. I am still trying to figure it out, but I am less worried than others that inflation will prove hard to control. Lets wait a few months and see. As for roasting the bankers, fair or not I think it was a huge strategic mistake on the part of Obama not to have gone after the bankers more nastily. Remember Ted Roosevelt’s “malefactors of great wealth”?
Ignacio, I think you are right. I would imagine the political pressure to change the liquidation system for mortgage holders will rise. It doesn’t make sense to tell a large number of workers that no matter how hard they work and how much money they make, everything above a minimum living allowance will go to the bank. Under those circumstances, why bother working, at least working legally?
Bena, for many years the fact that Europe was created “above” the heads of the (too stupid to get it) people was a little worrying. Perhaps the people aren’t as dumb as their leaders.
Shah8, there is no doubt that this is happening, but there is a real doubt in my mind that highly specialized and collectible items like pu’er tea are a significant component of the food basket of ordinary people. People are more likely to think of their eroding purchasing power when they look at pork, soy, milk, detergent, etc.
Rob, see my response to Bob. I am still working on the idea of monetary bifurcation in repressed systems. At some later date I will try to discuss it.
Xav, you are not reading my post. It is not that I think the Spanish people will go along with it. It is that the Spanish people will insist on it. Of course perhaps unlike you I remember being told in 2001 that my insistence that Argentina would break the Convertibility Law was ridiculous because Argentines would never approve.
Rien, that works both ways. Given my very long experience with currency crises and sovereign defaults, not to mention my extensive reading in financial history, I am always astonished when people insist on exactly the same set of reasons for denying the possibility of something that has already happened so many times before. What you refer to as a sense of reality I would call a total fantasy. And no I am not an evil speculator spreading false rumors in order to profit, but if I were, that would only strengthen my argument. If it will happen, it doesn’t matter why it will happen – it is still pointless to deny the likelihood of its happening. By the way, the longer the deniers control event, the worse the cost of the ultimate break likely to be. That also comes out very clearly from the history
Cavallo proposes a higher VAT tax in Greece, Portugal, Spain as effective devaluation without the chaos of leaving the Euro.
my point is that in the last 60 years governments have consistently neglected the opportunity to create a european polity – i.e. a european public with a sense of common identity and common purpose.
governments could have e.g. required all school children to learn another european language to fluency. they could have replaced national military service with a pan-european public service exchange programme for all 18-year-olds.
most importantly, they should have created a democratic process within the union that actually had meaningful outcomes, instead of the obscure charade of the european parliament. i.e. the voting public should have had the clear and decisive choice as to the european policy agenda. the governments could could have done this by making the european commission president subject to direct election (or indirect election through the parliament in the european model).
no doubt this would have slowed up considerably the economic / financial / business integration of europe. but creating a regular and meaningful political discourse between the european public and brussels would have given the public a sense of ownership of the project, and would have fostered a greater awareness of the common european interest.
whether or not this would have actually succeeded in creating a european polity, i cannot say. breaking down language, geographical and prejudice barriers is not an easy thing. it certainly would have taken decades at least.
but the point is it was never even tried. so now we can look forward to a crisis in which the eu will desperately need someone to stand up and speak for the common european good – someone who can be trusted by the european public – and no such person exists. instead, each nation and its public will focus on its own national interest, and the outcome will be a catastrophe.
Congratulations for the great piece!
It is impressive that conventional lying in such a scale is still legitimate in Europe, though completely ineffective. This pathetic attempt to generate the expectation that the bubble will go on forever is rather surrealistic. Explicitly unreliable reassurances by respected authorities simply sustain uncertainty. Things will change rapidly when the myth collapses and conventional expectations come suddenly close to your early stated predictions…
Why would the same argument not apply to Japan and the United States, as it only seems to think so.
Is it because both have a different monetary system that controls its own currency?
I think your point that raising interest rates will cause more inflation in China is well-taken. In fact, I think raising rates here in the US would actually be helpful. Contrary to the assumption that the reverse “wealth effect” of falling bond prices would be detrimental, higher interest rates would give greater income and expectations of future income to CD and short-term bond holders. Also, I don’t think that there are many investment decisions which would be changed by a rise in short-term rates–and even a bit of a bump up in long-term rates. Thirdly, I think demand is more driven by demographics and confidence than rates–and while an increase in rates would do nothing for the former, it might considerably help the latter.
I know this is anathema to conventional economics, but the correlation between short-term interest rate changes and economic activity is not as clear cut as those who subscribe to it as an article of faith might assume.
I have to say this is a very one sided view on Europe and in my opinion not realistic. Especially the comparison to Argentina is ridiculous. Yes Argentina said one thing and did the other, but Argentina was on its own and not in a monetary union. This is a very important difference.
1) The breakup of the Euro will not only lead to wealth destruction through hyper inflation in the southern countries as they will get very very very weak currencies, but also Germany will have its export killed as its own currency will revalue immensly.
2) Germany is profiting from the low yields at the moment due to the safe haven flows.
3) Germany is gaining considerably more political power (as you already mentioned as a possible solution)
4) Nobody will turn down the hand that feeds them. That is why none of the problem countries will leave the Euro. They are aware of the fact that their pensions are being paid by the north!
The problem is that investors are being forced to sell due to rating downgrades and adjustments to investment mandates beacuse of fear. And as FDR said “there is nothing to fear as fear itself”. That is what is happening at the moment an overshooting in sentiment.
I would suggest people have a closer look at the USA. Their problems are far worse. Roubine once said there is no Greece among US states. I think it is time to rethink that. The problem in the US is that the are in a similar situation as Europe with indebted states which are being supported through fiscal tranfers on federal level. So there is no incentive there to solve the structural problems. Dodgy accounting is one of key issues why people are not aware of the true liabilities of the USA. The steps Europe is taking are actually done to make sure we will never get into the situation the USA is in where we see states piling up debt without taking appropriate measures.
good luck…..
A number of points. First on Spain. QE3, in addition to what MP wrote, a major problem is exactly the superficial acceptance of Spainish official statistics. Lombard Street recently did everything but calling the recent 0% GDP report a lie by referencing other statistics and they are a very savvy consultancy. Edward Hugh has also taken several swings at the official statistics. Along those same lines, Ignacio, the banks have not remotely written down those CRE related loans and, as you correctly note, the residential writedowns are laughable. There is no way the official 10% correction in prices is sufficient given the enormity of the problem. Further, the reason the banks still forward payments on mortgages to the bondholders and occasionally replace mortgages held in the securities has everything to do with ratings and financing. This is the banks’ attempt to hide the extent of the problem. Otherwise those securities would lose their high credit ratings and could no longer be repo’d to the ECB.
As for the larger problem, Rien, I don’t wish to pile on, but MP is being kind. The selling of various nation’s debt into the market is not all speculators and does not start with simple events like the ECB wishing to move away from being the sole source of Irish bank financing. It is because the curtain hiding the failing foundation of the EMU has become tattered and the political class’ wish to ignore the fundamental problems and erect further curtains was doomed to eventual failure. These governmental reactions merely temporarily forestall for short periods the unfolding economics because the sellers can never be certain the leadership might not be able to craft a fiscal union or other potential real solution. Events are now accelerating because the window of opportunity to do so is dwindling.
Finally, Michael, wonderful exposition as usual. My one surprise was the absence of France from your list of European countries. On many levels the credit metrics bear strong similarities to many of the countries you cite and the French dirigiste mindset seems unlikely to pursue a course to avoid similar fate.
Couldn’t an argument be made that if Europe goes into crisis as you predict (I’m inclined to agree), that in a globalized economy the effect will be to slow global economic growth and dampen any global inflationary tendencies, including those within China?
Also, should we assume that in regard to how raising interest rates will affect the household sector, that you have considered the effect upon the informal loans made at higher interest rates to one part of the household sector from funds raised from another part of the household sector that are chasing yield?
You raise a compelling point about the wealth effect from higher interest rates, but to the extent households save primarily through the banking system, wouldn’t this simply encourage additional use of savings accounts? The wealth effect seems plausible, but I have a hard time seeing how it would be of higher magnitude than the increased savings. I think the net impact on consumption would still be negative.
It seem to boil down to a battle as to how much pain each society will bear to resolve the consequence of a system which has allowed large imbalances to build up for all these years, fought on our behalf by each of the governments. In a bankruptcy, how much haircuts should a creditor take? Between Germany and peripheral Europe, it seems that the Germans are having the upper hand (at least for now) in forcing the pain to mostly occur away from its banks. And the Germans are getting to dictate the terms of these bailouts through its influence on ECB. Between US and China, the equation seem to be a lot more muddled, because the US ultimately gets to dictate its dollar policy. How much inflation pressure can the Chinese society withstand? And the consequence of these resolutions is migrating beyond the realm of economics.
Maybe some of the enthousiastic Europe-bashers (not too many who reside in continental Europe by the way) should take the trouble and visit a few German, French, Dutch/Belgian and Italian news and commentary websites. Of course the Euro was a political project (with a smell of economics) intended to make EU integration irreversible. And once the candy had been consumed (in fact what happened in some countries was an analog of the “Dutch Disease” due to the jump to much looser budget constraints caused by cross border competition between banks no longer restricted to growing in their home currency) there was to be the inevitable hangover, a bit like Florida. Especially in countries with fast growing residential construction and EU adopters or hoping to become so (look at the Baltic states and Poland), foreign banks from mature markets tried to grow aggressively, no longer constrained by the lack of eg Escudo funding etc. Not necessarily German ones, or “banks’ GE was there too, in a big way.
That is what I meant by the “fun” mainly consisting of a temporary spike in residential construction (and a long tail of services and suppliers related to that plus a deceptive wealth effect among current home owners, not) based on speculative expectations mistaken for an acceleration of GDP growth. Now we are seeing an deceleration and the bricklayers are getting laid off again.In some of these countries, workers had been waiting for centuries to do well. Once this stabilises, demand for residenital property will after a while, start to revert to its pre-EUR trend and given that in many countries there is still pent-up genuine demand from household formation and technical obsolescence of the existing stock, I would expect that after the say minus 4% shock in a country like Spain has worked itself through the system (and people have returned to the ranks of the unemployed, or more likely, illegals have been dumped and prepared for deportation (especially in the UK, Italy and Spain) things will settle down om some sort of shallow groth path. Do not expect dynamics from a society without a technology-minded culture, but some general improvement in living standards could occur in the wake of countries with a proper industrial mentality.
But I believe that the political will among the European elite is still to form a more integrated political entity, maybe not a federation, but certainly something more robust than what we have now. It may not be very hard, because elites who believe in the primacy of politics will get their way. Just look at our beloved China. It would not be too hard to regulate or coax the banking system in such a way that the excess supply of bonds gets absorbed, especially when the BOP is in approximate equilibrium. All it takes is a few phone calls and stricter regulatory oversight of foreign firms. Much of that absorbing will have to be done by the Germans and the French, and they have a tradition of being able to show the finance people who is in charge. If not, we may have a problem, but do not bet your life’s savings on it.
Rien,
Actually I am from Spain and spend a lot of time in other places in Europe for my business and if you think very few Europe bashers live in Europe I can suggest that perhaps you spend too much time in Brussels, and this is especially if you think that someone who does not think the euro will survive is a Europe basher. I have noticed when Pettis says the Iraq War helped create the global imbalances he is called anti-American and when he says that a China adjustment will be more difficult than most people believe he is called anti Chinese. This is bad enough, but to say he is anti-Europe because he does not believe the euro will survive is too much. Perhaps he simply believes what his logic tells him, without being anti-American, anti-Chinese or anti-European. I am not saying I agree with all his predictions, but to be doubtful about the euro or to be doubtful about whether some European countries will default is just ordinary intelligence, not hatred of Europe. And many intelligent people in Europe are also very doubtful, including many businesspersons.
It looks like a bankers game to me. Sell the PIGS bonds until they are refinanced through a decrease in welfare and an increase in tax to stretch the game a while longer. The short-term price of a bailout is small compared to the alternative. If there weren’t so many baby-boomers upon their retirement, there would be much more of an appetite to stand up for sovereignty and except hard work that follows; which would have had enough life-span left in it to reward them. I personally don’t think the euro will break until the younger demographic feel enslaved enough to rebel or until the resources to refinancing the welfare states is exhausted. Which will come first?
I’m an ignoramus here, so I would appreciate comments from the always lucid Professor Pettis on the following: It seems that Europe has two related problems: a structural deficit problem on the periphery (as in Greece, Ireland, Portugal and, to some degree, Spain; and a banking problem – as in, the major banks throughout Europe are insolvent because of their large holdings of cross border sovereign debt. The first problem is difficult, but solvable – its not systemic because its just not big enough. The second problem is systemic because of the risk that the whole system simply freezes. Why isn’t the solution to the second problem a nationalization of the banks, not by the individual countries, but by the ECB, combined with much greater reliance on the old fashioned printing press to fund the changeover and the workout. To some degree it seems as if this is already happening, with Andrea Merkel playing the role of Yes, Minister! insisting on tight money for the benefit of her constituents. So why not just continue the game all the way? And is that what you meant by a a Europe ruled from Brussels? I can think of lots of reasons why this would not “work” politically; what I would appreciate comments on, is why it would not work structurally?
PS: Another great piece – you are the best!
China may not need to revalue to control food prices if the DX gets a boner. It’s already got a partial. EUR-USD parity can delay the inevitable, but forget the race to the bottom.
Buy silver crash JPM!
PatriciaA,
Sorry but I do not live in Brussels. My aim is not to suggest that people should not have their doubts (about the Euro, or FIFA or whatever), but that an incredible amount of uninformed debate is taking place.
Take one example. If one follows the logic of someone who believes that EUR member X, with a EUR denominated gvt debt of 100% of GDP, and current gvt revenues of 35%, with inflexible gvt spending of at least 30%, current deficit 5% (hence spending 40%) could benefit from leaving the EUR and letting its currency float down. The country has been borrowing for 18 months to service its maturing debt and the interest burden is now e.5% of GDP, or 10% of gvt revenues. The country must also finance an external deficit of 3% of GDP. Given the lack of attractive stocks (the main stocks are the distressed financial system’s, local property companies and retailers), inbound portfolio investment in equities has been negative for a while, hence most of the capital inflow to balance the external account has been in the form of borrowing from the international banking system, the ECB and some gvt bond sales abroad.
Question. Suppose the effect would be a 20% depreciation. Then initial GDP at current FX rates would also be down 20% (hopefully, the depreciation would influence the BOP positively and hence GDP. However, the gvt debt is now (roughly) 120% of GDP and that debt no longer enjoys the informal protection investors used to expect when country X appeared committed to EUR cooperation). Refinacing in its new currency may be very expensive, while the claims on the local banking system would also be a problem. Furthermore, servicing the gvt debt (with interest payments alone representing almost 5% of GDP) is putting further pressure on the gvt finances. Do you think country X would enjoy a much better period of adjustment in its new. “sovereign” state than during a “Germanic” austerity programma?
Maybe most people who believe that countries will not fight till the end to stay in the EUR, will also default on their EUR denominated debt once they have re-created their own currency, for instance by declaring it payable it their new currency only, or by simply legislating a conversion rate.
That has been a staple of the IMF approach, but I doubt that the good citizens of the peripheral EUR countries are ready for that, not to mention their elites.
Also:
People writing about Ireland (Michael I do not mean you!) here should take the trouble to visit the websites of Ireland’s NAMA or NTMA. Plenty of useful information. Unfortunately, then the issue becomes a little more complex..
Dean Jackson:
“As for the larger problem, Rien, I don’t wish to pile on, but MP is being kind. The selling of various nation’s debt into the market is not all speculators and does not start with simple events like the ECB wishing to move away from being the sole source of Irish bank financing. It is because the curtain hiding the failing foundation of the EMU has become tattered and the political class’ wish to ignore the fundamental problems and erect further curtains was doomed to eventual failure.”
Of course it is not all speculators. A lot of selling is by banks and other regulated entities. That is quite normal, but in the case of Ireland specifically, there is not a lot of Irish tradable debt around and it would not be very costly to support its price (ignoring the presence of CDS). So these price movements reflect a great deal of illiquidity/specialized players. There are two categories of Irish debt that are problematic: non-guaranteed bonds of Irish banks (and especially the paper about which the gvt has been ambiguous) and non-tradable liabilities such as bank deposits, direct claims on firms (probably very few). CDSs are probably a very complicating factor and given the OTC and private nature, maybe we will find out about that in the not too distant future. For the rest i refer to my reply to PatriciaA @ 65
Rien
Good luck and I hope you are not loaded with PIIGS debt in your portfolio.
Another excellent and thought-provoking post!
Once the dust finally settles Europe will either be a unified country with fiscal sovereignty firmly established in Berlin or Brussels, or it will be fragmented with little chance of reunion.
There is third option – a combination of the 1st and 2nd, where there is a federal core and some of the periphery is thrown off/leaves the Euro. I find the first alternative highly unlikely due to the multiplicity of problems across the Euro countries, which cannot be resolved via blunt monetary policies. The 2nd is IMHO what current ECB policies are trying to address – but with piecemeal efforts and very weak fiscal measures.
BTW, with regard to an earlier comment, the worst thing Poland could do is to give up its sovereignty and adopt the Euro. The zloty is doing well for Poland, thank you.
With regard to China and interest rates/inflation:
While hoarding may create a short-term price level rise, it is difficult for households to sustain a continual rise of inventory.
More likely disruptions are the whipsawing of demand which would be manifest in temporary under and over-supplies of consumption commodity categories. But a cause for a continual rise in the price level? Not likely, unless aggregate demand is successfully transferred from investment/export to consumption (see below).
I agree that raising interest rates in a high-saver/low consumer debt economy has a better chance of raising incomes rather than restraining demand. But, will this be sufficient to stimulate spending? And can the industrial sector generate sufficient profits selling to the interior at prices they can afford? Will the government provide subsidies to help with this transition?
Raising interest rates is only the beginning to capital reallocation. Yes, it will slow down the investment rates for the current capital composition. But there must be incentives to focus investment on internal demand – high interest rates reduce speculative ventures. And figuring out how to grow internal demand in a “controlled” fashion requires a great deal of speculation.
What will happen to those ventures that need to roll over debts if banks start closing their loan books? As well as the local government enterprises.
High interest rates buys a little time to reallocate – the key danger is increasing foreign speculation/hot money flows, currently expecting a revaluation bump, now also an interest rate bump and lower inflation bump. Speculators always act faster than the economy can adjust – there are and will be interesting battles in the markets.
Fiscal policies to be executed post-interest rate hikes must be well thought through and coordinated. Let us speculate on what these policy options consist and how they may play out considering market reaction and events in ROW.
Professor Pettis,
Why can’t the ECB just take a page from the Fed and BOJ’s playbook and create euros? Then use these euros to purchase Irish government bonds. It requires no fiscal commitment from Germany. If the ECB announced, say, a 700 billion euro bond purchase program for Ireland, Portugal, Spain, and Greece, it would calm the markets tomorrow.
An interesting read right about now is “Bloodlands” by Snyder which goes in horrifying detail the forces that made Europe – and Snyder “only” covers central Eruope as his books centers on Hitler’s and Stalin’s slaughter of Europeans. When one puts into the mix Franco and then the Greek Civil War and then right to 1968, it becomes clear what the central purpose, if not the only reaosnable purpose, of Europe is to this point in history. It is too stop blood flowing.
This means that almost all European intelligentisia, from leaders to pundits, if they live and work in Europe, have one word they cannot even mention. That word is “constitution”. For the very concept of constotution is thought to not only be beyond the European pysche, but has always led to massive blood letting.
And thats the problem. The fiscal metrics only lead to bafflement for the size of the “European” denominator makes any analysis of bank or soveriegn debt only a short term problem and of course a solution will be had.
But if the constitutional aspects – or total lack of a constitution – with even the word “constitution” unmentionable – makes this instead an impossible crisis and Europe will amost certainly cease to exist beyond some sort of trade pact. Unless, out of the blue, and despite how history screams, good men and women convene a constitutional convention. I just cannot find those people and I cannot see such a congress ever occuring.
In the end, Monet will be seen as the coward, who helped lead Europe down a 60 year road where a pyschosis and refusal to accept or even define reality become the dominant form of government. And not only is Europe where it is because of this fantasy, but a way of thinking, a “school” seeped out to the entire ‘Western” world and perverted governments and academia and the intelligentisia. That a “star chamber” of the elite plutocracy, if their goal was noble, would always be the best way to provide governance and leadership, versus the banality and the evil of a popular democracy. But we are finding that subsidiarity will never replace basic rights. So in the end, the very situtation Eruope was to avoid has come front and center. As Gaddis said, ; “…you come full upon, all the family at dinner. You seek it like a dream, and as soon as you find it you become its prey.”
Europe is not in the slightest a fiscal or a solvency crisis – it is a constitutional crisis of the first order. Only by seeing it in this way can one find any prescience and any ability to navigate with appropriate risk management in assets and liabilities. And given the almost certain path to dissolve Europe and revert back to nations – Monet and company only forestalled fait. Hopefully the 60 years of “sleeping beauty” ( Gaddis’s “half a life”) has actually allowed some maturity and civitas to develop when we find Germany can only look to Germany and the socialist parts of almost all nations dont derail their respective countries.
I figure not only will Europe cease to exist, if considered as a constotutional crisis, but the sorting out of the bill will must likely end in blood.
I may not agree with Yves Smith or most of her guest bloggers on most occasions but this piece bears some semblance to what looks likely for the near future. The part about german banks is really quite funny, the thought of deutsche being anything close to the conservatives they were a decade back is laughable in itself considering how they behaved in the MBS crisis. http://www.nakedcapitalism.com/2010/11/marshall-auerback-bankers-gone-wild-in-ireland-and-germany.html
Yet honestly, any real moves to split or leave the euro by any member will necessarily play into the hands of those “event” driven funds who will likely go on the attack and with the current atmosphere, countries who do “reinvent” their currency may find themselves in greater trouble rather than the envisioned relief.
After all, things don’t have a habit of repeating themselves in exact patterns. Individual countries doing this at a time when the rest of the world(3/4) is not in dire straits may have found positive solutions, but when much of the world is on edge, could it set off something close to chaos?
Purple, Cavallo proposed not just an increase in the VAT but also a reduction in payroll taxes. The former without the latter doesn’t help much. VAT hurts all producers, which include lots of non-Greek producers, and lowered payroll taxes helps Greek producers. I need to thin about this more, but to the extent that a large share of Greek consumption is imported, this does indeed have the effect of devaluing the currency by, in effect, raising import tariffs.
George H, yes, both Japan and the US mange domestic monetary policy. European countries don’t except in the aggregate, and this effectively means that everyone adopts German monetary policy.
Sjoewe, actually Argentina was effectively in a monetary union. Its currency union meant that it had no independent monetary policy but had to accept whatever the US did. If this is the “important difference” between Argentina and Greece, it is hardly enough to matter. As for there being no Greece in the US, Roubini is right. The point is not that there is no US government entity that will be forced to default. It is that the risk of a default for a US state has a very different set of impacts on monetary, fiscal, tax, and investment policy. A sovereign default is completely different from any other type of default, a point I tried to make as forcefully as I could in my book.
HJ, my entry tomorrow will discuss this whole issue of sharing pain, but in the context of national politics, not international.
Rien, I am definitely not a Europe basher. I was born and grew up in Spain, my mother is French, and my American father is one generation removed from Greece. I am, however, a passably knowledgeable financial historian, and I have to say there is little in the current crisis that convinces me that there isn’t going to be a very difficult adjustment, and one that will involve both defaults and currency breaks. I should also say that almost the same arguments as to why this won’t happen in Europe today were made in Argentina before 2001, in Latin America in the 1980s, and in Europe in the 1920s and 1930s, and with as much fervor. That doesn’t mean it must happen again, but it does suggest that things don’t change much.
JKB, the solution you propose is likely to be very difficult to accept politically, and I suspect that if it isn’t adopted immediately it will be increasingly difficult to accept. Tomorrow’s entry will discuss why I think this way.
Tallystick, “if the DX gets a boner”??? This sounds like day-trader talk.
Tony, it could, but this would effectively mean that Germany (and a few others) are basically bailing out the other countries and accepting domestic inflation. They might eventually do so, but this will first require a lot of difficult political maneuvering.
Dean Jackson,
None of your business. But, no. However, these yields are tempting..
Rien Huizer,
as I see it, if you break from the euro and you convert all your debt into the new local currency (hence partly defaulting), your situation is much better than when in the euro.
On the one hand, your debt as a % of GDP does not grow out of control. You are basically shut from the financial markets, so you’ll have 0% deficits. But in contrast to Germanic-imposed austerity, this will be more than compensated by a huge growth in exports/a fall in imports.
Suppose e.g. a weaker member state gets out of the euro and devalues 40%. Its debt-to-GDP ratio remains constant (40% haircut to creditors), but GDP starts growing at a very fast rate because your exports are 40% cheaper and imports more than double its price out of the blue.
Moreover, hyperinflation leads to very fast debt relief. Investment and consumption would resume a positive cycle in a very short period.
This has the added effect (put forward by prescient Michael Pettis several months ago) that default may be precisely the most convenient way for the PIIGS to show the Germans what they think about their “safe” banking system and their irresponsible behaviour during the debt crisis.
You must take into account that, under current policies, you’ll have mass unemployment and stagnation (if not outright recession) for over 5 additional years in these countries. Germans may feel it’s almost their right to impose those policies on the euro periphery. But others may feel it’s their right to default and give the Germans some of their own medicine.
Professor Pettis-
How would you revise your earlier comments, if at all? Thank you for the stimulating commentary.
“To summarize, and to make the sequence clearer using nothing more than explicit assumptions and accounting identities, let me suggest schematically the list of factors that require either much greater flexibility on the part of surplus nations or much greater deficits on the part of the US:
1. I assume that for the foreseeable future the major trade deficit countries in Europe are going to find it very difficult to attract net new financing. At best they will be able, through official help, to refinance part of their existing liabilities.
2. If these countries cannot attract net new capital inflows, their currency account deficits, currently equal to two-thirds that of the US, must automatically contract.
3. If European trade deficits contact, there must be one or both of two automatic consequences. Either the trade surpluses of Germany and other European surplus countries – larger than that of China and just a little larger in sum than the European deficits – must contract by the same amount, or Europe’s overall surplus must expand by the same amount.
4. We will probably get a combination of the two, but a much weaker euro – combined with credit contraction, rising unemployment, and German reluctance to reverse policies that constrain domestic consumption – will mean that a very large share of the adjustment will be forced abroad via an expanding European current account surplus.
5. If Europe’s current account surplus grows, there must be one or both of two automatic consequences. Either the current account surplus of surplus countries like China and Japan must contract by the same amount, or the current account deficits of deficit countries like the US must grow by that amount, or some combination of the two.
6. If the Chinas and Japans of the world lower interest rates, slow credit contraction, and otherwise try to maintain their exports – let alone try to grow them – most of the adjustment burden will be shifted onto countries that do not intervene in trade directly. The most obvious are current account deficit countries like the US.
7. The only way for this not to happen is for the deficit countries to intervene in trade themselves. Since the US cannot use interest rate and wage policies, or currency intervention, to interfere in trade, it must use tariffs.
Tariffs in the US, Asia and probably in Latin America and Europe will rise. These are big numbers and the risk is that the adjustments are likely to occur rapidly. This means the rest of the world will also have to adjust just as rapidly.
I don’t really see how the numbers are going to work. Europe, China and Japan are all implicitly demanding that the US trade deficit rise. The US is determined to bring the trade deficit down. Both sides cannot win. There doesn’t seem to be the much serious attempt at global coordination. In fact the easiest part of any global coordination – that between surplus Europe and deficit Europe – has already degenerated into a nasty round of accusations, counter-accusations and insults.
The hard part of the coordination is almost certain to fail. It will take a few months for the impact of the euro weakness and the withdrawal of net financing to deficit Europe to be felt, but it will be felt. Expect trade tensions to get nastier than ever by the end of this year or the beginning of the next.
By the way is there anything that China can do to head off conflict? Yes. It can buy euros. The more the better – and just lift every offer out there. By strengthening the euro, or at least limiting its weakness, this strategy will force the brunt of the adjustment back onto European surplus countries rather than onto the US and, via the US, back onto China. Sarkozy and other European leaders might not be very happy, of course, but they will be at least partially mollified by the net capital inflows and the reduced humiliation of a collapsing euro.
But make no mistake – if southern European trade deficits decline, someone somewhere must bear the brunt of the corresponding adjustment. The only question is who?”
Michael,
I am a bit surprised by your comments about Europe. I agree that default will be unavoidable in many cases, but I don’t see the benefit of leaving the Euro. Yes, most of these countries need to regain competitiveness which can be achieved through deflation or devaluation. The devaluation option is not very useful for Europe as debts are Euro denominated… So, deflation / devaluation will both entail a painful adjustment in standard of living (possibly following a default), but leaving the Euro complicates a recovery as currency risk becomes an obstacle for trade and capital raising. Furthermore, as a Greek pensioner, would I prefer a smaller Euro denominated pension, or some contract denominated in drachma??
Rgds
Michael:
Have you read this one, young man, quite astute.
http://clausvistesen.squarespace.com/alphasources-blog/2010/8/31/the-global-economy-old-maids-who-wont-play-anymore.html
CS
“Siggyboss, your arguments seem pretty self-contradictory. Why would you say that only monetary expansion, not consumer demand, can affect prices, but changes in production will affect prices?” – Michael Pettis
You have misquoted me. I typed “[o]nly increases in money supply or decrease[s] in the supply of good/services can raise prices.” The supply of goods/services will also affect prices. The change in prices will subsequently affect consumer demand. Supply creates its own demand (Say’s law).
Hi CS,
Thanks for that fine plug here in the comments section and the comment left on my blog; I appreciate it. I will drop a note on the whole discussion over at my blog. Interestingly, the chart in my post shows that while China actually HAS allowed some appreciation against the G3, it is Brazil and India who are laggards. Interestingly!!! India and Brazil are both running CA deficits (although brazil has a trade surplus) while China is still well in external surplus. So yes Virginia, exchange rates do matter, but China’s export/investment propensity is structural too.
More later (I need to go out and shovel more snow so that I get out! … I am in North Humbersidem, UK!)
Claus
Michael. I delayed so long in answering this because I wanted to get some input from a couple of my Chinese national friends. I had them read your article and comment. These are long time friends of mine who are “rags to riches” stories and are now both USD millionaires, and of course, Party members.
The most telling general comment (my take on this also after 30 years on the ground in China) was that the article was written from a very “Western” standpoint, and to quote one friend: (the article) “is not based on the Chinese real society. Chinese economy is a big big complex, some part is really free market, some part is monopoly, some part is operated by the government, some part is the between” ….
Meaning, & I often have to remind “consciousness” people (not close minded swine) trying to do business in China that crafting policy using your own “western” background as a lens, can be extremely difficult. I’ve been in China since 1980, made millions of dollars there, have life long Chinese friends, yadda, yadda, yadda…and still I know, that I don’t know. I can extrapolate , but that is all it is, I can only approximate the Chinese mindset.
Both of these guys agreed that the Investment quota was a much effective tool at reducing growth than changes in interest rates, but both also disagreed that changing bank interest rates would do anything to promote saving/spending. They said (& I agree). That for the Chinese,”money in the bank” was an unfortunate necessity created by the lack of a social safety net. They know they are getting ripped off, but it’s just a fact of life. They keep their money in other assets too (RE if they can buy in) but, no they absolutely do not reduce savings to run out & buy a plasma TV because they think prices will go higher.
Love your work. Please contact me directly if you wish to discuss further.
CG
I have a theory about why interest rate hikes are not as effective in China too. Most corporate activity is carried out by state-owned enterprises which are not price sensitive. They only care about the availability of money (i.e. loan growth) rather than the cost of money…thoughts?