Friday, June 15, 2012

Euro explosion

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

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

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

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

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

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


How do you stop a bank run?

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

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

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

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

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

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

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

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


Why are we here?

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

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

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

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

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

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


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

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

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

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

By arithmetic, here are the options:

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

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

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

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

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

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

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

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

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


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

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

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

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

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


  1. [Paul Krugman's] article is for once about economics, not the evil character of Republican politicians ...

    I am still waiting for you to prove that Krugman was unfair in calling Romney and Ryan fakers by you posting the list of the specific tax deductions that Ryan and Romney are proposing to eliminate. Until that comes out, "evil character" is a fair, if unstated, summary.

  2. Strange standards there, Absalon. Krugman regularly depicts republicans as evil (a position you seem to accept). Why focus so intensely on that particular example? Few politicians are forthcoming with details that will inevitably be wildly unpopular (mostly libertarians. That's why libertarians don't get elected). That hardly makes them evil. Krugman goes much further, however, and uses his articles primarily to propagate the fiction that republicans are interested only in protecting their own interests, or only the interests of the wealthy. This depiction is basically blood libel, and serves no purpose other than to stifle honest discourse. Supporters of free markets may well be wrong (although all the evidence seems to indicate that they're correct), but there is no indication that they are less altruistically motivated than statists like yourself. Also, various republicans might not actually advocate for free markets (mostly because they support the privilege of their constituents), but playing to special interests is a charge that could be leveled at least as much at Obama as Ryan or Romney.

    Double standards and ad hominem attacks just prevent us from having an informed, reasonable discourse on policy. Why do you read this blog if you're not willing to engage with an open mind or on a reasonable level?

    1. Jason - I am interested in engaging with an open mind. So, we have the Ryan plan and it now appears to be the center piece of the Republican and Romney economic agendas. I say the Ryan plan is important only because Romney and the Republicans say it is important.

      The Ryan plan calls for cuts to spending on the poor, big cuts in taxes for the rich and some unspecified, but very large, cuts to tax deductions to pay for the tax cuts and to balance the budget.

      The big tax deductions that might be reduced are things like the mortgage interest deduction, employer medical plan deduction and retirement savings deductions (pensions, IRAs, 401(k)s). Ryan refuses to say what will be cut - saying someone else will have to decide that, and thereby avoiding responsibility.

      The Ryan plan is meaningless without specifying the deductions that will be eliminated to pay for it. The major candidates for elimination that I have referred to are all very important to the middle class.

      The only appropriate response by responsible voters to the Ryan plan as it stands and all who endorse it are: derisive laughter and cries of "faker" or worse.

      However, being an open minded sort of fellow, I invite Mr. Ryan, or Professor Cochrane, to fill in the gap and say what deductions the Republicans would be eliminate. We could then engage in an appropriate and informed dialog about a specific proposal.

      You may believe that an essentially fraudulent proposal like the Ryan plan is a necessary evil to achieve the greater good of a Republican victory. I do not. I believe in a politics based on the electorate being told the truth and making informed choices.

    2. Wow, Absalon, you really are open minded. Obviously republicans just want to screw the middle class because it's politically expedient. Nothing says "vote for me" like spending cuts and entitlement reform. That makes a lot of sense. Also, it's super important to the middle class to subsidize poverty, and drive up the price of housing and health insurance.

      I'm glad you've open mindedly determined that republicans are sadistic monsters. Keep on laughing derisively, you've obviously got things figured out.

  3. I don’t follow the analysis in your third option.

    "The ECB buys up the sovereign debt, or lends to banks on sovereign 'collateral,' effectively doing the same. By turning trillions of debt in to money, we get inflation.”

    ECB base money is jointly and severally guaranteed eurozone public debt. Swapping base money for national sovereign debt does not change the amount of consolidated eurozone public sector debt. Monetization by itself, therefore, does not lift the price level.

    Do you assume that monetization implies to more rapid growth in eurozone public sector debt? It’s in order to prohibit this that the Germans insist on an explicit fiscal union as a precondition for further ECB interventions in sovereign debt markets.

    Do you think that the current level of eurozone public debt already is too large relative to what one can expect of future real primary public surpluses, so that the eurozone is set for fiscal inflation, and that monetization will speed up the price level shift by cutting the duration of the public debt?

    1. Good point. "ECB base money is jointly and severally guaranteed eurozone public debt." That should be carved in stone on the front of the ECB. The eurobonds have been issued. They're called euros.

      So, the ECB prints up a trillion euros and buys sovereign debt. Then the sovereign debt defaults. In principle, you are right: At this point, the ECB calls up the member states and says "we need a trillion euros more capital. Pony up." At that point, Germany is supposed to pay the bill and validate the bailout. But that is a straight fiscal transfer. They have to get the euros from tax revenues. Or the euros stay outstanding and lead to inflation. I was implicitly ruling out the former and implying the latter, but the former is possible, as you say.

  4. I was just at a conference listening to a paper on how France caused the Great Depression by soaking up so much of the world's gold supply, thus causing a worldwide monetary contraction.

    Could something similar happen in Europe? If all those Euros are leaving Greece, they're going somewhere else, increasing the money supply elsewhere. Of course, Greece is small and the ECB can reduce the monetary base to compensate, but I wonder if anybody is thinking about that.

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

    If there weren't exchange controls, would there be a problem? I would wake up with 10,000 drachmas, and I'd predict there would be drachma inflation, but the interest rate on drachma deposits would equilibrate at 50% or so and I'd be content. (Except, I guess, that drachmas would be a risky asset because of uncertain inflation--- but the interest rate would include a risk premium for that.)

  6. "If the ECB doesn't stop this massive lending, it understands well that it will essentially end up monetizing all the debt of the southern tier, and a huge inflation will eventually break out."

    So the ECB lends money to the banks to cover deposits and delivers bales of currency to the banks who pay it to depositors (with the result that the bank note is basically a zero interest loan back to the ECB) and the depositor takes the note and buries it in the back yard or stuffs it in a mattress - it is hard to see how that is going to fuel inflation.

    1. I don't really understand why the depositor wants to hold onto a currency that she expects to be devalued. If the Greek government declares Greek Euros as Drachmas and then devalues the depositor should not want to put it under her pillow.

      The way I imagine it would work is similar to "price gouging" during a hurricane. People start bidding up the price of "essentials". Though it is hard to imagine what an essential would be in the face of an economic disaster, black market foreign currency might be one example. I think it easily demonstrates how an inflationary mechanism could occur.

      As long as there are fears of inflation, inflation can easily my story anyway.

    2. So long as the depositor wants to keep bales of currency in his back yard, everything is in fact ok.

      But sooner or later people get tired of keeping bales of non-interest bearing currency in their back yards. Then, the ECB either has to buy back the money or the money chases goods and causes inflation. For the ECB to buy back the money it must have an asset people want instead -- no defaulted Greek bonds please. If its coffers are bare, basically the money has to get soaked up by more taxes or less spending, government surpluses somewhere in the eurozone. We're back to "let's run for the exit and stick Germany with the bill"

      In technical parlance, Europe does have a plausibly much higher money demand right now, as money demand in the US shot up during the financial crisis. But that will subside eventually. This is the year or so opportunity I mentioned for shock liberalization to work, between ECB bailing out the banks with freshly printed euros and those euros causing inflation.

    3. "For the ECB to buy back the money it must have an asset people want instead"

      If we are talking about enough cash to move the economy then it seems likely that the money will either: (1) go into real estate which might provide some relief to the bannks or (2) go into a bank account which the bank could then use to pay off the special loans they received from the ECB to cover the bank run and the bales of cash (musty and possibly dirty) go back to the ECB and are cancelled.

  7. Are Euro inflation expectations going up? Lars Christensen showed them dropping sharply in 2011. Does anyone know what those spreads are indicating now?
    Greece will probably be screwed no matter what, but Argentina was able to able to make a recovery after defaulting & devaluating. Iceland's recovery has relied a lot on devaluation. Sweden devaluated as well, though it didn't have the massive banking problems that Iceland did. Australia has maintained something like 4% inflation every year and avoided recession for decades. Canada was able to achieve "austerity" (cut government spending even in nominal terms, maintain growth) by devaluing the "loonie" during the 90s. Yglesias describes devaluation as "austerity done right". Alesina has been one of the big boosters of expansionary austerity, and I think that most of his examples of recovery were accompanied by inflationary monetary policy (leading Krugman to respond that they don't count and their lessons can't be applied). Maybe it is a "stealth" way of default, but it seems like some sort of default is inevitable.
    Does rapid growth often come from a short period of "shock" reforms? I thought that good "structural" growth tended to come from a long period of developing good policy and establishing the credibility of a responsible political system. I suppose the "German miracle" post-WW2 is the main example, not sure what happened with inflation at that time but they did replace the Reichsmark with the Deutsche Mark.

    1. Michael Darda (hat-tip to David Beckworth) says the German five-year breakeven inflation spread has bounced from its 2012 low, but eyeballing the chart it's still well below where it was even in the middle of May.
      He also says that markets have reacted positively when the ECB took accommodative steps and negatively when they backed off or reversed, but the only charts I see in support just indicate what happened when the ECB hiked rates in 2011.

  8. Can the Greek government reintroduce the drachma without seizing anyone's euros? I'm thinking that they could change over to paying pensions and government wages in drachma at 1:1, but banks keep separate accounts for euros and drachma and are not expected to honour 1:1.

    With a lot of customers whose only income is in drachma, local businesses will likely accept drachma, at say three drachma to the euro. Greeks with euros in their bank accounts and local purchases to make will get used to selling a euro for four drachma, instead of flaunting it in the local shops to get three euros of goods and services. So those with drachma income will have access (on unfavourable terms) to euros.

    1. Is that really that much economically easier or politically palatable than just cutting payments by 1/3?

      More generally, people who want devaluation: it would be almost as easy to say all prices and wages are cut in half tomorrow morning, as it is to say all euro contracts are now paid in drachma tomorrow morning.

  9. "The central ingredient is: sovereigns who can't pay their bills default."

    Right. So we need to have countries like Spain, which held a debt-to-GDP ratio of around 30 percent prior to the crisis, default. Makes sense, in some perverse and twisted world in which bankers inflate gigantic asset bubbles, get bailed out by the state, and then the state defaults because it's deemed "fiscally reckless."

  10. John, shock liberalization won't work. There definitely need to be structural reforms in Italy, Spain and Greece. But the reality is, these things take a long time. It's like saying "Russia should stop being a corrupt petrodollar state and it will grow faster". Yes it should and yes it will. But how can that just automagically happen? it cannot. In the mean time, the only answer is 3 to 4% inflation which is not super devastating as far as inflation goes, but at least will make the debt payments manageable

    1. What really matters is a clear commitment to liberalization. Persuade the bond market it will really happen, that you will have a free and hence growing economy sometime in the future. The crisis would instantly be over.

    2. I agree, but how realistic is this? They can announce any change of policy and reverse it in the next elections. I just don't see the bond market being fooled by that. Who is going to buy Italian bonds? Other than German and French banks?

  11. Greek economist Yanis Varoufakis came up with a strategy in dealing with the E.U "troika" for the radical left party Syriza which is angling to form a government in the new election. He explains it on I can't say it inspires much confidence, but like I said it seems Greece is doomed no matter what.


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