So, what to believe?

I don’t know, but it is interesting that Reuters are now reporting France and Germany to be in an agreement on a fast track move towards fiscal union as well as allowing the ECB to aid sovereigns more forcefully (i.e. unsterilised intervention).

I want to see this before I believe it. Germany is certainly sending conflicting signals. Yet, this may be because they are truly unsure how long they can play this game of chicken with the rest of Europe. Clearly, Merkel has a point in refusing to issue euro bonds and/or letting the ECB step in since the periphery needs to put their house in order or at least show a credible plan to balance the budget. This is essentially quid pro quo as Merkel knows that Germany needs to pay in the end.

But there is a rub. One issue is surely the fact that public finances across the eurozone are unsustainable but another is how these economies are going to achieve anything near the growth needed not to collapse (default) anyway.

We keep on coming back to two main points.

1) It was clear for all that pain was coming in the periphery already in 07/08 and that this would be a substantial period of negative growth/deleveraging consolidation.

2) But the question was always whether such pain could be administered from within the euro zone. We are steadily coming to the conclusion that this is not possible and Germany knows this. But the solution is not clear since jettisoning the euro would have grave implications for the EU too and therefore there is a very strong lock-in mechanism here which it is difficult to get out of.

Finally, there is always the risk that one or many of the Southern European economies will simply “get” enough and make some quick and devastating decisions. It is important to understand my point on this.

I am sure it would be catastrophic for Greece or another country to leave by their own accord and do a messy default, but at some point the rest of Europe and the market will simply corner whatever government that might be in place and they will start taking their own independent decisions.

I note that there are calls for the new government in Spain to play “hardball” with Germany. In this situation, Germany has a distinct interest in just letting the market squeeze the periphery, but of course the rest of the “core” is getting dragged down too and the whole banking system is now at risk of a major liquidity/solvency crisis. In this sense, I only agree conditionally with Felix Salmon:

El-Erian is very good at explaining the problem which needs solving:

“Europe must still stabilize its sovereign debt situation. But this is now far from sufficient. Policymakers must also move quickly to contain banking sector frailties, and do so using a more coherent approach to the trio of capital, asset quality and liquidity.”

It seems to me, though, that sequencing matters here. Liquidity is — always — more important than capital/solvency. Give an insolvent bank enough liquidity, and it can live indefinitely. Remove liquidity from a bank, and it dies immediately, no matter how solvent it might be or how high its capital ratios are. And as for asset quality, we’re pretty much talking a zero-sum game here: when the banks’ dubious assets are the sovereign’s liabilities, the real solution is inflation, not nationalization.

I agree that liquidity is a key issue at the moment in the euro zone banking system, but let us not kid ourselves. Europe has not had a functioning interbank market since 2008 and we are just now seeing the accumulated effect of this.

I just read a big and very detailed BC report on deleveraging among EZ banks and I am extremely concerned. It is clear to me that not only sovereigns are battling with solvency issues but so are many banks and the extent to which they are fighting it means that they will have to cut lending and asset growth substantially. As such, I am afraid that the problems in the euro zone are beginning to resemble a widespread solvency problem both amongst banks and sovereigns, a combination which, to boot, will feed off each other. Especially Eastern Europe are going to have big problems in 2012. They are going to see an almost complete stop of credit flows through the banking system due to parents cutting cross border lending.

I think  that we will see a wholesale and government driven process of bank nationalisations and restructuring in the next 6 months in the euro zone. I also think that most southern european economies are ultimately facing both public and private insolvency issues which will need balance sheet write-offs to get solved. It seems to me that, as so many times before, euro zone politicians are once again getting caught out by reality.

There are four perspectives on this question which are worth noting:

1. There is an obvious gap between the power structure at the IMF, which reflects the way the structure of the world economy after the Second World War, as compared with the present reality. As an example, at present, the Netherlands has 2.08% while India has 2.35%. But the Indian GDP is now $1.6 trillion while Netherlands is at half that.
2. The world would benefit from a competent and capable IMF. The best man (or woman) for the job will not be obtained by having any restrictions on nationality. As an example, in today’s world, a name that leaps out to me is Stan Fischer. But he’s not European, and hence was never even considered for the top job in the last decade. (As with Montek, he is now over age 65 and is hence not eligible for the job today). Given that a large fraction of the top economists of the world are not European, this rule yields a less capable IMF.
3. I feel that a quota system where the IMF MD must now be from an emerging market is as bad as a quota system where the IMF MD is only recruited from a European country. The key is to get away from all these quota systems, to only recruit the best person for the job. The emphasis should be on technical capability. The person recruited should be a technical expert and not a politican. As an example, see how in the UK, they recruited an American into their Monetary Policy Committee.
4. In the standard narrative, one hears the idea that in this crisis in Europe, the Europeans are gaining from their
   control of the IMF. I feel this is absolutely wrong. In the Asian crisis, it was good for Asia that the IMF was not conflicted
   by considerations of domestic Asian politics. Similarly, the IMF program in India in 1981 and 1991 was uncontaminated by domestic Indian political considerations. This helped produce a technically sound program, which helped jumpstart India’s growth. It is not accidental that we see structural breaks in India’s GDP growth around these two dates.

What Europe needs most is a tough IMF, which will be a stern taskmaster, which will force difficult political choices so as to heal the economy. Economic policy in Europe today needs to be cruel to be kind. Instead, by placing a string of career politicians from France into the IMF MD’s job, the valuable role which the IMF could have played in solving the European Crisis is being negated. This damages Europe. The wise thing for Europe today is to say: Give us a tough and competent taskmaster, and let him be
anything in the world but let him not be a European politican. The biggest loser from the present arrangement is Europe.

Ila Patnaik and I wrote a paper titled Did the Indian capital controls work as a tool of macroeconomic policy?

This is interesting, in part, in the discussion on Indian economic policy. But this has also become surprisingly interesting on an international scale.

Many years ago, policy makers and academics had figured out capital controls. Capital account liberalisation was an integral part of the package of policies that made up a modern nation. Plugging into globalisation meant shedding autarkic policy, and being open to ideas, trade, services, capital, etc. All good countries had an open capital account. One by one, emerging markets started figuring out how to remove capital controls. This led to many blow ups along the way, where countries tried to violate the `impossible trinity’. So the path has been a turbulent one, but the destination is clear. Once capital account openness came in, it was no longer possible to control the exchange rate except for extremely hard pegs such as Hong Kong and the Eurozone.

Policy makers and academics did not come to this conclusion from deductive reasoning. They came to this conclusion by getting bloodied over and over. The capital controls that were attempted did not deliver the required results, and the capital controls that could deliver the required results imposed too high a cost on GDP growth. The lack of usefulness of capital controls became the working consensus of practical people.

In recent years, these questions have been reopened, most notably by the IMF. These questions are, hence, back in the global economic discussion.

Among the G-20 countries, only India and China have a large system of capital controls. In most other places, practical experience with capital controls is actually hard to find. The generation which fought those issues has faded away. It is, hence, particularly interesting to study the experience of India and China with capital controls. This makes our paper a useful component of this global debate.

And, on these issues, also see The IMF needs to find its voice again, by Sebastian Mallaby in the Financial Times. The Frank Warnock paper that he talks about is also worth reading.

In truth however, I felt a good measure of sympathy for Ireland today as I read the Bloomberg report about how the country is now essentially on its way to accepting a deal that will have aid delivered from the EU, the IMF and, most painfully, from England.

Irish rebels fought for independence during World War I, boasting they served “neither King nor Kaiser.” Ireland may now have to do exactly that to qualify for a bailout partly funded by both Britain and Germany.  Prime Minister Brian Cowen is edging toward accepting a rescue package that may threaten the country’s low-tax policies and put voters on the hook to repay loans the central bank says may be worth “tens of billions” of euros. For critics of Cowen’s Fianna Fail party, which governed Ireland through its decade-long boom, national pride is at stake.  Cowen has “squandered” independence for a “German bailout with a few shillings of sympathy from the British chancellor,” the Irish Times newspaper said yesterday. The government should be “ashamed that Fianna Fail should be the ones to surrender sovereignty,” said Michael Noonan, finance spokesman for Fine Gael, the largest opposition party.

However, Ireland largely made the mistakes itself of which the biggest no doubt was to guarantee its banking system and essentially gamble that a) the economy could swallow the liabilities of its broken banks (which with a deficit of 32% of GDP in 2010 it obviously can’t) and b) that help could be reached elsewhere.

Iza’s report yesterday over at FT Alphaville about just how much European governments have promised during the past 2 years makes an extraordinarily important point and it well worth reading in its entirety;

As all eyes focus on what should be done about the Irish banking crisis, perhaps it’s time for the European Union, IMF and other related parties to take a closer look at some of the factors that may have exacerbated the problem.  After all, it’s now becoming abundantly clear that the dishing out of an elaborate 100 per cent deposit guarantee back in September 2008 was largely nothing more than a massive bluff designed to steal attract deposit flows from neighbouring states to for the purpose of propping up Irish banks.  Furthermore, as we’ve mentioned already, the EFSF is already turning out to resemble something like Paulson’s bazooka in its own right too.  Which means  — with everything becoming a high-stakes game of ‘Call my bluff‘ — it could be time to restrict the ability of sovereigns  generally to randomly guarantee things they clearly can’t afford to guarantee in the first place. (If confidence in the Eurozone is to be restored properly that is.)  After all, let’s just look at the dynamics of the Irish deposit guarantee itself.

So, this is about a deposit guarantees which if course is one of those guarantees a government never really can make due on in the case of the ultimate rout à l’End of Days. Yet, the point has general validity far beyond the issue of deposit guarantees. Basically, Ireland promised to make due for its banks … now that it appear that she can’t, it is up to the rest of the Eurozone to pay.

No doubt this view is shared in principle as well as sentiment by the prowling Proell from Austria who recently fired two stray missiles into the raging debate on how best to deal with the issue of solidarity in the Eurozone. Earlier in the week, he raised serious questions about whether Austria would make due on its promist to spit into the common funding scheme for Greece now that it was obvious that the country was missing its budget target yet again and most recently, he said to Bloomberg reporters that he was very interested in talking with Ireland about its famously low corporate tax rate in connection with the bailout.

You know, quid pro quo and all that.

Now, before we get into the blame game I should note that I agree with the Economist in their most recent take on the Eurozone mess in which they implicitly highlight that while timing is always difficult in politics there is still a continuum between good and bad and Merkel’s sudden urge to remind bondholders that they too might take a loss falls in the latter category.

At an EU summit at the end of October the German chancellor won agreement that any future euro-zone rescue scheme should include a mechanism for an orderly sovereign-debt default. The principle was absolutely right: unless default is a possibility, bond investors have no reason to distinguish between good and bad credits. But the idea of making bondholders lose money when sovereign credits turn sour was aired without any guidance about how and when it might apply. Astonishingly, the Germans failed to put together a detailed proposal for the summit.

I should make it clear that I fully back to idea of bondholders taking their share of the loss since if this is not a real possibility there is no way in which to secure an orderly default which is inevitably coming sooner rather than later to some of the most vulnerable Eurozone economies. Especially, and going back to Izabella’s point above the practical distinction between using bailout funds for governents and not banks is a mirage exactly because promises have been made and anectodal contracts have been signed with the electorate and, one is tempted to note, the devil herself. As I have said before, you may not like it and I agree with Izabella that the EU and IMF would be wise to monitor just what promises that are made in the future.

And speaking of promises; if Ireland seems to be mellow enough to be put into the bailout fold, there is another small country left in the waiting room in the form of Portugal. Again I think that the Economist has the right answer;

If only both sides gave up posturing, they would agree that the European rescue funds should be used to stabilise Ireland’s banks, insisting only on certain budget targets in return. Such a deal should satisfy Ireland’s euro-zone partners, which want an end to the uncertainty, and the European Central Bank (ECB), on which Ireland’s banks have become overly reliant for funding. It would also be wise to offer a similar deal to Portugal. Its banks are dependent on ECB support, and it too is in the bond markets’ sights.

I am not exactly tuned up on the actual difference between just pouring money into the banks or giving it to the sovereign which then uses the funds to make due on a foolhardy promise to secure the entire domestic banking sector’s liabilities. But really, the distinction should be next to none I think. And if you think that all this about Portugal is just me trying to kick up a bad mood, Bloomberg pulled one better on me with this elegant report about how investors are turning their attention away from Ireland and over to … well, you guessed it I think;

The markets indicate that country is Portugal with 10-year bond yields of 6.88 percent, compared with 8.26 percent in Ireland and 11.62 percent in Greece, which received rescue funds in May from the European Union and International Monetary Fund. Portuguese Finance Minister Fernando Teixeira dos Santos said Nov. 15 that while “there is a risk of contagion,” that doesn’t mean the country will seek financial aid.  “Portugal isn’t in the situation that it is now because of Ireland,” said Steven Mansell, director of interest-rate strategy at Citigroup Global Markets Ltd. in London. “If Ireland reaches an agreement to tap the European Financial Stability Facility or some other mechanism to support its banking sector, I don’t think that will alleviate the pressure on Portugal.”

So, it seems as if the next stop might very well be far western rim of the Eurozone and its beautiful Algarve coastline.

(quote Bloomberg)

Ireland expects its 20 billion-euro ($28 billion) cash pile to stave off a Greek-style rescue, as the government taps the funds to avoid paying record rates to borrow. The government canceled next week’s debt auction and another scheduled for November after the yield on 10-year Irish bonds rose to a record 454 basis points above benchmark German bunds. Finance Minister Brian Lenihan has said Ireland is “fully funded” through the middle of 2011. The country has 4.4 billion euros of bonds maturing next year, compared with about 27 billion euros in Greece.

I find this fascinating for a number of reasons. First of all there is root of the problem itself in the form of Anglo Irish Bank which will cost Ireland perhaps up to 30 billion Euros and will be responsible for a fiscal deficit in 2010 to the tune of of an unbelievable 32% of GDP. Naturally, this is expected to be a one-off expense and the whole exercise on cancelling auctions is because Ireland feels that the yields it would be able to borrow for at the moment would not reflect the long term health of the economy.

This makes sense. Why borrow if you don’t have to and especially if you are not happy with the terms put forward by your potential creditor. On this point I am, in principle, on Ireland’s side as it were. But what if costs for bailing out Irish banks are understated? Indeed, what is the real cost of assuming the entire bad loan book of Irish banks with no haircuts to bondholders or no restructuring of any kind? I don’t know, but more importantly; I am not sure the people concerned in Ireland know either. After all, the fact we are now looking at a +30% deficit as % of GDP in 2010 was not part of any of the official rescue manuals I think.

Consequently, let me throw another number at you; 3 % of GDP which is the fiscal deficit targeted for 2014 and which the market is supposed to take as collateral for a lower yield on Irish debt offerings in 2011.

Yet, is this plausible?

Basically, you have a confirmed 32%/GDP deficit today and you are promising to bring this down to 3% in a manner of 3 years. What are your assumptions here? What kind of nominal growth in GDP is build into the model? How will national debt evolve over this period? I am sure the good people at the National Treasury Management Agency are busy calculating just that as I type, but the problem is more profound.

Ireland has basically made the bet that in using its remaining reserves today and thus avoiding going to the market it can bring back its house in order and then return to borrow at that time, but this is circular thinking. The main question is whether Ireland has enough money to bail out its banking system such as it is. Alan McQuaid, quoted by Bloomberg, puts it well;

“They are taking a gamble that the budget will deliver and get spreads down,” said Alan McQuaid, chief economist at Bloxham Stockbrokers in Dublin. “If that doesn’t happen, maybe you skip a few auctions at the beginning of the year. But at some point, you have to go to the market. If you can’t go to the market, then you have to look at outside aid.”

And Danske is even more sanguine, but then again they would be wouldn’t they as they own National Irish Bank and thus effectively depend on this gamble to succeed (at least in terms of the health of their Irish operations).

“The government has a significant problem” unless yields fall, said Soerensen of Danske Bank, which owns Dublin-based National Irish Bank. “But it isn’t under any immediate pressure to raise cash, and even in the unlikely event that the government had to call upon IMF/EU aid, investors would still get paid. There isn’t going to be a default.”

But I think that we are still missing the main point here. This is not only a question of how dubious it is that Ireland can get its house back in order (and what kind of economic pain it will take) it is also a matter of whether it is in Ireland’s interest to enter the market at all. Essentially, the current interest rates are unpayable for Ireland today but also in the middle of 2011 since this is where, presumably, the full force of fiscal contraction will be put on the Irish economy.

So, my reading of this is that Ireland has now played itself into whatever deal it can broker with the IMF and EU and while I may be persuaded otherwise by a credible fiscal plan it is not the actual promise I will be looking at but the assumptions of debt/gdp and nominal GDP growth which underlies it.

Until then, Ireland can continue to heed the old proverb that cash is king; it sure is … until you run out.