Shilling on the outlook for the euro, treasuries

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Gary Shilling, president of A. Gary Shilling & Co., talks about Europe’s sovereign debt crisis and the prospects for the euro and U.S. Treasury market.

Source: Bloomberg (via YouTube.com), July19, 2010.

Considering the technical picture of the euro, Adam Hewison (INO.com) provides a short video analysis, arguing that the euro is on shaky ground. Click here to access the presentation.

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Euro wreckage reloaded

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This post is a guest contribution by Joachim Fels* of Morgan Stanley.

A pyrrhic victory… The joint euro area/IMF financial backstop package and the ECB’s recent climb-down on its collateral rules have clearly reduced the short-term liquidity risks for Greece. However, as our European economists have emphasised, long-term solvency risks remain firmly in place. More broadly, and more worryingly, recent developments significantly raise the (long-term) risk of a euro break-up, in our view.

… which gives rise to moral hazard: The bail-out and the ECB’s softer collateral stance set a bad precedent for other euro area member states and make it more likely that the euro area degenerates into a zone of fiscal profligacy, currency weakness and higher inflationary pressures over time.  If so, countries with a high preference for price stability, such as Germany, might conclude that they would be better off with a harder but smaller currency union. And because the Maastricht Treaty does not provide for the possibility of expelling euro area members, the only way how Germany could achieve this would be by leaving the euro to introduce a stronger currency.

Seceding to revalue is easier: It has been our long-standing view that such a break-up scenario – where a country or a group of countries want to leave to introduce a stronger currency – is more likely than a scenario where a country wants to leave to devalue. The reason is that the costs of leaving to devalue are extremely high.

• First, borrowing costs for the seceding country would likely rise significantly as investors will demand a currency and inflation risk premium.

• Second, while contracts between parties in the seceding country could by law simply be redenominated in the new currency, redenomination would not easily apply to cross-border contracts. Foreign creditors would still demand to be repaid in euros (‘continuity of contract’). Thus, a country that secedes and devalues would still have to honour its foreign-held debt in euros and would thus face a rising debt burden.  If it decided to default instead, it would, at least for some time, be totally shut off from foreign financing.

• Third, a country that decided to leave the euro to devalue would immediately face a bank run by domestic depositors who would want to shift their funds into banks in other euro area member countries. This would provoke a financial meltdown which could only be prevented by a freezing of bank deposits and the imposition of strict capital controls.

By contrast, none of these costs would apply for a country that wanted to secede in order to revalue. Its borrowing costs would likely fall rather than rise as it would attract an inflow of funds.

How it all started… None of these deliberations are new. In fact, we first started to worry about a potential euro break-up along these lines in 2003-04 in a series of notes (see, for example, Euro Wreckage? January 22, 2004, and Debating ‘Euro Wreckage’, February 9, 2004, with a reply by Noble laureate Robert Mundell).  Back then, it had become increasingly clear that the move towards political union in Europe had stalled, partly because the EU has simply become too large and diverse a club due to successive enlargements.  Moreover, the old Stability and Growth Pact (SGP), which was meant to ensure fiscal discipline within the euro, was effectively buried in late 2003 when both Germany and France kept violating the 3% budget deficit limit. It was later ‘reformed’ into a toothless tiger that allowed for much more fiscal flexibility.  Thus, we worried about an increasing divergence of fiscal policies with widening bond yield spreads and increasing political pressures for an easier monetary policy stance, which could make the monetary union unpalatable for countries like Germany.

…and why it has become more likely now: Obviously, we have not reached the end-game yet.  However, with the recent developments, such a break-up scenario has clearly become more likely, for two reasons.  First, the lesson for other euro area members from the Greek bail-out package is that no matter how badly you violate the SGP guidelines, financial help will be forthcoming, if push comes to shove. This introduces a serious moral hazard problem into the European equation.  Fiscal slippage in other countries has now become more rather than less likely.

Second, the ECB’s climb-down on its collateral rules regarding lower-rated bonds, which ensures that Greek government bonds will still be eligible as collateral in ECB tenders beyond 2010, adds to this moral hazard problem and confirms that the ECB is not immune to political considerations and pressures.

Don’t get us wrong: It is quite obvious that if Greece had not received a financial backstop package and if the ECB had stuck to its previous pronouncements on the collateral rules, the consequences not only for Greece but the whole euro area financial system and the economy could have been dire.  However, the unintended consequence of such action is that it sows the seeds for potentially even bigger problems further down the road.

What are the signposts that would indicate our break-up scenario is in fact unfolding?

• First, watch fiscal developments in other euro area countries closely: Our suspicion is that the aid package for Greece lessens other governments’ resolve to tighten fiscal policy, especially in an environment of ongoing economic stagnation or recession.

• Second, watch ECB policy closely: If the ECB turns out to be slow in raising interest rates once inflation pressures return, this would be a sign of a politicisation of monetary policy.

• Third, watch the political debate in Germany: Support for Greece has been extremely unpopular and fears that the euro will turn into a soft currency abound.  If the aid package for Greece, which so far is a backstop credit line, becomes activated, eurosceptic forces would receive a significant further boost. And, needless to say, if other countries also needed financial support, this would further strengthen euro opposition.

Bottom line: To be clear, we neither advocate a euro break-up, nor is this our main scenario. However, the risk that it happens is far from negligible and the consequences for financial markets would be very severe. Hence, investors ignore the euro break-up risk at their own peril.

Source: Joachim Fels, Morgan Stanley Global Views, April 16, 2010.

* Joachim Fels co-heads Morgan Stanley’s Global Economics Team (with Dick Berner) and is the Firm’s Chief Global Fixed Income Economist, based in London. His research focuses on monetary policy, the global liquidity cycle, and inflation.

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I’m still confused about this whole Eurozone thing …

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This post is a guest contribution by Rebecca Wilder*, author of the of the News N Economics blog.

This is a post about my confusion, rather than my reporting, of the Eurozone saga. Here are some pieces worth reading if you want to catch up:

The NY Times (the basics): Ed Harrison (via Naked Capitalism); From the billy blog; The Financial Times (Martin Wolf, a must read); The Economist (will reference below).

Okay, a conditional guarantee for possible lending, maybe, only with consultation from the IMF has been agreed upon by the Eurozone countries (Germany and France, really). But what I don’t understand is pretty well stated in the Economist article:

The Greek government has somehow to keep its economy on an even keel while pushing through a huge fiscal tightening. Countries that seek IMF help generally have to endure brutal cuts in public spending, which deepen recessions. To counter that effect, the IMF typically counsels a weaker currency. Sadly, this is not an option for Greece. Stuck in the euro, its exchange rate with its main trading partners is fixed. Greece cannot devalue, so it needs more time to adjust than the three years it has agreed with its EU partners—and a bigger safety net while it does.

Sadly? This is not an option? The Economist completely skips over the VERY LARGE issue of a currency peg in order to focus on the increased competitiveness that must be derived through internal devaluation, i.e., dropping wages and other nominal variables.

Financial crises, especially those in small-open economies (Sweden, for example), generally end with a massive currency devaluation that drives export growth (provided there is external demand to suffice). I honestly don’t see how a sufficient export-generated rebound is even a possibility, given that the rest of the Eurozone is essentially trying the “internal devaluation” bit simultaneously (chart above).

And who’s going to pick up the slack? In 2008, 64% of Greece’s export income was derived by the EU 27 countries, 70% for Spain, and 74% for Portugal. If the Eurozone as a whole is using this same internal deflation mechanism to spur export growth, only the “zone” as a whole really benefits, not any one country.

Without a massive surge in export-driven GDP growth no “zone” country can drop its financial deficit without incurring behemoth debt burden growth (in the case of the Eurozone, the term “burden” actually applies since Greece, nor any one economy, can print its own money).

Look at the government’s period budget constraint (left), where the lower-case letters “d” and “p” stand for the debt and primary deficit as a share of GDP, respectively. r is the nominal interest rate, and (1+g) is the rate of NOMINAL GDP growth (including price appreciation).

When Greece starts dropping p (the primary deficit), the fundamentals of the economy (i.e., nominal gdp growth (1+g)) must be robust enough to prevent a surging debt burden. And here’s the cycle: to drop the primary deficit, it does so by reducing G and raising T, which drags Y (as of Y = C + I + G + Ex – Im) and growth of Y, (1+g), since export growth is unlikely to be there to offset the decline in private spending; these effects then flow back to the primary deficit to raise p.

And likewise, only under the circumstances of heroic export growth can the government reduce its fiscal deficit to 3% WITHOUT the private sector levering up their balance sheets and contributing to a larger default risk (of the depressionary type). I’m confused.

All I’m saying is that this plan, in its current form, is really not much of a plan at all. The export competitiveness story is getting old, let’s think of something new.

Source: Rebecca Wilder, News N Economics, March 11, 2010.

* Rebecca Wilder is an economist in the financial industry. She was previously an assistant professor and holds a doctorate in economics.

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