The Velocity Of Modern Financial Crises

Jean-Claude Trichet, European Central Bank president, noted when speaking in Cambridge last Thurdsay that the speed at which financial disruption can spread had “accelerated tremendously over the past few decades”. While debt crises in the 1980s occurred over years, the effects of the Lehman collapse “spread around the world in the course of half-days”.

As Ralph Atkins pointed out, the Greek government is but the latest to learn that in the modern world you can be catapulted from relative obscurity to global prominence in a matter of hours. Everyone can be famous for five minutes, as Andy Warhol said, but this kind of fame most of us could well live without.

Faced with the assessment by Ratings Agency Standard and Poor's that Spain's economic and financial situation was deteriorating, the Spanish Prime Minister Jose Luis Rodriguez Zapatero simply limited himself to an outright rejection of such negative economic forecasts, declaring the naysayers to be wrong in the light of the -to him - self-evident fact that Spain was just about, at this very moment, to emerge from the recession which has now bedevilled it for so many months. Indeed he even went as far as to say they were wrong, since he he could find no reason why Standard & Poor's should downgrade Spain's long-term sovereign debt rating, "From our perspective there are no reasons for it, firstly because of the strength of the country (and) because the public accounts are solvent," he told the Onda Cero radio station. Standard and Poor's in fact argued that "The downgrade ... reflects our expectations that public finances will suffer in tandem with the expected decline in Spain's growth prospects", a viewpoint with which few external observers would disagree.

Indeed, Spain's representative on the ECB governing council Jose Manuel Gonzalez-Paramo told the Spanish press agency EFE, in an interview widely quoted in Spanish media, that he, himself, found the S&P opinion hard to disagree with: "The ECB is not taking issue with whether Standard & Poor's should cut Spain's rating, but the report that accompanies this warning is hard to deny....I'm convinced that Spanish authorities share this analysis and will do whatever is needed to avoid S&P's negative outlook resulting in a change in rating," he said.

Had Mr Zapatero found it within his repertoire to be able to express similar sentiments I am sure he would have done more to convince the world at large that he is aware of the problem, and is willing to take the necessary action. As it is, he simply leaves the impression that what just happened in Greece will eventually and inevitably happen in Spain, with all the suddenness and lightning-strike velocity M Trichet was warning about. What we seem to be facing is what Gabriel Garcia Marquez once called the Chronicle of a Death Foretold.

So what do the rest of us do, simply sit back and watch that "accident waiting to happen" actually happen? Angela Merkel may have other thoughts, since speaking in Bonn last Thursday she indicated that she, at least, was of the opinion pressure could be brought to bear on the national parliaments of countries with looming budgetary difficulties.

"If, for example, there are problems with the Stability and Growth Pact in one country and it can only be solved by having social reforms carried out in this country, then of course the question arises, what influence does Europe have on national parliaments to see to it that Europe is not stopped.....This is going to be a very difficult task because of course national parliaments certainly don't wish to be told what to do. We must be aware of such problems in the next few years."

Well, if such pressure can be brought it most certainly now should be. And not over the next few years, but rather, if M Trichet is to be believed, during the coming weeks and months. Lightning may well not strike twice in the same place, but it most certainly can strike twice.

A New Version of the Weak Euro Meme

Well, having been so lavishing in my praise of Ralph Atkins in recent posts, perhaps it is time for the administration of a gentle "rapapolvo" (otherwise, you know Ralph, people might start to talk), and just to hand he offers me the ideal opportunity to "discrepar". A little instability is, it appears, a dangerous thing, but not, it seems entirely and unequivocally dangerous:

True, Greece’s plight has weakened the euro, which has ended this week back down at levels last seen in early November. A weaker euro, however, will help boost eurozone growth - and thus come as a relief to eurozone policymakers. A little instability is not necessarily all bad.

Now, with all the other pressing topics I currently have on my plate I would normally have quietly passed this one by, had it not been for the fact that earlier in the week, over at the Economist, they came up with a similar "saving grace" for a partial Greek default.

How badly the euro’s standing would be hurt by a default would depend on the state of public finances elsewhere: if America were struggling too, the dollar might not seem an attractive bolthole. If the current struggles with a strong euro are any guide, euro members might even half welcome a tarnished currency.

I can think of a thousand and one different ways in which the euro might lose some of its current strong value, I can even imagine a goodly number of those which might be decidedly positive, but what I can't for the life of me accept is that one of them would be the sort of economic, financial and political chaos which we may now be about to see in Greece.

That Which The ECB Hath Separated, Let No Man Join Together Again!

In a recent post on the FT Money Supply Blog the ever perceptive Frank Atkins made the following, very interesting, observation which, I think, goes a long way towards helping us all understand what exactly the thinking is which lies behind the ECB's current strategy for its handling of the Eurozone economy.

One of the subtleties of yesterday’s complex package from the European Central Bank was that it attempted to re-assert the principle of “separation”. When the financial storm broke in August 2007, the ECB insisted, doggedly, that emergency financial market liquidity injections were not related to its monetary policy. That remained firmly aimed at controlling inflation and still very much determined the level at which it set the main policy interest rate. Indeed, in July last year the ECB famously raised the interest rate to 4.25 per cent because inflation appeared to be getting out of control.

The separation that is being talked about here is not then a matrimonial one, nor is it a Montesquieu type notion of a necessary and sufficient separation of powers between Brussels and Frankfurt, rather what is involved is a separation, which is customarily made by the ECB, between monetary policy and liquidity provision. Now all of this may seem rather obscure, and it is, but it is also, I will argue here, rather central to understanding what the ECB is up to, or trying hard to be up to, at the present moment in time, and why what it seems to be giving with one hand it also seems to be taking away with the other.

For over a month now the ECB has been busily trying to lay down, before an ever observant corps of financial journalists, the main lines of its exit strategy from the emergency liquidity provisions introduced in the midst of the financial crisis. The first significant decision was the raising of the collateral standards for asset backed securities - from March 1 2010 the bank “will require at least two ratings from an accepted external credit assessment institution for all” asset- backed securities submitted as collateral, according to the press release of 20 November.

It is important to note that, at this point in time, the ruling only applies to asset backed securities, and the ECB has yet to formally confirm that the temporary relaxation of the collateral criteria as applied to government bonds for the duration of the financial crisis will be withdrawn as planned at the end of 2010. This, of course, has become far more than an academic question following this weeks decision by Fitch Ratings to cut the ranking of Greek sovereign debt to BBB+. What this means, effectively, is that should the two other major ratings follow suit (a not improbable scenario) then the ECB will no longer be able to accept Greek bonds as collateral, since while the ECB is currently accepting bonds with a minimum BBB- rating, this gesture is surely going to be phased out as the enhanced liquidity support is withdrawn . As things stand, as of 2011 at least one A- will be the minimum level required.

More significantly for many perhaps, this month’s ECB meeting also saw the ECB move to scale back its emergency lending to the banking sector in a way that clears the path for a move back to variable rate tenders later in the year and leaves policy makers free to raise rates as needed. The bank announced that this months 12-month tender would be the last and indicated that the 6-month tenders would also be axed after 31 March. The 12-month tender would also be offered at what amounts to a floating rate that would be indexed to future changes in the ECB’s main refinancing rate in a way which means it is impossible to discern in advance any particular intention about the level of the main refinancing rate. At the same time they indicated that the weekly, 1 month and 3 month financing tenders would remain in place on a fixed interest rate full allotment basis for as long as necessary, and at least until April 13, which means that while enhanced bank financing is being slowly phased out, it is still in place, and there is no definitive date yet for the complete termination of the programme.

Basically this all seems fairly logical, and yet, as Frank Atkins asks, one obvious question remains, which is why the it should be the case that the ECB is so intent on implementing its “exit strategy” when, surely, given the seriousness of the problems which are still to be resolved in some key Eurozone economies, one might have thought they should continue to implement some sort of ultra-loose monetary policy just like their counterparts in the Bank of Japan, the US Federal Reserve, or the Bank of England?

Well, part of the key to unravelling the apparent dilemma the recent move presents is possibly to be found in a response ECB President Jean-Claude Trichet gave in answer to questions put to him by journalists after the last meeting. “We are not" he was at pains to say "signalling anything in terms of a hardening of our monetary policy - absolutely nothing,” So here we have it, as Frank Atkins suggests, the ECB is applying a straight principle of separation between monetary policy and liquidity provision (although I doubt that many financial journalists are quite as perceptive as Frank Atkins evidently is). Monetary policy remains as loose as it ever was, with the key refinancing rate staying firmly at the 1% level (hardly suprising in the context of the fragility of most Eurozone economies) while the enhanced liquidity provision is being systematically withdrawn. Now why should this be?

Greek Abuses


Well, one of the principal problems the ECB currently faces is the use which is being made of all that ever so generous enhanced liquidity ECB funding by Greek banks. According to analysts at Goldman Sachs Greek banks have been making very extensive use of the ECB liquidity provision. They estimate that at the end of the third quarter of this year, the four major Greek banks (Alpha, Eurobank, National Bank of Greece, and Piraeus) had availed themselves of some €28.3 billion in liquidity provision, down admittedly from the €42.3 billion they were soaking up at the end of the second quarter, but still way over the percentage of Greek participation in ECB capital. And even this reduction comes, it should be remembered, aftered the Central Bank of Greece directed local lenders to scale back their reliance on cheap funding from the European Central Bank.

Yet, as Goldman Sachs point out, such extensive use of the ECB exceptional liquidity provision might seem rather counterintuitive given that the loan to deposit ratio within the Greek banking system is pretty low (between 98% and 122% for the four major banks) and the liquidity position of the banks thus appears very sound. So why the hell do they need so much money you may ask?

Well, using ECB facilities made sense for Greek banks for a number of reasons. In the first place, ECB funding is relatively cheaper for Greek banks than for their European peers since the ECB makes no adjustment to the rates charged for the perceived higher risk of the Greek banks. As Goldman Sachs point out a Greek bank operating in Greece pays the same price as a French bank in France, even though the French bank operates in a lower risk environment and should, in theory, be able to finance at lower rates in the market. But this is what enhanced liquidity support is all about, if only those responsible for the financial and economic administration of Greece understood the situation.

Secondly, the current spreads on Greek government bonds (around 200 base points over German 10 year equivalents) offer Greek banks an exceptional arbitrage opportunity, since by taking advantage of the uniform ECB liquidity rate Greek banks can buy higher Greek government bonds with a much higher yield than the government bonds which their French or German counterparts buy. Regardless of the risk implied through by the Greek CDS spread, Greek government bonds carry a zero risk weighting when calculating riskweighted assets for capital purposes. So for Greek banks this arbitrage carries no capital impact whatsoever. That is to say the Greek banks have been doing very nicely indeed out of the Greek sovereign embarassment, than you very much. Hence it is not difficult to understand the ECB's growing sense of outrage with the situation.

On top of this we need to add the growing frustration of the ECB and EU Commission on finding that the Greek government not only had not taken advantage of these liquidity advantages to introduce effective policy action to stop the deterioration of Greek government finances, but in fact had gone in precisely the opposite direction, greatly exceeding in spending decisions all their earlier promises and guarantess. Finance Minister Papaconstantinou's final 2010 budget plan, as presented to parliament on November 20, made plain that the financial situation is much worse than anticpated, and that the government now aims to reduce the fiscal deficit from 12.7% of GDP this year to 9.1% of GDP next year. In the earlier draft, as made available to the EU Commission when it determined that Greece had taken insufficient action in 2009, the objective was 9.4% of GDP for this year. The Commission calculates that under unchanged policies, the Greek deficit would be 12.2% of GDP in 2010 with government debt at around 120.8% of GDP, up from 113.4% this year.

So to be absolutely clear, the Greek banks have been making money from arbitrage on ECB exceptional liquidity funding and in the proces financing the Greek government to carry out spending programmes while at the same time basically hoodwinking the European Commission about what it was they were actually up to. That is to say, the ECB has been effectively paying to lead the EU Commission straight down the garden path.

And In Spain Things Aren't Much Different

According to Bank of Spain data, Spanish banks were receiving approximately 82 billion euros in longer term financing from the ECB as of last September.



And, as in Greece, a large chunk of this money has been being immediately recycled to finance a ballooning government deficit, one which, as in Greece, is expected to hit 12% of GDP this year.



So the ECB has been providing, indirectly, funding to Spain's government in a bid to help Spain try to withstand the hefty economic crisis it is faced with, and this government spending (along with the significant drop in interest and loan payments produced by the 1% interest rate which impacts Spanish loans and mortgages) has given strong support to Spanish domestic demand. But after years of structural distortion, Spain's manufacturing sector is, let us remember, massively uncompetitive.



In fact, Spain's manufacturing sector was contracting in November at the fastest rate in any of the 26 countries included in the JP Morgan Global Manufacturing PMI survey.



And where, then,could we imagine that all this money which is being used to prop up demand has gone? Well, we could imagine couldn't we. On buying imports, that's where a big chunk of it has gone, even as Spain's unemployment queues grow longer and longer. After falling for several months, September's goods trade deficit was up again, and has in fact it has been rising since last August. So let's spell this out again - Spanish banks wer receiving a total of 82.5 billion euros in liquidity funding via your open market operations in September, up from 49.1 billion euros in September 2008, and this money, far from having a positive impact, has been going to sustain the unsustainable.



At the same time, Banco de España data show that over the same time period Spanish bank funding of government borrowing rose from around 300 billion euros to around 400 billion euros, while the monthly goods trade deficit increased from 2 billion euros to 5 billion euros between July and September 2009, and the September current account deficit bounced back to a rate of roughly 4.5% of GDP from the July low of around 2% (see chart below). So where, we might ask oursleves is the "correction" here? This kind of monetary and fiscal support on the part of the ECB is entirely justified and understandable, if it is really to give a cushion to countries like Spain and Greece to make a painful transition. But if the money is simply used to sustain the unsustainable, and even is used to make the situation worse, then what really is the ECB supposed to do?




It must be worrying ECB decision makers like hell that the enhanced liquidity provision which is being facilitated from the ECB is, in the context of the very low level of international competitiveness of a good part of Spanish industry and services following the distortions produced by the property bubble, having the rather perverse and completely unintended consequence of funding a rise in Spanish imports (thus putting ever more Spaniards in the domestic sector out of work) via the demand injection which is being administered by the Spanish government?


Monsieur Trichet Is Not Amused

Exactly these sort of concerns were put directly to Monsieur Trichet in his quarterly appearance before the Economic and Monetary Affairs Committe of the European Parliament last Monday by the Catalan MEP (and member of Convergencia Democràtica de Catalunya ) Ramon Tremosa. Here is is question:

Monsieur Trichet, there are countries in the Eurozone that are starting to recover and some others, like Spain, in which the absence of reforms will condemn them to remain in recession for the coming months.

In France, for instance, household lending and house purchases are now growing, while in Spain lending to households continues to decrease, and the housing market remains flat and lifeless. Therefore,

1.- Are you worried by such apparent diversity within the Eurozone?

2.- In your opinion, what practical implications such divergence will have for the conduct of monetary policy at the ECB?

Under a "European divergence" scenario, it could happen that the "Optimum Currency Area" assumptions wouldn´t be valid anymore, and that an "average" monetary policy would start being harmful instead.

For example, if some European countries (like Germany or France) start having positive inflation rates, while others (like Spain, Greece, Portugal or Ireland) continue in deflation, implementing an "average" monetary policy could be harmful: especially if the monetary policy, due to the high weight of the French and German economies, leads to the "average" monetary policy becoming slightly restrictive. This would lead to further rounds of deflation in the "deflationary" countries.

3.- Has the ECB a plan to cope specifically with this issue? Or will the ECB continue with the "average" monetary policy it has exercised until now?

Monsieur Trichet was not amused. In a strongly worded reply that was given extensive coverage in the Spanish press (but barely received a mention in the English language one), he told Ramon Tremosa in no uncertain terms that there would be no second chance for the banks, "There is not one Euro for Spain, and another for the other countries. There is only one Euro, one rate of interest, and one exchange rate".

So, the carving knives are now out. The ECB has been put in an impossible position, and intends to act as it sees fit. The lions share of the responsibility now rests on the shoulders of Europe's political leaders. Only this afternoon Angela Merkel came to the temporary rescue of an increasingly besieged Greece, by pointing out that healthier members of the euro zone aren't prepared to abandon Greece and other heavily indebted countries in the currency union. Worthy remarks, and absolutely to the point. But how far is it the responsibility of richer and economically healthy states to continually come to the rescue of those who insist on doing nothing to improve their own situation? On precisely the same day Spanish Prime Minister Jose Luis Rodriguez Zapatero came out fighting, and rejected all rejected negative economic forecasts that currently surround Spain, saying for the umpteenth time that Spain was about to emerge from recession. How much more in denial is it possible to be, and how much longer must the future of all Europeans continue to be put at risk by head in the sand statements like this?

It's All Greek To Me

In the long run we are all dead. But as someone else famously put it: we ain't dead yet, and in the space between these two undeniable truths move forex traders, financial markets and a host of other would be economic participants. The financial press is full right now of headline catching stories about how Greece is at imminent risk of sovereign default. The German newspaper Die Welt even had a lengthy piece this weekend with the catchy title After Dubai, Who Will Be Next (the answer is obvious isn't, otherwise what is the point of the question). One has the impression of a Europe filled to the brim with financial journalists busily rumaging the entrails, in search of the least glimmer of light which will confirm that something decisive and earthshattering might actually happen (soon), what with the German Der Spiegel announcing at the weekend that Greece's growing public deficit problem is to be an item on the agenda at the next Governing Council meeting of the European Central Bank on December 17 (surely the big news would be if it wasn't going to be there), and Bloomberg's Maria Petrakis telling us that Greek Prime Minister George Papandreou is toiling away in what many might consider was a vain attempt to "convince investors he can tackle the worst fiscal crisis in 15 years".

To add even more theatricality to the "drama" groups of protestors predictably battled it out with police on Athen's streets, in marches that were ostensibly to commenorate the death of a young teenager in last years riots. Even the normally staid and prudent Economist throws its weight in behind the charge with a piece whose title tells it all: "Default Lines" (perhaps the words "in the sand" could have been thrown in to add a bit more tension), which goes so far as to suggest that a partial Greek default might even be welcomed by some Eurozone member states, since it might take some of the heat off a hard pressed euro.

As if to add a little more spice to the story, Standard and Poor's decided to pick this Monday to announce it was putting Greece's A- long-term sovereign credit rating on Credit Watch with negative implications, with the unusual little "extra" that it gave the Greek government only 60 days, as opposed to the customary 90, to respond with adequate information to avoid the decision of downgrading to BBB+ (a level which if it was generalised across the rating agencies would imply that Greek Bonds would no longer be eligible as collateral at the ECB once the temporary relaxation of normal criteria which accompanies the extraordinary liqidity measures is withdrawn - although who really knows when this is likely to be). Naturally bondholders were not slow in reacting to the news and the spread on the 10-year Greek/German bond yield widened again, to 201 basis points from the 174 basis points level of late last Friday.

Actually, this is far from the first time that investors and journalists have been getting excited about the default risk on Greek public debt. In fact that very same Spiegel had an article headlined Greece Teeters on the Brink of Bankruptcy as far back as last April (that's a hell of a lot of "teetering" that has been going on), while the ever interesting Willem Buiter had a lengthy and influential blog post back in January on the worthy topic of whether or not it was structurally possible for a member state to default on its sovereign debt and remain in the eurozone (his conclusion was that it was, and in fact I don't disagree with him).

But gentlemen are we not getting rather ahead of ourselves. As I said at the start, in the long run Greek Sovereign debt may be dead than the deadest of ducks, but it ain't dead yet, nor is it likely to be in the most immediate future, there is far too much at stake for all of us for this to simply be allowed to happen, "sin mas". In fact it was the much more cautious Moody's who made the relevant points here in a press release issued last Wednesday where it argued forcefully that investors' fears that the Greek government may be exposed to a liquidity crisis in the short term are totally misplaced.

Now words here do matter, Moody's are completely right, the Greek government will not be exposed to a liquidity crisis in the short term (as opposed to a sabre rattling threat of one from the ECB among others), but this does not mean that they do not face a solvency issue in the longer term. That is, in the longer term I am absolutely sure that Greek public finances are deader than that proverbial dodo, the thing is, the long run simply hasn't arrived yet.

Let Moody's talk, since they do talk sense in this case:

"the risk that the Greek government cannot roll over its existing debt or finance its deficit over the next few years is not materially different from that faced by several other euro area member states".

So here's the first point, the Greek situation is a bad one, but it is not "materially different" from that of a number of other eurozone member states (I will return to this) even if the risk of its losing sovereign bond collateral eligibility is greater than that of any other member state, at this point. In the second place what Greece is inevitably facing is not a liquidity crisis (I'm sorry Maria, no financial crisis at this point), but a long term solvency one if it can't raise its trend growth rate in the context of the looming cost of maintaining an ever larger dependent population with a declining and ageing workforce. That is to say, the strategic problem for Greek public finance is not the quantity of debt accumulated to date, but rather the impending dead weight of future liabilities, and how these can be met. In this case, short term technical default to wipe the slate partially clean and start-up again would resolve nothing, since without a much higher underlying growth rate (without the aid of government deficit funding) the impending liabilites are not supportable, and decision takers at Ecofin and the ECB know this perfectly well, which is why they may well rattle the sabres, but in the short term at least we will see little in the way of exemplary action. For a sovereign default in Greece (a mature developed economy) would be a complete first, and would take us all into very new, and uncertain territory, since it could quite literally become a default from which there was no viable route for return.

So What Is The ECB Up To?

The FT's Frank Atkins has confessed to having been struck by the comments on Greece made by Jean-Claude Trichet, European Central Bank president, at the press conference which followed last weeks ECB rate setting meeting. I am sure he was not the only one who was listening, and given food for thought.

When asked about the country’s acute fiscal difficulties and the risk of a possible default, M Trichet simply stated he had every "confidence that the government of Greece will take the appropriate decisions”. This remark, as Frank Atkins says, was notable for its lack of forecfulness and could suggest he does not entirely rule out Greece facing sufficient problems servicing its debt that it might be forced into the hands of an external agency like the International Monetary Fund.

Indeed M Trichet's statement could be interpreted as meaning that an exasperated ECB would almost welcome such an eventuality, and might by withdrawing easy short term funding from Greek Banks even give things a hefty shove in the direction of just such an outcome. But an ECB which does not frown on the possibility of their most recalcitrant pupil being steered briskly towards the welcoming arms of the IMF is not the same thing as an ECB which envisaging, contemplating, or even in its wildest dreams vaguely imagining a Greek sovereign default. Any suchbdefault would surely follow, and not precede a (flawed and failed) IMF intervention, or would be the inevitable by prooduct of Greece being unceremoniously ejected from the Eurozone by sheer market forces, with the ECB relegated to meer spectator, unable despite its best efforts to contain the situation.

So my reading of the situation as it stands now, is that policymakers will do all that is in the power (which is a lot) to avoid the markets having so much say in the matter, but that what they do want to do is keep up the pressure on the new Socialist administration in Athens. Their aim is surely to try to turn back the “moral hazard” screw whereby European Union authorities, in giving the impression that they will always and ever ride to the rescue, no matter what the provocation (and Greek statistical authorities sure have been doing some provoking), simply encourage member state governments to continue to act recklessly. And this becomes all the more important given the fact, as I mentioned earlier, that Greece is only one among several problem pupils, and that more than the credibility of the Greek government (of which surely there is little left), what is being tested is the credibility of the European Union's institutional structure.

We might be forgiven for getting the impression that to date rather than acting as a stimulus to deep economic reform, Euro membership has rather acted to reward those countries who would get into more and more debt, with ever less sustainable economic models, by supplying them with funding at far cheaper rates of interest than the markets would otherwise make available. It is this particular clockhand that Europe's leaders would now dearly like to turn backwards, and this is why I have little doubt that it is in Greece that a stand will now be taken. If not, then that longest of long runs may arrive rather sooner than some of us, at least, are comfortable with.

The Almunia Syllogism

European Monetary Affairs Commissioner Joaquín Almunia recently, and possibly totally inadvertently, stumbled on a very interesting argument. Here it is:

"Who is crazy enough to leave the euro area? Nobody," Almunia said. "The number of candidates to join the euro area increases. The number of candidates to leave the euro area is zero."

Reductio Ad Absurdum

Now you don't need a PhD in economics to understand what follows, although a little bit of basic logic would help. What we have here could be construed as a kind of syllogism (and from now on let's christen this one "The Almunia Syllogism"). The Almunia Syllogism has the following form:

a) Anyone leaving (or aiding and abetting the departure of someone from) the Eurozone is crazy
b) The EU Commission, The ECB and The National Leaders are not crazy
c) Therefore no one will leave, or be allowed to leave, the eurozone (at least under current conditions)

Q.E.D. We Will Have A United States Of Europe.

Well, ok, I do need to add a lettle lemma here to the effect that the only way to enforce (c) is to build the necessary architecture, and there is room for debate about this, since this lemma is neither proven, nor is it self evident. You also need to accept that there is an excluded middle here, and we do not have a "now either the EU leaders are crazy ot they aren't" fork which we can get diverted down.

As I say, the lemma is not self evident, although my own opinion is that in the weeks and months to come its validity will become extraordinarily clear even to the most reticent among us, but this still needs to be established. The thing about the lemma is that it focuses the debate. Those who do not agree with it need to be able to show how we can have (c) within the present architecture (since here there is a middle to exclude, either we can or we can't). The results coming out from the "we can" camp are not entirely encouraging. For example, ECB Executive Board member Lorenzo Bini Smaghi's recent attempt to argue that Krugman has it wrong, and that (we can manage with what we have) fails stupendously to convince, in my opinion, and especially the extract I reproduce below (which exemplifies precisely the point those who want new achitecture are making).

For instance, for the period 2009-10, discretionary measures adopted in Germany total 3.5% of GDP, compared with 3.8%in the United States. In some European countries, such as Italy, the size of such stimulus measures is relatively limited owing to the high levels of debt, but in other countries the total fiscal stimulus is larger than in the United States.

The whole issue is that we need a mechanism to average out the stimulus, is that so hard to understand? Is this obscurantism, or simply stupidity?

A Literary Trope Not A Syllogism

On the other hand, the formal validity of the following "utterance" from Almunia is rather more questionable.

"Don't fear for this moment," he said. "We are equipped intellectually, politically and economically to face this crisis scenario. But by definition these kinds of things should not be explained in public."

The first phrase is an exhortation, one which I would agree with (but not for the same reasons), the second is an assertion whose truth content is, at least, questionable, while the third is an admission, one which would perhaps better not have been made, or a piece of advice, which the unfortunate Otto Bernhardt seems never to have received.

A senior German lawmaker said euro zone states stood ready to come to the aid of financially fragile members of the currency bloc, sparking furious denials from European leaders that a specific rescue plan existed. Otto Bernhardt, a leading lawmaker in Angela Merkel's Christian Democrats (CDU), told Reuters in an interview late on Thursday: "There is a plan."

and then Bloomberg let us know a bit more about the details of the plan.

The German Finance Ministry has no knowledge of a rescue fund organized by the European Central Bank for troubled euro-region members such as Ireland and Greece, spokeswoman Jeanette Schwamberger said.

Otto Bernhardt, finance spokesman for Chancellor Angela Merkel’s Christian Democratic Union, said in an interview with Reuters today that the ECB has a fund at its disposal to help troubled countries and can make money available at 24 hours’ notice.

Greece Introduces A Public Sector Wage Freeze

Ten Year Bond Spread Between Between Greek and German Benchmarks Post 1999

The Greek government announced this week that it is introducing a public sector wage freeze together with and a one-off tax for high-income earners in an attempt to prevent the budget deficit from spiralling yet further out of control. The measures, which were announced on Wednesday, constitute a significant change of discourse from a government which until now has claimed Greece’s service-based economy could avoid falling into recession. Speads on European government bonds widened again this morning The difference in yield between German and Irish 10-year government bonds, increasing five basis points (to 281 basis points), the most since February 1993. Portuguese, Spanish and Greek (see chart above) spreads also widened versus the German benchmark.

Basically what follows is a brief examination of the evidence we now have to hand for a sudden and sharp slowdown in Greek GDP, and of how this may influence future expectations on the spreads. This follows in the path of my two previous Greece related studies:

Why We All Need To Keep A Watchful Eye On What Is Happening In Greece

and

The Long And Difficult Road To Wage Cuts As An Alternative To Devaluation



The Noose Tightens

Today's decision follows mounting concern about the future competitiveness of the Greek economy and the sustainability of its mounting soveregin debt. Moody's Investors Service cut its outlook on Greece's A1 government bond ratings to stable from positive on Wednesday, saying any upgrade over the next 12-18 months was now highly unlikely due to evolution path of the debt levels. The agency stated they expect the public debt situation to worsen, with debt to gross domestic product (GDP) rising towards 100 percent, though it did note in passing that the pace of the deterioration was in fact in line with what was happening in the case of most other European Union governments. The issue is not so much the rate at which Greece is now extending its debt, but that the indebtedness starts from such high levels, and that so little has been done in recent years to effectively bring the situation under control.

'The global synchronised downturn is taking its toll on the Greek economy as it is on other advanced economies, with growth coming to a halt and public debt ratios reversing their decline from previous years,' Moody's said in a statement.

Greece, which currently expects its borrowing needs to reach 43.7 billion euros this year, up frm an earlier projection of 42 billion. Public debt to GDP, which is expected to grow to about 96 percent this year, is the second highest in the euro zone.

The move followed a February decision by Standard & Poor's to cut Greek sovereign credit ratings by one notch to A-/A-2 with a stable outlook, citing eroding economic competitiveness and a rising fiscal deficit.

South East Europe Dependence?


In fact, on the face of it Greek GDP has held up pretty well in the present crisis.The outlook for 2009, however, looks progressively less healthy. The Greek economy is quite dependent on its services sector, mainly shipping and tourism. And while the shipping sector is suffering badly from the decline in freight charges, tourist bookings have slumped by an average of 10 per cent, according to hoteliers and tour operators associations. But there is one more element we should be considering, the South East Europe (SEE) factor. In fact Greece's commercial banks, who had been expanding very rapidly in southeastern Europe over the last decade, acquiring subsidiaries or established branch networks throughout the Balkans, Ukraine and Turkey, are now faced with the pain of handling what is now becoming a very sharp slowdown in those CEE countries where they have opened shop.

The big four Greek banks - National Bank of Greece, Alpha Bank, Eurobank EFG and Piraeus - have all gotten involved, and are estimated to have combined market shares of around 40% in Macedonia, 35% in Albania, 30% in Bulgaria and 20% in Romania. And then there is Turkey, Serbia, Ukraine and Russia to think about.

During the last few years the SEE countries have all seen gross domestic product growth rates in the 5% to 8% region, compared with 4% in Greece. However, private sector credit in these countries averaged only around 25% of GDP, compared with 81% in Greece itself. Only last month, Bank of Greece Governor George Provopoulos estimated that Greek commercial banks exposure in SEE countries alone stood at about 55 billion - about 22% of Greek GDP, and about 13% of total banking system assets. So now, aprt from the homegrown housing slowdown the commercial banks face the prospect of an accelerating SEE slowdown too. In mid 2008, before the financial crisis hit the SEE region, bank analysts were cheerfully predicting 2009 GDP growth of 6% and above in the region; they are now forecasting zero or even negative growth. There are no detailed NPL figures as yet, but last month George Provopoulos estimated that loans in arrears to Greek commercial banks operating in SEE had already reached 10% of their regional loan books. The Greek government is already preparing itself for the shock, and has introduced a 28 billion euro liquidity stimulus package - again, a little over 10% of GDP and with as yet unkown impacts on the gross debt to GDP ratio.

Greek GDP Has Surprised On The Upside


So as SEE creaks, evidence of the impact of the slowdown on Greece itself is steadily building up. During the fourth-quarter GDP growth did slow to a revised 2.4% ratyear on year rate - down from the 2.7% rate regiseterd in the third quarter, but still a far cry from the substantial contractions in other countries . According to the statistics office the slowdown was a result of the falling rate of household spending combined with a contining drop in investments and exports. So the effects of the economic crisis are begining its seems to have an impact on the Greek economy.

Since mid-2004, Greece has been buoyed by an explosion in consumer spending and a booming property market that has helped fuel an average growth rate of over 4% in recent years. A strong tourist industry, and several record years of growth in the shipping industry have also helped. But over the wholeof 2008 the economy grew at a revised 2.9% rate, significantly down on that 4% average (see the obvious downward drift inheadline growth in the chart below), and with evidently worse to come in 2009.



The main reason for the downward revision was a lower rate of investment spending, produced by a continued decline in construction, a drop in purchases of transport machinery like trucks, and a decline in industrial machinery imports. According to the data, consumption spending was up only 1% on a year earlier. Fixed capital investment fell on the other hand by 5.3%, with a 30.3% decline in purchases of transport equipment and a 19.9% drop in residential housing. Exports were down 1.5% on the year, while imports were also lower, down by 5.3%. Thus the impact of external trade was actually positive for overall growth.

The Greek government now estimates the Greek economy will grow at a 1.1% rate this year. The European commission, on the other hand forecasts a 0.2% expansion rate, while the Bank of Greece expects the Greek economy to grow by 0.5%.

Industrial Decline


Industrial output in Greece fell at a an 8.7% rate in December, following several months of contraction.


In fact, as can be seen from the index in the chart below, output remained pretty flat in 2007, and has then fallen all through 2008.

And the situation lloks set to get worse, since the February manufacturing PMI showed the strongest contraction to date.



Construction industry activity was down by 12.9% year on year inDecember, and retail sales, after quite strong growth in 2007, were also pretty weak all through 2008.




Whopping Current Account Deficit


Basically Greece's problems can be summed up in two pices of data, the huge current account deficit, and the loss of international competitiveness which is reflected in those deteriorating industrial output numbers. In fact Greece's current account deficit reached a record 14.5% of gross domestic product in 2008, although, as the financing necessary to maintain such deficits dries up there are now signs that the gap is narrowing rapidly.





As compared with a year earlier December's current account deficit declined by EUR1.81 billion to EUR3.127 billion, according to Bank of Greece data, following a much smaller decline in November. The weight of the correction is being borne by a drop in imports, with good imports falling to EUR4.51 billion which compares with September's total EUR5.93 billion. Analysts in Greece seem to be expecting a fairly benign slowdown and correction - there is talk of the imbalance narrowing to around 12% to 12.5% of GDP this year - but in present conditions, and far less tolerance of such huge CA deficits, thereis the danger of amuch stronger correction.

Strong Loss Of Competitiveness

The weight of the correction will obviously have to be supported by import (and living standard) declines, since apart from the difficulty of increasing exports under current conditions, the Greek economy has obviously lost considerable competiveness in recent years (after recovering ground between 1991 and 2001.

One of the worrying features of of the Greek situation at present is the general lack of realism that is being demonstrated. Perhaps the most recent example ofthis was last weeks rejection by Finance Minister George Papathanassiou of the EU Commission’s forecast of flat growth for this year - he argues the economy could expand by up to 1.5 per cent - since this means that the budget estimates are bound to prove far too generous, with the consequent danger of deficit overshoot and subsequent credit downgrades.

Too Little Too Late?

The wage measures currently being enacted are far from Draconian , since the freeze will only affect public sector workers earning over €1,700 a month, while lower paid workers are to receive a one-off payment of €500, and the original budget proposals seemto have been ridiculous under the circumstances since they provided for increases of 8 per cent for public sector employees while the year-end inflation rate was projected at 2.5 per cent. The one-off tax is only going to affect the more than 100,000 Greeks who had declared incomes above €60,000 in 2008, and is expected to raise an additional €250m in revenues.

The government's forecast, revised at the end of January, is for 1.1% economic expansion this year; the European Commission says it will be just 0.2%; the central bank, 0.5%. All of these look rather optimistic under the circumstances, and a contraction in the region of 2% of GDP looks much more realistic, especially with wage tightening, and government cuts in the pipeline. Credit expansion, is also slowing internally as a result of the deteriorating economic climate, and this coupled with the more cautious approach to loan approvals will make it difficult for the government to maintain its 10 year on year new loan creation target, especially with joint public and private gross debt to GDP levels nearing the 200% mark, and the heavy external financing requirement making an over-rapid closing of the CA deficit now a distinct risk. In October, the rate of new loan growth was 18% year-on-year; by January it had decelerated to 15% - a rate last seen in 2005, and there is no end to the process in sight.

Eurozone Inflation Expectations Fall As The Output Gap Rises

It’s a depressing spectacle: on both sides of the Atlantic, policy-makers just keep falling short — and the odds that this slump really will turn into Great Depression II keep rising.

In Europe, leaders rejected pleas for a comprehensive rescue plan for troubled East European economies, promising instead to provide “case-by-case” support. That means a slow dribble of funds, with no chance of reversing the downward spiral.

Oh, and Jean-Claude Trichet says that there is no deflation threat in Europe. What’s the weather like on his planet?
Paul Krugman, yesterday

What follows here are simply a few charts to illustrate further the argument I developed yesterday as regards the significance of the deflation threat which now exists in the eurozone. The argument is that the ECB is once again being far too cautious, and risks allowing the entire eurozone to entire a deflationary cycle which may prove to be a lot harder to get out of than it was to get into. In my view the ECB should bring the refinancing rate close to zero % at next Thursday's rate setting meeting, and then explore what measures can be taken to introduce a zonewide version of US/Japan style Quantitative Easing as quickly as possible.

The key argument I am presenting is that it is a mistake to focus at this point on what is happening to energy, food and other commodity prices. The key issue is what is happening to core prices, and what will continue to happen to them as output contracts further. The other side of the coin are inflation expectations, and as we will see below these are now falling rapidly across Europe. It is very important at this point that these expectations do not get "locked in" to price fall expectations.

It is evident that the degree of economic slack in the OECD is now widening rapdily as unemployment rises and capacity utilization falls. The OECD output gap (the difference between current levels of output and some estimate of what "capacity" output could be at this point) continues to widen and is now only second in importance to the output gap seen in the early 1980s. In fact, the output gap is likely to have widened further since the OECD last made its forecasts in November 2008 (the OECD leading indicator has, for example, continued to decline since that point) but the output gaps shown for the US, the UK and eurozone in the chart below are already sufficiently pronounced to make the point quite clearly I think.

In fact, spare capacity is a phenomenon which extends way beyond the OECD, and economies throughout the world are operating at below their potential and look set to do so for both the remainder of this year and most of 2010. Global manufacturing has been contracting and global trade has collapsed. Here is the latest JP Morgan Global Manufacturing PMI.




The IMF currently estimates that the cumulative global output loss relative to potential over the period 2008-2010 will be as much as 5% (see chart below).


And inflation expectations are falling rapidly. The latest findings in the European Commission’s own consumer questionnaire show that the net balance of respondents in the UK and the Euro zone expecting prices to be higher this time next year is now at the lowest recorded level - just 2.7% and 4.1% respectively ( see chart below).

"There Is No Deflation Threat In Europe" - Jean Claude Trichet - Oh Really!

He's at it again. Last year he was busily trying to worry us all that inflation was set to get completely out of hand among the 16 countries who make up the eurozone. Now the President of the European Central Bank, Jean-Claude Trichet, is hard at it on another tack and is busying himself trying to convince us that there is no credible deflation threat facing these countries. Apart from getting it wrong on both occasions, the common point here would be a certain inbuilt "inflation bias", a bias which was earlier called "the original sin of the Bundesbank" by nobel prize winning Italian economist Franco Modigliani.

"There is presently no threat of deflation," Trichet told a committee of the European Parliament on Wednesday 14 February. "We are currently witnessing is a process of disinflation, driven in particular by a sharp decline in commodity prices." ..."It is a welcome development," he said, adding that the fall in energy, and other prices should help boost struggling economies.

Apart from manifesting a spectacular lack of economic judgement, the Financial Times's Banker of the Year 2007 is now forcing us to ask the embarassing question as to just how far "out of touch" you can get with the material you are supposed to be handling and continue to hold down your job. It seems we are forced to come up with the rather worrying response, that, in the case of the principal EU institutions (remember the sad case of Economy and Finance Commissioner Joaquin Almunia), the answer is "bastante" (consideably), since a quick look at the data we have to hand shows us that Eurozone inflation is already significantly undershooting the European Central Bank’s own target (and principle policy objective) of maintaining the annual rate “below but close” to 2%. Worse, by all appearances the rate of consumer price inflation in the eurozone is now set to head straight off into negative territory.

If we look at headline HICP inflation on an annualised basis, we will find that it fell more than expected in January - to 1.1 per cent, according to Eurostat data - down quite dramatically from the peak of 2.7 per cent hit in March last year. This was the lowest level we have seen since July 1999, and a sharp drop from the 1.6 percent rate registered in December. On a month-to-month basis, prices were down 0.8 percent. The "core" inflation rate - that is consumer inflation without the volatile elements of food, energy, alcohol and tobacco - we find it still stood at 1.6%, since the biggest impact on headline inflation comes from the decline in food and energy costs. But if we look at the monthly movement in the core index, we find that it dropped by a very large 1.3% (see chart below).



Now if we come to look at the core inflation rate over the last six months, we find that the index has only risen 0.1% (or an annual rate of 0.2%). This gives us a much more accurate reading on where inflation actually is at this point in time, and where it is headed. The chart below shows the six month lagged annualised rate for the last twelve months, and the sharp drop in January is evident. If things continue like this, then the eurozone as a whole is headed straight into deflation, for sure.



Why Should Prices Continue to Fall?

So what are the grounds for thinking that inflation may be now heading into negative territory (ie that we are entering deflation right now), despite the fact that the ECB revised forecast is likely to come out at about 0.7 per cent this year and 1.5 per cent in 2010, according to estimates from Julian Callow, European economist at Barclays Capital. Well let's look at a chart produced by Paul Krugman showing the relation between the US output gap and the inflation rate.



Now as Krugman explains the figure plots an estimate of the output gap — the difference between actual and potential GDP, as a percentage of potential — and the change in the inflation rate. (Both series are taken from the IMF WEO database, for convenience, and use data from 1980-2007).

The fit, as he says, is not perfect, but the correlation is evident, and there is an implied slope of about 0.5 — that is, every percentage point by which real US GDP fall short of potential tends to reduce the inflation rate by about half a point over the course of the year. Now I am not going to advance here estimates of the present output gap in the eurozone, but we do have clear indications of a sharp and ongoing contraction in demand in the GDP numbers. Eurozone GDP contracted by 0.2% between the second and the third quarters of last year, and by 1.5% between the third and fourth quarters.

What's more the key indicators suggest that the contraction is accelerating at this point. The February Markit euro-zone composite PMI reading dropped to a record low of 36.2 from 38.3 in January. Any reading below 50 on these indexes indicates month on month contraction.

Barring some spectacular (and entirely improbable) turnaround in March it now seems likely that the Q1 GDP contraction will be worse than the Q4 2008 one, and considering (as mentioned previously) that the eurozone contracted by 0.2% in Q3 2008, and by 1.5% in Q4, then, in my humble opinion, the data we are seeing for this quarter are entirely consistent with a 2% quarterly contraction (or an annualised 8% rate of contraction). For those of you who simply don't believe that PMIs can tell you so much, take a look at Markit's own chart (below), showing the strong underlying relationship between movements in GDP and the *flash* composite PMI. The results they achieve are pretty impressive I would say.

and if we look at an additional indicator (the EU's own Economic Sentiment Indicator for the eurozone) we will see that it hit yet another low in February (see below) which again suggests that the contraction is accelerating at this point, and substantially so.



So the core HICP index is on the point of turning negative on a six monthly basis, and the situation appears set to get even worse, and our Central Bank President assures us that "there is presently no threat of deflation". So which world am I living in, or which is he?

There are further reasons to anticipate a sharp downward pull on prices from some countries in the zone (like Spain and Ireland), since they have housing and construction booms which are in the process of unwinding, and the only way they can recover the competitiveness they have lost is by conducting a sharp and significant downward revision in prices and wages (since in a currency union there is effectively no currency to devalue). The two charts below show the loss of competitiveness experienced by the Irish and the Spanish economies (respectively) with regards to the German economy since 1999 as measured by real effective exchange rates (REERs).



REERs attempt to assess a country's price or cost competitiveness relative to its principal competitors in international markets. Since changes in cost and price competitiveness depend not only on exchange rate movements but also on cost and price trends the specific REERs used by Eurostat for its Sustainable Development Indicators are deflated by nominal unit labour costs (total economy) against a panel of 36 countries (= EU27 + 9 other industrial countries: Australia, Canada, United States, Japan, Norway, New Zealand, Mexico, Switzerland, and Turkey). Double export weights are used to calculate REERs, reflecting not only competition in the home markets of the various competitors, but also competition in export markets elsewhere. A rise in the index means a loss of competitiveness.



Now the eurozone being a common currency area presents us with specific problems in the context of deflation since, as the Irish economist Philip Lane argues a member of a currency union comes up against a natural limit in national-level deflation. Thus, he argues, while a country like Ireland may well face a sustained period of inflation below the euro area average (such that it may be negative in absolute terms for a greater or lesser period of time), the situation should tend to be self-correcting since the deflation implies an improvement in competitiveness, which should generate a boost in export driven economic activity and, over time, a return to an inflation rate at around the euro area average. I'm not sure that this argument is 100% valid, since sufficient internal demand lead deflation can so effect household and corporate solvency that debt deflation can at the very least send a country off into a sizeable and significant correction (say a decade long one) before the price level falls sufficiently to generate sufficient export activity to offset the decline in domestic demand and enable balance sheets to recover. But going into all this would get pretty wonkish, so, leaving that rather theoretical point aside, lets think about a more rather concrete and immediate reason for worrying about what is happening at the present time in the eurozone, and that is the possibility that the inflation and competitiveness benchmark country, in this case Germany, may itself be about to experience an internal price deflation process which is every bit as sharp as the fall in prices which is taking place in those economies which are supposed to be correcting vis-a-vis Germany itself. That is, let's consider the possibility that through this mechanism the deflation may become eurozone wide, and relatively self perpetuating, if something is not done to break the cycle.

So, if we now go on to look at the two relevant charts below (for Spain and Ireland) we will find that in each case core indexes are falling more or less in line with the German one. In fact, both the Spanish and the German indexes are unchanged over the last six months, the Irish one is down 0.5%. At this pace (a 1% a year differential with Germany) Ireland would recover its 1999 comparative position vis-a-vis Germany in around 30 years, a rather lengthy process to say the least.

But the point here is not that prices are falling in Ireland and Spain (they have to do this) but that prices are also set to fall in Germany, and this is where monetary policy from the ECB becomes vital, since if Germany is allowed to fall into deflation then it will be extremely difficult for Spain and Ireland to "correct" (the drop in wages and prices would have to be sharp indeed) but also monetary policy from the ECB would be in danger of becoming a complete mess.





Of course not everyone on the ECB governing council shares Trichet's rosier-than-rosy view, and in a comment that offered an insight into how at least some ECB council members are thinking, Mario Draghi, Italy’s Central Bank Governor said recently that “the governing council is keeping a close watch on the real cost of money”. What he means is that, if Spain's 1.5% drop in core prices over the last three months turned into a 6% annual drop, then the real rate of interest currently being applied would be around 8%, which would constitute a very tight monetary policy in the context of Spain's worst recession in living memory.

Perhaps some readers may feel I have been unduly hard on Jean Claude Trichet in this post, but I would simply close by reminding everyone of the conclusions reached in a once widely quoted paper - Preventing deflation: lessons from Japan's experience in the 1990s, by Alan Ahearne, Joseph Gagnon, Jane Haltmaier and Steve Kamin (2002) - where the authors argued:

We conclude that Japan's sustained deflationary slump was very much unanticipated by Japanese policymakers and observers alike, and that this was a key factor in the authorities' failure to provide sufficient stimulus to maintain growth and positive inflation. Once inflation turned negative and short-term interest rates approached the zero-lower-bound, it became much more difficult for monetary policy to reactivate the economy. We found little compelling evidence that in the lead up to deflation in the first half of the 1990s, the ability of either monetary or fiscal policy to help support the economy fell off significantly. Based on all these considerations, we draw the general lesson from Japan's experience that when inflation and interest rates have fallen close to zero, and the risk of deflation is high, stimulus, both monetary and fiscal, should go beyond the levels conventionally implied by baseline forecasts of future inflation and economic activity.

As some economist or other I read is in the habit of saying "history has a nasty habit of repeating itself, the first time as tragedy and the second time as tragedy". Or put another way, here we go again. Hello, is there anyone out there?