Diary of a Financier

European Policymakers’ Binary Options

In Economics on Fri 1 Jun 2012 at 11:20

I’ll say it until I’m blue in the face: Europe’s policymakers have only two options. They can assign whatever acronyms they want to their solutions (EFSF, ELA, LTRO, SMP, ESM). They can arrive at liquidity provisions by whatever Chutes & Ladders they want. They’ll ultimately be forced to choose between these binary options:

  1. Fiscal Consolidation
  2. Currency Dissolution

On Wednesday, Societe General summarized the “Six Policy Options for European Technocrats”:

  1. European Banking Resolution Fund– something akin to the “Banking Union” proposed by the European Commission to have the ESM directly recapitalize banks. This was promptly & publicly opposed by Germany, Netherlands, Austria, Finland & the ECB.
  2. Pan-European Deposit Insurance– while deposit guarantees exist at the national-level, Eurosystem deposits exceed GDP (US deposits ~68% GDP). Therefore, few EU sovereigns can cover a run on their own domestic banks, but at the same time, a looming threat of currency dissolution shakes confidence in the staying-power of an EU-wide guarantee.
  3. Extended LTRO– €3-4T has been deposited with the ECB, suggesting that banks are awash with cash and hesitant to lend. Asset-Liability matching will force banks to keep loan activity shorter than LTRO terms, plus banks (especially distressed ones) already lack suitable collateral for pledging, per the rise in ECB’s “deposits related to margin calls.” Finally, there’s the moral hazard of LTRO liabilities subordinating banks’ bondholders.
  4. Restart SMP– this was an uncapped ECB initiative to buy & sterilize sovereign debt. Again, ECB doesn’t want to subordinate preexisting bondholders in its operations.
  5. Project Bonds– €230mm in pilot bonds already being floated by the European Investment Bank (EIB) to promote growth. Proposal is for a €10B increase to EIB’s capital, providing ~€15B/year in increased infrastructure spending to the whole EU, a sum exceeded by Spain’s austerity cuts alone.
  6. ESM Banking License– would allow ESM to borrow from ECB like a normal bank, then recapitalize distressed banks, etc. The usual suspects (including ECB) oppose this since it monetizes deficits without sovereigns’ oversight.

Nothing original there from SocGen, just a summary of the menu already on policymakers’ tables. It’s a useful summary too, so I won’t shoot the messenger. I have a question though: why are policymakers squabbling over these half-measures?! Eurocrats need only to discuss their binary options right now: Fiscal Consolidation or Currency Dissolution. Have your pick, but make your choice now! If you want out, get out. If you want in, you’re in it together. Once you’ve chosen one of these extremes, your means are immutable:

  1. Fiscal Consolidation → Monetization
  2. Currency Dissolution → Revaluation

There’s nothing in between except infighting and death-spiraling. SocGen’s 6 options reside in such a halfway house. Those 6 options are all designed to defer this Eurocrisis. As with the shortcomings exhibited by LTROs, the sterilized measures merely reshuffle the deck. They create liquidity, but that liquidity is also a liability. It’s an emergency loan or a credit line. That’s part of why deferral redoubles the infliction. (Recall my suggestion to the US in 2009 that bailouts–if they must–should not bury banks beneath more liabilities; distressed banks need Tier 1 Capital, not debt. TARP, et al followed that advice by employing equity injections.) There’s an increase in gross debt with the promise of [at very least] proportionally increasing income (GDP) in the future. There’s no creation of a net new asset to displace the spiraling deflation of impaired & defaulted assets. The 6 “solutions” over which Europe deliberates are designed to work within the half-baked ERM II as it exists today. From this I infer that fiscal consolidation is as proximate as ever… it’s a distant chore for a rainy day.

~~~~

I warned that the Eurocrisis was a problem larger than the individual sovereigns. Given the leverage, incorporating just the distressed financial institutions would demand massive monetization if Eurocrats want to save the ERM system. Yet, recall my mention of the “6 cents or one-half-dozen” outcome, wherein both consolidation and dissolution effectively rear the same bottom line (net-net).

Germany can have 100cents of her TARGET2 credits, bailout assets, and vendor financed receivables repaid in devalued Drachmas/Pasetas/Lira. Or, Germany can pay for bailouts out-of-pocket or out of monetization, forfeiting her own autonomy either way.

Greece can defect and devalue to pay pensioners/creditors 100cents, but damage purchasing power. Or, Greece can take on more debt via Bailout III, mortgaging more of her future.

The first thing to realize is that the former ends the death-spiral, while the latter perpetuates the debt crisis (with deficit nations likely returning to the kitty in the future). Second, a United States of Europe’s visage depends on the balance of power. Whether power is allocated equally or prorated by GDP, peripheral members may still find themselves under the yoke of austerity.

The monetary union can only persist after fiscal consolidation. EMU states must form a homogenous, federalist bloc en route to non-steralized monetary & fiscal intervention. Either Germany & Greece can coexist or they can’t. Either surplus & deficit nations can submit to mutual interests or they can’t. With national artifices erected, there will always be a duelism between one’s country and one’s union. Blood or water?

Today, Europe is positioned at the same hinge upon which she swung on the eve of ERM I’s dissolution: Black Wednesday, September 16, 1992. Use that event as an example if you must. Fiscal Consolidation will prompt a short-term rally, followed by long-term retracement. Currency Dissolution will trigger a short-term capitulation, followed by long-term repair.

(I really hope this is my last permutation of the same Eurocrisis entry.)

–Romeo

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