>   
>   (email exchange)
>   
>   On Thu, Apr 15, 2010 at 3:29 PM, John wrote:
>   
>   Warren, I can’t tell from this article if the European Central Bank is
>   issuing new currency in exchange for national government bonds or not?
>   

This in fact is a very good article.

Yes, the ECB is funding its banks, and yes, they do accept the securities of the member nations as collateral.

However that funding is full recourse. If the bonds default the banks that own the securities take the loss.

The reason a bank funds its securities and other assets at the Central Bank is price. Banks fund themselves where they
are charged the lowest rates. And the Central Bank, the ECB in this case, sets the interbank lending rate by offering funds at its
target interest rate, as well as by paying something near it’s target rate on excess funds in the banking system. That is, through its various ‘intervention mechanisms’ the ECB effectively provides a bid and an offer for interbank funds.

In the banking system, however, loans ‘create’ deposits as a matter of accounting, so the total ‘available funds’ are always equal to the total funding needs of the banking system, plus or minus what are called ‘operating factors’ which are relatively small. These include changes in cash in circulation, uncleared checks, changes in various gov. account balances, etc.

This all means the banking system as a whole needs little if any net funding from the ECB. However, any one bank might need substantial funding from the ECB should other banks be keeping excess funds at the ECB. So what is happening is that banks who are having difficulty funding themselves at competitive rates immediately use the ECB for funding by posting ‘acceptable collateral’ to fund at that lower rate.

One reason a bank can’t get ‘competitive funding’ in the market place is its inability to attract depositors, generally due to risk perceptions. While bank deposits are insured, they are insured only by the national govts, which means Greek bank deposits are insured by Greece. So as Greek and other national govt. solvency comes into question, depositors tend to avoid those institutions, which drives them to fund at the ECB. (actually via their national cb’s who have accounts at the ECB, which is functionally the same as funding at the ECB)

As with most of today’s banking systems, liabilities are generally available in virtually unlimited quantities, and therefore regulation falls entirely on bank assets and capital considerations. As long as national govt securities are considered ‘qualifying assets’ and banks are allowed to secure funding via insured deposits of one form or another and the return on equity is competitive there is no numerical limit to how much the banking system can finance.

So in that sense the EU is in fact financially supporting unlimited credit expansion of the national govts. They know this, but don’t like it, as the moral hazard issue is extreme. Left alone, it becomes a race to the bottom where the national govt with the most deficit spending ‘wins’ in real terms even as the value of the euro falls towards 0. When the national govts were making ‘good faith efforts’ to contain deficits, allowing counter cyclical increases through ‘automatic stabilizers’ and not proactive increases, it all held together. However what Greece and others appear to have done is ‘call the bluff’ with outsize and growing deficits and debt to gdp levels, threatening the start (continuation?) of this ‘race to the bottom’ if they are allowed to continue.

The question then becomes how to limit the banking system’s ability to finance unlimited national govt. deficit spending. Hence talk of Greek securities not being accepted at the ECB. Other limits include the threat of downgraded bonds forcing banks to write down their capital and threaten their solvency. And once the banking system reaches ‘hard limits’ to what they can fund a system that’s already/necessarily a form ‘ponzi’ faces a collapse.

The other problem is that when the euro was on the way up due to portfolio shifts out of the dollar, many of those buyers of euro had to own national govt paper, as their is nothing equiv. to US Treasury securities or JGB’s, for example. That helped fund the national govs at lower rates during that period. That portfolio shifting has largely come to an end, making national govt funding more problematic.

The weakening euro and rising oil prices raises the risk of ‘inflation’ flooding in through the import and export channels. With a weak economy and national govt credit worthiness particularly sensitive to rising interest rates, the ECB may find itself in a bind, as it will tend to favor rate hikes as prices firm, yet recognize rate hikes could cause a financial collapse. And should a govt like Greece be allowed to default the next realization could be that Greek depositors will take losses, and, therefore, the entire euro deposit insurance lose credibility, causing depositors to take their funds elsewhere. But where? To national govt. or corporate debt? The problem is there is nowhere to go but actual cash, which has been happening. Selling euro for dollars and other currencies is also happening, weakening the euro, but that doesn’t reduce the quantity of euro deposits, even as it drives the currency down, though the ‘value’ of total deposits does decrease as the currency falls.

It’s all getting very ugly as it all threatens the value of the euro. The only scenario that theoretically helps the value of the euro is a national govt default, which does eliminate the euro denominated financial assets of that nation, but of course can trigger a euro wide deflationary debt collapse. The ‘support’ scenarios all weaken the euro as they support the expansion of euro denominated financial assets, to the point of triggering the inflationary ‘race to the bottom’ of accelerating debt expansion.

Bottom line, it’s all an ‘unstable equilibrium’ as we used to say in engineering classes 40 years ago, that could accelerate in either direction. My proposal for annual ECB distributions to member nations on a per capita basis reverses those dynamics, but it’s not even a distant consideration.

Where are ‘market forces’ taking the euro? Low enough to increase net exports sufficiently to supply the needed net euro financial assets to the euro zone, which will come from a drop in net financial assets of the rest of world net importing from the euro zone. This, too, can be a long, ugly ride.

As a final note, the IMF gets its euros from the euro zone, so using the IMF changes nothing.

Comments welcome!

The Next Global Problem: Portugal

By Peter Boone and Simon Johnson

Peter Boone is chairman of the charity Effective Intervention and a research associate at the Center for Economic Performance at the London School of Economics. He is also a principal in Salute Capital Management Ltd. Simon Johnson, the former chief economist at the International Monetary Fund, is the co-author of 13 Bankers.

April 15 (NYT) — The bailout of Greece, while still not fully consummated, has brought an eerie calm in European financial markets.

It is, for sure, a huge bailout by historical standards. With the planned addition of International Monetary Fund money, the Greeks will receive 18 percent of their gross domestic product in one year at preferential interest rates. This equals 4,000 euros per person, and will be spent in roughly 11 months.

Despite this eye-popping sum, the bailout does nothing to resolve the many problems that persist. Indeed, it probably makes the euro zone a much more dangerous place for the next few years.

Next on the radar will be Portugal. This nation has largely missed the spotlight, if only because Greece spiraled downward. But both are economically on the verge of bankruptcy, and they each look far riskier than Argentina did back in 2001 when it succumbed to default.

Portugal spent too much over the last several years, building its debt up to 78 percent of G.D.P. at the end of 2009 (compared with Greece’s 114 percent of G.D.P. and Argentina’s 62 percent of G.D.P. at default). The debt has been largely financed by foreigners, and as with Greece, the country has not paid interest outright, but instead refinances its interest payments each year by issuing new debt. By 2012 Portugal’s debt-to-G.D.P. ratio should reach 108 percent of G.D.P. if the country meets its planned budget deficit targets. At some point financial markets will simply refuse to finance this Ponzi game.

The main problem that Portugal faces, like Greece, Ireland and Spain, is that it is stuck with a highly overvalued exchange rate when it is in need of far-reaching fiscal adjustment.

For example, just to keep its debt stock constant and pay annual interest on debt at an optimistic 5 percent interest rate, the country would need to run a primary surplus of 5.4 percent of G.D.P. by 2012. With a planned primary deficit of 5.2 percent of G.D.P. this year (i.e., a budget surplus, excluding interest payments), it needs roughly 10 percent of G.D.P. in fiscal tightening.

It is nearly impossible to do this in a fixed exchange-rate regime — i.e., the euro zone — without vast unemployment. The government can expect several years of high unemployment and tough politics, even if it is to extract itself from this mess.

Neither Greek nor Portuguese political leaders are prepared to make the needed cuts. The Greeks have announced minor budget changes, and are now holding out for their 45 billion euro package while implicitly threatening a messy default on the rest of Europe if they do not get what they want — and when they want it.

The Portuguese are not even discussing serious cuts. In their 2010 budget, they plan a budget deficit of 8.3 percent of G.D.P., roughly equal to the 2009 budget deficit (9.4 percent). They are waiting and hoping that they may grow out of this mess — but such growth could come only from an amazing global economic boom.

While these nations delay, the European Union with its bailout programs — assisted by Jean-Claude Trichet’s European Central Bank — provides financing. The governments issue bonds; European commercial banks buy them and then deposit these at the European Central Bank as collateral for freshly printed money. The bank has become the silent facilitator of profligate spending in the euro zone.

Last week the European Central Bank had a chance to dismantle this doom machine when the board of governors announced new rules for determining what debts could be used as collateral at the central bank.

Some anticipated the central bank might plan to tighten the rules gradually, thereby preventing the Greek government from issuing too many new bonds that could be financed at the bank. But the bank did not do that. In fact, the bank’s governors did the opposite: they made it even easier for Greece, Portugal and any other nation to borrow in 2011 and beyond. Indeed, under the new lax rules you need only to convince one rating agency (and we all know how easy that is) that your debt is not junk in order to get financing from the European Central Bank.

Today, despite the clear dangers and huge debts, all three rating agencies are surely scared to take the politically charged step of declaring that Greek debt is junk. They are similarly afraid to touch Portugal.

So what next for Portugal?

Pity the serious Portuguese politician who argues that fiscal probity calls for early belt-tightening. The European Union, the European Central Bank and the Greeks have all proven that the euro zone nations have no threshold for pain, and European Union money will be there for anyone who wants it. The Portuguese politicians can do nothing but wait for the situation to get worse, and then demand their bailout package, too. No doubt Greece will be back next year for more. And the nations that “foolishly” already started their austerity, such as Ireland and Italy, must surely be wondering whether they too should take the less austere path.

There seems to be no logic in the system, but perhaps there is a logical outcome.

Europe will eventually grow tired of bailing out its weaker countries. The Germans will probably pull that plug first. The longer we wait to see fiscal probity established, at the European Central Bank and the European Union, and within each nation, the more debt will be built up, and the more dangerous the situation will get.

When the plug is finally pulled, at least one nation will end up in a painful default; unfortunately, the way we are heading, the problems could be even more widespread.

18 Responses

  1. Warren,

    Excellent article!

    I think the banks are not buying government debt out of choice – though in the end – ECB is financing the deficits. The ECB announced the €442 mid-2009 mainly to take the stress out of the interbank market. The daily transactions through the TARGET2 systems is around €2.7T – at least in good times mainly relating to securities transactions (goods and services purchases will be GDP/365 per day). Since this is huge and there are risks that banks may refuse to lend each other in the interbank market, the ECB took this step.

    Banks know that purchasing government debt is a risky game in this environment but I would imagine they are purchasing it to satisfy margin calls on collateral pledged at the ECB. The ECB has a set of rules for collateral as given in http://www.ecb.int/pub/pdf/other/gendoc2008en.pdf Don’t think they can pledge illiquid Loans as collateral, though there are some provisions.

    Banks usually have government debt in their books to meet liquidity pressures – if deposits move out, then so do reserves and they do repos to get back the reserves. In the US, they have a CD market as well, so banks have a choice of issuing CDs to bring back the reserves and avoid financial and non-financial penalties from the central bank but not sure if the CD market exists or is big in the Euro Zone. I guess they use the repo markets and even unsecured markets for for this they need some assets to pledge.

    The IMF gets the Euro from the Euro Zone only but I guess the banks where it will exchange its dollars will have its dollar assets go up which is good for the bank but a loss of reserves when the IMF buys the Greece debt. (The IMF FX settlement will happen in “bank money” – deposits increase of banks, when the IMF ends up buying newly issued Greece bonds it will cause deposits and reserves to go down) So I would imagine that it provides some support for the yields. Any loss of reserves for banks can be handled by the home NCB since it will lend reserves at the marginal lending rate till the next refinancing operation and then at the refinancing rate at the next weekly auction). At any rate, banks have a lot of reserves.

  2. Btw, I think the people in the Euro Zone have a good understanding of the monetary system. It seems that Banque de France long before it joined the Euro knew that money was endogenous. Its the government sector and things happening in the rest of the economy is what they probably couldn’t see – just like Michael Woodford in the US.

  3. Warren,

    Several points.

    1. There is a step before default and this is debt renegotiation and restructuring with extended duration and a haircut with discount/par bonds.
    2. Greek banks are not loosing any serious amount of deposits and they are diversified beyond Greece and Greek public debt is accepted by the ECB as collateral.
    3. 80% of Greek public debt is owned by foreign financial institutions and any Greek default will be at the peril of these institutions.
    4. The Greek public deficit spending was not to “call a bluff” but due to endogenous automatic stabilizers and a structural inability to deal with tax evasion by private interests in Greece and a failure to utilize 20 billion in EU cohesion funds.
    5. Your proposal for ECB fund distributions is a clever idea but it will not work if the these funds are used to repay public debt especially to foreigners and not used to deficit spend.
    6. The EU members public debt as a total to GDP is smaller than the one in Britain,the US and Japan. Thus, issuing more debt to bail out members will have small effect on the EU debt burden as long as they remember their pledge for solidarity which Germany seems to try to avoid.
    7. Euro devaluation will help not only Germany but also many of the weaker members whose production and services is not competing with Northern products but low cost production and tourist services from non-EU members.

    1. Please consider Saint-Etienne Swaps Explode as Financial Weapons Ambush Europe
      http://globaleconomicanalysis.blogspot.com/2010/04/numerous-derivatives-swap-deals-blow.html

      The worst global financial crisis in 70 years arrived in Saint-Etienne this month, as embedded financial obligations began to blow up.
      A bill came due for 1.18 million euros ($1.61 million) owed to Deutsche Bank AG under a contract that initially saved the French city money. The 800-year-old town refused to pay, dodging for now one of 10 derivatives so speculative no bank will buy them back, said Cedric Grail, the municipal finance director. They would cost about 100 million euros to cancel today, he said.

      Saint-Etienne is one of thousands of public authorities across Europe that tried to shave borrowing expenses by accepting derivatives deals whose risks they couldn’t measure. They may be liable for billions of euros, according to the Bank of Italy and consulting and law firms in France and Germany. As global economies climb out of recession, the crisis is hitting Saint-Etienne in central France, Pforzheim in western Germany and Apulia, an Italian regional government on the Adriatic. They may pay for their bets into the next generation.

      From the Mediterranean Sea to the Pacific coast of the U.S., governments, public agencies and nonprofit institutions have lost billions of dollars because of transactions officials didn’t grasp. Harvard University in Cambridge, Massachusetts, agreed last year to pay more than $900 million to terminate swaps that assumed interest rates would rise.

      Under the interest-rate swap deals popular with European municipalities, a bank would agree to cover a locality’s fixed debt payment and the government or agency would pay a variable rate gambling its costs would be lower — and taking on the risk that they could be many times higher.

      The financial institutions that sold the derivatives were many of the same ones that received government bailouts to weather the worst global credit crisis since the 1930s.

      “These municipal swaps are the same thing as Greece,” said Fruchard, a former banker at Credit Lyonnais, now a unit of Credit Agricole SA, who designed swaps in the early 1990s. “It’s all trying to dress up your accounts.”

      Germany, Italy, Poland and Belgium also used derivatives to manage fiscal deficits, Walter Radermacher, the head of Eurostat told EU lawmakers in Brussels yesterday without being specific.

      Municipalities are having to rewrite their budgets. Saint-Etienne raised taxes twice, slashed by three-fourths a plan to renovate a museum commemorating the region’s extinct coal mining industry and sparked the cancellation of a tram line. Pforzheim, on the edge of the Black Forest in Germany, is scrimping on roads, schools and building renovations.

      The town followed the advice of Deutsche Bank in taking out bets on interest rates in 2004 and 2005, according to Susanne Weishaar, Pforzheim’s budget director until March.

      For cities like Saint-Etienne, the risks from buying swaps were out of proportion to the potential savings.

      “This isn’t traditional asset management,” Fruchard said in reference to swaps based on currency moves in general. “It’s speculative, like a hedge fund. And it’s done in bad faith. An elected official who takes the benefit from the guaranteed low rates without understanding what happens after his mandate ends is acting in bad faith.”

      Accounting rules in Europe help keep derivatives deals hidden. Most local governments have no obligation to set aside cash against potential losses, and reflect only current-year cash flows in balance sheets.

      “It’s only transparency that will make elected officials scared to invest in dangerous products,” said Jean-Christophe Boyer, deputy mayor of Laval, in western France, which has swaps covering about 25 percent of its total debt of 86 million euros. “Even if we banned them today, the impact is coming now, tomorrow and 10 years from now,” he said, because of the number of derivatives contracts still in force.

    2. Panayotis Says:
      April 17th, 2010 at 7:15 pm
      Warren,

      Several points.

      1. There is a step before default and this is debt renegotiation and restructuring with extended duration and a haircut with discount/par bonds.

      CERTAINLY NOT IMPOSSIBLE BUT WOULD SURPRISE ME IF THAT HAPPENS WITHOUT SOME TECHNICAL DEFAULT.

      2. Greek banks are not loosing any serious amount of deposits

      I’VE HEARD THAT AND ASSUMING IT’S TRUE IT’S AT LEAST PARTIALLY BECAUSE THE CREDIBILITY OF THE DEPOSIT INSURANCE ISN’T BROADLY QUESTIONED YET.
      and they are diversified beyond Greece
      TRUE BUT I’VE ALSO READ THE BANKS ARE ALSO HOLDING A LOT OF PAPER OF THE OTHER EURO MEMBER NATIONS, TO MY POINT THAT THE EURO BANKING SYSTEM IS FUNDING THE MEMBER NATIONS.
      and Greek public debt is accepted by the ECB as collateral.
      YES, BUT IT’S FULL RECOURSE FUNDING AS I STATED.

      3. 80% of Greek public debt is owned by foreign financial institutions
      ‘FOREIGN’ INCLUDES BANKS FROM OTHER EURO ZONE NATIONS?
      and any Greek default will be at the peril of these institutions.
      YES.
      4. The Greek public deficit spending was not to “call a bluff”
      NOT ‘TO’ CALL A BLUFF BUT DID FUNCTION TO ‘CALL A BLUFF’

      but due to endogenous automatic stabilizers and a structural inability to deal with tax evasion by private interests in Greece
      RIGHT

      and a failure to utilize 20 billion in EU cohesion funds.

      5. Your proposal for ECB fund distributions is a clever idea but it will not work if the these funds are used to repay public debt especially to foreigners and not used to deficit spend.

      THEY WILL BE SPENT TO THE EXTENT OF CURRENT YEAR DEFICITS AND REDUCE BORROWINGS AS SECURITIES MATURE.

      6. The EU members public debt as a total to GDP is smaller than the one in Britain,the US and Japan.
      BUT WITH A MAJOR DIFFERENCE. THE EU MEMBERS HAVE PUT THEMSELVES IN THE POSITION OF US STATES, AS OPERATIONALLY THEIR SPENDING IS REVENUE CONSTRAINED. THE UK, US, AND JAPAN OPERATE THEIR CENTRAL BANKS AND ARE THEREFORE NOT OPERATIONALLY REVENUE CONSTRAINED. AND EU MEMBER DEBT IS FAR HIGHER THAN EVEN THE WORST US STATES.

      Thus, issuing more debt to bail out members will have small effect on the EU debt burden as long as they remember their pledge for solidarity which Germany seems to try to avoid.
      7. Euro devaluation will help not only Germany but also many of the weaker members whose production and services is not competing with Northern products but low cost production and tourist services from non-EU members.
      IT ‘HELPS’ ONLY IF THE ENSUING COST PRESSURES FROM THE FX CHANNEL DOESN’T CAUSE NOMINAL WAGES TO GO UP, AND IN ANY CASE IT WILL TAKE A VERY LARGE MOVE IN THE EURO TO GET THE FOREIGN SECTOR TO DIS SAVE EURO.

  4. ::liabilities are generally available in virtually unlimited quantities, and therefore regulation falls entirely on bank assets and capital considerations::

    “In a world of businessmen and financial intermediaries who aggressively seek profit, innovators will always outpace regulators; the authorities cannot prevent changes in the structure of portfolios from occurring. What they can do is keep the asset-equity ratio of banks within bounds by setting equity-absorption ratios for various types of assets. If the authorities constrain banks and are aware of the activities of fringe banks and other financial institutions, they are in a better position to attenuate the disruptive expansionary tendencies of our economy.”
    Hyman Minsky, 1986

    ::By 2012 Portugal’s debt-to-G.D.P. ratio should reach 108 percent of G.D.P. if the country meets its planned budget deficit targets. At some point financial markets will simply refuse to finance this Ponzi game.::

    Again didn’t Bernanke just make a similar claim about the USA, as the deficits increase, rates will rise and possibly we can’t get financing, but didn’t Koo just point out a different possibility concering Japan’s rising deficit while rates remained low? Why are so many making this assumption when the emprical evidence of Japan is different?

    Finally Warren, since you bring up the 13 bankers, here is the blog of the 14th banker, and as a former loan officer yourself perhaps you are unaware of how unethical things have become. He points out the ROT that is at the core of banks and loans system, something that has disgusted me for awhile seeing this myself, how can loans and loan officers and bad ethics be any different in the EU?
    http://thefourteenthbanker.wordpress.com/

  5. Warren,

    Technical default is not neccessary for renegotiation to take place. It happens in private deals all the time. EU members are revenue constrained but their total debt relative to GDP is still relatively small so they can collectively aid members with financial trouble.
    Devaluation will help because inflationary impact is still very small (around 1%) and unemployed resources and productive capacity is extensive. Regarding your proposal, the point is what the high debt members will do with it. ECB and EU pressures will induce them to repay debt owned by foreigners and not “finance” deficit spending. The rest of your points are forward dangers which might or might not occur.

  6. THANKS!
    ADDITIONAL COMMENTS IN CAPS:

    Technical default is not neccessary for renegotiation to take place.
    AGREED. JUST SEEMS THE RISK OF EVEN SUGGESTING ANYTHING LIKE THIS UNDERMINES ABILITY TO SUBSEQUENTLY FINANCE PRIVATELY.

    It happens in private deals all the time.

    YES,THOUGH MOST OFTEN WITH COLLATERALIZED WHICH CHANGES THINGS.

    EU members are revenue constrained but their total debt relative to GDP is still relatively small so they can collectively aid members with financial trouble.

    SEEMS TO ME THEIR DEBT LEVELS ARE FAR HIGHER THAN ANY OTHER REVENUE CONSTRAINED BORROWERS HAVE EVER ACHIEVED?

    Devaluation will help because inflationary impact is still very small (around 1%) and unemployed resources and productive capacity is extensive.

    YES, IT WILL INITIALLY RESULT IN A FALL IN REAL WAGES WHICH WILL BRING DOWN PRICES SOME, BUT NOT ONE TO ONE WITH THE DROP IN THE CURRENCY. AND THEY HAVE TO GET BY THE J CURVE EFFECT WHERE IMMEDIATE EFFECT IS A HIGHER IMPORT BILL AND LOWER EXPORT REVENUES UNTIL EXPORT VOLUMES PICK UP.

    Regarding your proposal, the point is what the high debt members will do with it. ECB and EU pressures will induce them to repay debt owned by foreigners and not “finance” deficit spending.

    THE FUNDS ARE ALL ‘FUNGIBLE’ IN THAT DEBT COMING DUE IS PAID OFF AND NET EXPENDITURES HAPPEN IN REAL TIME. THE FUNDS FROM THE DISTRIBUTION FIRST SIT AS BALANCES IN THE GOV’S ACCOUNT AT THE CB. THEY ARE WORKED DOWN BY THE EXISTING NEGATIVE CASH FLOW OVER TIME AS ALL THE NATIONS ARE SEEING CONTINUOUS NEGATIVE CASH FLOW THEY ADDRESS BY REVENUES TAXING AND BORROWING. THE DIFFERENCE IS THE NEGATIVE CASH FLOW WON’T INCREASE DEBT RATIOS WITH MY PROPOSAL.

    The rest of your points are forward dangers which might or might not occur.

    1. Ramanan,
      I read a report a while back that the Fed arranged the over $600B in FOREX swaps with global CBs in an afternoon, via some conference calls and some faxes. I guess thats what and how you can get things done when there is basic trust/respect between the counterparties.
      Resp,

  7. they were functionally unsecured dollar loans from the US to foreign ecbs.

    yes, easy to lend unsecured when you don’t need to go to congress for approval.

    but not good financial controls, either

  8. Warren,

    I said that your proposal is a good idea. However, knowing how the ECB and EU operate they will enforce a conditionality that will require that the debt will be repayed before any disbursements are available for deficit spending.

    Public debt restructuring is easier because no collateral is committed. Furthermore, it is neutral because it is already validated as the lenders have marked to market the discounts quoted in the secondary market revaluations.

    The total public debt of the EU members as percent of EU GDP is smaller than the ratio of the US, Britain and Japan and even if the Rogoff/Reinhart (orthodox) sustainability measures are applied they will have no problem financing a weak member bailout.

    The point of devaluation is that an additional euro devaluation can help all EU members, although in different degree and that will ease the need for a major deflation policy as the IMF prescribes. Of course I would had preferred, if weak members had their own sovereign non convertible fiat currency with flexible exchange rates, so they deficit spend without revenue constrain. Conditional, of course on structural reorganization required in those countries whose private sector suffers from inefficiencies/inadequacies that lead to output shortfall (discouragement) and rationing of demand(behavior). In their case, effective demand from automatic/vertical deficit spending (endogenous) will not increase output except services and lead to stagflation and current account deficit. Private sector restructuring/innovation will require public investment (voluntary/horizontal) in infrastructure, human capital formation, research & development and skills training, so private sector output credibility will be restored, business distress will be reduced and demand will be forthcoming as supply will be considered to be subject to less adversity and evasion.This is different from the traditional IMF restructuring that enforces austerity and market restructuring measures such as wage cuts, lay off flexibility and incentives for market entry/participation as if the problem was market defects!

  9. “The total public debt of the EU members as percent of EU GDP is smaller than the ratio of the US, Britain and Japan and even if the Rogoff/Reinhart (orthodox) sustainability measures are applied they will have no problem financing a weak member bailout.”

    Sustainability/solvency is not an issue with the US, UK, Japan, and Greece with its own currency. nor do R/R measures apply there

    The apples to apples comp. is more like comparing US states with eu national govs. and eu national govs are far higher.

  10. Warren,

    Comparing debt totals of eurozone members with the US, Britain, Japan is not inappropriate in terms of traditional sustainability measures. The US, Britain, Japan have no involuntary but they do have voluntary revenue constraints. In any event, the point is at what level these market discipline constraints become “effective”. The eurozone capacity constraint (involuntary)to borrow and deficit spend has not been reached yet.

  11. US, Britain, Japan are not subject to external ‘market discipline’ but only internal political discipline.

    the euro member nations are subject to a similar form of external, market discipline as the US States.

    Note the interest rates for Greece vs Japan, for example.

  12. Warren,

    I do not see why you compare Greece and Japan. How about comparing rates between Germany and the US and Britain? There is debt capacity in the eurozone to bail out weaker members before the involuntary constraint imposed by the markets is reached.It seems like we are talking across purposes. Internal political discipline (voluntary) becomes market doscipline when interest rate rises from shorting US debt is validated by the federal government behavior. Look at all the discusion regarding fiscal sustainability. It is not real but illusionary however very effective! We agree more than you think!

  13. my point is germany is subject to a liquidity crisis, just like greece, while the US japan uk are not.

  14. Overnight rates are determined by the central bank.

    To bring Greek overnight rates down, all that the ECB has to do is buy all Greek debt outstanding.

    Greece cannot default in such scenario, because investors would buy any new Greek debt, knowing that they can resell it to the ECB.

    (This is no different than the situation in the US, since the Treasury cannot sell debt directly to the Fed, but only to the public.)

    So it seems that it is the ECB that is responsible for the high Greek rates, not the market, no?

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