Yglesias tweets "mattyglesias Fed needs to let Italy reorganize as a Bank Holding Company with access to the discount window."

European Feedback Cycle of Doom (part due)
(or "Fantastic fears of inflation were expressed. That was to cry, Fire, Fire in Noah's Flood.")


As the rates of Italian ten year bonds pass 7 percent (after a brief pause at 6.66 (what's up?!?! Just stopped to say hi)) Krugman comments:

I still find it hard to believe that the euro will fail; but it seems equally hard to believe that Europe will do what’s needed to avoid that failure. Irresistible force, meet immovable object — and watch the explosion.

DeLong provides an explanation for the blissfully ignorant:

Italy's debt is sustainable if Italy must pay 4%/year in interest to borrow. If Italy must pay 7%/year in interest its debt is not sustainable: the Italian government must then com cup[sic] with an extra €60bn/year to appease the bondholders--that's an extra 4.3% of GDP in taxes.

And if nothing has done to convince bondholders that extra 4.3% of GDP tax increase dedicated to compensating them for default risk is coming, next year what will be needed will be not 4.3% of GDP but 8.6% of GDP.

Burlesque-oni looks to be on his way out as the bond vigilantes (and the German cult of 2 percent inflation) accomplish what numerous sex scandals could not.

John Quiggin* on the European Central Bank, crisis enabler.

But Mr. Draghi needs to do even more if he is to avoid becoming the first central banker in recent history to preside over the collapse of the currency he was appointed to manage.

The crucial step is to announce that the central bank will stand behind the sovereign debt of euro zone members, if necessary at the expense of the 2 percent inflation target. This would give governments the financial resources they needed to recapitalize banks. Since the crisis is largely one of confidence, it is likely that bond markets would stabilize without the need for large-scale bond purchases, once there was a credible commitment to intervene where necessary.

In his first news conference as the central bank’s president, Mr. Draghi gave mixed signals. Rhetorically, he emphasized consistency with the failed policies of the past. But in practical terms, he announced a cut in interest rates, effectively admitting that the last increase, only five months ago, was a mistake.

The opportunity for him to take a new path will not last long. If current policies are pursued, the European Central Bank will end up by destroying the euro in order to save it from (largely hypothetical) inflation.

-----------------------------
*author of the infamous 6-6-6 plan.

A Balance of Payments Problem (BOPP)

Financial Big Lies by Krugman

Barry Ritholtz has a fine piece in the WaPo taking off from Michael Bloomberg’s recent venture into the rewriting of history. And I think Ritholtz’s Big Lie framework is just perfect.

After all, the way to understand the “Barney Frank did it” school of thought about the crisis is that it’s an attempt to turn a huge defeat for conservative ideas into a win. The reality of the financial crisis was that deregulation — which was part of a broader rightward shift in policies that played a large role in creating rapid growth in income inequality — led to an economic catastrophe of the kind that just didn’t happen during the 50 years or so when we had effective bank regulation.

So the right’s answer is to claim not just that the government did it, but that it caused the crisis by its attempts to reduce inequality! It’s kind of a masterstroke, in an evil way.

And I think it’s important to recognize the motives here. By all means let’s debunk the claims on substantive grounds, which Mike Konczal does very well. But they’ll just keep spouting these claims, and make up new ones, so you need to understand the fundamental bad faith that is driving the whole debate.

I agree but Ritholz writes:

Fed Chair Alan Greenspan dropped rates to 1 percent — levels not seen for half a century — and kept them there for an unprecedentedly long period. This caused a spiral in anything priced in dollars (i.e., oil, gold) or credit (i.e., housing) or liquidity driven (i.e., stocks).

There was also Bernanke's Global Savings Glut. Is there a problem with a system where low interest rates used to counter deflationary pressures cause bubbles? What if those low interest rates were used to invest in productive enterprises?

Somewhat related, Krugman blogs about a Gavyn Davies piece:

Gavyn Davies has a very good piece today offering another way to think about the euromess. I say “another way to think” advisedly — his analysis of the basics is, as far as I can tell, identical to mine, but he offers a different angle of approach that may be better than the route the rest of us have been taking. Here’s Davies:

It is normal to discuss the sovereign debt problem by focusing on the sustainability of public debt in the peripheral economies. But it can be more informative to view it as a balance of payments problem. Taken together, the four most troubled nations (Italy, Spain, Portugal and Greece) have a combined current account deficit of $183 billion. Most of this deficit is accounted for by the public sector deficits of these countries, since their private sectors are now roughly in financial balance. Offsetting these deficits, Germany has a current account surplus of $182 billion, or about 5 per cent of its GDP.

The euro problem can then be defined a finding a way (1) to finance these imbalances in the short run (2) end the imbalances over the medium run.

It’s also worth noting that we’re not talking about imbalances that have been going on forever.The internal imbalances of Europe are a recent development, coinciding with and almost surely caused in large part by the creation of the euro itself (GIPS is Greece, Italy, Portugal, Spain):

So how are these imbalances to be closed? European leaders have been completely unwilling to confront that question. Yesterday’s big Times piece offers a portrait of leaders — Trichet in particular — engaged in furious denial. It wasn’t just the insistence on Trichet’s part that no default could ever happen. The European Central Bank also went all in for the doctrine of expansionary austerity, aka belief in the confidence fairy.

And what Davies’s post drives home is that implicitly at least European leaders went in for the doctrine of immaculate transfer — in effect, they wanted to believe that the huge payments imbalances could be ended without major changes in relative prices.

So what’s happening instead is forced austerity in the deficit countries, not matched by expansionary policies elsewhere, in a low aggregate inflation environment — the ECB actually raised rates! — that makes adjustment almost impossible. The result is a eurozone headed for recession, and one in which a breakup of the euro itself is looking ever more possible.

Awesome.

Eurodämmerung by Krugman

Dan Davies, whose Crooked Timber blogpost spawned the Occupy Wall Street protests which in turn sparked protests across the country and globe, twatted:

Just spoken to a couple of lads from MF Global. Am therefore not in mood for another round of "the bankers have not suffered!", thaksveymuch

I think he has a point. Bear Stearns gone. Lehman gone. Wachovia gone. Merrill Lynch* gone. Washington Mutual (Woot!) gone. Etc.

Wolfgang Schäuble, the German Federal Minister of Finance who Henry Farrell and John Quiggin applauded here for "floating the idea of real fiscal integration and accompanying democratic reforms of the EU," has recently come out for the EU to take the lead on a Tobin tax** although some people are skeptical that it will ever happen.

Plus it's heavy metal to have an umlaut in your name.***

Somewhat related: the Economist editor Zanny Minton Beddoes suggested on Charlie Rose that the German public isn't as Tea Party/NIMBYish as we've been led to believe.

Update: Looks like there was some skullduggery at MF Global. According to news accounts, Corzine made a bad bet and got caught in the Swirling European Vortex of Doom.

-----------------
*Margin Call's director's father spent forty years at Merrill Lynch.
**Financial Transaction Tax
***Fake Onion article on the topic.

The ECB’s Battle against Central Banking by DeLong

(via Thoma)

European Doom Loop by Krugman

Also know as the European Feeback Cycle of Doom

Italian Government Bonds 10 Year Gross Yield

New York Times graphic of the Euro house of cards

(or what do you call those long chain-reaction toys with marbles, chutes and swinging pendulums?)

The Fed meets next Tuesday and Wednesday. The argument for more action should include the notion of insurance against shocks. Policy should not be designed to merely prevent deflation and return unemployment levels to their natural rate eventually. It should help make the system resilient to shocks like, say, a disorderly unraveling of the Euro system.

The argument that they want to keep their powder dry and leave some quivers in their arrow in case of unexpected events sounds good but really doesn't hold up to scrutiny. If they don't do enough to help the economy it will be a self-fulfilling prophecy. If they do more and it doesn't prove enough, they can call for more fiscal help more forcefully. The Great Depression wasn't brought to an end by monetary policy alone. It took World War II.

A Brief History of Europe

1) Germany inflicts a Carthaginian Peace on France.

2) France inflicts a Carthaginian Peace on Germany.

3) The U.S. enacts the Marshall plan (while warily watching Stalin and the Soviet Union).

4) Soviet Union collapses

5) Together, France and Germany inflict a Carthaginian Peace on Greece, Ireland, Portugal, Spain, Italy, etc.

The Hole in Europe's Bucket by Krugman

...If the European Central Bank were to similarly stand behind European debts, the crisis would ease dramatically.

Wouldn’t that cause inflation? Probably not: whatever the likes of Ron Paul may believe, money creation isn’t inflationary in a depressed economy. Furthermore, Europe actually needs modestly higher overall inflation: too low an overall inflation rate would condemn southern Europe to years of grinding deflation, virtually guaranteeing both continued high unemployment and a string of defaults.

But such action, we keep being told, is off the table....

2-day General Strike in Greece

What Really Caused the Eurozone Crisis? by Kash Mansori

From a recent speech by Narayana Kocherlakota

But this connection between bank reserves and inflation is simply not operative right now. Banks have few good lending opportunities, and so they’re not trying to attract deposits. As a result, they are keeping nearly $1.6 trillion of reserves at the Fed in excess of what they need to back their deposits. In other words, banks have the licenses to create money, but are choosing not to do so.

Spain's Banking Mess by Floyd Norris

Origins of the Euro Crisis by Krugman

Reminds me of the 1997 East Asian financial crisis and others have pointed to the Latin American debt crisis of the 1980s.

I really like Fareed Zakaria's optimism. Take this piece on how the lessons of Iraq paid off in Libya. He gives the reader a sense that the glass is half-full.

I hope he is right about China and Europe in his newest piece, titled "How China can Help Europe Get out of Debt."

Facing a similar crisis in 2008, then-Treasury Secretary Henry Paulson talked about the need for a bazooka, a weapon large enough to scare markets into submission. Europe doesn’t have one. Even Germany — which has a debt-to-GDP ratio of 83 percent — can’t credibly bail out Italy and Spain. Together they need to roll over 600 billion euros of debt before the end of next year. Who has that kind of money*

Today, $10 trillion of foreign exchange reserves are sitting around across the globe. That is the only pile of money large enough from which a bazooka could be fashioned. The International Monetary Fund could go to the leading holders of such reserves — China, Japan, Brazil, Saudi Arabia — and ask for a $750 billion line of credit. The IMF would then extend that credit to Italy and Spain but insist on closely monitoring economic reforms, granting funds only as restructuring occurs. That credit line would more than cover the borrowing costs of both countries for two years. The IMF terms would ensure that Italy and Spain remained under pressure to reform and set up conditions for growth.

What’s in it for the Chinese, who would have to devote at least half the funds and who have already politely demurred when approached by the Italians? China invests its foreign exchange reserves looking for liquidity, security and decent returns. It isn’t trying to save the world. Premier Wen Jiabao made slightly encouraging noises this week, hinting that he would increase bond purchases and asking in return for greater market access to Europe. That’s classic Chinese diplomacy: cautious, incremental and narrowly focused on its interests.

The time has come for China to adopt a broader concept of its interests and become a “responsible stakeholder” in the global system. The European crisis will quickly morph into a global one, possibly a second global recession. And a second recession would be worse because governments no longer have any monetary or fiscal tools. China would lose greatly in such a scenario because its consumers in Europe and America would stop spending.

Of course, China would have to get something in return for its generosity. This could be the spur to giving China a much larger say at the IMF. In fact, it might be necessary to make clear that Christine Lagarde would be the last non-Chinese head of the organization.

In a world awash in debt, power shifts to creditors. After World War I, European nations were battered by debts, and Germany was battered by reparation payments. The only country that could provide credit was the United States. For America, providing desperately needed cash to Europe was its entry into the councils of power, a process that ultimately brought a powerful new player inside the global tent. Today’s crisis is China’s opportunity to become a "responsible stakeholder."

Would (will?) China be an enlightened, responsible stakeholder? I'd think human rights, democracy, and civil rights will be low on their list of priorities as well as environmental and labor regulations, such as they are. Still the Chinese Communist Party enacted a sizable fiscal stimulus after the financial crisis of 2008. This demonstrated they have much more wisdom and macroeconomic know-how than the American Republican Party.

Update: A New York Times news analysis on the European Central Bank says:

The E.C.B. can stop this crisis in a minute if they want to,” said Guntram B. Wolff, deputy director of Bruegel, a research organization in Brussels. The bank, he said, could simply overwhelm bond markets by buying huge quantities of debt from Greece, which is effectively insolvent, as well as other countries that have come under attack, like Italy. End of crisis.

Some economists have argued that the bank could buy more than $1 trillion in sovereign debt if it needed to.*

But such an action would provoke howls from Germany and countries like Finland,** where the bank is seen as having gone rogue because of its relatively modest purchases of debt from a list of countries that also includes Spain, Portugal and Ireland. In those beleaguered countries, meanwhile, the bank is regarded as insufficiently supportive.

------------------------------
* Apparently the ECB has that kind of money.
** Finland?

Euro Debt Crisis disccued on Charlie Rose

I [heart] Gillian Tett.

The situation sounds analogous to the one facing Paulson, Bernanke and Geithner back in 2008 except in place of financial institutions like Bear Stearns, Lehman and AIG, you have governments and in place of American regulators and government officials, you have German politicians and the ECB. There is also the question of the Euro Zone. The markets didn't trust the banks' books back in 2008 and now they don't trust these government books. Slow economic growth worsened the situation.

Martin Wolf on Germany and the European Union

This is what I heard from an Italian policymaker: "We gave up the old safety valves of inflation and devaluation in return for lower interest rates, but now we do not even have the low interest rates."

and

For small open economies such as Latvia and Ireland, regaining competitiveness and growth through deflation might work. For a big country such as Italy, it is too painful to be credible.

How would deflation work for a small open economy?

FT Alphaville on Trichet:

Reporter: What is your answer to German people and economists who want the return of the DM?
Trichet: You want answers?
Reporter: I think the Germans are entitled.
Trichet: You want answers? (SHOUTING)
Reporter: Germans want the truth! (SHOUTING)
Trichet: *You can’t handle the truth!*  (SHOUTING)
[pauses]…
Trichet: Son, we live in a world that has prices, and those prices have to be guarded by men with bonds. Who’s gonna do it? You? You, Sylvia Wadhwa? I have a greater responsibility than you could possibly fathom. You weep for Lehman Brothers, and you curse Ben Bernanke. You have that luxury. You have the luxury of not knowing what I know. That Lehman’s collapse, while tragic, probably saved banks. And my existence, while grotesque and incomprehensible to you, saves banks. You don’t want the truth because deep down in places you don’t talk about at parties, you want me on that committee, you need me on that committee. We use words like rate, target, expectation. We use these words as the backbone of a life spent defending something. You use them as a profitline. I have neither the time nor the inclination to explain myself to a man who rises and sleeps under the blanket of price stability that I provide, and then questions the manner in which I provide it. I would rather you just said congratulations and went on your way. Otherwise I suggest you pick up a Greek bond, and suffer a haircut. Either way, I don’t give a damn what you think you are entitled to!

(via Krugman)

The Spanish Prisoner by Krugman