The European Union
I am sure some readers have wondered why I have not devoted more to the comedy of the Euro and and Euro periphery nations. As it is, I have watched the crisis unfolding with genuine bemusement. How on earth are the politicians who created the mess of the Euro going to deal with the crisis in the Eurozone? A long, long time ago I discussed that the Euro would be in danger in the coming crisis, and even suggested that if you held Euros, you held them in a German bank account. I seem to recall that some commentators seemed to consider that this was considered to be a rather startling point of view......
As the situation stands, the contradictions within the whole Euro framework are now coming to an ugly fruition. My browse through the recent edition of the Economist just served to emphasise the tangle of complexity and impossibilities of digging the Euro out of its current hole. At the time I was first writing about the potential for the demise of the Euro, I added a strong caveat that the future of the Euro was as much a matter of political will as economic questions. Although economics is inherently mixed with politics, I hope that readers will forgive this use of political, by which I mean a matter of the support of the politicians and people in Europe.
I would probably have been described in the past as a 'little Englander' for my opposition to the extension of powers to the European Union. My concern was that the entire project lacked the democratic accountability that should be necessary for such a radical course of integration. Likewise, with regards to the Euro, my greatest concern was the lack of fiscal integration that was necessary to provide some kind of coherent foundation for the currency. The breaking of deficit rules early in the project by countries such as France only served to emphasise the weakness of the structure.
For the problem of accountability, the Charlemagne column in the Economist highlights the problem; calling him the 'godfather' of the EU, the column highlights how Jean Monnet set a course in which the end plan for the EU was left deliberately ambiguous, and how the policy of the EU accruing powers in a step-by-step fashion was established. What we are now witnessing is the destabilisation of the European Union that results from the method used for achieving 'ever closer union'. When it comes down to the crunch, the Germans are in the end concerned with Germany, not Greece, not Spain, not Portugal....Germany has undoubtedly, at least in some respects, benefited from the EU, but German politicians are increasingly reluctant to confront their electorate with further bailouts of those that are perceived as profligate and irresponsible.
What we are now seeing are politicians in contortions as they try to balance the European project and Euro against the concerns of domestic voters. The European Financial Stability Facility (EFSF) is widely regarded as inadequate as a means to stem the tide of financial stress in the European Union. The democratic deficit, and the lack of coherent structure in the EU will be tested today when the German constitutional court rules on the legality of the bailouts. I have no idea how the ruling will go, but it is illustrative of the structural problems that surround the Euro. As I pointed out in a recent post on money printing, the European Central Bank (ECB) is operating under constraints that will likely prevent major interventions in the crisis, or at least the ECB will not have the same degree of freedom as, for example, the US Federal Reserve. In the meantime, it has been easy for politicians in troubled countries to point accusing fingers at the rest of Europe for forcing austerity measures upon them. Lacking any real accountability, the Euro and wider European project have both become exposed.
Adding to the complexity is the massive exposure of the banks of bailout countries to the sovereign debt of the bailees. The IMF thinking has it that the European banks might already be exposed to Euro 200 billion of losses. Already, considerations for ameliorating the losses of the banks are being put on the table, including from the banks themselves. The point here is that, for the politicians, they are damned if they extend the EFSF, and damned if they don't. We should remember here that the Basel Accords that were critical in developing the structure of banking regulations that have helped create this crisis. In order to explain this, I will quote from a post that I made in December 2008:
The answer to this perceived problem, was Basel I. This is described in the BoE paper as follows:The Bank of England paper referred to can be found here. It is not difficult, with the benefit of hindsight, to see how the banks became entangled in the current sovereign debt crisis. In the post, I go on to discuss Basel II, and the way in which it also created new variants on the theme that certain kinds of lending might be viewed as risk free. As the situation stands, risk free assets have turned out not to be risk free, but are actually very high risk. A quick review of the Basel I risk categorisation now looks distinctly mad and the Basel II accords look just as absurd. When looking at the hopeless ineptitude of the regulators, I can only reiterate my earlier position on trying to regulate risk in banks; it is a hopeless cause...The 1988 Accord represented a revolutionary approachSo here we have a determination of risk which assumes that, for example, OECD based banks are safe. We now see that this is not the case, and many of the banks in the OECD would, without government support, now be bankrupt. We also see that lending into government securities is also 'safe' but, as I have argued elsewhere in this blog, countries such as the UK are extremely unsafe at present.
to setting bank capital—an agreement among the
Basel Committee member countries that their
internationally active banks would at a minimum carry
capital equivalent to 8% of risk-weighted assets (with
the Committee setting broad classes of risk weights).
The agreement was made against a background of
concerns about a decline in capital held by banks,
exacerbated by the expansion of off balance sheet
activity, and worries that banks from some jurisdictions
were seeking a short-term competitive advantage in
some markets by maintaining too low a level of
The introduction of the Accord seems to have led to
some rebuilding of capital by the banks in the G10, but
over time the broad nature of the risk categories created
strains.(2) The Accord differentiates between exposures
using general categories based on the type of loan—
exposures to sovereigns (split into OECD and
non-OECD), exposures to banks (split into OECD and
non-OECD, with the latter split into less than one year
and more than one year), retail mortgages, and other
private sector exposures. Little allowance is made for
collateral beyond cash, government securities and bank
So here we have the essential problem. A bunch of very smart people got together and said that they were able to determine levels of risk. Their conclusions have been shown to be wrong. In particular, OECD banks have demonstrably been shown to be, in a very large number of cases, unsound. I will reiterate this point once again - they were wrong.
Another point in the Basel I accord was that it creates a perverse incentive to lend to governments. Investing in government debt means that money is not being invested into potentially wealth creating investments in the private sector. It also virtually guarantees that government will have access to credit, regardless of whether the governments are acting responsibly or irresponsibly. Such guaranteed provision will almost certainly have been a factor in the growth in Western government / OECD debt. However, it would be impossible to prove one way or another.
Sitting underneath all of the troubles in the Euro area is the illusion of GDP growth. As long as a country appeared to be experiencing economic growth, it seemed safe to lend to the country. The trouble is that the growth was determined by the debt, not by any real increase in genuine wealth. As borrowed money was circulating around an economy, with the multiplier effect magnifying the impact of the borrowed money, it gave an illusion of real economic growth. So called 'austerity' just commences the process of exposing the real underlying wealth generating capacity of the country in question. As the borrowing spigot shuts, the economy contracts, and with it tax receipts, and this drives a need for further austerity, and this in turn sees further contraction. And so the process continues up to the point where the real wealth generating element of the economy is apparent. It is the point at which an economy is actually on a sustainable path, and it is a painful exposure of the real level of wealth in an economy.
Of course, this painful contraction is considered to be something that might be stopped. Economists argue for restraint in austerity measures, to push austerity to some undefined point in the 'medium term'. They argue that the contraction is self defeating. However, in doing so they ignore that the debt was accumulating even in the good times, that there was a massive accumulation of private/public debt before the crisis. The economies that are now in trouble were building up piles of debt in the good times, and their economies are now structured around debt. I do not agree with Keynes, but suggesting that debt accumulation should be ongoing, during both good and bad times, seems to be stretching even Keynesian thinking to breaking point.
As the situation stands, the Euro area is in distinct trouble. The lack of political structure, and the deficit in accountability have left the Euro and the European Union with no solid foundations. There is some political will to resolve the crises, but the lack of a coherent accountable framework makes resolution of the crisis nearly impossible. The crisis threatens to engulf both sovereign states and the banking system. It may be possible for the ECB, and the politicians to cobble together some kind of temporary fix, but the scale of the problem is such that any long term resolution is nearly impossible. The political backlash threatens the 'European Project' itself, as the limits and contradictions of the integration are laid bare. Politics and economics and the fruits of mad banking regulation are all riding in the same handcart. What a mess...
As a final point on the European situation, I recently discussed the impact of extreme policy making in one country rippling out and impacting on the policy of other countries. The ripples are now taking effect, with what appears to be the start of a major currency 'war':
The Swiss national bank (SNB) said it would “no longer tolerate” a euro rate below 1.20 francs. “The SNB will enforce this minimum rate with the utmost determination and is prepared to buy foreign currency in unlimited quantities. The massive overvaluation of the franc poses an acute threat to the Swiss economy and carries the risk of a deflationary development,” it said.
The franc plummeted against all major currencies, falling 9pc against the euro as markets opened on Tuesday. The Swiss action will be studied closely in Norway, Singapore and above all Japan, where the yen has also rocketed to levels that threaten to blight exporters and tip the country into deep deflation.
“The market must fear this will lead to a sharp escalation in currency wars,” said David Bloom from HSBC. “Gold is the only safe haven asset that will not do QE, put in capital controls or complain.”
Mr Bloom said the Swiss move will exacerbate Europe’s debt crisis by widening the spreads betweeen core EMU and the periphery. “This is a risky policy for the Swiss,” he said.
With regards to the US economy, it is difficult even to know where to start...is it the banks with their mark to fantasy asset valuations, the housing and mortgage fiasco, or unemployment or the deficit, or the central bank, or...
A good starting point is to look to the past and the banks during the banking crisis. A Bloomberg report presents some shocking numbers as a result of a freedom of information request:
I strongly recommend taking a look at Bloomberg's interactive chart and reading the full article. As the crisis progressed, the Fed was willing to lend to the big banks against just about anything. It is a shocking picture, and therefore no surprise that the Fed fought against disclosure of the information. It seems that the major banks have a position in which, come what may, they will not be allowed to fail. This does not look anything like capitalism, but instead looks like....I genuinely struggle to find a word which might express this.
Citigroup Inc. (C) and Bank of America Corp. (BAC) were the reigning champions of finance in 2006 as home prices peaked, leading the 10 biggest U.S. banks and brokerage firms to their best year ever with $104 billion of profits.
By 2008, the housing market’s collapse forced those companies to take more than six times as much, $669 billion, in emergency loans from the U.S. Federal Reserve. The loans dwarfed the $160 billion in public bailouts the top 10 got from the U.S. Treasury, yet until now the full amounts have remained secret.
Fed Chairman Ben S. Bernanke’s unprecedented effort to keep the economy from plunging into depression included lending banks and other companies as much as $1.2 trillion of public money, about the same amount U.S. homeowners currently owe on 6.5 million delinquent and foreclosed mortgages. The largest borrower, Morgan Stanley (MS), got as much as $107.3 billion, while Citigroup took $99.5 billion and Bank of America $91.4 billion, according to a Bloomberg News compilation of data obtained through Freedom of Information Act requests, months of litigation and an act of Congress.
“These are all whopping numbers,” said Robert Litan, a former Justice Department official who in the 1990s served on a commission probing the causes of the savings and loan crisis. “You’re talking about the aristocracy of American finance going down the tubes without the federal money.”
As if this were not bad enough, a deal is being offered to restrict the liability for banks flouting the law over robosigning and other illegal/dubious mortgage practices:
This is actually a very complex story, and one I can barely do justice to in a short discussion (here for an introduction). The core of the story is that the major banks set up a system for documenting mortgages that was extra-legal, and which undermines the foundation of title on real estate, and was followed by illegal practices to force through foreclosures. In short, the banks may be about to be able to get away with illegal practices for which any ordinary person would be, if you forgive the expression, nailed to the wall.
The talks aim to settle allegations that banks including Bank of America, JPMorgan Chase, Wells Fargo, Citigroup and Ally Financial, seized the homes of delinquent borrowers and broke state laws by employing so-called "robosigners," workers who signed off on foreclosure documents en masse without reviewing the paperwork.
The FT, citing five people with direct knowledge of the discussions, said state prosecutors have proposed settlement language in the "robosigning" cases that also might release the companies from legal liability for wrongful securitization practices.
This is not the end of the problems in the mortgage market for banks. In a related problem, their sloppy processing, and dubious sales of Mortgage Backed Securities (MBS) are now coming back to haunt them. This from the the Atlantic:
An excellent summary of the foundations of the claims is as follows:
These days, it's hard to keep all of the mortgage-related lawsuits against banks straight. Investors are suing banks over bad mortgage-backed securities, claiming that securitization procedures were flawed. The Federal Housing Finance Agency has also filed lawsuits, saying that banks misled Fannie and Freddie about the quality of the mortgages underlying the bonds they purchased. Finally, states are suing big banks over their foreclosure practices, alleging that they didn't follow the law. The banks have reportedly been offered a settlement on that last suit by the group of state attorneys general. Unfortunately, the deal the states are offering isn't likely to be accepted.
The big question is how much? There is considerable speculation about the size of the claims versus the final amount that might actually be achieved. The problem is that the banks were knowingly selling MBSs that they knew were complete junk (this extends beyond the examples given here):
So, let's take a look at what Fannie and Freddie are claiming and how the banks are likely to respond. As an initial matter, it's important to distinguish between the two kinds of suits investors can bring against MBS issuers and originators of the underlying mortgage loans. One class of cases involves contract claims based on the representations and warranties issuers and originators made about the underlying mortgage loans. Under standard MBS securitization agreements, if investors can show that underlying mortgages don't measure up to the stated standards, they can demand that issuers buy back those deficient loans. Those are straightforward breach of contract claims, but there's a big catch: In order to bring a so-called put-back suit under standard securitization contracts, investors have to control 25 percent of the voting rights within an individual MBS trust. Gibbs & Bruns was able to negotiate the proposed $8.5 billion Bank of America MBS settlement, which would resolve investors' representations and warranties claims, because its group of 22 large institutional investors had the requisite voting rights in more than 200 Countrywide trusts. Fannie and Freddie previously settled their own reps and warranties claims against BofA (for mortgages they bought directly from Countrywide) in a $3 billion deal last January. But generally, plaintiffs lawyers have struggled to piece together coalitions of investors to cross that 25 percent threshold and bring contract claims.
Most investors -- including Fannie and Freddie in the suits filed Friday -- have instead asserted securities law claims against MBS issuers under federal, state, and common law theories. The housing finance agency's federal claims are based on the Securities Act of 1933. There are two key reasons why. The '33 Act sections FHFA is asserting involve standards for offering documentation. Under those provisions, investors don't have to show that issuers intended to deceive them or that they relied on the allegedly misleading documents. As I've previously explained, the '33 Act holds issuers to a strict liability standard, meaning investors just have to show that an offering statement contained false representations about the securities. As alternative routes to the same damages they're seeking under the '33 Act, Fannie and Freddie are also making claims under Virginia and District of Columbia securities laws, and under common law fraud or negligent misrepresentation theories.
Under both the state and federal claims, FHFA can demand that the banks repurchase securities issued under false offering documents. Here's where MBS contract cases and securities cases intersect: Both types of suits rely on investors' claims that issuers misrepresented the underlying mortgage loans. Fannie and Freddie's complaints against the banks offer pages and pages of evidence that issuers fed investors false information about the quality of the underlying loans. On their face, the complaints make quite a compelling case for issuer liability.
Documents released by the US Federal Housing Finance Agency (FHFA) claim that Royal Bank of Scotland (RBS) and HSBC retained the services of Clayton Holdings, a risk analysis specialist, to scrutinise loans before they were placed in bundles of mortgage-backed securities.
According to the filings, reports from Clayton show that 18pc of the mortgage loans RBS submitted to Clayton between the first quarter of 2006 and the second quarter of 2007 were rejected. However, 53pc of them were subsequently included in debt packages by the bank.
By contrast, 27pc of the mortgage loans HSBC submitted to Clayton were rejected, although 62pc of these were eventually included. RBS and HSBC are among 17 banks being sued by US regulators to recoup the $196bn (£120bn) Fannie Mae and Freddie Mac spent on mortgage-backed securities. RBS is facing action over $30.4bn of sales, HSBC over $6.2bn and Barclays in relation to $4.9bn.
Overall, it is apparent that there is something going horribly wrong in the US, and this has become ever more apparent over the course of the economic crisis. The major Wall Street banks seem to be immune to any negative results of their own misconduct, whether that misconduct is fraud or simple incompetence. It seems that, whatever they might do, they end up making fat profits. Again, this is not capitalism, and again I am at a loss for words that might describe this situation. What I do know is that this treatment of the Wall Street banks is not good for the economy. After all, as I have argued before, the purpose of banks is to service the rest of the economy, not for the rest of the economy to service the banks (and their profits). This gross distortion of the US economy is a fundamental problem, and the only way to resolve it is to take the pain that should have taken place at the time of the Lehman crisis. The problem is that, the problem has just grown, with for example more risk concentrated in fewer institutions.
Having discussed the entirely disfunctional banking system, what of the government. The story of the credit downgrade of the US needs no telling. The comedy of politics that led to the downgrade is astounding. Obama seems to have no direction and, even if finding a direction, it would likely lead the wrong way. In the meantime, the US debt mountain grows ever higher. There is, of course, the bipartisan debt super-committee, but it is already mired in political infighting:
As it is, the committee will 'kick the debt can down the road'. The Bank for International Settlements offers a timely article that identifies that debt levels such as those seen in the US need to be addressed urgently, not some time in the future. The article points out that debt stabilisation measures are not sufficient when debt reaches the 80-100% of GDP level, in particular where there are problems with rising costs due to demographics. I am cynical about the role of BIS, so I hope I will be forgiven for cherry-picking this article. It might also be noted that, as long as the US continues to kick the can down the road, the longer and more entrenched will be an economic structure that is built around debt. Think of the example of Europe (e.g. Greece) and we can see that delay is only going to be worse in the long run. The longer that debt accumulation is a major part of the economy, the more the economy will structure around debt accumulation. It will be ever harder to structure the economy back to real wealth creation.
As the U.S. Congress returns to work, the budget-cutting supercommittee is expected to take center stage amid no signs the August break eased raw relations between Republicans and Democrats.
President Barack Obama and House Speaker John Boehner, an Ohio Republican, clashed anew last week over the scheduling of a presidential speech outlining a jobs agenda, a spat that could help set the tone among the 12 lawmakers on the bipartisan committee.
“They have given tremendous amount of leeway and power to the supercommittee, that’s where all the eyes are,” said John Feehery, who advised former Republican House Speaker Dennis Hastert, of Illinois. “Republicans and Democrats have to decide whether they are comfortable with the status quo going into the election or if they need a game changer.”
The supercommittee’s work will start as more immediate skirmishes loom over competing job-creation plans and federal funding for highways, air travel and federal disaster aid.
Confrontations over those issues could feed the public’s discontent in advance of next year’s elections. Obama’s approval rating, at 42 percent in yesterday’s Gallup tracking poll, has been as low as 38 percent since he signed into law the agreement passed in early August to raise the federal borrowing limit and instruct the six Republicans and six Democrats on the supercommittee created by the accord to find $1.5 trillion dollars in budget savings by Nov. 23.
Above all else, the debt is not working. Regardless of how much borrowed money is being thrown into the US economy, and despite bouts of money printing and a general policy of targeting extremely low interest rates, the US economy simply refuses to move. It is no surprise to see that comparisons with the recent history of Japan are coming thick and fast. This from the Sydney Morning Herald:
At least then, though, governments were in a position to ride to the rescue. Today, governments are seen not as the solution but as part of the problem. The debt burden accumulated by the banks was, in effect, nationalised during the crisis.
It was hoped this would prove temporary, but the persistence of weak growth means that a private-debt crisis has become a sovereign-debt crisis. What's more, the markets sense that policymakers have run out of bullets to fire.
They can't cut official interest rates, they find it hard to justify more quantitative easing when inflation is at current levels and almost every Western government is trying to cut its budget deficit.
Put it all together and you get the full Japanese package: weak growth, weak banks, weak policy response. Not a good recipe for shares. Today Tokyo's Nikkei is at less than 25 per cent of its level at the peak of the sharemarket boom in the late 1980s.