Convertibility Risk: Acknowledged but not addressed

Further to my previous post on Mr Draghi’s recent undermining of the Office of ECB President, Gavyn Davies of the FT penned the following line: “It is risky for a central banker to acknowledge that the payments system on which the currency stands may not be fully credible. Mr Draghi could simply have repeated the old line that the operation of the Target 2 system is enough to ensure that the euro can never fall apart. By admitting the reality that the system is no longer 100 per cent credible in the eyes of the market, the ECB president has invited investors to ask whether his proposed interventions are powerful enough to deal with problem he has raised.” And, as I have argued, investors will inevitably come to the conclusion that they are nowhere near powerful enough. Put simply, the policy of having the EFSF-ESM use its severely circumscribed fire power, in conjunction with a limited bond purchasing program by the ECB, to push Spanish and Italian yields down, will fail as miserably as the combined efforts of the EFSF and the ECB failed in 2010/11 to prevent Portugal and Ireland from following Greece into the mire. 

The question now becomes (even if it is an academic one): What would it take to convince investors that the proposed measures will annul the ‘convertibility risk’ that Mr Draghi now acknowledges to be “not insignificant”. Everyone, including Gavyn Davies and Tim Geithner, seems to believe that the answer lies in giving the ESM a banking licence, thus allowing it to use the ECB’s balance sheet as a means of levering up whatever monies it has available (from less than 200 billion to the required 2 trillion!). 

I have no doubt that an announcement along these lines would cause a frenzy of enthusiasm in the money markets, and that spreads throughout the Eurozone will collapse. But I also have no doubt that this would be another temporary measure. The reason? The toxicity of the EFSF-ESM funding structure. Toxicity? Yes, toxicity. As I have explained a long time ago, the bonds issued by the EFSF (which will have the same structure with those that the ESM will issue, assuming the German constitutional court gives the green light in September) are structured very much like the awful CDOs that brought the house of cards down in 2008. If this analysis was correct last summer, then levering the EFSF-ESM up, by granting it a banking licence, would be tantamount to creating a CDO mountain on steroids and planting it in the heart of the Eurozone. It may work for a while (just like the CDO market was buoyant for a while) but in the end that new, Eurozone-constructed, house of cards will come crashing down. And if investors have learnt anything from the recent past, they should see thins coming fairly early on, which means that the half life of a new ba king-licence-carrying ESM will cause more problems than it will solve very, very soon. 

So? What policy can address ‘convertibility risk” effectively? The answer is: Nothing short of proper mutualisation of the Maastricht Compliant Debt. And since we do not have a Federal Treasury to do this (and won’t get one before the ‘convertibility risk’ turns into ‘convertibility reality’), the only tool that I think can do the trick is ECB-bonds as per Policy 2 of our Modest Proposal. That this is not on the cards is as evident as it is indicative of the low probability that the Eurozone will survive.


  • What’s is wrong with good old market forces and defaults? Since 2008 it somehow became socially acceptable for governments to get involved with banks, in the past the public would have been crying foul. I prefer the past.

    • And by past I suppose you mean Herber Hoover’s “liquidate, liquidate, liquidate” response to a financial collapse. Not FDR’s…

    • Yanis, I was not referring to Hoover, just anything pre 2008. About Hoover, are you implying he was different from FDR because he was not. I think you have also stated you believed they were different in other posts/articles but I stand to be corrected.

      It is now accepted that Hoover expanded government as much as FDR. ie, he did the exact opposite of his election “promises”

    • “It is now accepted that Hoover expanded government as much as FDR…” By whom exactly? The Cato Institute? The very people who argued in favour of instant contraction following the financial implosion of 2008? Libertarians for whom Hoover’s ‘liquidation, liquidation, liquidation’ was a paragon of macro-management following 1929? The claim that Hoover and FDR macro and financial sector regulatory policies were similar is the economic theory equivalent of holocaust denial. You can deny that Hoover’s administration was turbocharged idiocy all you like. But it will not invest your claim with legitimacy.

    • HI Yiannis – I thought you might be alarmed by the Cato link with is why I also included a link to the Encyclopedia Britannica. I am not sure if you class Britannica as credible? If not I will find other sources.

      If I can just add, FDR vs Hoover, we are not arguing about philosophy here, we are talking about facts. If you can highlight anything that Hoover did that shrank government then I would love to read it. I do not rule out the sources I have listed being wrong, but I have not seen anything that contradicts them. Specifically I am talking about government spending during Hoover’s times as president.

    • yeah, unfortunately there are a lot of more myths which are widely accepted thanks to the more and more undemocratically organized control of the public discourse

    • Salvo – I’ll take a lot of myths if it means seeing even a little bit of truth

    • Yani,

      Would you consider FDR a radical? Did he go far enough in his New Deal to change the system? At the time, the U.S establishment faced serious threats to its power, a Bastille Day moment, so to speak; hence, the New Deal.

    • Well, be that as it may, think of the Eurozone today: it is also facing an implosion and yet it is sitting on its hands. No reformist FDR is ever guaranteed to emerge. (While FDR was a conservative, as opposed to a radical, he had the nous to implement amazingly radical policies within his first 100 days in order to save capitalism from itself.)

    • ” in order to save capitalism from itself.” – Yianni, I think you are confusing fascism with capitalism. The US never had such a depression as “the great depression” prior to the granting of a monopoly on the control of its currency to a private company.

    • We disagree most strongly on the direction of causality. The creation of the Fed was a repercussion of the evolutionary turn toward oligopoly capitalism which, later, led to the Great Depression. The Fed never caused the Great Depression.

    • Yianis – Okay point taken on causality. However….. looking at GDP per capita graphs for the US on Visualising Economics shows even if banking were an oligopoly it did not cause depressions. The US currency maintained its value and the economy was generally more stable looking at 2-3 year windows before the Fed was created.

      I do not think this is in dispute?

      The was never a great depression in the 100 years pre Fed, and yet 10 years in there was the Great Depression. Assuming you are right, what is your explanation for the previous 100 years? Do you believe it took 100 years for the oligopoly to develop into a problem?

      If you look at Standard Oil, it only took 20 years for that company to take 88% of the market. I think if the oligopoly in banking were really the problem, it would have shown itself long before 1913.

      As a side note, do you acknowledge that the Fed is a private business? ie it is not owned or in any way controlled by the US government?

    • It is very much in dispute! In fact your account is in direct conflict with the facts. The first great depression in world history occurred during the 1870s. To be precise, in 1873 a speculative bubble (caused by banking largesse) burst when a major bank, Jay Cooke &Co., could not sell several million dollars of Northern Pacific Railway bonds. Its collapse spearheaded the depression. A mere three years after the US economy had recovered, another recession began in 1882 which was to last three years. In its midst, a major investment firm and the Penn Bank (of Pittsburgh) went under, together with around ten thousand businesses. Then again in 1893 another financial bubble which had also began with railway overbuilding that banks were eager to finance burst, giving rise to a run on gold reserves, a precipitous rise in unemployment (from 4% to 18%), a series of industrial strikes and a change in the US political terrain. The depression lasted until 1896 when a new gold rush raised the economic tempo, thus ushering in a period of rapid growth which lasted until 1907 at which point a fresh financial crisis, involving a 50% drop in the New York Stock Exchange, whipped up mass panic, widespread unemployment, business closures etc. Indeed, it was the crash of 1907 which led to the creation of the Fed in 1913, with an explicit remit to prevent similar occurrences. Your fantasy that the Fed was the cause of depressions would have been quaint if it were not shared by a large number of misled, well meaning, critics of the Fed’s policies (which I have spent much time criticising).

    • Yanis – You highlight some interesting events but they don’t seem to dent this graph, except 1906.

      Banking panics & inflation – – Undoubtedly there were more banking panics but this is a problem of the banks not a problem with their customers. If people are not satisfied with the strength of their banks there are an infinite number of other places where they can put their money, gold, silver, stocks, bonds, under the mattress, foreign currencies, property etc. (FDR made it much more difficult for people to hedge by revoking gold’s status as legal tender)

      I think the lack of dents in the first graph illustrates that the public were hedging hence the lack of damage to their wealth.

      Just because banks were/are not capable of instilling confidence in their customers, I do no think it is grounds for them to be given a lender of last resort. People do not have a lender of last resort, so why should banks?

      I do not see why banks should be given a free pass for bad decisions. It is not the duty of the private citizen to be a lender of last resort to banks.

      You may say that the Fed does not take money from the citizens directly, okay, but do you agree inflation robs people of their wealth?

      If the banks in the USA were/are so weak then there was/is something clearly wrong with their business model if the only way they could/can function reliably is by being give a lender of last resort which has a currency monopoly.

  • You don’t necessarily need the federal treasury to operate quickly, just a convincing way to get there. It’s almost a given already (give or take the finns I guess). And stop worrying about the German constitution, if the red gnomes say no, they’ll just amend it.

    As for the toxic structure of the ESM route, it’s also no issue if you see it as a transition path: if/when it blows up, you merge it with the ECB, monetise the loss into perpetual goodwill, and Bob’s your uncle

    Compared to monetising now, it does look a bit clumsy, but has some strategic advantages re political process, and also leaves the non monetising option open should the eurozone economy surprisingly bounce anyway (which may not be as unlikely as you’d like to think, I’d give it a 1/3 chance).

    Exec summary: the modest proposal’s essence is being implemented, not just as fast as impetuous latin traders would like. If you have the patience to wait until 2020 for your next post, you’ll see a job well done.

    • That isthe point: the transition path…

      The transition is and will be manipulated by Germany to be as slow as it suits the plan.

      The first part of the plan is to DEVASTATE ALL THE OTHERS so that, at the end of the path, Germany can exchange the debt the others accumulated buying German products with their resources that are becoming really cheap, as these economies are weakening during the “transition path” an the crisis.

      The old German trick Mr Halevi explained to us in a post hosted here

      Not very different to the economic policy they implemented upon the countries they conquered during WWW2.

      The second part of the plan is to become the command center of Europe through the fiscal pact.

    • Waves – I am not saying I disagree with you, but where do you believe Germany’s wealth comes from & how does this fit in with the plan to devastate other economies?

    • Hence the contradictory and confusing comments of these newcomers but here-to-stay as Mr Draghi is, that professor Varoufakis analyzes here.
      What they are really saying is that nothing is for sure anymore, so that the victims of this policy remain terrified of a breakdown and choose to walk down the bottomless drill using the stairs.

    • Richard

      Germany is the debtor of the others which were indebted to Germany buying German products.

      Germany is leaving them with no choice to come out of this situation.

      It is holding their heads inside the water.

    • waves – my question was how does Germany as an economy, gain by devastating economies like Greece? I put it to you they do not.

      Germany’s strength comes from its export industries, how can these companies export? Because people in other countries can afford to buy them.

      If Germany had an economy like Greece, ie a trade deficit, it would have no power over other countries.

      You agree with that right? So the answer is simple, the Greek government needs to reduce the taxes and regulations on its citizens so companies in Greece can compete with businesses in Germany, so Greek companies can be successful.

      For Germany to have power, Greeks need to be rich, to be rich Germany needs Greeks to have low taxes and low regulation.

      ***This is Germany’s “plan”, to make other countries richer so they can buy German stuff. That is the start and the end of it.***

      Germany, as an economy, has no long term benefit from bankrupting the Greek people, NONE.

      Does Germany have anything by cutting the Greek state, reducing the taxes and regulations on Greek citizens? Absolutely.

      Greeks should be asking questions of their government as to why they are INCREASING taxes and not slashing the government. Why is the Greek government making Greeks poorer? Greeks do not want this and Germany certainly does not.

    • Germany is leaving them with no choice because of the common currency. That is the trick.

    • Richard

      Your thoughts on the way out of this crisis and especially about what Germany is doing, is wishful thinking. It is obvious that thing are not evolving the way you think which I too think it’s the right way.

      What is happening reminds me of the way they robbed the German Jews before and during WWW2.

    • What is he? an illiterate German peasant? What is Gold and Silber? Does he mean Gold and Silver?

      When are you people would stop embarrassing yourselves? I think we need to speed up Germany’s downgrade from Moody’s to an immediate CCC-.

      Let’s get it over with. The more you people talk the more messes you make. Cut. Cut. Cut. Now.

    • Dear Dean
      You may not have guessed but the youtube that’s been linked by N EU D is actually in German!
      And yes, Gold und Silber is German for …
      … Gold and Silver.
      Amazing, isn’t it?

    • Dear Martin:

      1. All barbarian languages in Europe are immediately suspended.
      2. The credit rating of Germany has already started on a serious downgrade.

      You haven’t seen anything yet. This is just the beginning.

    • “All barbarian languages in Europe are immediately suspended”

      All financially irresponsible countries should be bombed!

    • Dear Dean
      You may consider German a “barbaric language” if you want.
      But it happens to be the language with the most native speakers in the EU – how annoying!
      Let’s all switch to aramaic instead if you don’t like German. Or maybe, we just continue with English…
      Also a barbaric language or civilized, according to your definition?

    • Martin, maybe you don´t know but German and Greek are not too different. Both old (or barbaric) and complicated grammar…

  • While we wait for the Troika’s verdict, let me humour you on the exact procedure the Europeans have come up with, to service that maturing Greek bond on August the 20th.

    The Greek financial institutions are not in a position to participate in the ECBs open market operations for quite some time now, due to the shortage of eligible collateral. Instead, they have been taping the ELA (Emergency Liquidity Assistance) mechanism, on non competitive terms (200bs penalty on funding costs). This mechanism, until recently, had a ceiling of €3.5 billion on the amount of T-Bills it was allowed to fund. With the consent of the ECB, that ceiling went all the way up to €7 bill.

    Well, to make a long story short, the Greek government is to issue T-Bills amounting €3.2 bill. that the Greek banks will be obliged to cover. The proceeds of this issue will be used by the Greek government to repay the ECB. Afterwards, the Greek banks will fill their liquidity gap through the ELA (practically the ECB itself). Isn’t finance a wonderful thing?

    Given all the above, how can anyone seriously believe that the ECB has any power over the convertibility risk investors are facing? If our European partners don’t tackle the sovereign debt/insolvent banks issue with a demonstration of sheer political will to keep the Eurozone afloat, an imminent collapse is lurking around the corner.

    • What’s wrong with that?

      BTW so that you know ELA financing is more expensive for Greece.

      So instead of getting upset at the German morons who created the artificial funding drought, you are humoring us with your nonsense that somehow Greece escaped?

    • You just can’t be serious. Did you really read my previous post and came to the conclusion that I -in any way- support this absurd funding scheme? Nevertheless, being by nature more careful with my words than obviously you are, I won’t be returning the characterizations.

  • The only topic worth discussing at the moment is the assured downgrade of Germania’s credit outlook.

    Moody’s downgraded the economic outlook for Germany from “stable” to “negative” on Monday along with outlooks for the Netherlands and Luxembourg, citing risks from a possible Greek exit from the eurozone and potential bailouts for Spain and Italy.

    AFP – Moody’s took the first step toward stripping Germany of its coveted AAA credit rating on Monday, cutting the outlook for Europe’s largest and most pivotal economy to “negative.”

    Delivering a stark warning that no one is immune from the eurozone’s rolling crisis, the ratings agency lowered Germany’s credit outlook from “stable” to “negative.”

    A similar move was announced for fellow AAA ranked economies, the Netherlands and Luxembourg.

    Moody’s said all three faced risks from Greece leaving the eurozone and from the need to stump up cash for potential bailouts for Spain and Italy.”

    • Dean – Bond markets are completely manipulated by central banks and the international banks. They are not reality. And remember this, for Germany to default, all the countries and companies that owe Germany money would have to default first, ie the USA, China, UK, Spain, Italy etc etc

    • Put your money where your mouth is: CZ33C5
      10x Short Certificate Euro-Bund Future

    • Richard:

      I fail to understand what you are trying to say.

      You want me to put Germany in a higher position than the markets because?

      Why are you having such difficulty with the concept? When global markets decide that something is bad for them then they show their displeasure in a number of ways, one of them being a downgrade of credit worthiness.

      The logic behind the credit worthiness is very straight forward: A lethargic Germany will in the end pay an even higher price. Hence, the downgrade.

      Why is this manipulation?

      If I see a person on the street and that person is fairly ugly and then I say “this person probably could not get any prettier anytime soon”, is that manipulation?

      Is truth telling manipulation? Where did you get the notion that somehow credit agencies are manipulators? Because they had in 2008 misjudged the collapse of the US market?

      Well, that’s precisely why credit agencies are much more careful now. Because they learned and are doing their job. And their job is to tell the truth. And the truth is that Germany is on a sure path to ruin. Why embellish such truth with euphemisms and niceties? Their job is to tell it as it is.

    • Dean – okay, you believe the bond markets with Germany. In which case you also agree the Greek government must default because that is also what the bond markets say.

    • No, Richard. You are wrong again.

      What has defaulted Greece is not the markets. It’s the combined morony of Merkel’s austerity and Merkel’s PSI. It’s the PSI which has resulted in the default classification.

      What do you want the markets to do? Ignore the fact that Merkel is a moron?

      Of course, when the markets see a totally amateurish attempt to cut out private holders by 80% of value without a doubt such is an event of default. And to compound on the morony, the official sector is still holding Greek debt because the German moron does not have the ability to write it off because of some political nonsense or another.

      So, what you are telling me is that the markets ought to be indifferent at an assault on private holdings and fully forgiving for central bank holdings because Germany decided so?

      It’s precisely because Germany is involved with such ignorance and financial illiteracy that the markets are reacting.

    • Hello Dean – Im not saying anything, I was just checking you were consistent in your assessment of the market’s reactions!

  • “In recent days, negative sentiment against Germany and Chancellor Merkel has been growing in Italy. Last week, the Italian daily Il Giornale published a story with the headline “Quarto Reich,” or “Fourth Reich” on its front page. It featured an image of Merkel raising her right arm with the caption “Heil Angela.” The paper … reflects the increasingly shrill tenor of the political debate in Europe over the euro crisis and it mirrors similar coverage of the chancellor in the Greek media.


    Meanwhile, the chancellor of neighboring Austria, Werner Faymann, has said he believes Merkel will shift her policies. In an interview with the Vienna daily Kurier, Faymann said he believed that Merkel would abandon her opposition to providing the ESM with a banking license, which would essentially give it unlimited borrowing capacity with the European Central Bank, if it became clear that was the only way to save the euro. “I anticipate that when it is necessary for the protection of the euro, that the German chancellor will go along with the next step.” When a reporter at the newspaper reminded Faymann that Merkel opposed the banking license, the Austrian chancellor replied: “We’ve already had the experience that the German chancellor has changed her mind during the course of a political debate — always to protect the euro.””

    • Dean – you dont believe the news right? So what more evidence do you need that Germany is fighting for ordinary Europeans? Germany are being vilified by the European press, the same European press that tells us we need to give our money to banks in order to “save the world from disaster”

      Or do you disregard the news when they say the banks need our help and you believe the press when they say Germany is the bad guy.

      You cant have it both ways. You either think the press is neutral and honest or you do not.

    • Richard:

      There are at least 2 types of press: factual and then interpretive(i.e. opinion).

      The excerpt above is factual. That’s why I cut and pasted the factual part. To avoid these endless and quite frankly pointless private interpretations.

      I don’t see even an ounce of opinion in the above text. It’s all straight news. It shows the positions and sentiment without any effort to spin it or interpret it in a certain way.It’s all Der Spiegel stuff in case you are wondering.

      And no, Merkel is not fighting for the common person. Only someone not feeling very well could make such bogus assertion.

    • Dean – “There are at least 2 types of press: factual and then interpretive(i.e. opinion). ” – I agree, Merkel constantly asks for pre conditions on bail outs and Schauble has called the Greek government a “black hole”. These are facts.

      I have not met a single Greek that disagrees with Schauble and yet the media in Europe portrays Schauble’s comments as somehow against the Greek people. How, why???

      Dean, if you work for the Greek government, I can understand why you dislike Merkel/Schauble.

      If Merkel has done anything anti-Greek, it is giving money to the Greek government in the first place. Things are rapidly progressing to the point where the German government can be accused of propping up an oppressive regime in Greece.

    • Richard:

      In case you don’t know Greece is a “black hole” because Germany has miscalculated.

      It’s the German erroneous calculations that had created the false impression that the German plan was executable to begin with.

      So, when the German FM says it’s a black hole that’s code for “Germany screwed this one up” big time. That’s all it means.

      And to repeat it as if there is any blame of Greece in it further compounds on the realization that the Germans are out of depth.

      And no, I am not part of the Greek government.

      As for Merkel she has the IQ of an average German peasant. She is neither particularly bright nor knowledgeable on the subject of economics. To her the euro crisis is a feeble attempt at creating a platform for re-election.

      Whether Merkel is re-elected or not that’s a matter of internal German politics. None of our concern.

      Because with or without Merkel Germany remains a country unfit to guide European affairs.

    • Dean – “In case you don’t know Greece is a “black hole” because Germany has miscalculated.” – Hold on, your saying that Greek politicians have given control of the Greek economy to Germany and it is Germany who is at fault?

      Lets pretend I believe Germany told Greek politicians to increase taxes (which I dont, but lets pretend)

      Your blaming Germany for REQUESTING tax increases and NOT Greek politicians for handing over control of the Greek economy to the German government?

      Please explain to me who is the bad guy here, the Greek government for betraying the Greek people or the German government giving bad advice?

  • Maybe you should care more about nepotism risk? From the Athen News:

    Former speaker embroiled in nepotism scandal

    by Costas Papachlimintzos 9 Aug 2012

    NEPOTISM in Greek politics reared its head again after revelations that parliament speaker Vyron Polydoras got his daughter a job in parliament

    Although he retained the position of the speaker for the hung parliament that resulted from the May 2012 elections just for one day, Vyron Polydoras rushed to hire his daughter, Margarita, as an employee in his office.

    “She worked for me both when I was a Minister for Public Order and when I was the deputy speaker of the parliament. As the parliament speaker, I hired her as a revocable employee,” Polydoras said in an interview to the website

    He also underlined that his act was not illegal. “I was entitled to hire six employees. I hired none except for my daughter, who assists me by working twenty hours per day,” he said, suggesting that the attacks by the media on his decision are “a planned act”.

    Polydoras had also sparked reaction with another decision he made as parliament speaker when he approved a two million euro “election bonus” for parliamentary staff and police.

    Under the arrangement, parliament’s 1,300 staff were to receive 1,000 euros each, while police officers attached to parliament were to be paid an extra 300 euros.


  • Looks like our money is taken care of well:

    Vyron Polydoras, who held the position of speaker for just a single-day during the hung parliament of May 2012, rushed to hire his daughter – Margarita – as an employee of his office.

    Not only did he hire her on his one and only day in office, despite defending himself by stating he was entitled to hire up to six staff, but he also managed (all in this one day remember) to approve a two million euro ‘election bonus’ for his staff and police.

    • If you want to complain, go tell Merkel.He is a member of the party she was favoring for the elections.

    • In response to Crossover:

      This is amazing. So even when a Greek politician shows an acute case of nepotism, it’s still Merkel’s fault. Could you please offer an instance when Greek malfeasance isn’t Germany’s fault. I’d like to know.

    • Murkey – I too would love to hear an example. Since when is allegedly giving bad advice (Merkel) a bigger “crime” than selling out the people you are supposed to represent (ie treason by Greek politicians for following advice they claim is against the interests of the Greek people).

    • @MurkeyWaters

      I was obviously being sarcastic.The actual meaning is what we’ve been saying since a long time ago.Merkel is on the same side with those most Germans believe she is against.Germany has accused Greece for cooking statistics on the low,yet they had no problem accepting Papademos as PM.In fact they pushed for him.Papademos was the head of the BoG at the time the so called cooking took place.

      Same thing in the latest elections.PASOK and ND are wholly responsible for Greece’s role (however big or small this may be) in the creation of this time-bomb which eventually exploded,yet Germany was pushing for and achieved a coalition government with these 2 parties and DIM.AR.

      Im sorry but it doesnt get any more obvious what fools out of you Merkel makes.

  • The STRATFOR intelligence website had the following piece today:
    By George Friedman

    Louis M. Bacon is the head of Moore Capital Management, one of the largest and most influential hedge funds in the world. Last week, he announced that he was returning one quarter of his largest fund, about $2 billion, to his investors. The reason he gave to The New York Times was that he had found it difficult to invest given the impossibility of predicting the European situation. He was quoted as saying, “The political involvement is so extreme — we have not seen this since the postwar era. What they are doing is trying to thwart natural market outcomes. It is amazing how important the decision-making of one person, Angela Merkel, has become to world markets.”

    The purpose of hedge funds is to make money, and what Bacon essentially said was that it is impossible to make money when there is heavy political involvement, because political involvement introduces unpredictability in the market. Therefore, prudent investment becomes impossible. Hedge funds have become critical to global capital allocation because their actions influence other important actors, and their unwillingness to invest and trade has significant implications for capital availability. If others follow Moore Capital’s lead, as they will, there will be greater difficulty in raising the capital needed to address the problem of Europe.

    But more interesting is the reasoning. In Bacon’s remarks, there is the idea that political decisions are unpredictable, or less predictable than economic decisions. Instead of seeing German Chancellor Merkel as a prisoner of non-market forces that constrain her actions, conventional investors seem to feel that Europe is now subject to Merkel’s whims. I would argue that political decisions are predictable and that Merkel is not making decisions as much as reflecting the impersonal forces that drive her. If you understand those impersonal forces, it is possible to predict political behaviors, as you can market behaviors. Neither is an exact science, but properly done, neither is impossible.

    Political Economy
    In order to do this, you must begin with two insights. The first is that politics and the markets always interact. The very foundation of the market — the limited liability corporation — is political. What many take as natural is actually a political contrivance that allows investors to limit their liability. The manner in which liability is limited is a legal issue, not a market issue, and is designed by politicians. The structure of risk in modern society revolves around the corporation, and the corporation is an artifice of politics along with risk. There is nothing natural about a nation’s corporate laws, and it is those corporate laws that define the markets.

    There are times when politics leave such laws unchanged and times when politics intrude. The last generation has been a unique time in which the prosperity of the markets allowed the legal structure to remain generally unchanged. After 2008, that stability was no longer possible. But active political involvement in the markets is actually the norm, not the exception. Contemporary investors have taken a dramatic exception — the last generation — and lacking a historical sense have mistaken it for the norm. This explains the inability of contemporary investors to cope with things that prior generations constantly faced.

    The second insight is the recognition that thinkers such as Adam Smith and David Ricardo, who modern investors so admire, understood this perfectly. They never used the term “economics” by itself, but only in conjunction with politics; they called it political economy. The term “economy” didn’t stand by itself until the 1880s when a group called the Marginalists sought to mathematize economics and cast it free from politics as a stand-alone social science discipline. The quantification of economics and finance led to a belief — never held by men like Smith — that there was an independent sphere of economics where politics didn’t intrude and that mathematics allowed markets to be predictable, if only politics wouldn’t interfere.

    Given that politics and economics could never be separated, the mathematics were never quite as predictive as one would have thought. The hyper-quantification of market analysis, oblivious to overriding political considerations, exacerbated market swings. Economists and financiers focused on the numbers instead of the political consequences of the numbers and the political redefinitions of the rules of corporate actors, which the political system had invented in the first place.

    The world is not unpredictable, and neither is Europe nor Germany. The matter at hand is neither what politicians say they want to do nor what they secretly wish to do. Indeed, it is not in understanding what they will do. Rather, the key to predicting the political process is understanding constraints — the things they can’t do. Investors’ view that markets are made unpredictable by politics misses two points. First, there has not been a market independent of politics since the corporation was invented. Second, politics and economics are both human endeavors, and both therefore have a degree of predictability.

    Merkel’s Constraints
    The European Union was created for political reasons. Economic considerations were a means to an end, and that end was to stop the wars that had torn Europe apart in the first half of the 20th century. The key was linking Germany and France in an unbreakable alliance based on the promise of economic prosperity. Anyone who doesn’t understand the political origins of the European Union and focuses only on its economic intent fails to understand how it works and can be taken by surprise by the actions of its politicians.

    Postwar Europe evolved with Germany resuming its prewar role as a massive exporting power. For the Germans, the early versions of European unification became the foundation to the solution of the German problem, which was that Germany’s productive capacity outstripped its ability to consume. Germany had to export in order to sustain its economy, and any barriers to free trade threatened German interests. The creation of a free trade zone in Europe was the fundamental imperative, and the more nations that free trade zone encompassed, the more markets were available to Germany. Therefore, Germany was aggressive in expanding the free trade zone.

    Germany was also a great supporter of Europewide standards in areas such as employment policy, environmental policy and so on. These policies protect larger German companies, which are able to absorb the costs, from entrepreneurial competition from the rest of Europe. Raising the cost of entry into the marketplace was an important part of Germany’s strategy.

    Finally, Germany was a champion of the euro, a single currency controlled by a single bank over which Germany had influence in proportion to its importance. The single currency, with its focus on avoiding inflation, protected German creditors against European countries inflating their way out of debt. The debt was denominated in euros, the European Central Bank controlled the value of the euro, and European countries inside and outside the eurozone were trapped in this monetary policy.

    So long as there was prosperity, the underlying problems of the system were hidden. But the 2008 crisis revealed the problems. First, most European countries had significant negative balances of trade with Germany. Second, European monetary policy focused on protecting the interests of Germany and, to a lesser extent, France. The regulatory regime created systemic rigidity, which protected existing large corporations.

    Merkel’s policy under these circumstances was imposed on her by reality. Germany was utterly dependent on its exports, and its exports in Europe were critical. She had to make certain that the free trade zone remained intact. Secondarily, she had to minimize the cost to Germany of stabilizing the system by shifting it onto other countries. She also had to convince her countrymen that the crisis was due to profligate Southern Europeans and that she would not permit them to take advantage of Germans. The truth was that the crisis was caused by Germany’s using the trading system to flood markets with its goods, its limiting competition through regulations, and that for every euro carelessly borrowed, a euro was carelessly lent. Like a good politician, Merkel created the myth of the crafty Greek fooling the trusting Deutsche Bank examiner.

    The rhetoric notwithstanding, Merkel’s decision-making was clear. First, under no circumstances could she permit any country to leave the free trade zone of the European Union. Once that began she could not predict where it would end, save that it might end in German catastrophe. Second, for economic and political reasons she had to be as aggressive as possible with defaulting borrowers. But she could never be so aggressive as to cause them to decide that default and withdrawal made more sense than remaining in the system.

    Merkel was not making decisions; she was acting out a script that had been written into the structure of the European Union and the German economy. Merkel would create crises that would shore up her domestic position, posture for the best conceivable deal without forcing withdrawal, and in the end either craft a deal that was not enforced or simply capitulate, putting the problem off until the next meeting of whatever group.

    In the end, the Germans would have to absorb the cost of the crisis. Merkel, of course, knew that. She attempted to extract a new European structure in return for Germany’s inevitable capitulation to Europe. Merkel understood that Europe, and one of the foundations of European prosperity, was cracking. Her solution was to propose a new structure in which European countries accepted Brussels’ oversight of their domestic budgets as part of a systemic solution by the Germans. Some countries outright rejected this proposal, while others agreed, knowing it would never be implemented. Merkel’s attempt to recoup by creating an even more powerful European apparatus was bound to fail for two reasons. First and most important, giving up sovereignty is not something nations do easily — especially not European nations and not to what was effectively a German structure. Second, the rest of Europe knew that it didn’t have to give in because in the end Germany would either underwrite the solution (by far the most likely outcome) or the free trade zone would shatter.

    If we understand the obvious, then Merkel’s actions were completely understandable. Germany needed the European Union more than any other country because of its trade dependency. Germany could not allow the union to devolve into disconnected nations. Therefore, Germany would constantly bluff and back off. The entire Greek drama was the exemplar of this. It was Merkel who was trapped and, being trapped, she was predictable.

    The euro question was interesting because it intersected the banking system. But in focusing on the euro, investors failed to understand that it was a secondary issue. The European Union was a political institution and European unity came first. The lenders were far more concerned about the fate of their loans than the borrowers were. And whatever the shadow play of the European Central Bank, they would wind up doing the least they could do to avert default — but they would avert default. The euro might have been what investors traded, but it was not what the game was about. The game was about the free trade zone and Franco-German unity. Merkel was not making decisions based on the euro, but on other more pressing considerations.

    Modern Trading
    The investors’ problem is that they mistake the period between 1991 and 2008 as the norm and keep waiting for it to return. I saw it as a freakish period that could survive only until the next major financial crisis — and there always is one. While the unusual period was under way, political and trade issues subsided under the balm of prosperity. During that time, the internal cycles and shifts of the European financial system operated with minimal external turbulence, and for those schooled in profiting from these financial eddies, it was a good time to trade.

    Once the 2008 crisis hit external factors that were always there but quiescent became more overt. The internal workings of the financial system became dependent on external forces. We were in the world of political economy, and the political became like a tidal wave, making the trading cycles and opportunities that traders depended on since 1991 irrelevant. And so, having lost money in 2008, they could never find their footing again. They now lived in a world where Merkel was more important than a sharp trader.

    Actually, Merkel was not more important than the trader. They were both trapped within constraints about which they could do nothing. But if those constraints were understood, Merkel’s behavior could be predicted. The real problem for the hedge funds was not that they didn’t understand what they were doing, but the manner in which they had traded in the past simply no longer worked. Even understanding and predicting what political leaders will do is of no value if you insist on a trading model built for a world that no longer exists.

    What is called high velocity trading, constantly trading on the infinitesimal movements of a calm but predictable environment, doesn’t work during a political tidal wave. And investors of the last generation do not know how to trade in a tidal wave. When we recall the two world wars and the Cold War, we see that this was the norm for the century and that fortunes were made. But the latest generation of investors wants to control risk rather than take advantage of new realities.

    However we feel about the performance of the financial community since 2007, there must be a system of capital allocation. That can be operated by the state, but there is empirical evidence that the state isn’t very good at making investment decisions. But then, the performance of the financial community has been equally unacceptable, with more than its share of mendacity to boot. The argument for private capital allocation may be theoretically powerful, but the fact is that the empirical validation of the private model hasn’t been there for several years.

    A strong argument can be made — corruption and stupidity aside — that the real problem has been a failure of imagination. We have re-entered an era in which political factors will dominate economic decisions. This has been the norm for a very long time, and traders who wait for the old era to return will be disappointed. Politics can be predicted if you understand the constraints under which a politician such as Merkel acts and don’t believe that it is simply random decisions. But to do that, you have to return to Adam Smith and recall the title of his greatest work, The Wealth of Nations. Note that Smith was writing about nations, about politics and economics — about political economy.

    Read more: Financial Markets, Politics and the New Reality | Stratfor

    • You could have said that Merkel is a phony and that she has been consistently screwing up since day one. And that she is about to get a big come uppance.

      Here, I just saved you a few paragraphs of weird Austin talk.

    • David, thanks for the post – I agree with this guy, Merkel should have let the Greek government default at the start.

    • So what is the difference of a free trade zone with trade partners broke with a non free trade zone ? Austerity kills the trade partners of Germany.

    • A very interesting post.
      I like the approach to analyze the interests of the actors (here with a focus on Germany) in order to understand what are the driving forces that in the end determine what Ms. Merkel does.
      I am not sure that Germany is quite so dependent on Europe in terms of exports as the post suggests. Don’t get me wrong: Exports to the Eurozone are important to Germany, of course. But exports to non-Eurozone countries make up a growing share of German exports. Furthermore, exporting to countries that are insolvent involves giving away the money to the foreign customers, lent by German banks or the ECB or whatever (ultimately with Germany bearing a large part of the cost if the south defaults) is not in the interest of Germany as a whole.
      It may well be in the interest of the exporting companies (e.g. Mercedes, Siemens, etc) but overall, it destroys wealth in Germany.
      The money is just given away to others who then consume German products. That is a stupid growth model.
      I believe that slowly but surely, German decision makers are becoming aware of this and over time this will change.
      Exports to customers that can’t pay are non-sense as we can observe with the Greece experience.

    • Dean, the only phoney thing Merkel has done is to scapegoat the Greeks, which she did for mostly domestic political consumption to keep an economically unsophisticated German electorate even more uninformed. But her propaganda was a very successful misdirection Europe-wide to distract from Germany’s having the Euro Zone’s “house of cards” stacked in Germany’s favor. The writer makes this point clear.

      Richard, I thought the writer made a strong case for why Merkel didn’t, and still doesn’t, want Greece to default. The house of cards would likely come crashing down, leaving financial/fiscal ruination all over the EU, and most especially for Germany, the biggest benefactor of Europe’s integration.

      It’s a big mess, becoming bigger, and as likely as Yanis’ modest proposal would been to have once solved the crisis (if done early in the crisis), it seems, to me, less likely it can solve this crisis in its present dimension. I don’t know whether the writer is right that Germany/Merkel will eventually have to absorb the costs of cleaning up this big mess

      “…the rest of Europe knew that it didn’t have to give in because in the end Germany would either underwrite the solution (by far the most likely outcome) or the free trade zone would shatter.”

      The Handelsblatt, Bild, and other German papers regularly carry articles by prominent economists and politicians urging Germany to exit the Euro, despite predictions of disaster by Deutschbank and most mainstream politicos and economists if the EZ falls apart or Germany exits.

      The writer’s prominently mentioning German corporations was not accidental.There’s so much neoliberal poison in unelected part of Euro’s leadership, plus elected neoliberal leadership in Greece, Germany, Spain, Italy, and Ireland who so want to crush labor that they will carry this as far as they can, short of armed rebellion by masses, to reshape Europe into a fascist’s best fantasy – corporate rule with the bankcorps leading the way!

  • Amartya Sen:
    What happened to Europe? Democracy and the decisions of bankers.

    “The unification of Europe is an old dream. It is not quite as ancient as it is sometimes suggested—the dream is not of classical antiquity. Alexander and other ancient Greeks were less interested in chatting with Goths, Vikings, Angles, and Saxons than they were in conversing with ancient Iranians, Bactrians, and Indians, and Julius Caesar and Mark Antony identified more readily with ancient Egyptians than with Europeans located to the north of Rome. But Europe went through successive waves of cultural and political integration, greatly helped by the powerful spread of Christianity; and by 1464 King George of Poděbrady in Bohemia was talking about pan-European unity. He was followed by many others in the centuries to come, and by the eighteenth century, even George Washington wrote to the Marquis de La Fayette that “one day, on the model of the United States of America, a United States of Europe will come into being.”

    “Those who advocated the “unity of a European currency” as a “first step” toward a united Europe have in fact pushed much of Europe into an entirely counterproductive direction for achieving European unity. There is, of course, no danger of a return to 1939, but, to use Auden’s analogy of the “dogs of Europe,” barking from sequestered regional bases of resentment and contempt does immense harm to the cause of cultivating European amity and unity.”

    “Some of the policies that were chosen by the financial leaders and economic powers of Europe were certainly mistimed, if not downright mistaken; but even if the policy decisions taken by the financial experts were exactly correct and rightly timed, an important question of democratic process would have remained.”

    “…If democracy has been one of the strong commitments with which Europe emerged in the 1940s, an understanding of the necessity of social security and the avoidance of intense social deprivation was surely another. Even if savage cuts in the foundations of the European systems of social justice had been financially inescapable (I do not believe that they were), there was still a need to persuade people that this is indeed the case, rather than trying to carry out such cuts by fiat. The disdain for the public could hardly have been more transparent in many of the chosen ways of European policy-making.”

    “…Many of [the] “rescue” proposals are certainly worth considering and may prove useful, but none of the proposals address—or are meant to address—the long-run viability problem arising from the inflexibility of the exchange rate through the shared euro, even as countries with relatively lower productivity growth (such as Greece and Spain and Italy) fall behind other countries in the euro zone in terms of competitiveness in trade. A country such as Greece may find that it has increasingly less it can sell abroad at the fixed exchange rate of the euro, unless what is not done by exchange rate adjustment is brought about by the brutal process of cutting wage rates— …In the absence of exchange rate adjustments, competitiveness for the countries falling behind can indeed be recovered through sharp wage cuts and other ways of cutting earnings, thereby reducing living standards more drastically than would be otherwise necessary. …Sooner or later the difficult question of the longrun viability of the euro would have to be addressed, even if the rescue plans are completely successful in preventing a breakdown of the euro in the short run.”

    “…Europe has been extraordinarily important for the world, which has learned so much from it. It can remain globally important by setting its own house in order—economically, politically, and socially. The first step is to understand properly, with some clarity, the policy challenges that Europe faces today. A failure to do so will reverberate far beyond Europe’s own borders.”

    Amartya Sen teaches economics and philosophy at Harvard University and received the Nobel Prize in Economics in 1998. He is the author, most recently, of The Idea of Justice (Harvard University Press). A version of this essay was given as a lecture at the Bank for International Settlements in June.

  • This is a simple but loaded question:

    Is there anything – anything at all – that the Germans could do that does not lead to ultimate defeat and disgrace?

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