The Politics of Stealth Bailouts and Plausible Deniability in the Eurozone

My post yesterday on how the German banking sector can likely withstand a restructuring of Greek debt touched on, but did not dwell on, another important aspect of the Euro crisis: it's not just the banks in the Eurocore that own debt in the periphery, but also the governments. I wrote "The taxpayers have already loaned Greece a lot of money, either directly or via the ECB" and quoted a Der Spiegel report that said:

Taxpayers might need to step in, as might the savings banks that are owned by municipalities.

In addition, the European Central Bank (ECB) has bought up tens of billions of euros of Greek sovereign bonds. Because the Bundesbank, Germany's central bank, holds more than a quarter of the ECB's capital, it would have to take its share of losses accordingly.

This latter point is the subject of this Martin Wolf column that has made the rounds of the blogosphere (Salmon, McArdle, Krugman) and yielded the above graphs. Wolf's column is provocative -- he begins with "The eurozone, as designed, has failed." -- but makes a very important point about the centrality of the European banking system to the broader regional economy:

The role of banks is central. Almost all of the money in a contemporary economy consists of the liabilities of financial institutions. In the eurozone, for example, currency in circulation is just 9 per cent of broad money (M3). If this is a true currency union, a deposit in any eurozone bank must be the equivalent of a deposit in any other bank. But what happens if the banks in a given country are on the verge of collapse? The answer is that this presumption of equal value no longer holds. A euro in a Greek bank is today no longer the same as a euro in a German bank. In this situation, there is not only the risk of a run on a bank but also the risk of a run on a national banking system. This is, of course, what the federal government has prevented in the US.

The ECB doesn't technically have legal authority as a lender of last resort (although it's taken on part of that function since 2007), so domestic central banks as well as the US Federal Reserve have had to fill that role. The upshot? Central banks in the Eurocore, such as the German Bundesbank, are now heavily exposed to debt from the periphery. At current rates of lending they're likely to run out of cash by 2013, and unlike the US Fed, they can't just print more. This is becoming a slow-moving liquidity crisis, in other words, and as London Banker wrote a few days ago, liquidity crises (such as occurred in the Fall of 2008) are really nasty. As Wolf notes, this is serious business:

Government insolvencies would now also threaten the solvency of debtor country central banks. This would then impose large losses on creditor country central banks, which national taxpayers would have to make good. This would be a fiscal transfer by the back door.

In a sense this is already a fiscal transfer, since debtor countries are spending the funds on financing the state, and the creditor central banks don't have a printing press. So why, given that a fiscal transfer was needed, was it done in a way that risks the solvency and credibility of Eurocore central banks? Because they are unelected. Such a large transfer plan on top of the EFSF is unlikely to have been approved by voters in the Eurocore, as my post from yesterday indicates. And as Hans-Warner Sinn notes (via Henry Farrell's Twitter), the size of these hidden transfers "dwarfs the parliament-approved bailouts extended to Greece, Ireland and Portugal." It's easy to see why European leaders would opt for a bailout mechanism that was less transparent, and that involved non-elected actors pulling the strings: it allows bailout financing to continue, but with plausible deniability.

Sinn draws an analogy between the situation in the Europeriphery and Britain in 1992, when Soros sank the pound by selling it off. Eventually, the British Treasury ran out of marks and francs to exchange for pounds, and was forced to devalue. Soon, writes Sinn, there won't be enough funds in Bundesbank to cover the borrowing in the periphery. At that point, the Euro will collapse like the pound. If Sinn is right, then the Euro has two years. I've been saying for awhile now that 2013 was key to the Euro's future. 2013 is officially when haircuts begin, and when new bailout lending ends. It's also when the "stealth bailout", through the central banking system in the EU, can no longer sustain itself. At that point, either the peripheral economies have righted the ship by balancing the budget and/or regaining access to private credit markets, or they exit the Euro.

So right now it's a waiting game. The Eurocore doesn't want a restructuring, which would cost taxpayers (and banks) billions, if it can avoid it. The Europeriphery doesn't want the economic collapse that would accompany a Euro-exit. But both of them want the other to pick up more of the tab. But there's not much more the periphery can pick up, with unemployment above 11% in Portugal, 14% in each of Greece and Ireland, and 20% in Spain. And there's not much more the core can pick up without risky the solvency of their domestic central banks. More direct fiscal funding mechanisms look to be politically impossible. Maybe one of those things changes by 2013, but I wouldn't bet on it.

Spain Feels the Pressure

To this point Spain's economy hasn't suffered as much as Portugal, Greece, or Ireland, but that doesn't mean things are going well. Economic pressures continue to mount, and Spain faces the same exchange rate pressures as those other countries. A currency devaluation would help boost competitiveness and thus employment, but that isn't possible under the euro. In a fixed exchange rate system, internal devaluation via wage cuts and increased unemployment is the only option. And democratic publics don't like that very much:

About 28,000 people, most of them young, spent Friday night in Puerta del Sol, a main square in downtown Madrid, the police said. They stayed even as the protest ban went into effect at midnight under rules that bring an official end to campaigning before the election in 13 of Spain’s 17 regions and in more than 8,000 municipalities.

Fueling the demonstrators’ anger is the perceived failure by politicians to alleviate the hardships imposed on a struggling population. The unemployment rate in Spain is 21 percent.

And Spain looks likely to be the next European country to tilt right since the economic crisis:

Sunday’s election is expected to result in a countrywide sweep by the Popular Party, the main center-right opposition, at the expense of the governing Socialists, whose popularity has plummeted because of the economic crisis. The most recent opinion polls suggest that the Socialist Party may lose in regions and municipalities where it has been in power since Spain’s return to democracy in the late 1970s, notably Castilla-La Mancha.

There are other issues at stake, including concerns about corruption, but those get magnified when unemployment is at 21%. Some folks on Twitter are saying that the police tried to break up some protests, but I haven't seen a credible report on that yet. Either way, these issues aren't going away.

Downgrading Islamist Terror As A Public Threat?

We should, says Dan Gardner:

Islamists? They were behind a grand total of one attack. Yes, one. Out of 294 attacks [in Europe]. In a population of half a billion people. To put that in perspective, the same number of attacks was committed by the Comite d'Action Viticole, a French group that wants to stop the importation of foreign wine.

Obviously the trend is similar in the U.S. We've just had an act of domestic terrorism that (apparently) had nothing to do with Islam. And despite several feeble, failed attempts, we've had almost zero attacks from Islamist groups in nearly a decade. This does not match with the rhetoric we often here.

Gardner also gets a good one in on Mark Steyn:

But half a decade has passed since Steyn declared the outbreak of the "Eurabian civil war."

And yet, there are no waves of bombings. No armies of bug-eyed jihadis. No pale-faced boat people bobbing about the North Atlantic in rusty scows. ...

Mark Steyn has a new book in the works, apparently. Something to do with the end of civilization. Given his track record, this is grounds for optimism.

Contrast that with the ongoing drug wars in Latin America. Twenty-seven people were killed in Acapulco just yesterday, including fourteen beheadings. Since 2006, there have been more than 30,000 drug killings in Mexico alone. And of course that doesn't include other countries where illicit drug activity is high, especially Columbia.

As for ETA... they've officially laid down their arms.

Obviously many more people die from Islamist groups in the Middle East and Asia than in the Americas or Europe, but that fact does not bode well for "clash of civilizations" hypotheses like Steyn's.

The point is not to minimize real threats, or to ignore problems of assimilation in Europe (and the U.S.). The point is to have a more realistic understanding of what's going on. Despite many warnings, a wave of Islamist violence has just not infected the West.

Parsing the IMF PIGS Package

Mark Copelovitch writes about Spain and the IMF, and how his own research sheds some light on these issues, in a guest post at Menzie Chinn's place:

As the Fund's largest quota contributors, the "G-5" countries (the US, Germany, Japan, UK, and France) exercise de facto control over IMF lending decisions. At the same time, the G-5 countries are also home to the largest private creditors in global markets, including the world's largest commercial banks. Consequently, G-5 bank exposure heavily influences these governments' preferences over IMF lending policies. In particular, I find that IMF loan size and conditionality vary widely based on the intensity and heterogeneity of G-5 governments' domestic financial ties to a particular borrower country. When private lenders throughout the G-5 countries are highly exposed to a borrower country, G-5 governments collectively have intense preferences and are more likely to approve larger IMF loans with relatively limited conditionality. In contrast, when G-5 private creditors' exposure to a country is smaller or more unevenly distributed, G-5 governments' interests are weaker and less cohesive, and the Fund approves smaller loans with more extensive conditionality. ...

So, what are the implications for a future EU/IMF bailout of Spain (or Portugal, or Ireland)? Despite the heated rhetoric by Angela Merkel, Nicolas Sarkozy, and others about the need for the PIGS to put their own house in order by imposing staunch austerity measures, we are quite likely to see even stronger support for Spain (and Ireland), given its importance for the profitability and solvency of French and German banks. Portugal, in contrast, is likely to fare worse than Greece, given its limited importance for the major eurozone (and G-5) banking sectors. At the same time, we are also likely to see tensions within the IMF over the size and terms of any contribution to future PIGS rescue packages, given that American and Japanese views about the importance of eurozone bailouts are colored by their own, less extensive, financial interests in these countries. Ultimately, whether the "core" countries in the EU and the IMF view a rescue package as a "bailout" or a worthy endeavor depends not only on whether the borrower in question has been "profligate," but also on their own domestic financial interests and the vulnerability of their own commercial banks to a potential financial crisis.

We've covered similar themes for quite some time on this blog (see, e.g., here), and the way in which domestic political constraints influence the actions of international institutions has been a major theme in IPE for quite some time. It's good to see it get more play in bigger outlets. It's too bad to see Tyler Cowen refer to it as "public choice" rather than IPE, but hopefully this sort of analysis will catch on with bigger blogs and other media outlets, and the profile of the discipline will be raised a bit.

Copelovitch's soon-to-be-released book expands on these themes, and certainly appears to be worthwhile reading.

In Which Tyler Cowen Is Much More Dismissive of Krugman Than I've Ever Been

Here. The title refers to commenters on recent previous posts.

Check out the CDS spread, the market is now more worried about a Spanish government default than a default from either Banco Santander or a major telecom company.

And yet we are told there are no market signals that European governments are spending too much. We are also told that the Spanish government can do OK with its halfhearted austerity plan or maybe they should even be spending more. Those discussions usually stop at the mention of a single interest rate or perhaps an unemployment figure.

In case you were wondering, Banco Santander and major telecom companies are in big trouble. I've been reading Marginal Revolution every day for six or seven years, and that has to be the most hysterical that I've ever seen Cowen. And while this post is not addressed to Krugman, it is certainly directed at him. Quite frankly, there is so much nuance in this discussion that I'm not sure who is right on the economics. But I do know who is wrong on politics -- the detailed answer is in posts from earlier this week, but psst: it's Krugman!! -- and I know that those wrong views about politics are influencing the economic advice that Krugman is giving. Which makes me think that even if Krugman is right on the economics given his assumptions, his assumptions do not hold in this case, and therefore he is also wrong on the economics.

But maybe not.

The Situation in Europe

I am now starting to argue that either we move soon on this, or Germany will inevitably have to go back (temporarily) to the Mark. The system won’t hold otherwise.

That is Edward Hugh, writing not about Greece but Spain, and advocating a 20% internal devaluation. Much more at the link, including second-hand commentary from Dani Rodrik.

My question: if Germany goes back to the Mark, why would it be temporary?

UPDATE: Rodrik comments here.