A Financial Story IPE Folks Should Love

Because it reinforces our priors:

Its membership in the euro currency union hanging in the balance, Greece continues to receive billions of euros in emergency assistance from a so-called troika of lenders overseeing its bailout.

But almost none of the money is going to the Greek government to pay for vital public services. Instead, it is flowing directly back into the troika’s pockets. ...

If that seems to make little sense economically, it has a certain logic in the politics of euro-finance. After all, the money dispensed by the troika — the European Central Bank, the International Monetary Fund and the European Commission — comes from European taxpayers, many of whom are increasingly wary of the political disarray that has afflicted Athens and clouded the future of the euro zone.

More here. I have said for awhile now that the story in the eurozone is that the north would keep the south liquid until the north's banks were sufficiently capitalized to handle a default, at which point the money would stop flowing. I thought that would be sometime in 2013 (I think I wrote a post saying that, but can't find it now), but now I think it could be this year.

Why should IPE folks like this story? Because this is the type of tale we tell all the time: "bailout" funds are used to bail out the donor, not the recipient. Just like "aid" funds to the developing world are often tied to certain types of disbursement and are thus a form of subsidy for corporations in the developed world.

There are parallels here (of course) to the Latin American debt crises of the 1980s, where much of the debt was owed to commercial banks in the U.S. The U.S. Treasury pushed for IMF intervention, mostly so U.S. banks could get their money back without the federal government having to officially bail them out. (The story is even more nuanced -- Congress understood what was happening and demanded new regulations of the banking sector, which led to the creation of the first Basel accord -- as Thomas argues here.)

Annals of Silly(?) Policymaking: Procyclical Financial Regulations During a Bank Run Edition

This (via @dandrezer) does not seem smart:

Banks must raise their core tier one capital ratios to 9pc by the end of this month or face the risk of partial nationalisation. The global Basel III rules are also pressuring banks to retrench.  

The International Monetary Fund said banks will have to slash their balance sheets by $2 trillion (£1.6 trillion) by the end of next year even in a "best-case scenario".

That is only within the European Union, and it came about due to panic over Greece last month. Basically, this means that EU banks have to increase their capital cushions by over 200% by the end of this month. What does that mean?

The Bank for International Settlements (BIS) said cross-border loans fell by $799bn (£520bn) in the fourth quarter of 2011, led by a broad retreat from Italy, Spain and the eurozone periphery.

Note that this just in Europe. But it made me wonder (on Twitter): why do this now? After all, it was Germany that insisted on a longer phase-in period for Basel III during negotiations, while the US/UK/Switzerland wanted that stricter capital requirements. Now the EU is doing a rapid phase-in and tougher capital limits years before they are required to by Basel. And they're doing it in the middle of a bank run during a continent-wide recession. What gives? A few things.

1. Banks do have to get to 9% tier 1 capital by the end of the month, but they don't have to come fully into compliance yet. That is, a lot of junk capital that is prohibited by Basel III -- but was allowed under Basels I and II -- will still be allowed. (ht to @Procyclicality for this point)

2. Nevertheless, this is still a big boost to minimum capital standards. So how will banks come into compliance? Two quick and easy ways are to:

a. Hold more cash.

b. Buy more sovereign debt.

The first of these is contractionary -- it's basically hoarding more cash rather than lending it out -- although the ECB can facilitate it if they want to pump eurozone banks full of cash. Non-euro EU central banks, such as the Bank of England, can do the same thing if they want and the US Federal Reserve has injected a bunch of liquidity into foreign banks when needed in the past as well. As a zero-risk instrument, cash has a zero risk weight, so adding more of it to your portfolio brings your overall capital ratio up.

The second of these is expansionary. OECD sovereign debt also carries a zero risk weight under Basel III, as it did under Basels I and II. This might seem bizarre at first, but remember who's making these rules: OECD governments. And OECD governments want to pay low interest on their debt. To do that, they rig the regulatory rules to make it more attractive for financial institutions to buy that debt. Hence, a zero risk weight in Basel.

So what does that mean? If banks need to boost their capital stock, there are two ways to do it: by raising more capital (e.g. by selling equity) or by shifting their risk portfolio. The former latter will be often preferred to the latter former, so banks are essentially being encouraged to buy sovereign debt (and other zero risk weight instruments) in order to come into regulatory compliance.

Was this the point of this policy? I don't know. Probably it was mostly a freak-out after runs started on Greece and then Spain. But I imagine it was part of the calculus, or at least has become so since. In practice this will likely be a transfer of private funding for public funding. Given that the ECB cannot provide liquidity directly to eurozone governments, but can accept sovereign debt as collateral when lending to banks, this could be part of a stealth bailout program that began when Mario Draghi took over as ECB chief from Jean-Claude Trichet last year. Call it "bailout by regulatory arbitrage".

Will it work? I don't know.

Not Quite Crony Capitalism?

I haven't read this yet, but Lucas Puente -- a PhD student at Stanford -- has an interesting-looking article in the new PS (I don't see an ungated version). Abstract:

I investigate one mechanism through which financial institutions could have used political influence to receive preferential treatment in the US Department of the Treasury-administered “bailout.” I find that neither proxies of political influence nor other political variables, such as public interest in specific deals, can explain variance in the sale price of warrants (a type of financial asset) Treasury acquired through TARP's Capital Purchase Program. Moreover, I find that the more politically active the firm is, the more likely Treasury is to auction its warrants (thereby receiving fair market value). This conclusion is not consistent with recent studies investigating the role of such variables in the initial administration of TARP and can be interpreted as good news for American taxpayers.

PS summary (bold added):

In the wake of the recent global financial crisis, many have suggested that the US government's administration of the taxpayer-funded rescue of the financial industry offered disproportionate benefits to politically active firms. However, quite the opposite occurred. Puente's research into Treasury's handling of the disposition of warrants (assets similar to stock call options) acquired through the Capital Purchase Program (CPP) shows that, at least in this phase of the "bailout," political variables did not matter. That is, lobbying expenditures, campaign contributions, and connections with Secretary of the Treasury Geithner, among other independent variables, cannot explain variance in the percentage of market value Treasury received for these warrants. Moreover, according to Puente, the more politically active a firm is, the more likely Treasury is to auction its warrants (thereby receiving fair market value). This suggests that Treasury is attempting to counter-act allegations of preferential treatment. Taxpayers should be pleased. By insulating itself from politics and making efforts to maximize the taxpayer return on the warrants, Treasury may have prevented billions of dollars in taxpayer losses.

I personally don't find this very surprising. Nor would I find it surprising if preferential treatment came mainly through less transparent channels, e.g. the Fed. It looks like Puente might be investigating that question in his ongoing research.

Baking Banking Instability into the European Cake

Apologies for the long absence. The past few weeks have been extraordinarily busy on several fronts. I think I'll be able to get this place back into fighting shape pretty quickly.

The decision of S&P to downgrade more or less the whole of Europe has made a lot of headlines, but I'm not sure how much it matters. The plan for Europe before that happened isn't much affected by the downgrade: the ECB prints money and gives it to the banks, accepting EMU sovereign debt as collateral. The banks use the funds to buy sovereign debt. The banks get financing for sure, and if all goes well so do the governments. As far as I can tell, for regulatory purposes all OECD sovereign debt still counts as "risk-less" -- meaning that banks are not forced to hold any capital against it -- under the Basel accords, so there is a regulatory incentive for banks to buy some of this stuff.

There's something absurd about all of this... every step in the chain is an attempt to hear no evil by sticking fingers in one's ear. But if the eurozone is going to survive the European banking system has to stand upright and be able to finance governments. That requires ECB support.

JP MorganChase CEO Jamie Dimon, who often says things in public that are more revealing than he perhaps realizes, recently claimed to believe that there is no banking problem in Europe:

“It eliminates bank liquidity or funding problems for at least the next year, that’s a pretty powerful statement,” Dimon said today after his company reported a drop in fourth-quarter net income. “That was the biggest single risk of an uncontrollable surprise right there, so if that’s taken off the table, that’s a good thing.” ... 

“Europe is trying mightily to solve its problems. I still think the likely outcome is they will muddle through,” Dimon said. “The longer you wait, the higher you run the risk of something disorderly that you can’t really control. I think the ECB took off the worst outcome, i.e. a bank failure.”

Dimon might be right about Europe being able to muddle through, although I still have my doubts. He might even be right that a bank failure is the "worst outcome" in Europe, although I can think of some worse outcomes. But what he doesn't say, indeed what no one has much talked about, are the negative effects this will likely have in the European banking sector if the plan works.

The problem that the new ECB policy is supposed to resolve is this: banks won't lend to needy European governments except at punitive rates. Why? Because those governments are highly likely to default. This is exactly what we want a responsible, healthy banking sector to do.* What we don't want is what we're now hoping to get, which is to say that we don't want a banking sector whose investment behavior is skewed by political institutions pursuing dubious policy goals. We don't want a banking sector that has an expectation of future support if their investments go bad, and we don't want a banking sector that cannot discipline either itself or those to whom it lends.**

We don't, in short, want a situation in which government interventions make Jamie Dimon smile. (Or interventions that make him rich.)

Is this road less bad than the one Europe was on previously? In short run, surely. In the medium-to-long run it's hard to say. Perhaps we think that once the crisis is resolved the ECB can make a credible future commitment to be more standoffish towards the European banking sector. Perhaps we think that we can rein in banks and national governments in other ways, via strict capital standards for the banks and "Hard Keynesianism" for the governments. But I have little confidence that those things are likely. They cut against almost every identifiable political current.

The only way it works is if this crisis really scares everybody so much that a significant (and durable) shift is made in the regulatory and fiscal infrastructure of Europe. While not impossible, I remain highly skeptical that that will happen. I believe it's more likely that policymakers will conclude that the institutions in place are pretty resilient already -- "How else could we have pulled through this crisis?" -- particularly when coupled with a more activist ECB that will support the banking sector when needed.  I believe the banks will conclude that the ECB is their friend, and will therefore count on support when needed, particularly if the cause of the trouble are the member nations of the EMU. That is a recipe for a lot of future financial instability.

The ECB cannot, and should not, be in the business of resolving Europe's political problems. Forcing it into that role is likely to make things worse in the long run.

*The "we" here being an imagined societal consensus in possession of the general will, which reflects more-or-less center-left neoliberal technocratic principles. Yes, I know this "we" does not exist in nature.

**I have a paper, currently R&R, that argues that when banks expect preferential policies from governments they act less prudently. Simple argument, I know, but it's not in the literature yet. I find statistical support. I'll post it if/when it gets accepted somewhere; if someone wants it sooner e-mail me.

The World's Central Banker, Again

Foreign banks are arbitraging the Fed:

Up until April this year, US banks had a nice little earner.

As Freakonomics explained, big banks were able to borrow cash from the Fed funds or repo market for say, 15 basis points, posting US Treasuries as collateral, and then deposit the cash received with the Federal Reserve overnight at 25bps, earning some 10bps. The FT has estimated that since late 2008, this risk-free arbitrage may have netted America’s banks as much as $200m in profits.

The arbitrage-opp came to an end in April, however, when the US Federal Deposit Insurance Corporation’s (FDIC) introduced a new fee on banks, essentially eliminating the 25bps-grab.

Small problem. It seems the new FDIC rules don’t apply to many non-American banks. And foreign banks, we should all know by know, also have access to the repo markets and federal funds.

Moreover, this is a good thing. The Eurocrisis may have been more destabilizing than it has been if foreign banks didn't have an easy way to recapitalize. And it doesn't hurt the US. Well, it hurts US banks, which don't have the same opportunity, but that provides an incentive for them to lend to the real economy, which is needed.

Also note this:

... the reported assets of US branches of foreign banks are up 250 per cent since the end of last year, now making up a whopping 48 per cent of their total assets. Basically, foreign banks have absorbed all of the growth in reserve balances in 2011.

Re: That EMU Stealth Bailout

See Daniel Davies' comments on my original post, plus this from Whelan at IIEA and this from Storbeck. Via Felix Salmon, who also had this to say.

The upshot is that this appears not to be the stealth bailout that I thought it was, although I have to admit that at this point I'm confused on a few points and will need a bit of time to sort through it all. Also, even if this isn't a stealth bailout I think that's probably a shame. The monetary authorities can do much more to help the Europeriphery, while the fiscal authorities are out of political bullets. So I'd rather have some clandestine bailouts than not.

Euro Developments

First, the ECB is quarreling with Berlin:

The cold war between Berlin and Frankfurt reached a new high last week. Should Germany implement its plans, the ECB would have to cut off funding for Greece, the monetary watchdogs warned. The consequences for Europe's banks and the Greek economy would be devastating.

The mere suggestion of what the Financial Times called the " central bank equivalent of nuclear deterrence" was enough to prompt German Finance Minister Wolfgang Schäuble to withdraw the German proposal immediately. A debt restructuring, Schäuble admitted sheepishly, could lead to a repeat of the events triggered by the bankruptcy of Lehman Brothers in September 2008.

In addition to revealing how serious the euro's problems are, the slugfest proves how much of its reputation the Frankfurt-based ECB has lost in the euro zone's strongest economy.

In the past, the central bank was seen as the undisputed economic authority in Germany. Anyone who opposed the monetary policy experts was quickly marginalized. Today, however, the central bank must threaten with the most drastic of measures just to force the German government to toe the line. A majority of German economic politicians and economists see the ECB's crisis strategy as unrealistic and contradictory.

But would a Greek restructuring really be so devastating for Germany? It would have some costs, but at this point these would be manageable:

A debt reduction -- known as a "haircut" -- of as much as 50 percent would be an expensive proposition for Greece's creditors. With around €330 billion ($467 billion) in loans, that would mean cutting as much as €165 billion. Most of Greece's debt is with foreign creditors, and so foreign banks and governments would have to take massive hits over the loans Athens is unable to repay in full.

But what would this mean in reality for Germany? ...

The answer to all of these questions is reassuring -- at least at first glance. The consequences of a debt write-off against the government in Athens would be manageable for Germany. At the moment, some €25 billion in Greek debt is held by Germany's commercial banks and the so-called "bad banks" set up to take on toxic assets. This debt takes the form of either Greek sovereign bonds in their portfolios or loans made to the Greek government. ...

With a 50-percent haircut, the two bad [government-backed] banks would lose around €4.4 billion in total. Taxpayers would end up indirectly footing the bill. ...

Of mild comfort is the fact that the state would probably not have to come to the rescue of any private institutions. Commerzbank, Deutsche Bank and the DZ Bank, which acts as the central bank for Germany's roughly 1,200 partly state-owned co-operative banks, are (once again) in a position to be able to cope with possible shortfalls by themselves.

But that's just the banks. The taxpayers have already loaned Greece a lot of money, either directly or via the ECB:

But the situation looks different for the German government and the federal states. At the very least, the large exposure of KfW and the bad banks of Hypo Real Estate and WestLB could end up being expensive. 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.

However the Irish and Portuguese banking sectors are still exposed to Greece, and are much weaker than Germany's banking sector. Still, the fact that the Germany financial system has largely healed since 2008, and has already taken many steps to lessen their exposure to Greece, gives Germany a lot of negotiating leverage in the EU. And, as EU Monetary Affairs Commissioner Ollie Rehn says, political will for continued aid is running low in northern Europe.

In Brussels, we Finns are referred to as "English-speaking Germans," because we pursue the same economic policy principles: stability, sustainable growth and fiscal responsibility. The Germans aren't the only ones who are concerned. There is a certain aid fatigue in all of northern Europe. And we are experiencing a certain reform fatigue in southern Europe. As monetary commissioner, I feel this schizophrenia every day. We must try to build a bridge between these two camps.

Put it all together? Time is running out for Greece.

The Politics of IMF Leadership

Daniel Davies titles a recent post on the selection process of the new IMF chief "Taking the politics out of politics, and the international relations out of international institutions". Davies is correctly pushing back the notion that the IMF exists for technocratic perfection, specifically the argument (by Martin Wolf among most other popular writers) that the IMF chief needs to be an economist.

This is real "too important to be left to generals" territory. A "merit-based" selection process for the IMF top job is effectively assuming that all the issues the IMF faces are technical (not political), and that the problem is to find someone with sufficient technical economic skills to pick the right solution from a mass of confusing alternatives.

In fact, in general the IMF tends to face situations in which there are only about three or four real options, one of which is usually both massively obviously the best idea, and politically very difficult for some powerful constituency or other. That's why it's a political job. And the allocation between the USA and Europe was agreed at the original Bretton Woods conference as part of a very dicey compromise between the only two blocks which can print unlimited hard currency. It's an international institution, and one of the biggest problems in designing such an institution is to persuade the major powers that it is worth their while working through the institutional framework rather than through bilateral diplomacy. That's why the UNSC has permanent members, for example, and it's why France and Germany tend to get first dibs on important Commission posts.

I am no fan at all of the IMF (or of the way in which history is being rewritten to cast them as opponents of pointless austerity). But it does at least kindasorta work as an international institution, which is why I'm in favour of not fixing it.

Davies is right that the IMF is more about politics than about economics. That's the whole point of having an established international institution rather than a series of ad hoc transfers as needed: sometimes the ad hoc transfer won't come for political reasons, and that can lead to disasters like the 1930s. There are a number of political dimensions related to the IMF. One is the austerity politics in the debtor nation. The IMF is routinely portrayed (including by Davies here) as some kind of bogeyman, externally imposing its imperial will (or the imperial will of the US) onto smaller, less powerful countries. This is only some of the story. James Vreeland has done a lot of the best research on the IMF, and here's the abstract of a new working paper by him:

Many argue that governments use IMF programs to push unpopular policies past domestic political opposition. Many others have argued that the IMF is merely a tool of US foreign policy, providing loans without enforcing policy conditions. This paper addresses the inconsistencies between these two views, presenting large-n evidence supporting both. The domestic politics story, however, depends on international politics. The IMF can only be used to push through unpopular policies when the institution is not being used to reward friends of the US.

In other words, the IMF is a useful bogeyman for domestic leaders that want (or need) to pursue unpopular reforms, but do not have the domestic political constituency to do so. To the extent that some of these reforms are necessary (as they certainly are in Greece today), we may not want a kinder, gentler IMF. Better for the IMF to remain the scapegoat, thus giving domestic reformers some political room to move. Blame the institution, but pass the reform. Some of Vreeland's other work supports this idea.

There's another political aspect of the IMF that is less discussed. Dr. Oatley wrote a post last year about the politics of bailouts in creditor nations. Basically, the story runs like so: it is often politically unpopular for one country to give aid to other countries in times of need. Think about the typical German voter, who wonders why her tax dollars should be spent to reward the Greeks for their profligacy? A direct funding mechanism (like EFSF?) may not be politically sustainable in democracies. But an indirect funding mechanism (like the IMF) may be more politically successful, by making the bailout one step removed from budget politics in creditor countries.

We're seeing both elements at play in this crisis. Austerity is unpopular in debtor countries like Greece but is inevitable in some form, so if politicians can shift some of the blame onto the IMF it may help them get necessary reforms through. At the same time, voters in Germany and France don't like being expected to pick up the tab of the Europeriphery indefinitely, and have set 2013 as the expiration date for bailout funds. But the IMF doesn't have such a limit. It can extend funds when and where they are necessary. And funding the IMF is not as politically salient as funding other countries directly.

Because the IMF is facing domestic political pressures in creditor and debtor nations, as well as international political pressures from its constituent governments (particularly the US, but the role of EMs are growing too), its next leader should be someone that can navigate the political space and doesn't mind be blamed for everything that goes bad in debtor countries. The next leader should not be someone chosen for their technical economic nous, much less for their country of origin, but for their political sensibility.

I have no idea of Christine Lagarde is that person. I know very little about her. What I do know is that she's a bureaucrat, not an academic, and so presumably has a good sense of the European political situation. That's a start.

The EU Crisis In One Picture

The Economist has it on their cool "Daily Chart" blog. The full article is sub-titled "Is Germany bailing out euro-area countries to save its own banks?" The answer, of course, is "yes". This is why Germany is insisting on austerity throughout the union. This is why the ECB is intervening in bond markets. This is why the EFSF is providing loans until 2013, but not after. This is why Ireland, Greece, and Portugal are so unhappy. The entire EU response to the debt crisis is to construct policies that protect German -- and to a lesser extent French -- banks.

We've written about this before. When folks like Krugman are bewildered that the ECB's monetary policies are "one size fits one", they're absolutely right. But that's because this policy is about distribution, and about appeasing powerful domestic interests. Those are the banks.

ECB Fact of the Day

Remember when I said that, by ignoring its legal mandate to not be the lender of last resort, the ECB was the only thing holding the EMU together? Here's what I meant:

As the scope of the Irish losses has grown clearer, private investors have been less and less willing to leave even overnight deposits in Irish banks and are completely uninterested in buying longer-term bonds. The European Central Bank has quietly filled the void: one of the most closely watched numbers in Europe has been the amount the E.C.B. has loaned to the Irish banks. In late 2007, when the markets were still suspending disbelief, the banks borrowed 6.5 billion euros. By December of 2008 the number had jumped to 45 billion. As Burton spoke to me, the number was still rising from a new high of 86 billion. That is, the Irish banks have borrowed 86 billion euros from the European Central Bank to repay private creditors. In September 2010 the last big chunk of money the Irish banks owed the bondholders, 26 billion euros, came due. Once the bondholders were paid off in full, a window of opportunity for the Irish government closed. A default of the banks now would be a default not to private investors but a bill presented directly to European governments. This, by the way, is why there are so many important-looking foreigners in Dublin, dining alone at night. They’re here to make sure someone gets his money back.

To put that into perspective, 86bn euros is roughly 112bn dollars. Irish GDP is about $230bn, so they've borrowed 50% of GDP from the ECB. Without those funds, they'd have to default and (probably) leave the EMU.

That's from Michael Lewis' story on Ireland. I wonder where he's booked his next ticket? Portugal?

UPDATE: Okay, I just finished Lewis' piece. This part stood out:

Ian turns out to have a good feel for what I, or anyone else, might find interesting in rural Ireland. He will say, for example, “Over there, that’s a pretty typical fairy ring,” and then explain, interestingly, that these circles of stones or mushrooms that occur in Irish fields are believed by local farmers to house mythical creatures. “Irish people actually believe in fairies?,” I ask, straining but failing to catch a glimpse of the typical fairy ring to which Ian has just pointed. “I mean, if you walked right up and asked him to his face, ‘Do you believe in fairies?’ most guys will deny it,” he replies. “But if you ask him to dig out the fairy ring on his property, he won’t do it. To my way of thinking, that’s believing.” And it is. It’s a tactical belief, a belief that exists because the upside to disbelief is too small, like the former Irish belief that Irish land prices would rise forever.

Apparently Lewis has a thing for mystical creatures, because that immediately reminded me of his story about the Icelandic belief in elves that lived underground, from his Iceland article (now gated, unfortunately). Among other facts and descriptions in the Iceland piece, the elves story was widely disputed; perhaps the fairies will be too. I don't remember anything from the Greece article, but I may go back and check.

Parsing Ireland, Germany, and the Euro

Here's how Tyler Cowen sees it:

My model here is simple. The Germans fear that if Ireland pulls the plug on the bailout deal, some of the other PBIIGS will meet immediate financial crises, and that spills over onto both German lending banks and Germany as the country holding the eurozone together. Ireland feels that if it pulls the plug on the bailout deal, the Germans don't lend enough support and a) they lose what's left of their banking system, and b) their next government bond auction goes very, very badly.

Here's the most recent news:

Despite rising pressure for new measures to draw a line under the debt crisis, Germany moved Monday to close off debate on an increase to a 750 billion euro bailout fund, or the more radical step of issuing common euro-zone bonds. ...

European diplomats say privately that there has been a debate in recent days on whether to increase the fund to make it clear that a big economy like Spain could be defended, if needed. But many believe that the public mood in Germany makes such a move politically impossible for Mrs. Merkel, unless it was presented as a last-ditch effort to save the euro itself.

“It is a last-resort mechanism,” said a European official who was not authorized to speak publicly. “We still have enough money for Portugal, if needed, and Spain is not drowning. There is also the question of whether this would send the right signal to the market. It might be misinterpreted as suggesting that there was more to come.”

Right now the domestic political equilibrium in Germany seems to be "We like regional integration but not being the PIIGS' sugardaddy. Greece was one thing, but Ireland, Portugal, Spain, and Italy are quite another. We can go back to the mark without too much problem. We'll have to bail out our banks, but that's cheaper than bailing out all of the PIIGS. If the PIIGS won't commit to austerity in order to make our banks whole, then we're not footing the bill. It's insane and immoral that we should be forced to pay for bad governance in the Euro's periphery." This is a reasonable and even right perspective.

The political equilibrium in Ireland seems to be "It is insane and immoral that we should be forced to pay off the bad bets of foreign bankers while they are made whole. Our government made a huge mistake in guaranteeing those foreign bets, thinking that a strong guarantee would never actually be called, but now it is being called and we're not paying. Any Irish government that wishes to pay will be removed from power immediately. We'd rather be Iceland than the alternative." This is also a reasonable and right perspective.

I have less information about attitudes in Portugal, Spain, and Italy, but if I were a citizen of one of those countries I'd be very hesitant to engage in austerity before it is clear what the outcome will be in other countries. If the Euro is going to break up or contract, why go through the pain? Just wait, then default and/or devalue.

Everybody in this equation -- Germany and the PIIGS -- have strong incentives to defect even if cooperation would yield a better outcome. And it's not even clear that it would. Those who gain the most from the Euro while contributing the least -- Belgium, Luxembourg, France, etc. -- are the ones pushing the hardest for cooperation.

I don't think it is very accurate to describe things this way (from the article):

Germany, once the driving force behind European integration, now has to placate public opinion, which is openly hostile to measures that could require Germany to pick up more of the tab for weaker economies.

This was always a concern, hence Maastricht. Now that it's clear that Maastricht is meaningless, German fears have been fully realized. As far as Germany is concerned, they've already donated billions of euros plus sacrificed the integrity of their central bank to peripheral economies that may or may not ever get their house in order. There is now discussion about moving to a fiscal union. Germany rightly recognizes that continued bailouts is a de facto fiscal union already. They don't want that. Why would they?

Germany isn't interested in sharing its credit rating either, and no wonder. Who in their right mind would co-sign for the PIIGS right now?

Mrs. Merkel has rejected a separate call from Luxembourg and Italy to create a common euro-zone bond. Such a move would not be permitted under the European Union’s governing treaty, she said. Creating the legal possibility to issue euro-zone bonds, German officials suggest, would require a substantial rewriting of the European Union treaty, something most countries would be unwilling to do because it could require referendums in several countries where it lacked enough support.

The question is now: how much is the Euro worth to Germany? How much is it worth to the PIIGS? Will Germany continue to add hundreds of billions of euros to the tab? Will the PIIGS enact and enforce the sort of austerity that Germany will need to see to keep the price down? Is there any way to ensure that this won't be a recurring feature of the monetary union?

Here's what will happen when one or several countries leave the union. Here's Barry Eichengreen going off. Here's a post asking IPE scholars to step up to the plate. Here's a very good discussion of the economics and politics of the situation, including a reference to Beth Simmons' book on the politics of adjustment during the interwar gold standard years, and this quote from Kindleberger:

[W]hether deflation and unemployment would saddle a major share of the load on the working class, as contrasted with the rentier. ... Keynes observed in 1922 that the choice between inflation and deflation comes down to the agonizing outcome of a struggle among interest groups.

I would note that during the interwar years not all of Europe were democracies; nevertheless, everyone left the gold standard eventually. The working classes have certainly gained bargaining power since then.

At this point, I think the IMF needs to prepare to lend currency to the PIIGS following a break-up of the Euro. That might not happen, but they need to be ready for it if it does, and those countries will need access to foreign exchange. The IMF needs to have a program of organized devaluation + writedowns ready in that case.

Many in the U.S. are quick to point out the lessons from Europe regarding debt. They should also note the lessons regarding currency. An inflexible currency leads to all kinds of other problems, including the ability to manage debt. This should be a warning to all those who want the U.S. to go back to a gold standard now, or to abolish the Fed in favor of a fixed monetary policy.

Want to Know Who Got Money from the Fed in 2008?

WSJ has got you covered.

Slate's Annie Lowrey breaks it down, and got this quote which backs up what I've been saying over the past few days:

"We knew the Fed helped foreign companies," Petrou says. "But this speaks to the Fed's credit. In the midst of a global financial crisis, the Fed mustered liquidity support when all of the other central banks were acting slowly. The Fed became the global central bank—and that was a very good call, given that everyone's backs were against the wall."

Why TARP Was Good, and Why Bailout Guarantees Are Necessary

The CBO has once again lowered its estimate of the cost to taxpayers of TARP. It's not down to $25bn, from an expected $109bn in March. At this rate, the program might make a profit overall, rather than just a profit from the bank portion of the program. Even if it loses $25bn, it's hard to argue that that's poor value for money, as Ezra Klein and Jon Chait point out.

Ryan Avent is not convinced. He says that the success or failure of TARP cannot be measured solely in dollars, but also in how it reshaped the political economy of finance in a way that exposes taxpayers to future defaults:

But to cite the dollar cost of the bill and declare it a roaring success is to totally misunderstand what TARP actually did. ...

What's important to realise is that built into the rise in value of the companies backed by the government (the banks especially) is the government's guarantee against failure. The government hasn't yet withdrawn this guarantee, and so it's still on the hook. President Obama could go before the country and say, "Ok, having sold our shares we now promise to never again bail out troubled companies". Markets would go "Ha ha ha", and continue behaving as if the government was still on the hook. Because it is. ...

But having convinced markets that the banks won't be allowed to fail, the government has accepted some set of unknown future obligations, which are growing all the time thanks to the moral hazard of the government guarantee. ...

So what has TARP cost American taxpayers? The correct answer is: we don't know. It's almost certainly less than the cost of the Depression that would have resulted from cascading failures at the nation's largest banks. But it's a lot more than $25 billion.

I think this is exactly wrong. The first wrong thing is thinking that a bailout guarantee didn't exist before the crisis. It did. The pattern of U.S. government intervention into financial markets, from the Latin American crisis (using the IMF) to LTCM, always suggested that the government would step into to prevent financial collapse. This was the Geithner plan, forged from his experiences in the Tequila and Asian crises. The Bear Stearns deal in March, 2008 reinforced that pattern. The exception was Lehman, and that's why the Lehman collapse was so devastating: markets expected the government to intervene when necessary. When it didn't, it set off a major panic. That is not something we should be keen to replicate.

The second wrong thing is to think that this is bad. As I wrote some while ago:

At some point in the future some financial institutions will become illiquid. If the government makes a credible commitment to not provide funds to those distressed institutions, then the first sign of trouble will touch off a run on those firms. Bank runs are contagious, so even if only a single firm is affected initially, the trouble could sink the whole system. It's much better for the government to instill confidence in the system by guaranteeing that they will support illiquid firms than to guarantee that they won't.

And:

How do escape the vicious cycle of bank runs? The government intervenes by guaranteeing the funds of depositors. This intervention may be costly, but is much less costly than continuing to let a panic eat the financial system from the inside out. Nevermind the fact that the government cannot make a credible commitment to not bailout systemically-important financial institutions: it would be a bad thing if they could! Such a commitment would lessen confidence in the financial system and thus make runs more likely, not less.

Of course there are concerns about moral hazard, but there are ways to address these without pretending the U.S. government can make a commitment to not bail out financial firms when everyone knows they will if things get bad enough. For example, the government can protect counterparties and depositors while still punishing bank management and shareholders.

In fact, some governments choose to do this. Guillermo Rosas wrote a very good paper (pdf) in 2006 describing why some governments opt for bailouts, while others follow Bagehot's advice to shutdown illiquid firms. Rosas also has a book on the same topic, which I've not yet read.

The point is that we can make the punitive cost of intervention severe enough for bankers to restrict moral hazard, while still working to maintain confidence in markets and prevent runs. This is what we should do. (Note that my view has shifted on this over time; at the height of the crisis I was unconvinced that punitive damages were a good idea, but now I think they are. For management and shareholders at least.)

Avent argues that TARP cheerleading is damaging because moral hazard prices in that we will bail out distressed firms automatically in the future. I worry about the opposite: that the TARP slagging (by progressives and Tea Party types alike) weakens confidence in markets and makes the system more susceptible to damaging bank runs. Perversely, this could make public intervention more likely rather than less. To see an example of this in real time, look at the tepid commitment from the EU to support the PIIGS. If they had made a bigger commitment at an earlier date, the overall cost of intervention would likely have been much lower.

In other words, we don't want the political equilibrium to shift further away from engaging in emergency actions to stabilize teetering markets. That's the world of the 1930s. If we can make a commitment to maintain stability in financial markets (thus benefiting the country at large) without rewarding financial managers and shareholders for profligacy (thus hurting those that took excessive risks without harming innocent bystanders), then we definitely should. I'm not saying that we did that effectively in this crisis, but that should be the goal.

So here's the story we should be telling: TARP was an exceptionally successful program. The best thing about it was that it stabilized markets at relatively low cost, and perhaps even a profit. The worst thing about it was that it was not severe enough towards management and shareholders. But we can fix that the next time this happens. We can pass legislation today that if financial firms require government bailouts, they come with harsh penalties. We should not throw out the good with the bad, and we don't have to. We should always insist that we will do whatever is necessary to maintain confidence in markets, but in so doing we will try very hard not to reward those that make bad investment decisions. They should be forced to bear the cost of their actions.

I'm not sure if there's a winning political coalition for that perspective right now. The financial industry obviously wouldn't appreciate that sort of commitment. Neither would most progressives, libertarians, or Tea Party conservatives. But that's that the narrative we should present.

When An E.U. Bailout Is A U.S. Bailout

Yesterday I posted about how the Fed has been acting as the world's central bank, and how those of us who learned from Kindleberger view this as a very good thing. But it's not just the Fed, as the other parts of the U.S. are ready and willing to step in and provide funding for Europe via the IMF:

The United States would be ready to support the extension of the European Financial Stability Facility via an extra commitment of money from the International Monetary Fund, a U.S. official told Reuters on Wednesday. ...

The remarks foreshadow a visit to Europe this week by a U.S. Treasury envoy who is expected to visit Berlin, Madrid and Paris to hold talks on the ramifications of the debt crisis. ...

The developments have echoes of the pressure applied by Washington on European capitals last May to create the near $1 trillion EFSF safety net that was last week used to rescue Ireland after its banking crisis spiraled out of control.

Given what we know about how the U.S. uses the IMF for strategic purposes, we should think of this as primarily directed at protecting the American financial sector. Just as the European Emergency Financial Stabilization Fund is primarily intended to protect the German and French banking sectors. That is, large European financial firms are heavily exposed to southern European debt, and are also counterparties of large American banks. Remember that U.S. are exposed to European banks to the tune of $3.5 trillion. If debt defaults harm European banks, this could undermine financial stability in the U.S. as well. Given that EU regulators are requiring another round of stress tests for European banks, the solvency of the European banking system is still very much in doubt. For that matter, the U.S. banking system is still quite weak.

In other words, the E.U. sovereign debt crisis is starting to resemble the Latin American sovereign debt crisis in some important ways. The response of the U.S. to both is to mobilize the IMF to shore up the system with emergency funding to the counterparties of American banks, and turn to the Basel Committee to push the costs of stricter regulatory regime onto other states. We've seen this movie before (pdf).

I've noticed some howls of complaint about this (from Facebook friends, for instance, although I'm sure it will percolate into the punditocracy soon enough). The argument goes: "How can we afford to bail out Europe, when we can't afford to take care of ourselves?" The answer is twofold: First, we can't afford not to work for financial stability around the globe. The costs of doing nothing are likely much higher than any bailout costs. If the U.S. abandons the rest of the world, the result would be disaster and chaos. Second, as I said above, U.S. actions are about the U.S., not Europe. It's not even about preserving the monetary union, or happy-go-lucky feelings that come from European integration.

A proper view includes many more dynamics than just money going from the U.S. to the E.U.

Hegemony and Bank Bailouts

Back in October I argued that Ben Bernanke, as a scholar of the Great Depression, may have emphasized the global economy over the domestic economy since 2008. In other words, perhaps he had not followed the advice of Sumner, Williamson, and others to engage in quantitative easing on a massive scale because he did not want to encourage competitive devaluations. As I wrote then:

Scott Sumner and Paul Krugman don't agree on much, but they do agree that the Fed isn't doing enough. Some have expressed bemusement that "Helicopter Ben" Bernanke, student of the Great Depression, hasn't done more to prevent the worsening of the recession. ...

I have no reason to think this is true, but perhaps Bernanke is influenced by another scholar of the Depression - Charles Kindleberger. Kindleberger argued that the Great Depression became a cataclysmic international event because of the unwillingness of the U.S. and inability of the U.K. to supply public goods to stabilize the international system. Those public goods include maintenance of a system of stable exchange rates and open markets. ...

In other words, perhaps Bernanke is acting as the world's central banker. If Bernanke believes that a U.S.-led currency war would have adverse consequences for the global economy, then perhaps he is willing to prolong the U.S. recovery in order to prevent a large global downturn. Such a deterioration of the global economy would also affect the negatively affect the U.S. of course. So while, ceteris paribus, a dollar devaluation would help the U.S., ceteris is not paribus. A U.S. devaluation would prompt a series of actions in Frankfurt, Tokyo, and Beijing. The resulting exchange rate instability would spook financial markets and hamper trade. Cries for protectionism would grow louder, and the net effect would be sharply negative.

Now we see that the Fed's global actions have not been limited to refusing to engage in competitive devaluations. The Fed also provided emergency funding to many of the world's largest banks:

Foreign banks were among the biggest beneficiaries of the $3,300bn in emergency credit provided by the Federal Reserve during the crisis, according to new data on the extraordinary efforts of the US authorities to save the global financial system.

The revelation of the scale of overseas lenders’ borrowing underlines the global nature of the turmoil and the crucial role of the Fed as the lender of last resort for the world’s banking sector. ...

The biggest cumulative borrower from the Term Auction Facility was Barclays, which bought the US operations of Lehman Brothers out of bankruptcy in September 2008.

Barclays borrowed a cumulative $232bn from the TAF through various subsidiaries. ...

Bank of Scotland and RBS of the UK, Société Générale of France, Dresdner Bank and Bayerische Landesbank of Germany, and Dexia of Belgium were all among the top 10 users of TAF. The second-largest user was Bank of America, which bought Merrill Lynch during the crisis, and borrowed a cumulative $212bn. The biggest seller of commercial paper to the Fed’s Commercial Paper Funding Facility, which bought illiquid short-term loans, was UBS of Switzerland, then insurer AIG. Five of the top 10 CPFF users were European banks.

This is a major revelation, indicating that the U.S. government was prepared to secure the stability of financial firms regardless of national origin. This provides further evidence that the Fed's behavior cannot be understand out of a global context. If you are a follower of Kindleberger, as I am, you have to think of the Fed's actions as a very good thing. So of course the domestic politics of this are going to be ugly, stupid, nativist, and parochial. In other words, the recent political chatter over whether the Fed should have a single mandate or a dual mandate is misguided. Regardless of the domestic de jure mandate, the Fed has a de facto global mandate. It needs to be able to fulfill it, or else we risk a return to the 1930s.

The Ireland Bailout, Animated

Via everybody. I also found this analysis of the Euro situation by Ryan Avent to be pretty good.

Just Who Exactly Is Being Bailed Out in Europe?

(link to bigger image here)

Remember when I said that Greece wouldn't default, because Germany and France would bail them out in order to keep German and French banks solvent? The same is true of Ireland. The above table shows exposure of major banks in Europe's core to sovereign debt in Europe's periphery. The EU will continue to use the EFSF and IMF to bail out its members as long as that is necessary to preserve the stability of the banking system in the core EU countries. The EU is essentially going through it's own version of the 1980s Latin American debt crisis. The only difference is that in this case the periphery shares a common currency with the core. For now.

In short, it isn't Greece or Ireland that's being bailed out; it's German and French banks.

It gets interesting if/when Spain, which is probably too big to bail out, gets into trouble.

Why Greece Won't Default (Yet)

Yglesias:

Thanks to the Euro, none of that’s possible and it’s not at all clear to me what the endgame here really is. For understandable reasons, German (and Austrian, Dutch, etc.) taxpayers don’t want to bail out the government of Greece. And also for understandable reasons, German policymakers prefer the European Central Bank to run a monetary policy that’s appropriate for Germany rather than one that’s appropriate for Greece. So Greece is stuck on a path to default.

This is all right, but it stops where the interesting analysis begins. If Greece defaults, who will it affect? Well, it will hurt the owners of Greek debt, as well as the owners of debt of other troubled Eurozone countries. Who owns that debt? Banks in Germany and France, mostly:

German and French banks carry a combined $119 billion in exposure to Greek borrowers alone and more than $900 billion to Greece and other countries on the euro-zone's vulnerable periphery: Portugal, Ireland and Spain.

Together, France and Germany's banking sectors account for roughly half of all European banks' exposure to those countries. Nearly half of the outstanding debt is with Spain, according to data from the Bank for International Settlements. The data include government bonds, corporate debt and loans to individuals.

So the integrity of the French and German banking sectors are vulnerable to a Greek default. Of course, the integrity of the U.S. and U.K. banking sectors are at risk to the collapse of French and German banks. The question is whether these countries want to bail out their banking sectors directly after a Greek default, or bail out Greece before a default. So far they have chosen the latter, just as the U.S. did following the Latin American debt crisis in the 1980s. If banks are able to reduce their exposure to a debt default, we might see that change. Until then, we likely won't.

Remember the Fall of 2008?

Times were different then. Here's a reminder:

Good news: AIG is paying back $4 billion to the U.S. government.

Bad news: They must pay back over $90 billion more to gain independence from the state.

Parsing the Euro Bailout

Well. The much-anticipated Euro bailout plan has been revealed, and it's impressive: just short of $1tn, $625bn of which comes from Euro governments, and the rest from the IMF*. Why so large?

Officials are hoping the size of the program — a total of $957 billion — will signal a “shock and awe” commitment that will be viewed in the same vein as the $700 billion package the United States government provided to help its own ailing financial institutions in 2008.

Yes, that's part of it. But the reason why TARP was so big was so that it wouldn't actually have to be. In other words, the U.S. government hoped that by making an enormous commitment to secure illiquid/insolvent institutions that were susceptible to runs, it would prevent those runs from even occurring, thus saving the actual financial commitment in the long run. To some extent this happened, as only about half of TARP's funds were ever disbursed (even after extending loans to non-financial firms, like the auto makers). I'm sure that Euro governments are hoping for the same thing; if the commitment is perceived as being sincere, then part of the follow-through may become unnecessary.

Euro governments aren't the only ones hoping to instill confidence:

Underscoring the urgency of the situation, President Obama spoke to the German chancellor, Angela Merkel, and the French president, Nicolas Sarkozy, on Sunday about the need for decisive action to restore investor confidence. And in a sign of the spreading anxiety, the United States Federal Reserve, along with the European Central Bank and the central banks of Canada, Britain and Switzerland, announced the establishment of instruments known as swap lines. The swaps are intended to ease pressure on European banks and money markets by providing more liquidity. ...

The actions by the United States represented significant concern that the European crisis could spill over and hinder the American recovery.

Why might that be? Well, who owns all the sovereign debt of Greece and the other PIIGS? Already-weakened banks in the U.S. and Europe. U.S. banks are exposed to European banks to the tune of $3.5tn (yes, trillion), and if Greece or any other countries default, those European banks will go under and take U.S. banks with them. Obviously that can't be allowed to happen. The recent ratings downgrades of Greece's debt have already dealt a blow to banks' capital ratios. A default or restructuring would be devastating.

But this new bailout cash has only been pledged, not actually raised, so here's what I'm going to be watching over the coming days:

In a statement after their meeting, the ministers emphasized that the [funds] would expire after three years and that its use would be strictly dependent on “national constitutional requirements.”

The language most likely reflected the reservations of some governments to providing even more money than is available in bailout packages already approved.

Remember that TARP did not pass the House the first go-round. Europe now has to pass several of them in several different countries. There are strong domestic political pressures in some countries (notably Germany and Britain) to not bail out the PIIGS at all, and it might be very difficult to muster enough domestic support to actually procure this huge level of funds. Perhaps more distressing is the fact that Greece could end up defaulting anyway because of domestic politics there. A lot of national polities have to play ball in order for this to work the way it's supposed to work, and I'm not sure whether that will actually happen.

One thing is clear: one way or another, the eurozone will never again be as it was from 1999-2009. The mandate of the ECB is already shifting, the likelihood that one or more countries will leave the monetary union is still somewhat high, and the rise of economic nationalism throughout the zone indicates that there is less camaraderie than previously thought. Something's gotta give.

*Presumably the IMF funds will also be coming from Euro governments, although I'd be interested to see if that's actually the case. How will voters respond if the U.S. is spending $100bn to bail out Europe? Not well, I imagine.