I’ve always been a fairly optimistic person, but the following article from Barron’s instantly turned me into a bear. Thoughts? Opinions? ECB: Stuck in the PIIGS Pen By VITO J. RACANELLI | The focus on Greece’s woes has led investors to overlook the risky situation enveloping Europe’s central bank itself. The investor focus on Europe’s worsening sovereign-debt crisis has centered on teetering Greece. That, combined with the bickering between officials of the European Union and European Central Bank about how to resolve this Gordian knot, has distracted investors from an important fact. The ECB itself is up to its neck in risky debt, about 444 billion euros ($637 billion) from the so-called debt-challenged PIIGS pen—Portugal, Ireland, Italy, Greece and Spain. Given the ECB’s leverage, should one or more countries fail, there’s a good chance the write-downs to the ECB’s capital would force the central bank itself to recapitalize. A report last week from Open Europe puts ECB PIIGS exposure, which includes directly held bonds, loans and collateral such as PIIGS bonds, as well as asset-backed securities, at about €444 billion. It isn’t all toxic, but enough—such as the Greek portion, an estimated €190 billion—gives pause. (Open Europe is a think tank skeptical of monetary union and backed by U.K. businesses.) The ECB is leveraged at more than 23 times, with about €82 billion in capital and reserves, versus €1.9 trillion in assets, which, since the ECB is a bank, are the credits outstanding, like government bonds and loans. The U.S. Federal Reserve sports leverage double the ECB’s, at more than 50 times, but its holdings of U.S. Treasuries are higher-quality than PIIGS debt. With that kind of leverage, the report maintains, the ECB’s entire capital base would be wiped out if its asset values fall by just 4.25%, from booking losses on its loan or government-debt holdings. Open Europe estimates that if Greece were to restructure half of its debt, the ECB “is set to face losses of €44.5 billion to €65.8 billion on the government bonds it has purchased and the collateral it is holding from Greek banks,” or about 2.4% to 3.5% of assets, which would come close to wiping out its capital base. Though high, the leverage itself is less controversial than what’s behind it, notes Mats Persson, Open Europe’s director and one of the report’s authors. First, the nature of some of the assets booked is suspect. Second, the ECB’s acceptance of risky paper, like Greek bonds and loans, is effectively transferring risk from investors to taxpayers, and from weaker, debt-challenged euro-zone economies to the richer economies, like Germany’s, says Persson. The ECB is ultimately taxpayer-underwritten, but its vulnerable finances and the potentially huge public costs haven’t been properly understood, argues Persson. Unless the ECB revs up the printing press—highly unlikely—any losses would be passed on to taxpayers in one form or another, he contends. At a Frankfurt news conference Friday, ECB member Jürgen Stark said: “Additional balance-sheet risk is manageable,” according to Dow Jones Newswires. Some observers believe that the ECB’s national-bank members would shoulder most of any sovereign losses and that leverage ratios are flawed if they don’t include other financial-buffer assets, such as €300 billion in revaluation accounts, generally related to gold and foreign-exchange holdings. The ECB has adamantly opposed any restructuring of Greece’s debt. You’d expect a central bank to support bondholder rights. The problem is that the ECB itself stands to be one of the biggest losers when Greece restructures.
Yeah, Europe is pretty messed up right now. Anyway, am I the only one who read this sentence: “the following article from Barron’s instantly turned me into a bear.” Like this? 1. (-_-) ^hmm this is an interesting article 2. ?? 3. (’’)-.-(’’) Rawr!
The ECB is ultimately taxpayer-underwritten, but its vulnerable finances and the potentially huge public costs haven’t been properly understood, argues Persson. Unless the ECB revs up the printing press—highly unlikely—any losses would be passed on to taxpayers in one form or another, he contends. ~~~~~~~~ Why is printing unlikely? Having Greek bonds in your portfolio default isn’t some kind of inflationary event. The ECB can continue on as always, the issue is more that if Greece defaults then the ECB has effectively given free cash to Greece and the other EU countries did not get the same benefit.
As the sole entity with rights to issue Euros, the ECB can never and will never default except by choice. Once you accept that fact, the idea of “recapitalizing” the ECB is clearly nonsensical. They can sustain any leverage level. It does not matter since paying interest on debt or paying down debt is accomplished simply by entering numbers into a computer. I recommend reading up on the description of how monetary systems operationally function as laid out by Modern Monetary Theory. There are a number of free resources on the web, this one sums things up pretty well. http://pragcap.com/resources/understanding-modern-monetary-system A major problem is that there is not a fiscal union and little labor mobility in the Euro Zone. Since the governments are fiscally constrained (unlike in a fiat currency) they are unable to offset the widespread drop in aggregate demand and their economies contract, paradoxically worsening the debt profiles of the PIIGS. The “austerity measures” have clearly not been effective in Greece, Ireland, or Portugal and will not be elsewhere because of the paradox of thrift. IMO the way out is wage inflation in Germany or internal wage devaluation of the PIIGS which is very difficult to accomplish (see the riots as evidence). Currency fluctuations would already have helped even the imbalance out if the respective countries could allow their currencies to float, but they cannot due to the Euro. Over the past couple of years the region has been taking steps toward more fiscal unity which is almost certainly a requirement for survival. No monetary union in history has been able to stay together without fiscal union. There is a lot of political pressure to remain separate government entities, so the likely course is for some of the member countries to split out in the long run.
Saying there is no way out is overly dramatic. Germany is booming right now. Unemployment is falling and confidence is high. The rest of the Eurozone core is doing ok. The Eurozone deficit/GDP ratio is much better than the US, Japan or UK. Obviously there are stuctural issues here because of a common monetary policy but separate fiscal policies, but if Germany wanted to it could solve this problem tomorrow by writing a cheque to the Greek government.
Dwight Wrote: ------------------------------------------------------- > Over the past couple of years the region has been > taking steps toward more fiscal unity which is > almost certainly a requirement for survival. No > monetary union in history has been able to stay > together without fiscal union. bingo > There is a lot of > political pressure to remain separate government > entities, so the likely course is for some of the > member countries to split out in the long run. is there a ‘pentaly box,’ or something like that, being worked up?
mar350 Wrote: ------------------------------------------------------- > is there a ‘pentaly box,’ or something like that, > being worked up? What do you mean?
No way out might be a bit harsh, but just wanted to get some attention. So what happens when the ECB has to take a haircut on all of this debt? Because eventually it seems like that’s the only way out. So the ECB would have to raise capital at the expense of taxpayers right? I was under the impression that tax rates from $25,000-$200,000 brackets are already quite high in the area, this was posted in the WSJ yesterday. Aren’t we already at a point where individuals are losing incentive to work? People stop working, people stop spending, people don’t upgrade homes, etc. Let’s pretend Greece is a person…and that person cannot afford their mortgage payments at 5%, how on earth can they afford the same payment at 25%+? Would you really want to pay for your wreckless neighbor who cannot afford their bills? I certainly wouldn’t. As someone mentioned above, higher taxes in the PIIGS would probably result in strikes/riots. The million dollar question is whether investors are so used to seing these headlines that a default/restrucuring event would have little impact or if this could get bad.
Why does the ECB need capital? Are they going to forget how to use their keyboard? If you think it through and read the link above, there is no solvency risk for any entity that issues its own currency and pays debt in that currency. There is no exception to this rule.
Posted by: Dwight (IP Logged) Date: June 14, 2011 07:23PM Why does the ECB need capital? Are they going to forget how to use their keyboard? If you think it through and read the link above, there is no solvency risk for any entity that issues its own currency and pays debt in that currency. There is no exception to this rule. Perhaps I am missing something. I get the first part but the second part… Wouldn’t that imply that Sovereign ratings are a hoax?
C3Po Wrote: ------------------------------------------------------- > Posted by: Dwight (IP Logged) > Date: June 14, 2011 07:23PM > > Why does the ECB need capital? Are they going to > forget how to use their keyboard? > > If you think it through and read the link above, > there is no solvency risk for any entity that > issues its own currency and pays debt in that > currency. There is no exception to this rule. > > Perhaps I am missing something. I get the first > part but the second part… Wouldn’t that imply > that Sovereign ratings are a hoax? The key is “pays debt in that currency”. If all your debt is denominated in your local currency you will always be able to meet your obligations - just print more money man.
C3Po Wrote: ------------------------------------------------------- > Perhaps I am missing something. I get the first > part but the second part… Wouldn’t that imply > that Sovereign ratings are a hoax? Well the ratings have some justification if a country is in a monetary union like the euro because the governments do not issue their own currency. Also they would make sense if debt is issued in another currency, like many of the Latin American countries used to issue debt in dollars, weimar Germany had war debt that had to be paid in foreign currency, etc. Or it would make sense on the gold standard. For a country issuing its own debt and own currency though it is meaningless. Economic theory is just starting to catch up to the fact that currencies are fiat rather than gold backed, so much of the old neoclassical textbook economics is outdated. Check out the pragmatic capitalism blog and Billy Blog for in depth explanations of mmt since I have pretty limited space to contribute here.
What happens in the US with states like Nevada? Does the federal government transfer money to the state? Is the federal government obliged to help states that face bankruptcy?
Understand the MMT argument and believe that in reality that is what CB’s are doing around the world. However, I cannot come to terms with the fact that there can be no limit. Continuing down this path will lead to currency devaluation and eventually loss of faith in the currency. As an investor , why should I continue to purchase an investment where my returns are less than my investment in real terms? At some point I gotta say no more. I think that this Fiat experiment has worked thus far thanks to the USD’s reserve currency status. My 2C. As far as ratings are concerned, I agree they are meaningless but for other reasons.
Simply print cash? Wouldn’t they need members to provide the capital… I am missing something?
Carson Wrote: ------------------------------------------------------- > What happens in the US with states like Nevada? > Does the federal government transfer money to the > state? Is the federal government obliged to help > states that face bankruptcy? I do not know. A state could default. They are required to balance their budget. I am talking about fiat currency issuers, not users like municipalities. States need to fund their operations whereas central banks and fiat currency governments do not.
C3Po Wrote: ------------------------------------------------------- > Understand the MMT argument and believe that in > reality that is what CB’s are doing around the > world. However, I cannot come to terms with the > fact that there can be no limit. Continuing down > this path will lead to currency devaluation and > eventually loss of faith in the currency. As an > investor , why should I continue to purchase an > investment where my returns are less than my > investment in real terms? At some point I gotta > say no more. > > I think that this Fiat experiment has worked thus > far thanks to the USD’s reserve currency status. > My 2C. > > As far as ratings are concerned, I agree they are > meaningless but for other reasons. There is no limit to the amount of deficits a government can run. There IS however a practical constraint concerning how many resources are available to be spent on. For example in Zimbawe when 70% of the productive economy was destroyed by the land grab and redistribution, the resulting economy was not sufficient to sustain the government and private sector spending, thus “too much money chasing too few goods and services” and then inflation. In the US and Europe we do not have the same problem since much productive capacity remains unused. The US has 9% unemployment and idle factories, Spain has 20%+ unemployment. So the deficits are too low and the austerity is self-defeating (paradox of thrift: one man’s spending equals another man’s income). If you are say China and “say no more” what do you do? You have $3T of reserves and $1.5T of US Treasuries. If you sell Treasuries you just have dollars that are sitting in an account earning zero (actually negative) interest. There are very few assets with large enough markets to absorb $1.5T. So China can either save the dollars or spend them. If they save things continue as status quo. If they spend the dollar loses some value and we begin to export to China and the trade balance reverses over time. The critical concept to get from MMT is that things are a balance and debt is savings to someone else. There is no net loss to the system. When people say “we are loading our children and grandchildren with debt” they forget that that debt represents wealth accumulated by the private sector and the interest payments on the debt will go to their children. The point remains: as long as the ECB is willing to write checks they have no need to finance their spending. The ECB will not need to be “recapitalized”.
LiquidAssets10 Wrote: ------------------------------------------------------- > Simply print cash? > > Wouldn’t they need members to provide the > capital… I am missing something? Not as long as the Euro remains a fiat currency and citizens can pay their taxes in it. See the MMT references above for more details.
Dwight Wrote: ------------------------------------------------------- > C3Po Wrote: > -------------------------------------------------- > ----- > > Understand the MMT argument and believe that in > > reality that is what CB’s are doing around the > > world. However, I cannot come to terms with the > > fact that there can be no limit. Continuing > down > > this path will lead to currency devaluation and > > eventually loss of faith in the currency. As an > > investor , why should I continue to purchase an > > investment where my returns are less than my > > investment in real terms? At some point I gotta > > say no more. > > > > I think that this Fiat experiment has worked > thus > > far thanks to the USD’s reserve currency > status. > > My 2C. > > > > As far as ratings are concerned, I agree they > are > > meaningless but for other reasons. > > > There is no limit to the amount of deficits a > government can run. There IS however a practical > constraint concerning how many resources are > available to be spent on. For example in Zimbawe > when 70% of the productive economy was destroyed > by the land grab and redistribution, the resulting > economy was not sufficient to sustain the > government and private sector spending, thus “too > much money chasing too few goods and services” and > then inflation. > In the US and Europe we do not have the same > problem since much productive capacity remains > unused. The US has 9% unemployment and idle > factories, Spain has 20%+ unemployment. So the > deficits are too low and the austerity is > self-defeating (paradox of thrift: one man’s > spending equals another man’s income). > If I understand correctly, what you are saying is that as long as there is slack in the economy piling on debt will have a positive impact and not be inflationary a la Zimbabwe. We have taken on 2+ trillion in debt and what has it given us? Unemployment is still high, productive capacity is still below potential and GDP is anemic.would you spend 30% of your worth to get a measly 1 to 2 % return? > If you are say China and “say no more” what do you > do? You have $3T of reserves and $1.5T of US > Treasuries. If you sell Treasuries you just have > dollars that are sitting in an account earning > zero (actually negative) interest. There are very > few assets with large enough markets to absorb > 1.5T. \> \> So China can either save the dollars or spend \> them. If they save things continue as status quo. \> If they spend the dollar loses some value and we \> begin to export to China and the trade balance \> reverses over time. China's situation is unique. If China was to sell treasuries then demand for would rise which in effect would raise the yuan because of its /$ peg. If China’s economy were self sustaining, this would not be a problem. > > The critical concept to get from MMT is that > things are a balance and debt is savings to > someone else. There is no net loss to the system. > When people say “we are loading our children and > grandchildren with debt” they forget that that > debt represents wealth accumulated by the private > sector and the interest payments on the debt will > go to their children. I can understand that upto a certain point this is true. However, how can it be termed wealth creation when the value of my savings are eroding due to currency develauation. > > The point remains: as long as the ECB is willing > to write checks they have no need to finance their > spending. The ECB will not need to be > “recapitalized”. I do not profess to have an advanced understanding of these issues but d have an open mind. However, I am still not convinced that unlimited amount of debt is a viable option. I do ot mean to be stubborn for the sake of it. Thanks for your time all the same.
Not at all - hope I don’t come across as a jerk. I don’t pretend to have all the answers just think their is a lot of misinformation out there. C3Po Wrote: ------------------------------------------------------- > If I understand correctly, what you are saying is > that as long as there is slack in the economy > piling on debt will have a positive impact and not > be inflationary a la Zimbabwe. We have taken on 2+ > trillion in debt and what has it given us? > Unemployment is still high, productive capacity is > still below potential and GDP is anemic.would you > spend 30% of your worth to get a measly 1 to 2 % > return? You have to think of debt as the other side of the coin to savings. The 2T of federal debt we have taken on has gone into the pockets of citizens who are paying down debt. (Savings - Investment) + (Taxes - Gov't purchases) + (Imports - Exports) = Zero Or stated another way, if the government runs a deficit, the private sector is saving (assuming zero trade balance). As of now the Financial Obligation Ratio ( = [debt service + rent + car lease + HO insurance + property taxes] / disposable income) is the lowest it has been since 1995. The private sector is able to deleverage because the government is running a deficit. Were we running a trade surplus then either the deficit could be lower or savings higher. The important thing to realize is that the three factors net to zero. If you look at every financial crisis in US history, they have occurred after the government ran a sustained budget surplus for a long period of time, as we did during the Clinton administration. When the government is running a surplus, it means that the private sector is borrowing as a whole, which tends to lead to asset bubbles and lots of defaults culminating in a "minsky moment" where the system falls apart. This balancing effect between private sector and public sector deficits and savings is an accounting identity that holds in every case (again ignoring exports to simplify). My point regarding the deficits is that they are clearly too low because we have persistent unemployment. Coming out of a normal recession, private demand would be booming as well as government stimulus spending, so we would have a much stronger economy. In this case, as the private sector is paying down debt, the increase in consumption is much more moderate. That is consistent in financial crises in history and a key reason why gov't debt runs up in the wake of such crises (so households can repair their balance sheets). \> China's situation is unique. If China was to sell \> treasuries then demand for would rise which in > effect would raise the yuan because of its /$ peg. > If China’s economy were self sustaining, this > would not be a problem. You are absolutely right the situation is unique. The point is that people worry about China stopping lending to us, which does not make any sense at all. The correct way to think about it is that China has a choice, they can 1) hold on to their dollars and continue to purchase US assets (treasuries) or 2) they can sell treasuries for dollars, which would even out the exchange rate and the trade balance would bring us back into a normal equilibrium. Note that there is no panic or financial crisis involved in that situation. > I can understand that upto a certain point this is > true. However, how can it be termed wealth > creation when the value of my savings are eroding > due to currency develauation. In my opinion, wealth creation has to come from the private sector, so we want a small government. However if there is persistent unemployment and people want to save rather than spend, the government has the capacity to cut taxes substantially or spend more to utilize those wasted resources. As long as the services purchased provide any benefit at all (bridges to nowhere, parks, education, or just maintain current skills), then the net impact is better than letting the productive capacity of the economy go to waste due to the paradox of thrift. The dollar may lose value which could be bad for you personally as a saver, but it is good for the economy as a whole since we would then be exporting and employment would pick up. Would you rather have a strong dollar with 10% unemployment and no earnings on your money or a weak dollar with a booming economy and plenty of investment opportunities? There is no free lunch.