Friday, November 25, 2011

EUROZONE MELTDOWN I

Things worsened in the Eurozone this week, as the graph at left vividly demonstrates (compare my post of Nov. 5, 2011, less than three weeks ago). The Italian 10 year bond yield now seems firmly over 7 percent (it closed today at 7.26), an unsustainable level. Today, Italy auctioned off three year bonds at a yield of 8.13 percent--and the auction price reflects market demand from real investors because the ECB can only buy on the secondary market. Rome now pays more to issue short term debt than Greece. These rates of interest mean that interest paid by Italy to roll-over its debt will explode and wipe-out any gains from any new austerity initiatives. Italy's budget deficit is now destined to expand, not decrease, as it faces a vicious cycle of spending cuts leading to lower growth leading to higher deficits leading to more not less interest expense. Austerity now failed in Italy just as it failed in Greece. I noted the failure of Greek austerity on Sept. 2, 2011. So, Italy now appears in train-wreck mode.

Things similarly darkened in Spain this week. As the chart at right shows, Spanish 10 year bonds now yield 6.7 percent. Spain too now pays more to rollover its debt than Greece and the market issued a negative verdict on Spanish austerity this week:

"Bond market investors have given Spain no relief despite the election victory on Sunday of Mariano Rajoy, the centre-right Popular party leader who has pledged further austerity and economic reforms once he becomes prime minister in December."

Meanwhile, the contagion from the debt problems in southern Europe has now gone viral. S&P downgraded Belgium today due to political instability and the lack of growth throughout the Eurozone. French debt yields are now surging with the expectation of a imminent downgrade. Hungary solicited an IMF bailout and was downgraded to junk yesterday. Fitch downgraded Portugal to junk. And, perhaps most ominously, Germany (yes, Germany), suffered a failed bond auction, and the Bundesbank had to step in and buy 39 percent of the bonds offered. Suddenly, pundits are discussing the possibility of a German downgrade.

A fairly horrendous week, by any standard. The market reaction confirms this. The Euro sits at a seven week low. The European stock market now has lost over 30 percent in the last six months. Over the same period, US financials are down 25 percent. Over the last two weeks, the Dow is down 7.6 percent and the S&P 500 is down 7.9 percent in just the last seven sessions. Due to the exposure of our banks to Eurozone debt and to European banks (almost $ 2 trillion), the US cannot survive a European collapse unscathed. Think MF Global times 100.

Over the next few weeks I will explain how we got into this mess, and how the Eurozone cratered. For Europe the story is excess current account imbalances and the failure of austerity as a means of addressing a debt crisis. For the US it boils down to the failure of Dodd-Frank to change any of the following:

1) Derivatives deregulation that allowed global financial institutions to manipulate the system for their personal profit;

2) Corporate governance law and regulation that continues to permit CEOs to impose huge risks upon their firms in pursuit of short term bonuses;

3) The failure to limit excess leverage in the financial sector and thus excess risk;

4) The failure to end Too-Big-to-Fail which leads to excess risk in the financial sector and excess debt in the government sector, while limiting growth;

5) The failure to institutionalize fiscal policy in an economically rational way to limit excess debt while maximizing growth.

10 comments:

  1. Henry T/Memphis LawNovember 27, 2011 at 3:50 PM

    This is a scary situation for Europe. I heard a report that economists projected that if Italy's 10-year bond yield reached 7 percent, the Italian economy would essentially collapse, which is obviously a very serious situation. Italy's economy is essentially the size of Greece, Ireland, Portugal, and Spain combined, and now that Italy has to continue to borrow more money to pay the amount of interest that their bonds yield, there seems that there simply isn't a way for Europe to rescue the country -- it's too expensive. The higher this yield climbs, the more expensive it becomes for Italy to borrow the money to pay the interest -- it's essentially a downward spiral with no end in sight.

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  2. Henry T/Memphis LawNovember 27, 2011 at 3:53 PM

    See NPR: Planet Money Podcast from November 8, 2011 entitled "Kill the Euro: Win $400,000."

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  3. With regard to the failings of the Dodd-Frank Act, it seems that points 2, 3, & 4 have some notable (and necessary) overlap. Addressing Point 2 ("Corporate governance law and regulation that continues to permit CEOs to impose huge risks upon their firms in pursuit of short term bonuses") -- it seems that it may be in the best interests of corporations for their boards to reevaluate CEO compensation packages. For example, giving restricted stock as part of a compensation package could help deter the desire to take big risks in pursuit of a short term bonus and encourage CEOs to instead focus on the long-term health of the company. Many banking organizations offer restricted stock for this very reason -- because of their long-term stock interest, employees are motivated to act for the overall benefit of the company rather than for short-term payouts.

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  4. A somewhat radical, yet possibly helpful solution to CEO compensation could be to have their compensation on pace with the health and stability of the company. Really it would be a performance based package. The plus is that they now have incentive to play it a little safer and actually try to smart investments; because they would essentially be investing with their own money. On the down side, it could encourage managers to hide the health of their company and deceive shareholders.

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  5. A somewhat radical, yet possibly helpful solution to CEO compensation could be to have their compensation on pace with the health and stability of the company. Really it would be a performance based package. The plus is that they now have incentive to play it a little safer and actually try to smart investments; because they would essentially be investing with their own money. On the down side, it could encourage managers to hide the health of their company and deceive shareholders.

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  6. Josh makes an interesting suggestion with performance based packages for CEOs. A key factor in any change-up in CEO compensation packages would likely be consistency throughout the corporate sector. If one company began compensating CEOs based on performance and with restricted stock, for example, that company would become a less desirable employer and would no longer be able to attract the most desirable candidates to function as their CEOs. Thus, these types of changes would only be successful if new regulations required changes in CEO compensation across the board.

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  7. I think the author's position that the U.S. "got into this mess" as a result of various failures of the Dodd-Frank Act is a bit of an overstatement. If by "this mess" the author is referring to our current financial climate, that is obviously a result that was decades in the making before the 2008 crisis even occurred, and certainly before the Dodd-Frank Act was passed in response. Although the legislation might not have been the Mr. Fix-it we expected, it's a classic "act vs. omission" argument: although Dodd-Frank might now have affirmatively helped it some areas (i.e. failure to limit excess leverage in the financial sector), that doesn't imply that it actively contributed to or exacerbated the problem. Some regulation is better than none at all. We got ourselves into this mess.

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  8. Franklin A (Memphis Law)November 28, 2011 at 8:40 PM

    European countries, as well as the U.S., are going to have to make some difficult decisions to rectify the current situation and to prevent similar situations in the future. States need to spend their money wisely. Investing and spending millions on destined failure is no way to succeed. For example, the money Greece spent for the Athens Olympics proved wasteful and an epic failure. For some European countries the road to recovery may be long. With rising unemployment, particularly among the youth, discontent will continue to grow. Hopefully positive change in the financial sector will result.

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  9. Izabela M- Memphis LawNovember 28, 2011 at 10:58 PM

    I agree with Franklin. Several countries, not only in Europe, will be substantially affected by this situation if things do not get better. I also agree with the fact that in recent years certain countries in Europe have not been spending their money wisely. For example, while I was in Europe this summer there was a lot of road work going on in the countries that will be hosting the 2012 European Cup and some, if not most, of this is funded by the European Union. While this is a great idea because the roads in Europe are difficult to drive on, in some parts, this is perhaps an expenditure that could have been avoided. The hosting countries could have paid for this themselves perhaps.

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  10. Zach H (Memphis Law)November 28, 2011 at 11:08 PM

    I'm with Katie, not sure how Dodd-Frank ties into any of this. Dodd-Frank has flaws, but it is neither responsible for our recession nor for our jobless recovery.

    The failure of the Eurozone seems almost predestined at this point. The underlying flaws in its structure, as pointed out in the Telegraph article linked in this post, seem overwhelming. With no central lender of last resort, who will step in to save the Union? I think the most likely result will be an abandonment of the Euro. I wish I knew more about this topic, as I have no idea how this will affect the global markets.

    Being either the 1st or 2nd largest economy, (depending on which source you use,) any crash in Europe is going to send ripples throughout the world. The close ties between Europe and the US means things will be particularly bad here, and our half-hearted recovery is likely going to be drug back into full recession. Tim Duy had a frightening post today (http://economistsview.typepad.com/timduy/) about how difficult it will be for the US to decouple from the Eurozone.

    That said, beyond an immediate recession or perhaps depression, what are the real consequences of the failure of the Eurozone? So far US bond rates have not been impacted, but how long can that last? It seems inevitable for China to rise here, but their growth is entirely dependent on exports. If both the EU and the US dive into recession, the world market for Chinese exports dries up and we're looking at a global depression.

    I doubt things will get this bad. At some point, it becomes like the nuclear threat of the cold war. The threat of mutually assured economic destruction will hopefully be strong enough to force through the underlying changes needed. You can't always depend on rational self interest, but it at least offers a glimmer of hope.

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