Tale of Two Euros

The past two weeks of the Cyprus banking crisis have been chaotic at the least, and challenging known economic theory at the worst.  The most recent developments, in my opinion, may be creating the biggest risk the unified currency has faced at any point in this crisis.

The first steps involving “resolving” the banks are exactly as they should be:  Burn up the stockholders, then the bondholders, then the uninsured depositors.  Moral hazard is removed from the equation and risk is compensated in the accepted hierarchy.

The next step, however, is the source of my concern.  That step involves implementing capital controls.

Implementing capital controls is neither a new nor unilaterally negative phenomenon.  Their use has ebbed and flowed throughout history.  They were prevalent during World War I, eased in the years leading up to the rise of the Nazi party, and returned in forms such as the tax imposed by the Nazis on the Jews attempting to leave Germany to avoid oppression.

During John Maynard Keyne’s heyday (the Bretton Woods era), capital controls were widely implemented and were considered a lynchpin in controlling the breakouts of banking crises.  The history of that era would certainly validate that correlation (although not necessarily proving causation).

August 15, 1971 marked the end of Bretton Woods when Nixon abolished the gold standard.  From that point until the most recent financial crisis, capital controls were largely eliminated – first in the developed countries and later in the emerging markets.  Lack of capital controls accelerated globalization while, at the same time, increasing the likelihood of banking crises.

Then came the 2008 financial crisis and the Great Recession.  Suddenly countries pined for the good old days of Bretton Woods – or at least the financial stability capital controls brought to that era.  Keynesian economic policies began being implemented across the West with bond-buying programs and the manufacturing of money being the perceived saviors from the crisis.  Perhaps it was a natural progression, then, that Keyne’s other belief – the usefulness of capital controls – would surface at this time.

Which leads me to my confusion about the controls about to be implemented in Cyprus.

Capital controls don’t exist in a vacuum.  In fact, one model of capital controls involves the idea of the “Impossible Trinity.”  Basically, the Impossible Trinity says that countries desire three fortuitous things:

  • Free capital flows (no capital controls)
  • A fixed exchange rate
  • Sovereignty over monetary policy

The rub, however, is obtaining all three is an impossible trinity.  A country can only have two at the expense of the third.  Graphically, it works like this:

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A = Free capital flow and fixed exchange rates; therefore, there will be no sovereignty in monetary policy

B = Free capital flow and sovereignty in monetary policy; therefore, there can be no fixed exchange rate

C = Fixed exchange rate and sovereignty in monetary policy; therefore there will be no free capital flows

Flipping the formula for “C” over, implementing capital controls leaves you with two desirable levers:  Fixing your exchange rate and implementing monetary policy as a sovereign.  Unfortunately for Cyprus, neither of those two desirable levers is at their disposal as part of a unified currency.

I think that puts Cyprus in uncharted territory.  In a way, having no levers puts Cyprus at the full mercy of the decisions made by the monetary union as a whole.  The union has free capital flow (for now) providing it with flexibility in exchange rates and monetary policy.  Cyprus, on the other hand, is now singly focused on stemming the exodus of cash when its banks reopen.  But that cash is denominated in Euros.

By restricting the mobility of Cyprus Euros, do you not create a second class of Euros – those that are mobile and those that are restricted?  And shouldn’t the restricted class of Euro’s be worth less than those maintaining their mobility?  And since Cyprus has no fortuitous levers at its disposal to find equilibrium, won’t this imbalance persist?  And, by the way, doesn’t whole idea violate the European treaty forbidding the use of capital controls by any country within the monetary union?

To me, this is a troubling crack in the facade; both from monetary and a legal perspectives.  History may look back at these “Hail Mary” attempts to save the common currency as the very seeds of its demise.

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Hey Mister, Can You Tell Me Where A Man Might Find a Bed?

This post is not so much an homage to Levon Helm, the recently passed member of The Band, as it is a commentary on the Europe problem.

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Make no mistake, though…  Levon will be sorely missed.

If you recall the next line of “The Weight, ” the reply to the question was “He just grinned and shook my hand.  ‘No’ was all he said.”

These days, a lot of squirming, posturing, and gamesmanship have been the standard as Europe grapples with the Greek issue.  And the Spain issue.  And, as indicated by their bond yields, the Italy issue.  Never mind the Ireland issue.  They’ve already nationalized all their problems and went from corporate bankruptcy to sovereign bankruptcy.   And never mind Portugal; they’re just that little country hanging off the Eastern edge of Spain that is as bankrupt as Ireland.  And never mind that Lisbon is about 90 minutes from Seville.  Contagion can be contained.

Or so we’re told.

As U.S. Treasury prices hit record highs, Switzerland and Germany are issuing bonds with negative interest rates.

That’s not a typo.

Negative.  Interest.  Rates.

Wrap your head around that.

People are willing to pay Switzerland and Germany a “fee” to hold their cash because the cash under their mattresses, if re-denominated into their home currency, is perceived as worth less than a negative interest rate bond.  Maybe the space in the prior sentence should be omitted and the sentence should read that the “currency is perceived as worthless.”

Now, truth be told, Switzerland has been trying to implement negative interest rates for a couple of years in an attempt to stem the relentless appreciation of their Franc.  What’s stunning (to me, at least) is that people are willingly investing in these negative rate bonds.

I know a lot of U.S. investors who have been buying Swiss Francs to diversify their currency exposure.  But I know none, who are buying negative interest rate bonds.  But those in Europe seem happy with the idea.  Well… “happy” may not be the correct word, but there is no shortage of bond demand.

It’s rare that you have the opportunity to witness a train crash in slow motion, in real-time, played out right on your HD TV.  I think this may be one of those rare times.

It’s also a rare time when the capital markets may be helping to slow the train crash to a frame-by-frame video.

The threat of massive government intervention is preventing the short sellers from cratering the values of the zombie banks, zombie countries, and zombie continents.  It’s preventing the zombies from being priced honestly.  You know the drill.  Don’t fight the Fed.  Or the ECB.  So the shorts are just nibbling. For now.  And they cover with any rumor of intervention.  This periodic short-covering provides rallies that “pundits” rely on to declare the start of the next hot trade.

The frog is getting warmer.

You see, I fear we’re becoming boiled frogs.  Maybe you’re familiar with the story.  A frog is cold-blooded, deriving its body heat from the environment rather than its internal regulatory system (the system you and I enjoy).  Put a frog in a pan of water and slowly turn up the heat and the frog will ultimately boil, not sensing the need to jump.

Every rumor, news story, ECB plan, or Euro banking proposal, causes a spike in stock prices.  Until the next day.  The news cycle numbs us into thinking the problem may have a tidy solution.  Or maybe a temporary solution that will last long enough to allow the formation of a long term solution.  Stock prices react accordingly while risk does not get priced appropriately.

The frog is getting slowly boiled.

The uncomfortable truth is that Europe’s problems are not comfortably solvable.  Nor are those of the U.S.

Is there a place where a man might find a bed?

He just grinned and shook my hand.

“No”, was all he said.

Pip, Pip, Cheerio! We’re Out!

With the European economic summit now ended, I thought it might be useful to bullet-point the outcomes; to the extent they are understandable.

  • There will be a new agreement for better economic integration in the euro zone.
  • The new treaty could take up to three months to negotiate, and may require referendums in certain countries.
  • The new treaty would include automatic sanctions for countries exceeding stated deficit restrictions.
  • The European Central Bank (ECB) will cap the amount of its euro zone government bond purchases at 20 billion euro per week.
  • The ECB will provide unlimited 3-year funds to European banks, reducing the odds of liquidity induced bank failures and providing funds for those banks to buy government bonds.
  • Surprisingly, the European Stability Mechanism was held at 500 billion euro, much less than the expectations leading into the summit.
  • 9 of 10 countries that do not use the euro agreed to negotiate a new agreement alongside the new EU treaty, subject to parliamentary approval.
  • Britain refused to agree to the new treaty idea, since it did not include guarantees to protect its financial services industry.
  • Finland calls this agreement “The beginning of the beginning of the end of the crisis.”

Our takeaway from the summit…

  • The biggest positive for the near-term is the 3-year bank funding provided by the ECB.  Preventing a major bank failure is Job One in avoiding a contagious financial crisis.
  • The overall plan seems nebulous and subject to referendums and parliamentary approvals in countries where that may not be possible (ie. Ireland).
  • The treaty, should it come to pass, represents an historical surrender of sovereignty on the part of the 17 member countries, and could lead to increased social unrest in those countries that are sanctioned in the future.
  • Britain has taken a huge risk by isolating itself against the other 26 countries involved in this agreement.  50% of its economy is transacted with the EU, and the decision to vote “no” removes Britain from having any formal say in the details of the treaty.
  • We remain skeptical that this will end up being a significant event in terms of ending the crisis.  The bond market seems to agree, with Italian 10-year bonds still trading above 6.5%.

Has the slack gone from the rope so soon?

Three business days ago, we (somewhat skeptically) blogged about the proposed Euro-bailout plan and the relief rally it brought in its wake.  The gist was that the risk markets may be misinterpreting some slack in the rope that could hang the European Union as a severing of the rope altogether.

Last night, Greece reminded the world that the rope remains snugly in place.

Greek Prime Minister Giorgios Papandreou stunned the Euro zone last evening with the announcement that he will take the recently agreed-upon bailout plan to the citizenry for a referendum vote.  On one hand, there doesn’t seem to be anything particularly distasteful about asking a governed population in a democratic system their opinion on increased austerity.  On the other hand, all other European players at the table have to be questioning how in the world to negotiate with a leader who could pull such a stunt in the 11th hour.

In an article from Der Spiegel, expressions like, “shocked and furious, ” “stunned, ” “irritated, ” and “disorderly default” dominated the quotes from other European leaders regarding the referendum decision.  The Finnish minister said, “The situation is so tense that it would in principle be a vote on Euro membership.”

Should such a referendum actually take place, the results would be hard to handicap.  While over 70% of the polled Greek population believe it is beneficial to remain in the Euro zone, 60% view the new agreement as either negative or probably negative.

Rather than handicapping the outcome, we’d prefer to handicap the content of the referendum question.  Since we perceive the idea to be a purely political move by Papandreou, the referendum would likely be worded in such a way that its passage would be virtually assured.  If that wasn’t the case, why would Papandreou risk his country’s Euro membership and his political future on a stunt such as this?

And, to make this theater of the absurd even more…  well, absurd…  this just in from a socialist party official:  The referendum is “basically dead.”  That sentence fragment sent the Euro/USD up 90 pips and lifted the stock market 130 points from its pre-announcement lows.

Trading on sentence fragments…  Seems like a tough way to make a living.

 

 

 

Eurozone “Resolution” Gooses Equities and the Euro

In the wee hours of the morning, Euro zone leaders arrived at a deal that pushed the European sovereign crisis back from the precipice — if only by a few feet. The basics of the deal are as follows:

  • Private banks and insurers will accept a “voluntary” loss of 50% on their Greek government bond holdings. Public institutions will not share in the haircut.
  • This haircut will reduce Greece’s debt burden by 100 billion euros, and will drop their projected debt to GDP ration to 120% by 2020
  • Holders of CDS are now holding worthless paper, as the “voluntary” nature of the haircut avoids a technical default upon which the CDS would have paid out. There’s a lesson for those pesky speculators.
  • The Euro zone will provide 30 billion Euro’s of credit enhancements to the private sector as an incentive for them to accept the “voluntary” haircut.
  • The 250 billion Euro’s left in the EFSF will be levered into 1 Trillion Euros in the form of either offering insurance or some form of an SPV (Special Purpose Vehicle).
  • On the news, the DJIA rallied over 300 points and the Euro/USD has traded up over 1.42.

Far be it from me to curse a good tailwind, but I think it pays to remain skeptical, if not dubious.

According to Bloomberg, the “tag along” effects have already begun as Ireland is now sniffing at the handout trough. Further, this new levered structure reminds me an awfully lot of the structure of the mono-line insurance companies — and we all know how well things worked out in for them in 2008. But, for the time being, impending doom has been reduced to delayed discomfort.

It reminds me of something I read about being hanged. From The Flexible Bullet: “You may wonder about long-term solutions; I assure you there are none. Take what’s given. You sometimes get a little slack in the rope but the rope always has an end. So what. Bless the slack and don’t waste time cursing the drop. A grateful heart knows that in the end we all swing.”

Hopefully Europe will use the slack this move has provided to arrive at a more permanent, believable solution. Otherwise, we may all swing.