Monday, October 10, 2011

Thoughts on Europe

Honestly, I am too busy with more important matters to write much on Europe, through my recent perusal of the Economist on the eurozone crisis could provide sufficient material for another post criticizing the Economist.

John Cochrane's opinion piece summarizes my views best. However, I wish to write them in my words.

On the policy front, I can not help but think that the problem boils down to:

  1. No credibility that Greece will be able to pay its bills, and hence an inevitability of default;
  2. Greece can not inflate its way out because it has no control over monetary policy (I'm shedding tears that they default on a payment plan via inflation... not really);
  3. Eurozone banks that loaded up on Greek bonds because of the tempting yields and no need to hold capital against those bonds per Basel II capital requirements now are caught with their pants down because they do not have a capital buffer for defaults (honestly, doesn't that sound like the regulators giving a subsidy to eurozone nations by incentivizing banks to buy government debt, creating an artificial demand that reduces the interest rate those sovereign nations needed to pay to issue their debt?);
  4. Funnily enough, no one has mentioned the insurance companies, but they likely hold government bonds too. They likely have some capital to charge off against, but they will still be affected.
  5. "Those who do not remember history are doomed to repeat it," or This Time is Different syndrome: 2000-2007 was abnormal insofar as there was a paucity of sovereign defaults. We're really regressing to the mean, which was inevitable because of the stupidity/corruptness of politicians
  6. Unlike prior default periods, because people suffered from This Time is Different syndrome and the regulators made matters much worse by not requiring any capital be set aside to back purchases of government bonds, the financial system is much more exposed to systemic risk, ironically the thing regulators are supposed to prevent.

There is probably more to it, but that is what I am able to discern.

I can not help but analogize this to the United States and California though. Why? Let's say that California had an excruciating amount of debt which it could not service. Naturally, it can not inflate its way out because it uses the U.S. dollar for its currency as part of its currency union with the rest of the United States. Naturally banks and insurance companies across the U.S. will have some Californian bonds in their liquidity portfolios or insurance float, and hence a Californian default will eat into their capital and hurt them.

But the U.S. dollar itself won't be hurt by a Californian default - it will still be used in the currency union. California can still pay its debts in U.S. dollars as long as their government enacts austerity measures. If it does not, California can restructure and continue paying in U.S. dollars, but at higher rates.

So the U.S. dollar would not necessarily be threatened by a Californian default. But it would likely be if California was bailed out, because nationalizing Californian debt would add to inflationary pressures on the U.S. dollar since the federal debt would go up.

That to me is the Greek situation - a Greek default will be painful because the regulators created systemic risk. However, the euro itself, the currency, would not be threatened by this systemic risk unless a bailout occurred because of the added inflationary pressure of "Europeanizing" this debt.

So ultimately, my thoughts are that the government was instrumental in creating this mess. To believe that they can fix the system when their prior fixes destabilized the system is to continue to run an experiment proving the definition of insanity.

N.B. I sincerely hope that the Slovakian parliament can not reach a compromise on endorsement of expanding the eurozone bailout fund. Besides the fact that it is highly irresponsible of Europe to expect poor Eastern European nations to bailout a wealthier neighbor who could not control its spending, I clearly think a bailout will be worse for the system than letting the default occur, the banks which have bad assets to be hit, and people needing to learn the hard way that "this time is not different."

Of course, I'm not a European, so why should I care?

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