The Smell Of Coffee

The late Rudi Dornbsuch of MIT had a way of cutting to the chase, preferably in public and with a minister of finance present.  He knew a huge amount about financial crisis, and could distill a lifetime of study and involvement in collapses succinctly: “it always takes longer than you think; but when it happens, it always happens faster than you can imagine.”

The latest credit default swap data for European banks bring Rudi’s perspective to mind – for the United States.  We’ve debated this week what to do about U.S. banks, arguing about which unappealing options are less bad.  In my view, the choice is not “nationalize vs. don’t nationalize,” but rather “keep our current partial nationalization/bottomless pit subsidy system vs. start down the road to reprivatization.”

But, honestly, this entire debate may be overtaken by events. 

Economic developments in East-Central Europe are very bad.  Almost everyone will get IMF loans but, be that as it may, there is a big contraction underway.  Nonperforming loans will increase for the West European banks lending to East-Central Europe or lending to firms that are (or were) exporting.  Prominent European governments will struggle to afford the implied bailouts – remember, back in October these governments made it quite clear they are on the hook if their banks come under pressure.  At the same time, of course, we have a nose dive in property in Ireland, Spain, and the UK.

My point is not that Europe is in big trouble, with no plausible regional rescue mechanisms in place.  This is completely obvious – the debate among prominent Europeans is now whether or not to send distressed eurozone members to the IMF, and on what basis.

Focus on this instead: the European banking and fiscal fiasco is a dagger pointed at the heart of major US banks, which have a great deal of exposure – one way or another – to much of Europe.  Ask any U.S.-based “global bank”.

Treasury is constructing an elaborate transfer mechanism through which big banks can be kept in business, thanks to the public purse, without the taxpayer acquiring a majority of the common stock.  The contortions required are striking.  But this entire approach is predicated on a rosy stress scenario, which assumes the global economy cannot get much worse, at least in the short run.

It may soon be time to wake up.

37 responses to “The Smell Of Coffee

  1. Looking forward i think there are three basic scenarios:
    1. We get lucky and limp along until all the government stimulus starts to work (just with the size of the increase in money supply). There is i suppose some chance of this.
    2. There is an orderly contraction of the global economy, i.e. there are no bank runs and a few governments that were pretty unpopular anyways fall (elected out of office, not revolution). We all tighten our belts for two or so (famous last words) lousy years.
    3. Bad things happen – natural disaster, terrorist strike etc – probably come under the oh so fashionable black swan event category. It probably isn’t a black swan though, with the global economy as vulnerable as it is, it probably would not take much to cause serious problems all around.

    Have i missed any fundamentally different options?

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  3. Eastern Europe gets €24.5bn
    Posted by Izabella Kaminska on Feb 27 12:30.

    Eastern Europe has received its own special bailout after all. Well, not technically a bailout, it comes as “aid” via the World Bank, European Bank for Reconstruction and Development and the European Investment Bank in a bid support the region through its first technical recession since the breakdown of the communist system. Bloomberg reports:

    http://ftalphaville.ft.com/blog/2009/02/27/53033/eastern-europe-gets-e245bn/

  4. 25 bn Euro is not even close to enough, particularly when it’s in the form of a “loan”. Without a rapid economic bounce-back, the servicing costs of the loan eventually mount and choke off development.

    Europe is in a bad loop – their banks own foreign debt (in their own currency). As foreign currencies depreciate at the same time that exports dry up due to lost western demand, effective servicing costs in local Eastern currencies rise. Eastern economies must borrow more and more to service increasingly large and unproductive debt loads because the debt is denominated in foreign currency. Seeing this, no one wants to own Eastern currencies, the currency devalues further, and effective debt load increases yet more. This cripples domestic consumption as well.

    Western economies become more crippled due to balance sheet losses (Eastern loans become dead assets) and lost exports to the east, even as imports from the east become even cheaper (further killing western jobs) and threatening price stability (e.g., causing deflation).

    That’s a lot of badness… 24.5 billion Euro? Laughable. Truly laughable.

    The parallel to this event is Latin America in the early 80’s. The ultimate result of that was a lot of debt forgiveness, as the US realized that in the long term it was more unproductive for its banks to hold onto worthless debt claims rather than get the southern economies moving again. However, the US government defended the claims of its banks (which refused to recognize the losses) for a long long time, largely due to its anti-communist stance.

    If the rest of the world was growing and had demand for Eastern European goods, they might pull off an austerity policy combined with export led growth (e.g., the IMF’s Chile model). Not so in this era.

    Notably, can anyone recall which bank was one of the chief culprits in making bad loans to Latin American countries?

    Yep, Citibank!

    In Eastern Europe, it’s hard to see how the Western governments will justify defending their banks claims against Eastern European governments, but I’m sure they’ll find a way.

    The EU is strangling itself – they’re destroying their own investments in Eastern Europe and crippling their own economy.

    Again, the only solution is to print a whole damn lot of Euros and try to revalue the entire economy fast, or to watch everything unwind. Every day they wait it gets harder and harder.

    It seems there really are two roads:

    Inflate to devalue debt (with the problems this entails, such as higher interest rates)

    OR

    Settle into deflation, and allow debt to clear itself through mass bankruptcies.

    The US seems intent on a third road – Settle into deflation, but instead of allowing debt to clear itself through mass bankruptcies, prop up the banks as long as possible with vast injections of borrowed money. Their hope, I suppose, is that they can avoid debt-reducing-inflation and higher interest rates, and then lead the world out of the crisis (with 3.4% growth in 2010!), then tighten our belt and pay everything back (even as our active workforce shrinks and retirees proliferate).

    I can envision no possible scenario in which this rosy world comes to pass – nor can the markets, which is why everything is tanking so incredibly fast.

    Our government is clearly in denial, and seems frustrated that we won’t join them in denial.

    The timeline to start inflating worldwide currencies and start spending down debt to rebuild demand is rapidly dwindling. I don’t know if we’ll make it to the April G20, even if the world governments miraculously got their acts together.

    Honestly, academic economists should be required to take 2 semesters of psychology before getting their degree – the only way out of this is an even of such magnitude that it changes mass psychology.

    The Fear of losing everything needs to be replaced by a Fear of being left out. In a situation like this, Greed does not beat Fear.

    Investors need to see a Fear of inflation, so that they become afraid to hold onto to too much cash. Moreover, if that fear is concentrated in any one nation, then that nation is toast (except those nations which hold debt denominated in their own currency).

    The problem is that the banks are controlled by – you got it, bankers. And by banks, I mean the CENTRAL banks, which are also run by bankers. And the banks are therefore far more worried about inflation than the country should be.

    That is why I believe we are all hosed.

  5. I’m hanging on really tight here… this roller coaster has just hit the scariest part yet.

  6. The biggest issue for the governments involved may be the CDS overhang, since the prospect of its unwinding has scared governments into bank/AIG support at all costs. You properly point out the very troubling pending EE fiasco (and its first international rescue attempt). But, the European banks are exposed not only to EE but also to US subprime (50% exposure vs. 75% for US banks), the UK’s own housing crisis which is only beginning to be manifest, and to even higher leverage than for the US banks. So their problems and thus the US banks share in them have only begun. Governments may find themselves being forced to throw in the towel before going the way of Iceland. At risk from bank support are Ireland, Switzerland, Netherlands, and even perhaps the UK.

  7. I don’t know about you chaps, but I’m not smelling coffee this morning. I smelling something inedible. By the way, I looked at the amount of money Citi ( $25 Billion ) is getting, and how much money Eastern Europe is getting ( $31 Billion ), and I found it odd. But that’s just me. As for the new bank plan, we need Martin Gardner to do an annotated edition. Actually, James Kwak did it. I wonder how his head feels this morning. I bet he needs coffee.

  8. Why does the CDS graph seem to be retreating from its highs if we are approaching the brink?

  9. Between recent economic developments and the US government’s inability (or ideological/politic disinclination) to tackle the crisis in a bold and direct fashion, I think we all might need some whiskey in the coffee.

  10. Eastern Europe is “only” rolling over $400 billion of its $1.7 trillion this year. If they can get Europe to fund $235 trillion through official loans, then this will avoid short term bankruptcy. (Remember that most of these loans are short term, and a lot of the CDS insurance is on short term debt.) So there’s a good likelihood that (when push comes to shove) Europe will fork over the money rather than watch their banks go under anyway. They’ll probably try to get the US and Japan to pony up some through the IMF since US banks have exposure too, and the Europeans are all about cost-sharing.

    Essentially, this means transferring the debt from European banks to multinational institutions (the IMF) or to national European institutions. From the CDS market perspective, this is “good”.

    From a global economic perspective, it fixes nothing – we still have crushing debt loads and paralyzation of productive economic assets that are depreciating instead of generating value. Every day they sit, rusting or growing obsolete, value is being destroyed, and that value represents the hoped-for capacity to pay down debt. The margins needed to pay down that debt were never huge (that’s the beauty of leverage), so once we get to a point that the forward-looking expectations of revenue are less than the cost of debt servicing, things implode extremely rapidly (particularly when debt is owed in foreign currency).

    Let’s call this the “Event Horizon” – the point of no return, so to speak.

    Debt needs to be reduced or demand cannot rebound. Bankruptcy (horrific), forgiveness (unlikely), or inflation (we can only hope) are all possibilities. In the meantime, we are desperately piling on more debt at the national level (or international level). I suppose this gives new meaning to the phrase, “Sh$t floats to the top.”

    Team Obama and the Eurocrats seem to be thinking that we can “stabilize things”, then grow and “pay down” our debt. If only the future were so happy….

  11. I’m glad someone is still mentioning the credit default swaps. I’ve believed for some time that a recovery in the financial system cannot occur until these instruments are out of the system. It has been said that they are the only way to price risk, but although they let people make fancy graphs, they only price perceived risk, in my opinion, since the system doesn’t provide enough information to understand real risk. I think the notion that risk should be able to be bought and sold as if it were a commodity is inherently absurd, and that a financial system built on that absurdity is pure folly. I think risk can only be assumed and then managed by individuals familiar with the underlying assets.

    Wouldn’t a typical FDIC rescue of the big banks void their swaps, since they are unsecured private obligations? What if we bumped up the maximum guaranteed account value to, say, $500,000 and then let the FDIC do what it does well. Then how about a law (preferably concurrently with one in as many other countries as possible) voiding all naked swaps? Everyone needs to take a haircut here.

    I know everyone is afraid of unwinding these things, but I really don’t see how it can be avoided. It will eventually happen on its own anyway and only the undeserving will profit in the process.

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  14. “Economic developments in East-Central Europe are very bad.”

    Simon, care to be more specific? Have you noticed Ireland and Greece?

    Unlike most of West Europe which is in recession Poland for one, thus far has expected GDP growth of c.a. 1%. Non-performing loan numbers for Polish banks are thus far essentialy flat. And while even numerous anecdotes do not make data press reports indicate that some west european production is being moved to Poland as result of cost cuting in the West. On the average the Polish bank’s loan book is 100% financed with deposits. The total banking system liabilities are at just 85% of GDP, unlike say Ireland where they are at 950%. And last but not least why are Greek long-term government bond yields above Polish long-term government bond yields?

    So thanks for the precise and data rich insight “Economic developments in East-Central Europe are very bad” but please do try harder next time…

  15. Ex-communist economies
    The whiff of contagion

    Feb 26th 2009
    From The Economist print edition
    Eastern Europe’s woes are not unmanageable. But they are not being managed. The result could be catastrophe

    http://www.economist.com/displayStory.cfm?story_id=13184594&fsrc=nwlgafree

  16. Perhaps Simon’s focus is more towards the east than the center of Europe. I don’t think he was particularly dissing Poland.

  17. I think it’s time to go long on guillotine manufacturers…

  18. Reading the Economist article in the link a couple of posts up it seems Poland deserves a bouqet. Congratulations Pawel D. for belonging to such a country

    Really, well done Poland!

  19. Simon, thank you for your vision.

    A few of you, thanks for the laughs!

  20. So. We defeated the FSU by getting it to spend itself into oblivion on non-productive armaments. Excellent strategy. The results permitted neo-liberal capitalism to grab our national minds and treasures without check or restriction.

    Now, it appears the FSU has offloaded its former responsibility for holding up the economies of Eastern Europe to the North Atlantic countries. The support of the Eastern European economies may not force us to spend ourselves into oblivion. It may even be productive. But it is going to have consequences in the short term.

    Meanwhile, Russia appears to still have, and be taking responsibility for shoring up the economies of the FSU in Central Asia. And one Russian official has claimed they are buying gold hand over fist. I assume this would be in anticipation of a world wide devaluation and doubling of nominal gold prices?

  21. I am persuaded, for all the good that will do.

    We clearly seem to be attempting to thread the eye of the needle, by takeing the third road you describe. And “Our government is clearly in denial, and seems frustrated that we won’t join them in denial” is a perfect description of a Tim Geithner interview. He does a good interview, much better than those staged announcment briefings. But the net effect is as you say.

    You despair of Bernanke ever unholstering the Fed purchase of Treasury debt – and I suspect you doubt that even that weapon would be effective without world wide coordination, at this point.

    I wonder if you think attempting to go it alone in releveraging the money supply might crash the US’ credit rating?

    Clearly, at this point measures need to be taken to restore the fear of inflation as the center of Central Bank’s attention. Are other countries banks onlywaiting on the US to do this first, or do they want to leave us twisting slowly in the wind, in hopes they will benefit by picking up the pieces. It must be a temptation to them.

    I can forgive Russia taking this position. They are not really part of the club, have serious problems of their own with commodity prices, and have been beat upon pretty hard by our neo-liberal media and financiers. But for the rest of the financialists to do so is unforgivable.

  22. The stuff under the CDS overhang is bad debt. Bad in the sense of fraudulent. I don’t see how it cannot unwind.

    We don’t want to support bad derivatives made up from fraudulent debt instruments. We don’t want those bad bank assets. Here are two weblinks that will tell you why:

    http://www.sfgate.com/cgi-bin/article.cgi?f=/c/a/2007/12/09/IN5BTNJ2V.DTL
    Interest rate ‘freeze’ – the real story is fraud – December, 2007 – 2007 is correct.

    http://www.huffingtonpost.com/william-k-black/the-two-documents-everyon_b_169813.html
    Another article on Fraud in these investments and how that fraud makes the value of the derivitaves indeterminate, and invalidates “stress tests”

  23. They are going to unwind, or be taken off the books in some way. The instruments which they “cover” include many which are fraudulent. The true values cannot be determined because the institutions which traded them do not even have copies of the paper on which they are based.
    http://www.huffingtonpost.com/william-k-black/the-two-documents-everyon_b_169813.html

  24. Hungarians feel force of economic storm
    http://news.bbc.co.uk/1/hi/business/7916042.stm

  25. Option#4 People say”F@!k it, and start looting en masse. Example: Medford Oregon in local nightly news cast showed live coverage of home foreclosures where the occupants simply walked away and put signs up saying come in and get whatever you want. These homes were cannibalized for everything from carpeting, light and plumbing fixtures to stome mason and pool artifacts.

    The contraction is a reset for decades of socially engineered capitalistic consumption brainwashing to run up debt to offset stagnant non-realistic COLA’S wages which is now tapped out leaving the banks holding the bag on a global bais since globalization caused the world to follow suit on our living model to consume.
    We have no history of this phenomena to create models but human nature will give yoy reasonable conclusions and that is mass rage.

  26. maybe,,,maybe not…..i believe not but do we deserve it?

  27. great…coffee won’t do it…bring on the SMELLING SALTS!!!!! OUCH.

  28. ………..:)

  29. recognition of the inevitable–and of the fraudulent –has not been a strong suit of the banks thus far; the governments have steadfastly served as enablers of their ostrich mentality. Thanks for the link & comments.

  30. Why are we trying to drive through this storm with the same drivers who couldn’t keep it between the ditches under much better conditions? I hope somebody is praying.

  31. Why don’t we just admit it. Nobody I mean nobody knows the depth of the problem we are trying to to solve. I see absolutely no way that we can prop up what we have to work with now if nobody took the time to look at what they are buying in the first place. They have absolutely no idea of what is good or what is bad. We just need to scrap this whole mess and start clean.

  32. …….:(

  33. I recall that young woman in Texas who was driving through a storm, and praying, but skid and hit a tree. A med evac helicopter came to pick them up. Later she said the next thing she remembered was waking up in the dark and the rain, alone, with bones sticking out all over, and realizing the ‘copter had crashed, and wondering if she would be rescued again.

    A parable for out times?

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  35. I think there is a lot of wisedom in the ‘it always takes longer than you think…’ concept. Its amazing all that we know but this doesn’t seem to help us.

    One of my classmates from France commented yesterday…that the Obama plan was not going to save Europe…and that he soon expected to hear Sarko reaching out…“Obi Wan Germany, you are our only hope!”

    I can only imagine how well that is going to go over.

  36. hsg,,,,europe has been a simple minion to our bad habits….shame on them for not recognizing…..faith is inevitable