The eurozone financial situation continues to worsen.  The latest idea from the eurogroup of finance ministers is apparently to have the European Central Bank make a massive loan to the International Monetary Fund, which would then turn around and lend to countries like Italy.  This is a bizarre notion.  If the IMF takes the credit risk of a mega-loan to Italy – e.g., an amount around the $600 billion mark, greater than the fund’s current lending capacity – this would represent an unprecedented and unacceptable risk to the IMF’s shareholders, including U.S. taxpayers.  If the IMF does not take this credit risk, what’s the point?  The ECB should provide financial support directly to Italy, if that is the goal.

But that goal increasingly seems both to be the only idea of officials and the last failed notion of a fading era.  More bailouts and the reinforcement of moral hazard – protecting bankers and other creditors against the downside of their mistakes – is the last thing that the world’s financial system needs.   Yet this is also the main idea of the Obama administration.  Treasury Secretary Tim Geithner told the Fiscal Times this week that European leaders “are going to have to move more quickly to put in place a strong firewall to help protect countries that are undertaking reforms,” meaning more bailouts.  And this week we learned more about the underhand and undemocratic ways in which the Federal Reserve saved big banks last time around.  (You should read Ron Suskind’s book, Confidence Men: Wall Street, Washington, and the Education of a President, to understand Mr. Geithner’s philosophy of unconditional bailouts; remember that he was president of the New York Fed before become treasury secretary.)

Is there really no alternative to pouring good money after bad?

In a policy statement released this week, Governor Jon Huntsman articulates a coherent alternative approach to the financial sector, which begins with a diagnosis of our current problem: Too Big To Fail banks,

“To protect taxpayers from future bailouts and stabilize America’s economic foundation, Jon Huntsman will end too-big-to-fail. Today we can already begin to see the outlines of the next financial crisis and bailouts. More than three years after the crisis and the accompanying bailouts, the six largest U.S. financial institutions are significantly bigger than they were before the crisis, having been encouraged by regulators to snap up Bear Stearns and other competitors at bargain prices”

Mr. Geithner feared the collapse of big banks in 2008-09 – but his policies have made them bigger.  This makes no sense.  Every opportunity should be taken to make the megabanks smaller and there are plenty of tools available, including hard size caps and a punitive tax on excessive size and leverage (with any proceeds from this tax being used to reduce the tax burden on the nonfinancial sector, which will otherwise be crushed by the big banks’ continued dangerous behavior).

The goal is simple, as Mr. Huntsman said in his recent Wall Street Journal opinion piece: make the banks small enough and simple enough to fail, “Hedge funds and private equity funds go out of business all the time when they make big mistakes, to the notice of few, because they are not too big to fail. There is no reason why banks cannot live with the same reality.”

The path we are on leads to more state ownership of banks in Europe – not a good idea – and, in the United States, huge open-ended subsidies to private banks.  Executives in those banks get the upside and American taxpayers and workers get the downside – a huge recession, damage to millions of lives, and a huge run-up in government debt due to lost tax revenue.

Everything else Mr. Huntsman wants is also eminently sensible, including full transparency in the derivatives market.  Who will argue with that proposal as we watch the European financial sector spiral downwards – driven partly by the fear of what lurks in prominent opaque transactions and balance sheets?

Mr. Huntsman has also spotted the fatal flaw in Basel III: “The Basel III Accord primes the pump for the next financial crisis by putting its thumb on the scale of sovereign debt, making it less expensive for banks to invest in those instruments without making a realistic risk assessment.”  Again, in the light of recent developments in Europe, who can seriously dispute this?

These are not fringe or unproven ideas.  When I talk with sensible people in and around the financial sector, these are exactly their views.  These are also natural Republican ideas – what we have now is not a market, it’s a huge, unfair, and dangerous subsidy scheme.  Such points are made by top academics like Gene Fama (University of Chicago) and Alan Meltzer (Carnegie Mellon), former officials such as Nicolas Brady and George Schultz (both former treasury secretaries), as well as by top Federal Reserve officials, like Richard Fisher (president of the Dallas Fed) and Tom Hoenig (recently retired from being president of the Kansas City Fed; nominated to become the number two person at the FDIC).  (See my coverage of this strong current of Republican thinking in past Economix columns, including these two.)

Only Teddy Roosevelt could take on the industrial and railroad monopolies in 1901, only Richard Nixon could go to China in 1972, and only Jon Huntsman can face down the Too Big To Fail banks today.

An edited version of this post appeared this morning on the NYT.com’s Economix blog; it is used here with permission.  If you would like to reproduce the entire post, please contact the New York Times.

Some officials and former officials are taking the view that a large fund of financial support for troubled eurozone nations could be decisive in stabilizing the situation.  The headline numbers discussed are up to 2-4 trillion euros – a large amount of money, given that German GDP is only 2.5 trillion euros and the entire eurozone GDP is around 9 trillion euros.

There are some practical difficulties, including the fact that the European Financial Stability Fund (EFSF) as currently designed has only around 240 billion euros available (although this falls if more countries lose their AAA status in the euro area) and the International Monetary Fund – the only ready money at the global level – would be more than stretched to go “all in” at 300 billion euros.  Never mind, say the optimists – we’ll get some “equity” from the EFSF and then “leverage up” by borrowing from the European Central Bank.

Such a scheme, if it could get political approval, would buy time – in the sense that it would hold down interest rates on Italian government debt relative to their current trajectory.  But leaving aside the question of whether the ECB – and the Germans – would ever agree to provide this kind of leverage and ignoring legitimate concerns about the potential impact on inflationary expectations of such measures, could a, for example, 4 trillion euro package really stabilize the situation?

To answer this question, think through the “best case” scenario in which the big package is put in place and, at least initially, believed to be credible.  Proponents of this approach argue that in this case the “market would be awed into submission”, business as usual would prevail – meaning that Italy and other potentially troubled sovereigns could resume borrowing at low interest rates – and the 4 trillion euro fund would not actually need to be used.

This seems implausible.  If the big government money shows up and this pushes down yields on Italian government debt, what will the private sector holders of that debt do?  Some of them will sell – taking advantage of what they worry may only be a temporary respite and, for those who bought near the bottom, locking in a capital gain (as interest rates fall, bond prices rise – there is an inverse relationship).

So the European/IMF bailout fund would acquire a significant amount of Italian, Portuguese, Spanish and other debt (including perhaps Greece and Ireland).  If the credit utilized from this fund, with its ECB backing, reaches – let’s say – 1 trillion euros, how will the Germans feel about the situation?  Their worries will only be exacerbated by ongoing budget deficits, exacerbated by recessions, throughout the periphery.  Someone will need to finance those deficits, and the stabilization fund is likely to be the financier.

On current form, the Italians will have promised moderate austerity but delivered little.  The life styles of rich and famous Italian leaders will start to grate on north European taxpayers.  Stories about corruption in Italian public life – perhaps exaggerated but with more than a grain of truth – will become pervasive.

In fall 1997, the IMF – with US and European backing – provided what was then regarded as a substantial package of support to the Suharto government in Indonesia.  But then the government refused to close banks as agreed – and after one of President Suharto’s sons finally lost one failed bank, he immediately popped up again with another banking license.  Stories about Indonesian official corruption and the ruling family were on front pages of major newspapers in the US.

Donor fatigue set in.  In January 1998, when the Indonesian government announced a budget that had slightly less austerity than planned, it was roundly castigated by the international community.  This set off a further sharp depreciation in the Indonesian rupiah, which worsened the debt problems of the Indonesia corporate sector – which had borrowed heavily and at short maturities in dollars.  Panic set in, social unrest became increasingly manifest, and the real economy declined further.

Italy is not Indonesia and Mr. Berlusconi is not President Suharto – who ended up leaving office.  But the comparison is still has value.  Will the countries backing the enhanced and highly leveraged EFSF be willing to face substantial potential credit losses, i.e., actual and ongoing transfers from their taxpayers to Italians and others?

Lech Walesa famously remarked, it is easier to make fish soup from fish than to do the reverse.  So it is with fiscal crises – once fear prevails and markets start to think hard about the stress scenario, it is hard to solve the problem simply with reassuring words or financial support that never needs to be used.

Crisis veterans like to say, quoting former President Ernesto Zedillo of Mexico: When markets overreact, policy needs to overreact in the stabilizing direction.   But what really matters is not overreacting; it is making sure you do enough.

In Europe, the first thing peripheral governments need to do is stop accumulating debt, and quickly.  Italian fiscal plans to balance the budget in 2012 look implausible as they assume unrealistic growth.  The currently planned Greek debt restructuring and increased taxes will not turn that economy around — nor prevent Greece from accumulating even further debt.  Despite all the reported austerity, the Irish  government is still running a budget deficit near 12% of GNP in 2011 while nominal GNP actually declined in the first half of 2011.

Europe’s periphery also needs to recognize that it signed up to a currency union, and that requires a new approach to adjustment.  Instead of having massive devaluations like Zedillo’s Mexico, or Suharto’s Indonesia and Walesa’s Poland, Europe’s troubled nations need to improve competitiveness through reducing local costs.  That must primarily come through wage reductions and more competitive tax systems.  In Ireland a pact with the major unions is preventing further wage reductions, while in Greece the government is strangling corporations with taxes in order to avoid deeper wage and spending cuts.  The proposed Portuguese “fiscal devaluation” – meaning lower payroll taxes to reduce labor costs and increase VAT to replace the revenue – looks like a weak attempt to avoid talking about the need to much more sharply cut public spending  and wages in real, purchasing power terms.

Putting in place a huge financial package is not enough.  Policies have to adjust across the troubled eurozone countries so that nations stop accumulating debt, and the periphery moves rapidly from being least competitive nations in the euro area, to the most competitive and this includes lower real wages, even if debts are restructured appropriately. The European leadership is a long way from even recognizing this reality – let alone talking about it in public.

An edited version of this post appeared this morning on the NYT.com’s Economix blog; it is used here with permission.  If you would like to reproduce the entire post, please contact the New York Times.

In recent days, Greece’s parliament adopted new austerity measures and Europe’s finance ministers approved another round of Greek loans. So the European debt crisis is under control, right?

Probably not. One obvious reason is Standard & Poor’s July 4 threat to declare a default if banks roll over Greek government bonds coming due over the next year. That could force everyone back to the drawing board.

Less obvious, but no less worrisome, is Italy. With a precarious fiscal picture, it could be the next to come under pressure. And this time, U.S. banks are in the line of fire, with about $35 billion in loans to Italy and potentially more exposure to risk through derivatives markets.

U.S. regulators should call for a new round of stress tests that assume sovereign-debt restructurings in Europe and take a realistic view of counter-party risks in opaque markets such as foreign exchange swaps. Based on those tests, the biggest banks probably need to suspend dividends and raise more capital as a buffer against losses.

To read the rest of this post, click here (this link is to the full article on Bloomberg: http://www.bloomberg.com/news/2011-07-05/could-italy-be-next-european-domino-to-fall-commentary-by-simon-johnson.html)

The Greek government owes more than it can afford to pay, now or in the near future, at market interest rates.  There are two options: reduce the payments through some form of restructuring, or move the debt into the hands of people who are willing to charge below market rates for the foreseeable future.

In this decision, the International Monetary Fund has relatively little say – this is really a political decision to be made by the European Union, with discrete backing from the US and China.

While the EU leadership is surely tired of Greek politicians at this point, they also fear greatly the implications for other eurozone countries if Greece says it can’t pay or won’t pay.  The realization that spreads on Spanish government debt will rise sharply concentrates the mind wonderfully. 

And the damage would not be limited to Spain – do not underestimate the smugness with which the eurozone has completely and utterly failed to prepare for any kind of sovereign default.  The lack of loss-absorbing capital in major European banks is a first-order scandal that could bring down governments.

Fortunately for the undeserving European policy elite, the IMF has plenty of money it can lend at low rates and the Europeans have plenty of votes at the IMF.  The IMF can also access considerably more funding as needed, with the agreement of the United States – which really does not want another short-term shock to the world economy.  And funding is available from China and other emerging market countries with large stockpiles of foreign exchange reserves.

China has every interest in making sure that the euro survives and prospers as a major reserve currency – to make sure that, over a longer period of time, the US dollar will decline as the primary place in which to hold public and primary rainy day funds.

The IMF will do as it is told by its major shareholders: help to refinance Greece, effectively protecting creditors and eurozone politicians to the fullest extent possible.

An edited version of this post appeared this morning on the NYT.com’s Room for Debate; it is used here with permission.

The big question of the week in Europe is deceptively simple – will any countries that share the euro as their currency default on their government or bank debts in the foreseeable future?  The answer to this question determines how you regard bonds from countries such as Portugal, Spain, Italy, and Belgium.

Answering this question is not as simple as it seems, however, because it involves taking a view on three intricate issues: What exactly is the eurozone policy now on bailouts, can big eurozone countries really be bailed out if needed, and what happens to the politics of these countries and of the eurozone has a whole as pressure from the financial markets mounts?

The prevailing consensus – and definite official spin – is that over the weekend European leaders backed away from the German proposal to impose losses on creditors as a condition of future bailouts, i.e., from 2013.  The markets, in this view, should and likely will calm now; there is no immediate prospect of any kind of sovereign default or (more politely) “reprofiling” on debt, including the obligations of big banks.

But a close reading of the Eurogroup ministers’ statement from Sunday suggests quite a different interpretation.  It’s a straightforward text, just 2 ½ pages long, but it has potentially momentous consequences – as it envisages dividing future eurozone crises into two kinds.

“For countries considered solvent, on the basis of the debt sustainability analysis conducted by the [European] Commission and the IMF, in liaison with the ECB [European Central Bank], the private sector creditors would be encouraged to maintain their exposure according to international rules and fully in line with the IMF practices. In the unexpected event that a country would appear to be insolvent, the Member State has to negotiate a comprehensive restructuring plan with its private sector creditors, in line with IMF practices with a view to restoring debt sustainability. If debt sustainability can be reached through these measures, the ESM [European Stability Mechanism] may provide liquidity assistance.” (from the middle of p.2; emphasis added)

Translation: if it is decided your country is “insolvent”, rather than illiquid, then you have to restructure your debts.  But who exactly will decide?  Look at the preceding one line paragraph in that document (again on the middle of p.2) for the bombshell.

“On this basis, the Eurogroup Ministers will take a unanimous decision on providing assistance.”

In other words, any one member of the eurozone can veto a country being determined merely illiquid – thus cutting them off from cheap and endless credit (from the ECB or ESM or any window to be named later).  So now Germany effectively has a veto – as do other fiscally austere countries including Estonia (from January 1^st when it becomes the 17^th member of the eurozone.) 

Most likely we will witness the creation of an Austere Coalition (actually a modified Hanseatic League) of Germany, Austria, Finland, Estonia, and a few of the smaller countries.  Ending moral hazard – the prospect of soft bail out money forever – is an admirable goal.  But getting there under current conditions is going to be rocky because that new regime implies countries need to have less total debt and a longer maturity on their debt than they do now.  Transitional arrangements have not been put in place – other than the ad hoc sequential bailouts that we now see unfolding.

As for the resources needed to “bail out” countries now facing market pressure, the IMF and EU combined definitely have enough money in hand to help with Portugal and Spain – if this becomes necessary.  But they do not have enough funding currently to deal with Italy, Belgium and other larger countries (if there is a sequence of crises in the year ahead).

The IMF can, in principle, raise further resources beyond what it already has in hand; its membership (and effective owners) includes almost all countries in the world. IMF resources are shrouded in jargon; here is a relatively clear recent statement – bottom line: the IMF has no more than $1 trillion, but in terms of usable cash, the experts start to look pale as you discuss committing more than $500bn. 

But in the US this would involve a very awkward conversation with the Republican House of Representatives, among others.  Who else around the world has a stock of hard “convertible” currency sufficiently large to make a difference?  The call list for the IMF’s Managing Director is short: China, Abu Dhabi, Saudi Arabia and perhaps Singapore, Russia, and a few others.  This is not an easy scenario for anyone.

The IMF could also create its own money – known as Special Drawing Rights.  Again, check with your elected representative and the head of your central bank to see how they feel about this.  No one wants a global central bank that would operate without the prospect of proper political oversight.

The 27-member European Union could come up with further resources for itself.  But this would involve more taxes for the fiscally sound parts of the eurozone, including Germany.  And at some point soon the German taxpayer may decide enough is enough – which is exactly where the terms around the ESM come into play.

The euro is also a “reserve currency”, meaning that other countries like to use it for their precautionary savings.  Again, in principle the European Central Bank could create enough new money to enable all indebted governments to discharge their debts in full.  No one wants to contemplate the inflationary consequences of that.

In short, the larger European countries are “too big to bail”.

But do they really need a bailout or are we just looking at a “run on sovereign debt” or pure financial panic in Western Europe?

There are definitely elements of a panic at work but keep in mind one important point – such runs can become self-fulfilling, i.e., they create the exact conditions that started people worrying in the first place.

In fall 1997 in Indonesia, for example, financial markets began to worry about the collapse of the Suharto regime.  Initially, this seemed farfetched – after all Suharto had been in power for more than 30 years.  But the rapid depreciation of the rupiah put great pressure on the Indonesian corporate sector, which had borrowed heavily in dollars, and this contributed to undermining Suharto politically.  After many twists and turns, Suharto fell.  (As always, I recommend Paul Blustein’s book, The Chastening: Inside the Crisis That Rocked the Global Financial System and Humbled the IMF; Blustein is the Michael Lewis of international finance.)

The market proved itself right in the sense that dramatically lower asset prices reduced perceived legitimacy of the regime and generated a great deal of political uncertainty.  This uncertainty justified the fall in asset prices.

Could something similar happen in Europe today?

Just as for Asia in September 1997, such a sequence of events does not seem very likely, but there is no question that European domestic and regional political institutions are undergoing a severe stress test.

Whose coalitions will collapse?  Where will governments prove unable to stay the course on fiscal policy?  And, at the end of the day, whom do the Germans trust enough to provide with unlimited financial backing?

Governance in Asia did not change in 1997 – there were long-standing issues with the way companies operated (chaebol in Korea, family firms in Thailand) and with the relationship between the state and business (Suharto’s family in Indonesia).  During the boom, investors did not particularly worry about what this implied.

But when downturn comes – in Asia’s case with a rapid depreciation of currencies; in Europe’s case it is a crisis of confidence in “investment grade” debt – governance becomes a salient question for everyone who can move money.

The biggest issue today is not how Europe could be governed in some future ideal world, but rather how it is governed – and how any misgovernance will play out and be perceived as the pressures now really begin to mount.

An edited version of this post appeared this morning on the NYT.com’s Economix blog; it is used here with permission.  If you would like to reproduce the entire post, please contact the New York Times.

In the aftermath of the Irish bailout, the German proposal for a future sovereign and/or senior bank debt restructuring mechanism within the eurozone makes complete political sense to the electorate in stronger European countries.  They do not want to write “blank checks” to weaker countries and to out-of-control financial institutions going forward; creditors to countries that run into trouble will face likely losses.

While the details of this “burden sharing” approach remain to be hammered out (after Sunday’s announcements), there is no way for German or other politicians to backtrack on the broad strategic principles.  But once this arrangement is in place, say in 2013 or thereabouts, all eurozone countries will (a) be able to sustain less debt than has recently been regarded as the norm, and (b) become vulnerable to the kinds of speculative attacks in debt markets that we have seen in recent weeks – to reduce funding rollover dangers, they will all need to lengthen the maturity of their outstanding debt. 

The end point is clear.  Last week the markets began to work backwards to today’s debt profiles; major disruptions still lie ahead.

Ultimately, there will be a eurozone will greater shared fiscal authority, a common cross-border resolution authority for failed banks, and likely greater economic integration.  But there are four scenarios regarding who ends up in that eurozone – and how we get there.

First, as officials hope, the IMF bailouts for Greece and Ireland may work – by stopping the panic and reassuring the investors that there will be enough growth to make even those debt burdens sustainable.  This seems most unlikely, particularly given what we have seen of the IMF package for Ireland so far.

In this scenario, everyone can continue to stay inside the eurozone.  The debt profiles of Greece and Ireland would remain vulnerable, as would slow growth in Portugal and whatever Spanish banks are hiding in their so-called “stress tests.”  Germany agrees to foot an open ended bill because its leadership becomes scared of the consequences.  The ECB buys a lot of bonds, one way or another.

Second, there is the current market consensus that a package of IMF-European Union support for Portugal and perhaps Spain would truly stabilize the situation.  This consensus is fragile – and perhaps more wishful thinking than anything else – but likely to motivate official efforts in the week ahead.  But this is what we call the Maginot Line Illusion, i.e., an idea that ignores the potential for trouble to jump to other potentially weaker eurozone countries, such as Italy, France or Belgium.

In this scenario, Greece probably leaves the eurozone and restructures its debt.  The Germans say “Greece should never have been admitted; this was the original and only mistake.”  Ireland stays in the eurozone but many of its citizens emigrate.  There could be significant grants from Germany and even from outside the eurozone, depending on how much fear spreads around the globe.

Third, there is the thoughtful view of Willem Buiter – currently chief economist at Citigroup and still a brilliant critic of the global financial system.  In a presentation circulating last week (not publicly available), he predicts “three or more sovereign defaults in the next five years.”  His logic is impeccable – once it is easier to restructure debts, the temptation is to do exactly that; the market knows this and so brings everything forward in time.

Fourth, we have the unthinkable – nicely articulated by the Financial Times’ Lex column on Friday.  Divide the eurozone into “relatively prudent” and “relatively imprudent”, in terms of fiscal policy.  Adjust that for the forward-looking ability to run a primary surplus (i.e., can a country run a budget surplus on a pre-interest basis, needed to pay down the government debt if under pressure.)  Adjust this further for off-balance sheet losses incurred by a country’s banks in the “extreme stress” scenario that begins with the default on senior Irish debt guaranteed by the sovereign – another “Lehman moment”.

Now the eurozone (more likely, some kind of Neue Deutsche Mark, NDM) becomes Germany, the Netherlands, Austria, Finland, and a few smaller countries.  Italy is out – even though northern Italy should remain, two currency zones within one country probably does not make sense (sorry Catalonia).

In this scenario, France is the interesting case.  Does France leaving the eurozone break the Franco-German alliance that has underpinned European integration since its inception? 

Even this extreme scenario is not so bad for political stability and economic recovery.  The weaker peripheral countries will be damaged for a generation, but European integration is about more than attempting to share a currency between countries with divergent fiscal policies and no convergence in productivity.

The NDM area will do well; in fact, growth there is already strong – they will probably want to raise interest rates soon.  The rump eurozone will flounder but the positive effects of exchange rate depreciation will be rediscovered, at least for those without too much debt.

Ireland will get a package of support from the EU and the IMF.  Will the money and the accompanying policy changes be enough to stabilize the situation in Ireland or more broadly around Europe?  Does it prevent Ireland from restructuring its debt – or move the Irish (and other parts of the European periphery) further in that direction?

And who gains from the delay and mismanagement we continue to see at the highest European levels?

This is complicated economic chess within Ireland, across Europe, and at the international level.  In my Bloomberg column this morning, I suggest we look several moves ahead, recognizing the underlying political dynamic:

There is a much more general or global phenomenon in which powerful people cooperate to build an economic model that provides growth based on a great deal of debt. When the crisis comes, those who control the state try to save their favorite oligarchs, but there aren’t enough resources to go around

…..

Here is the present problem: It’s not just the Irish elite that is under pressure and struggling to sort out who should be saved. It’s also the European bankers who funded them.

If the Europeans continue to fight among themselves, regarding who bears what losses – and who has to face what kind of public accountability – which other countries gain on the global stage?

Who has the ready money available to recapitalize the International Monetary Fund, if needed?  And it will be needed if Spain comes under serious pressure.

Who understands the strategic concept that piles of “reserve currency” can give you great political leverage?  It is hard to find such thinking among today’s generation of American politicians.

And who is already playing international economic chess at the highest level?

China.

For my full assessment, please follow this link: http://www.bloomberg.com/news/2010-11-19/ireland-crisis-might-give-china-break-it-seeks-simon-johnson.html

Last week’s renewed anxiety over bond market collapse in Europe’s periphery should come as no surprise.  Greece’s EU/IMF program heaps more public debt onto a nation that is already insolvent, and Ireland is now on the same track. Despite massive fiscal cuts and several years of deep recession Greece and Ireland will accumulate 150% of GNP in debt by 2014.   A new road is necessary: The burden of financial failure should be shared with the culprits and not only born by the victims.

The fundamental flaw in these programs is the morally dubious decision to bail out the bank creditors while foisting the burden of adjustment on taxpayers.  Especially the Irish government has, for no good reason, nationalized the debts of its failing private banks, passing on the burden to its increasingly poor citizens.  On the donor side, German and French taxpayers are angry at the thought of having to pay for the bonanza of Irish banks and their irresponsible creditors.

Such lopsided burden-sharing is rightly angering both donors and recipients.  Rising public resentment is testing German and French willingness to promise more taxpayer funds.  German Chancellor Angela Merkel’s hasty and ill thought out plan to demand private sector burden sharing, but only “after mid-2013”, marks a first response to these popular demands.  We should expect more.

Financial crises are actually not rare, and the rules for their resolution are clear. The fundamental insight is that huge amounts of financial losses, of seemingly real value, need to be distributed across creditors, debtors, equity holders and taxpayers. The first step is to bring the current budget deficit under control to achieve a primary balance, which both Greece and Ireland are now attempting. The second is to attract sufficient emergency funding, which the IMF and the EU essentially have done. But in neither Greece nor Ireland is that sufficient. They still have unaffordable debt burdens.  Therefore, one more measure is needed, namely a reduction of the public debt.

The public debt can be contained in two ways. The first and preferable option is that the state never nationalizes private bank debt as Ireland has done.  For Ireland, this opportunity has probably passed, but other countries should be warned not to make the same mistake. Kazakhstan’s refusal last year to bail out its major banks, despite strong demands from the senior creditors of these banks, has proved a far more successful path.  Banks can and should go under if they have failed. The state should only defend small and medium-sized depositors.

If the state has taken on too large debt, sovereign default is the natural outcome. In their excellent book This Time Is Different, Carmen Reinhardt and Kenneth Rogoff argue that 90 percent of GDP is the highest sustainable level of public debt for a developed country. This limit is not absolute, but there is little reason to believe that Greece and Ireland would belong to the exceptions. As Germany and France so sensibly, though perhaps not very cautiously, have argued in public, the EU needs a facility for sovereign debt default.

Sovereign defaults are always contentious, but they don’t need to end in catastrophic financial collapse.  This is especially so in Europe, as Lee Buchheit and Mitu Gulati have argued in a well-read paper on “How to Restructure Greek Debt,” because over 90% of these debts are issued under domestic law.  Troubled nations, as part of their rescue plans, can and should introduce legislation that permits a qualified majority of creditors to change terms on outstanding sovereign and bank debt, while protecting bank deposits.  Such rules could, for example, require 2/3 of non-protected creditors agree to a restructuring plan.  This reduces the risk that holdouts can prevent a deal from being reached, but still gives creditors clear powers to negotiate terms.

Well-planned debt restructuring will not cause a systemic financial collapse.  It is misleading to draw parallels from the chaotic liquidation of Lehman Brothers for the outcome of debt relief in Europe.   The direct impact of debt relief for Greece, Ireland and others is easily measured and managed.  The debtors and creditors are well known.

If Greece’s reform program included a write-down of 50% (in net present value) on its debts, and they received an additional 20% of GDP in bridge financing over the next three years, its debt burden in 2013 would be a comfortable 80% of GDP.  As Greek debt already trades below face value, the total additional losses to creditors could amount to 35% of debt, or approximately 100bn euros.   Ireland is smaller so total costs should be less.  This debt relief could be conditional on successful implementation of IMF monitored programs, similar to traditional Paris Club debt restructurings.  Fears that debt relief could spark panic selling and contagion in other debt markets can be arrested through temporary interventions by the ECB, and the EU needs to publicly declare strict criteria when debt restructuring may occur.

Opponents to debt relief for Greece and Ireland are wrong to think that Europe’s current strategy makes Europe safe from systemic collapse.  The implied risk of default on Spanish, Italian and Portuguese debt rose sharply during the last month as concerns over Ireland and Greece spread, and this in turn caused yields on related bank debts to soar.  The potential economic time bombs left in Europe’s periphery are growing.  They can and must be resolved. Otherwise the economic and political risks might become overwhelming.

Anders Åslund, Senior Fellow at the Peterson Institute for International Economics; Peter Boone, associate at the Center for Economic Performance, London School of Economics and principal, Salute Capital Management; Simon Johnson, Senior Fellow at the Peterson Institute for International Economics and Professor MIT Sloan.

On the Project Syndicate website, Peter Boone and I argue, with regard to the European situation in this coming week:

The Germans, responding to the understandable public backlash against taxpayer-financed bailouts for banks and indebted countries, are sensibly calling for mechanisms to permit “wider burden sharing” – meaning losses for creditors. Yet their new proposals, which bizarrely imply that defaults can happen only after mid-2013, defy the basic economics of debt defaults.

…

Given the vulnerability of so many eurozone countries, it appears that Merkel does not understand the immediate implications of her plan. The Germans and other Europeans insist that they will provide new official financing to insolvent countries, thus keeping current bondholders whole, while simultaneously creating a new regime after 2013 under which all this debt could be easily restructured. But, as European Central Bank President Jean-Claude Trichet likes to point out, market participants are good at thinking backwards: if they can see where a Ponzi-type scheme ends, everything unravels.

Like it or not, it’s time for the Europeans to decide: Who gets unlimited liquidity support because they are essentially solvent, and who has to restructure their debt – with bridge financing and help from the outside?

This will be painful and intense.  The case for debt restructuring in Ireland and Greece is clear.  What about Portugal and, even more controversial, Spain – and other eurozone sovereign borrowers? 

For our complete assessment, please see the Project Syndicate column.  Here is the full link: http://www.project-syndicate.org/commentary/johnson14/English

With the European Central Bank announcing that it has bought more than $20 billion of mostly high-risk euro zone government debt in one week, its new strategy is crystal clear: We will take the risk from bank balance sheets and give it to the central bank, and we expect Portugal-Ireland-Italy-Greece-Spain to cut fiscal spending sharply and pull themselves out of this mess through austerity.

But the bank’s head, Jean-Claude Trichet, faces a potential major issue: the task assigned to the profligate nations could be impossible. Some of these nations may be stuck in a downward debt spiral that makes greater economic decline ever more likely.

Prime Minister George Papandreou said this week that Greece needs to see strong investment in order for the austerity program to work.  While the government cuts fiscal spending, he said, it needs new private business to employ the dismissed workers so that they are productive, can pay taxes and do not need unemployment benefits.

The problems are strikingly reminiscent of Latin America in the 1980s. Those nations borrowed too heavily in the 1970s (also, by the way, from big international banks) and then — in the face of tougher macroeconomic conditions in the United States — lost access to capital markets. For 10 years they were stuck with debt overhangs, just like the weak euro zone countries, which made it virtually impossible to grow.

Debt overhangs hurt growth for many reasons: business is nervous that taxes will go up in the near future, the cost of credit is high throughout society, and social turmoil looms because continued austere policies are needed to reduce the debt.  Some Latin America countries lingered in limbo for a decade or more.

Mr. Trichet and Mr. Papandreou can look more closely at home to see what might soon be going wrong.  Ireland was one of the first nations to introduce tough fiscal austerity in this cycle — in spring 2009 the government slashed public-sector spending and raised taxes. Despite the cuts, the European Commission forecasts that Ireland will have one of the highest budget deficits in the world at 11.7 percent of gross domestic product in 2010. The problem is clear: when you cut spending you also lose tax revenues from people who earned incomes from that money. Further, the newly unemployed seek benefits, so Ireland’s spending cuts in one category are partly offset by more spending in another. Without growth, the budget deficit still looms large.

Ireland’s problems are, sadly, far deeper than the need for simple fiscal austerity. The Celtic tiger’s impressive reported growth over the past decades was in part based on its aggressive attempts to help major corporations in the United States reduce their tax bills. The Irish government set corporate taxes at just 12.5 percent of profits, thus attracting all sorts of businesses — from computer services such as Google and Yahoo, to drug companies such as Forest Labs — that set up corporate bases and washed profits through Ireland to keep them out of the hands of the Internal Revenue Service.

The remarkable success of this tax haven means that roughly 20 percent of Irish gross domestic product (G.D.P.) is actually “profit transfers” that raise little tax for Ireland and are owned by foreign companies. Since most of these profits are subject to the tax code, they are accounted for in Ireland where they are lightly taxed; they should not be counted as part of Ireland’s potential tax base. A more robust cross-country comparison would be to examine Ireland’s financial condition ignoring these transfers. This is easy to do: a nation’s gross national product excludes the profits of foreign residents. For most nations, gross national product and G.D.P. are near-identical, but in Ireland they are not.

When we adjust Ireland’s figures accordingly, the situation is dire. The budget deficit was about 17.9 percent of G.N.P. in 2009, and based on European Commission projections (and assuming the G.N.P.-G.D.P. gap remains the same) it will be roughly 14.6 percent in 2010 and 15.1 percent in 2011, while the debt-to-G.N.P. ratio at the end of this year is expected – by our calculation – to be 97 percent, and 109 percent at the end of 2011. These numbers make Ireland look similarly troubled to Greece, with a much higher budget deficit but lower levels of public debt.

Ireland’s politicians, rather than facing up to their problems, are making things ever worse. Simply put, the Irish miracle was a mirage driven by clever use of tax-haven rules and a huge credit boom that permitted real estate prices and construction to grow quickly before now declining ever more rapidly. The biggest banks grew to have assets twice the size of official G.D.P. when they essentially failed in 2008. The government has now made a fateful choice: rather than make creditors pay some part of the losses, it is taking the bank debt onto the national balance sheet, effectively ballooning its already large sovereign debt. Irish taxpayers are set to be left with the risk of very large payments to make on someone else’s real estate deals gone bad.

There is no simple escape, but if the government hopes to avoid a sovereign default, the one overriding priority should be to stop bailing out the banks. Instead, the government should wind down existing banks in a “bad bank,” while moving their deposit base and profitable businesses into new, well-capitalized banks that can function without a taxpayer burden. This will be messy, but it is far better than a sovereign default.

Second, the Irish must take the tough fiscal steps that will be required under any circumstances. The International Monetary Fund and the European Union have made clear that funding is available to Ireland — so the government should use this to bridge the tough journey of fiscal cuts ahead.

Finally, the Irish need to consider seriously whether being in the euro zone is worth the cost. The adjustment to this awful situation would be far easier outside the euro zone — even though leaving the zone might have adverse repercussions for other nations. Once again, a comprehensive program with European Union/I.M.F. support might make this the least worse option.

Given the depths of Ireland’s problems, it is no wonder the markets are looking with skepticism at the announced eurozone-wide bailout package provided by the E.U. and the I.M.F. Policy makers are still not dealing with the core problems of each nation in the euro zone.  With the debt hangovers remaining, who will want to invest in Europe’s periphery, and so how can Greece, let alone Ireland, grow? One thing we can be sure of: Europe’s political leaders are doomed to be spending much more time at emergency meetings in Brussels over the coming months and years.

An edited version of this post appeared this morning on the NYT’s Economix and this material is used here with permission.  If you wish to reproduce the entire article, please contact the New York Times.

The UK also faces serious pressure, and there is no telling where this goes next around the world – or how it gets there.

There may be direct effects on the US, as our banking system remains undercapitalized.  Or the effect may be through making it harder to export – one of the few bright spots for the American economy over the past 12 months has been trade.  But this is unlikely to hold up as a driver of growth if the euro depreciation continues.

Some financial market participants cling to the hope that the stronger eurozone countries, particularly Germany, will soon help out the weaker countries in a generous manner.   But this view completely misreads the situation.

The German authorities are happy to have the euro depreciate this far, and probably would not mind if it moves another 10-20 percent.  They are convinced that they must – in fact, should – export their way back to acceptable growth levels.

Competitive depreciation is of course a no-no in international policy circles.  But if your dissolute neighbors – with whom you happen to share a credit union – threaten to implode their debt rollovers, and makets react negatively, how can you be held responsible?

Germany and France have no objection to euro depreciation – they are confident that the European Central Bank can prevent this from turning into inflation.

It’s the US that should be concerned about the effect on its exports (and imports; goods from the eurozone become cheaper as the euro falls in value) if the euro moves too far and too fast.  But the US failed to raise the issue with sufficient force at the G7 finance ministers conclave in Canada and the course is now set – at least until Thursday.

The euro depreciates, the dollar strengthens, and our path to recovery starts to run more uphill.

And if these European troubles start to be reflected in difficulties for leading global banks over the next few days or weeks, the negative impact will be much greater.

By Simon Johnson

Now Jean-Claude Trichet, head of the ECB, with reference to the latest eurozone (0%) inflation rate, says that we should disregard the data because a recovery is just around the corner.

Alternatively, we are close to the baseline eurozone view laid out in my January presentation (part of a panel discussion with Mr Papademos).  You can break this down into three specifics.

1. Private sector demand is weak; it’s hard to see who will lead the recovery within the eurozone.  In addition, the demand for European exports has fallen much more than expected, as seen – for example – in the big decline in German Q1 output.
2. The ability of the public sector to offset this decline with discretionary fiscal policy is quite limited, due to balance sheet constraints in some countries (look at the latest credit default swap data from weaker euro sovereigns; CDS primer) and clear policy preferences in others (i.e., how Germany worries about inflation, even when there is none).
3. Banks look troubled across many eurozone countries, and as the real economy surprises on the downside these problems will increase – with presumed implications for government bailout programs and balance sheets (the IMF was quite negative, see Tables 1.3 and 1.4 on pp.28 and 34 respectively, on European banks before the latest round of bad news).  Remember that the European economy depends on banks much more than does the US.

If the world turns around and/or oil prices continue to rebound, the eurozone can presumably avoid deflation.  But it’s hard to see inflation rising any time soon due to the eurozone’s own dynamic.

And if deflation takes root, it is hard to see this proving more tractable or less damaging than deflation in Japan during the 1990s.  Which part of Japan’s lost decade now looks easy to avoid in Europe?

By Simon Johnson

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.

But you do have a choice on when to come to help your neighbors and your friends, and you can definitely choose the form of this assistance.  if you come in earlier and in a more systematic fashion, the cost for everyone is lower and the chances of a fast recovery are stronger.

The sensible decision might seems obvious from a distance or in retrospect, but it’s this exact choice that the richer and more stable countries in Western Europe are now struggling with.

Back in October, we argued for a eurozone stabilization fund, as a means of mutual support and – most importantly – as a way to provide liquidity and buy time for euro sovereigns who need to make fiscal adjustments.  Circumstances have changed, of course, but I would like to reiterate the following proposal,

Create a European Stability Fund with at least €2tn of credit lines guaranteed by all Eurozone member nations and potentially other European countries with large financial systems such as Switzerland, Sweden and the UK. This fund should provide alternative financing to member countries in case market rates on their government debt become too high. This will prevent a self-fulfilling cycle of rising interest rates. The fund should be large enough to have credibility; countries could access the fund automatically, but should then adopt a 5-year program for ensuring financial stability, subject to peer review within the Eurozone.

I should also clarify that we are not suggesting that countries leave the eurozone (this would be bad for everyone) or that this is likely (the adverse consequences are sufficiently obvious on all sides).  In fact, my presentation in early January – which has circulated to some effect – very much emphasizes that eurozone fiscal austerity is our baseline expectation.

The German Minister of Finance this week suggested that financial support within Western Europe is on the cards for the first – presumably, his mind is being concentrated by potential developments for Austrian banks.  At the same time, there are strong voices opposed to any kind of bailout, e.g., represented by Charles Wyplosz writing yesterday on VoxEU.org.  Europe should really have had the full moral hazard theology debate back in the fall; better than late than never, but it’s awfully late.

Remember this.  Eventually, you will go to help your neighbors (again, see Iceland for details).  And the longer you delay, the more it will cost, in both monetary and human terms.  And, for those of you still hung up on moral hazard, I can assure you that support provided today will not prevent middle class and poorer people from being hammered hard by the crisis – and I would suggest that they will sort out their rulers at a time and place of their choosing. 

Provide generous support, come in early, and insist on a sensible macroeconomic framework – some fiscal adjustment is almost always needed.  Do not require eurozone countries to go to the IMF.

My point is not that collapse is imminent.  Rather, I would suggest that now is the time for preemptive policy action – presumably at the European Union level – to head off these problems.  As we have been arguing since last October, there needs to be an integrated European-wide approach to these problems, including agreement on who receives what kind of financial support and under what circumstances.  The roles of the European Central Bank and the IMF (if any) in this context are in particular need of further explicit elaboration.

It is simply astonishing that, after all we have seen, senior European policymakers remain in substantial denial about the depth of global problems, the way in which these have direct impact on Europe, and value of thinking ahead.

Even if you are convinced that the CDS market represents pure speculative pressure, i.e., unrelated to “fundamentals”, spreads at this level are still a call for action.  In fact, in that case there is no excuse for not putting in place transparent and well-communicated fiscal policies with massive external financial support.  That should scare any speculators away.

Of course, if you believe that the CDS market is completely uninformative, there is nothing to worry about.  And there was, in retrospect, nothing to worry about when the same market pointed to growing dangers for UK mortgage lenders in fall 2007, US banks in 2007-2008, Iceland in fall 2008, and emerging markets right before the IMF started handing out big loans.