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Monday, November 29, 2010

Another Lesson In How Not To Go About Things From The EU Commission

by Edward Hugh: Barcelona

The present generation of European leaders will doubtless be remembered for many things, but somewhere high up there on the list will be the appauling sense of bad-timing they seem to have when making critical announcements. The confusion caused by certain ill-considered remarks from Angela Merkel about how private sectors bondholders would need to participate in future EU bailout processes is evidently one good example. Another, without doubt is going to be the decision by EU Commissioner Olli Rehn to appear before the world's press today (yes, today of all days, one day after the sensitive announcement of the Irish Bank Bail-out plan and the decision to create the European Financial Mechanism), and inform the assembled throngs that as far as the EU Commission could see Spain will not be sticking to its 6% of GDP fiscal deficit committment next year, simply because according to EU calculations the deficit is going to be 6.4% - unless, of course - there is another round of fiscal reduction measures.

I think Spanish has a suitable word for this kind of persistent badtiming: "gafé". But the thing is, if Europe's leaders insist on continually showing the markets just how "gafé" they all are, then we are never going to find our way out of this hole we have all dug for ourselves.

And so it was, that by 16:30 this afternoon the yield on 10 year Spanish bonds hit 5.5% (up from around 5.2 at Friday's close), and the spread over equivalent German Bunds hit a Euro-era record high of 273 basis points. These sort of numbers were totally unimaginable at the start of 2010.

The root of the problem comes from the fact that the EU Commission had identified today as the day when their economic forecasts for national economies were to be published, and so it was. As part of the forecast the commission fractionally lowered its 2011 growth outlook for Spain, to 0.7% from an earlier expectation of 0.8%. Hardly earth-shattering news, and not normally the sort of thing to send bond yields off into a "death spiral", but given the times we live in, markets are extraordinarily sensitive to any such revision. In fact, a downward revision of 0.1 percentage point is well within the bounds of any reasonable margin of error, and no one really has the foggiest idea of what Spanish growth will actually look like next year beyond the most approximate of approximate guesses. This is because the degree of uncertainty is unusually high in the external environment, and the impact of the very strong fiscal correction that is planned (from this years 9.2% deficit, to next years 6% one) is very hard to evaluate. Personally I think it will be very hard for Spain to get positive GDP growth at all next year given all we are seeing, but I certainly don't want to engage in a Dutch auction with the Spanish authorities on this point.

But in fact the potential difficulties for Spain to achieve the 6% target for 2011 were already reasonably well known. I had already written about it in this post, were I pointed out the difficulty Spain's regional and local governments were having this year in meeting targets, and how important it was going to be to stick by the letter of next years budget plan if the administration did not wish to face the wrath of the markets.

My points were backed up the day after by Bank of Spain Governor Miguel Angel Fernandez Ordonez, who told a Spanish parliamentary committee that:

“Recent budget data point to the achievement of objectives for 2010, at least for the central government.... but (as far as the regional governments go) my impression is that the measures [they've announced] are far from sufficient”

The Bank of Spain governor reinforced this point by adding that in a highly decentralized Spain, where the central government directly controls less than a third of spending, and lacks sufficient means to supervise the fiscal policies of regional and local administrations, it was extremely difficult for the central government to get an exact result. His opinion was that these august bodies be required to publish budget data in a more timely fashion and be given an annual spending ceiling. In fact, these days the Spanish government cannot afford to ignore what the Governor of its Central Bank says, and so the administration has gone some way to putting such controls in place, but whether they are sufficient to do the job or not still remains to be seen.

Mafo's point was backed up later the same week by former Bank of Spain deputy governor and current IMF Official José Viñals, who stated "Spain should be willing to carry out additional fiscal adjustments to achieve a budget deficit of 6 percent of gross domestic product by 2011 because markets have “zero tolerance” for failure to meet stated targets."

So these issues are already known, Spain may well need to formulate a plan "B" if the governments hand is forced, but it was a pity to unsettle the markets just one more time by raising them again precisely today.

Not everything in the report was bad news for Spain, however, since the commission did improve its forecast for this year. The EU now expects the country's GDP to contract by 0.2% in 2010, compared with the 0.4% contraction it had projected in the spring forecast, giving a little more power to the elbow of a struggling Elena Salgado who has recently been belabouring the point that her forecasts are better than those of the EU and the IMF. But next year will be the "test of fire" on this front, since it is starting next year that all those rather optimistic expectations on domestic consumption start to lock-in.

Having said that, the EU now predicts that annual average unemployment will rise again next year, and hit 20.2% (above Salgado's forcecast). In fact this may well be an underestimate, since the September figure was 20.8%, and at the present time unemployment is still rising, and not falling. Indeed Olli Rehn himself stressed that there were "significant but balanced risks to the baseline scenario." And in particular he pointed out that further drops in house prices could lead to a "deeper-than-expected adjustment in construction, dent household wealth and sap consumer confidence." And yet that is just what Spain seems to continue to be facing, a slow drop-by-drop downward trickle in house prices.

So what can the Spanish government do to stop the rot? Basically at this point very little. The ammunition has nearly all been fired off, and most of it has been wasted. And yet one more time we all seem to be in agreement. When asked what Spain and Portugal should do to stop the so-called contagion, I was quoted by the Financial Times as saying: “Not do anything wrong..... The only thing you can advise these people to do at this stage is to be absolutely frank and stick absolutely to what they say.” “From this point on, the more you do fiscal austerity, the more you contract and the less you can pay".

The following day Manuel Campa, Spain's deputy finance minister for the economy was quoted by Bloomberg in a similar vein as saying that the best thing “to generate credibility in the Spanish economy is to execute the measures we have announced at the time and in the way they were announced, and that implies not taking additional measures.”

And as luck would have it Miguel Angel Fernandez Ordonez was back before the Spanish senate the following day (his timing, unlike that of Olli Rehn, seems to be impeccable), telling all those senators that “We have to convince people that we’re going to do exactly what we said we were going to do.” Seems logical, doesn't it, I mean whyever would they imagine you might not do what you say you are going to do? Whatever put that wicked thought in their heads?

And Mafo was also on this occasion perfectly frank about the growth situation: "The outlook for a gradual recovery is surrounded by uncertainties," he told the senators."In an environment where financing conditions will foreseeably remain restrictive and in which the public and the private sector have a pressing need to clean up their financial position, we can expect the pace of recovery in household consumption to slow versus the first half of the year."

I couldn't have put it better myself.

So, summing up. Spain is suffering from the serious restrictions imposed on trying to make a major economic correction while participating in a monetary union (Paul Krugman is once more making similar points in today's New York Times). In particular this means that not only does the country not have a currency to devalue, it does not have a central bank with capacity to print money and buy its bonds. It also has a very substantial exposure in terms of the external position (ie debt) that makes it dependent on international financial markets for funding in a way that means that the extremely low interest rates that are on offer at the ECB are not really (beyond some limited non standard liquidity measures) passed on to the countries banks, her citizens, her companies or her government.

Spain has the benefits of neither expansionary fiscal or monetary tools in the midst of a huge output slump, where the underlying contractionary tendencies in the economy are still substantial. Given all of this, and given that Spain's leaders have at last shown some signs that they are aware of the seriousness of the situation that faces the country, I think it is being cruel beyond belief to haggle over whether the deficit next year will be 6% or 6.4%, let alone send Spanish bond values into a suicidal downward spiral that risks destroying what is still left of the countries banks over the issue.

Spain needs to stick to its deficit reduction targets, but it also needs more help from those who are running the system by which it is trapped and which it is struggling hard to defend. Pile the pressure on and the country is only going to crack. What Spain needs is to get back to growth, and to put people back to work, then the deficit problems will sort themselves out almost on their own. And in this sense it is the authors of the latest EU forecast, and not those who run the Spanish administration who are the unrealistic ones. Spain is in a corner which it can't get out of alone. She needs help, and that help is going to have to come from the top.

As Krugman says:

If Spain still had its own currency, like the United States — or like Britain, which shares some of the same characteristics — it could have let that currency fall, making its industry competitive again. But with Spain on the euro, that option isn’t available. Instead, Spain must achieve “internal devaluation”: it must cut wages and prices until its costs are back in line with its neighbors.

And internal devaluation is an ugly affair. For one thing, it’s slow: it normally take years of high unemployment to push wages down. Beyond that, falling wages mean falling incomes, while debt stays the same. So internal devaluation worsens the private sector’s debt problems.

Internal devaluation is coming, there is now no avoiding it. When I advanced the idea for Spain some three years ago it wasn't some sort of contribution to a collective brainstorming session, it wasn't just one option on offer together with a whole series of others. What I was saying was if we don't go down this path then would would inevitably end up where we are now. But as Krugman points out, seeing it through means the private sector debt problem will only deteriorate, which is why we need help, to share the burden. The other alternative, of seeing the Euro fall apart, is in the interests of no one. Not even the Germans, who would soon see the current record growth in their exports shifted into reverse gear as the new DeutscheMark was quoted at values (as is happening to the Japanese yen right now) which robbed the country of all semblance of competitiveness.

Well, today we have a new government in Catalonia. So maybe its time to change. Maybe finally we could now start to address the problems of the Spanish economy head-on, and put the future of the country on a sound and sustainable footing. It's certainly worth a try, and, at least, as the English saying goes: where there's life, there's hope.

Greece Is Almost Certainly "On Track" - But Towards Which Destination Is It Headed?

by Edward Hugh: Barcelona

"There is a difficulty that is widely recognized that the amount [of debt] to be repaid is high in 2014 and 2015," Giorgios Papaconstantinou (the Greek Finance Minister).

"We are confident that Greece will be able to return to the markets. But whether it will be able to return to the markets on a scale that allows Greece to pay off its European partners and the IMF, that is a question."..."We have a number of options. If paying off the €110 billion loan proves to be a question, we stand ready to exercise some of those options" - Poul Thomsen, head of the IMF team in the ECB-EU-IMF troika delegation.

"In the rushed last-minute deal to forestall certain bankruptcy, everyone missed one very important fact. That the memorandum created an unrealistic and immense borrowing squeeze on the feckless Greek state for the next five years."
Nick Skrekas - Refusing Greek Loan Extensions Defies Financial Reality, Wall Street Journal

Get On The Right Track Baby!

According to the latest IMF-EU report Greece’s reform programme remians “broadly on track” even if the international lenders do acknowledge that this years fiscal deficit target will now not be met and that a fresh round of structural measures is needed if the country is to generate a sustained recovery. My difficulty here must be with my understanding of the English lexemes "remains" and "sustainable", since for something to remain on track it should have been running along it previously (rather than never having gotten on it), and for something - in this case a recovery - to be sustained, it first needs to get started, and with an economy looking set to contract by nearly 4% this year, and the IMF forecasting a further shrinkage of 2.6% next year, many Greeks could be forgiven for thinking that talk of recovery at this point is, at the very least, premature. A more useful question might be "what kind of medicine is this that we are being given", and "what are the realistic chances that it actually works". Unfortunately, in the weird and wonderful world of Macro Economics, witch doctors are not in short supply.

As the representatives of the so-called `troika`mission (the IMF, the ECB, and the EU) told the assembled journalists in last Tuesday's press conference “The programme has reached a critical juncture." Critical certainly (as in, in danger of going critical - just look at the 1,000 basis point spread between Greek and German 10 year bond yields, or the 4% contraction in GDP we look set to see this year), but the question we might really like to ask ourselves is what are the chances of the patient surviving the operation in one piece?

The statement came at the end of a 10-day mission visit to Athens to review the extent to which the country was complying with the terms of the country’s €110bn bail-out package and take a decision on whether or not to authorise the release of the third tranche of the agreed loan.

In the event the decision was a foregone conclusion, with the rekindling of the European Sovereign Debt Crisis as a background, and the very survival of the common currency in the longer term in question, this was no time to tell the markets the tranche was not being forwarded. But still, the expression "on track" continues to fall somewhat short of expectation with the lingered issues like the recent upward revision of the Greek deficit numbers (up to 15.4% for 2009), the failure to increase revenue as much as anticipated, and the need for a further round of “belt tightening” measures in 2011 to try to attain the agreed objective of a 7.4% deficit as a backdrop. The upward revision in the deficit numbers only added to all the doubts many economists have about the long term payability of the Greek debt, which the IMF now expect to peak at around 145% of GDP in 2013, although again, many analysts put the number much higher.

Independent analyst Philip Ammerman who is based in Greece, and whose expectations about the evolution of Greek debt have proved to be reasonably realistic, now expects debt to GDP to come in much higher than anticipated in 2010, due largely to 10 billion euros in debt from the train company OSE being added to the total and downward revisions in 2009 GDP from the Greek statistics office.

The key to payability is of course a resumption of economic growth, which at the present time looks even more distant than ever. The IMF is arguing for another round of structural reforms – like opening up “closed-shop” professions, or simplifying administrative procedures and modernising collective wage bargaining, and while many of these are necessary, none of these are sufficiently “short sharp shock” like to restart the economy, and in general don’t target the main issue which is how to restore competitiveness to the country’s struggling export sector.

Just One More Moment In Time!

Doubts about how Greece was going to start financing its debts in the market after the expiry of the loan programme in 2013 had only been adding to market nervousness in recent days, since in addition to the fact that loan repayments to the EU and the IMF would need to start in 2014. Most critical are the first two years, when the bulk of the debt to the EU and IMF falls due. Under current repayment schedules, In fact, as things stand now, Greece's gross borrowing needs for 2014 and 2015 (when most of the EU-IMF debt falls due) will balloon to over 70 billion euros a year from around 55 billion euros a year in 2011-2013. This represents having to finance about 40% of GDP each year. Not an easy task. The difficulty presented by this looming repayment mountain lead the FT’s John Dizard to speculate that the Greek parliament might be tempted to go for the rapid passage of a law allowing for the application of “aggregate collective action” on bondholders – using the reasoning that, since the money being borrowed at the moment is basically being used to pay off existing bondholders (who are relatively easy to haircut) while the new lenders (the IMF and the EU) are (at least on paper) not. As John says, “Greece is exchanging outstanding debt that is legally and logistically easy to restructure on favourable terms with debt that is difficult or impossible to restructure. It’s as if they were borrowing from a Mafia loan shark to repay an advance from their grandmother”.

What a (retroactive) aggregate collective action clause would mean is that if a specific fraction, say 80 per cent or 90 per cent, of existing Greek bondholders agree to a restructuring that lowers the net present value of Greek debt by, say, half, then the remaining “holdout” bondholders would be forced into accepting the same terms. It is the consideration that the Greek Parliament might be tempted to go down just such a road that possibly lies behind this weekends Reuters report that The EU and the IMF could extend the period in which Greece must repay its bailout loans by five years, to make it easier for it to service its debt. According hot the agency Poul Thomsen, the IMF official in charge of the Greek bailout, stated in an interview with the Greek newspaper Realnews "We have the possibility to extend the repayment period ... from about six years to around 11," This follows earlier reported statements from Mr Thomsen the the IMF “could provide part of the funding on a longer repayment period, or give a follow-up loan.” Indeed the announcement of the Irish Bailout details seems to suggest there has been a general change of position here, since the Irish loan is initially to be for seven and a half years (which certainly does suggest we are all trying hard to kick the can further and further down the road), while - in what you might think was a token nod in the direction of John Dizard's argument, aggregate collective action clauses are now to be written into all bond agreements after 2013. It will be interesting to see how the existing bondholders themselves respond to this proposal when the markets open tomorrow (Monday) morning.

So now we know that in fact Greece is likely to be able to extend its dependence on the IMF all the way through to 2020, the only really major question facing us all is: just how small will the Greek economy have become by the time we reach that point.

To start to answer that question, let’s take a look at some of the macro economic realities which lie behind the “impressive start” the Mr Thomsen tells us the Greek economy has made.

Austerity Measures Provoke Sharp Economic Contraction

The IMF-EU-ECB austerity measures have - predictably - generated a sharp contraction in Greek GDP, with falling industrial output, falling investment, falling incomes, falling retail sales, and rising inflation and unemployment. The big issue dividing Macro Economists at this point is whether countries forming part of a currency union which have a competitiveness problem are best served by their fiscal difficulties being addressed first.

Arguably countries which do not have the luxury of implementing a swift and decisive devaluation to restore their competitiveness would be best served by receiving fiscal support from other part of the monetary unionion to soften the blow as they implement a comprehensive programme of internal devaluation to reduce their price and wage levels. That is to say the current approach has the issue back to front, and will undoubtedly lead the countries concerned into even more problems as slashing government spending at a time when no other sector is able to grow is only likely to create a vicious spiral which leads nowhere except towards eventual and inevitable default. To date Greek GDP has fallen some 6.8% from its highest point in Q1 2008, yet far from bottoming out, the contraction seems to be accelerating under the hammer blows of ever stronger fiscal adjustments, and the downard slump still has a long way to go.

The Greek economy contracted by 1.1% quarter-on-quarter in the third quarter of 2010, making for the eighth consecutive quarter of contraction. And evidently there are still have several more quarters of GDP contraction lying out there in front of us.

Year on year the Greek economy was down by 4.5% on the third quarter of 2009. This is the fastest rate of interannual contraction so far. Far from slowing the contraction seems to be accelerating at this point.

Domestic Consumption In Full Retreat

Looking at the chart below, it is clear that Greece enjoyed quite a consumption boom in the first years of the Euro's existence, a boom which is in some ways reminiscent of those other booms in Ireland and Spain, and a boom which came roundly to an end when the credit markets started to shut down. As in other countries, the government stepped in with borrowing to try to keep the boom going, with the major difference that deficitfinance went to levels well beyond those seen in other European countries in 2009, as did the efforts the Greek government went to to try to cover its tracks.

One of the clearest indications that the party is now well and truly over is the way in which the level of new car registrations is slumping.

Retail sales have now fallen by something over 15%.

And With It The End Of The Credit Boom

The Greek consumption boom came to an end, just as it did in Spain and Ireland, when the credit crunch started to bite in 2008. Pre-crisis household borrowing was increasing at the rate of around 20%, the interannual rate of change has now fallen more or less to zero, and will stay there for some time to come. Since in a mature modern economy aggregate demand (whatever you do in the way of supply side reforms) can only grow in a sustained way as a result of either credit expansion or exports, export growth is going to have to give the Greek economy what little demand growth it can eventually get.

Along with the general stagnation in household credit, lending for mortgage borrowing has also ground to a sharp halt.

And credit to companies has also become pretty tight if we look at the next chart.

Asin many other heavily indebted countries (the US, the UK, Spain) the only sector which is still able to leverage itself is the public one, or at least which was still able to drive demand by leveraging itself, but now, with the IMF EU adjustment programme, increases in government borrowing are also going to suddenly come to an end, with the evident consequencethat the economy goes into reverse gear. I can't help feeling that people aren't using enough emotional intelligence here. Obviously people are outraged by the level of fiscal fraud that was going on in Greece. But outrage and demogogic press headlines seldom form the basis of sound policy. Arguably the competitiveness issue is more important at this point than the fiscal deficit one, since the position is asymmetric - solving the competitiveness issue will automatically open the door to solving the fiscal deficit one, while addressing the fiscal deficit does not necessarily resolve the competitiveness problem, and does not return the country to growth - only a strong supply side dose of ideology can lead you to (mistakenly) think that.

The Best Way Not To Restore Competitiveness: Raise VAT

In fact, the fiscal adjustment programme contains two components, reducing spending, and increasing taxes. Of these the most damaging measure as far as growth and competitiveness goes is without doubt the decision to raise VAT by 5%. Not only (as we shall see) does this increase not raise the extra money anticipated (in an economy which is increasingly export dependent the tax base for a consumption tax weakens by-the-quarter in relative terms), it also sharply raises the domestic inflation rate, effectively ADDING to the competitiveness problem. I would say this obsession of the IMF with raising VAT in these economies which are effectively unable to devalue is just plain daft, frankly. And it doesn't impress me how many times respected micro economists describe raising VAT as the most benign of measures: all this does is convince me that they don't really have an adequate understanding of how economies work from a macro point of view, and especially not export dependent economies.

As we can see in the chart below, the VAT rise not only adds to the consumer price index, it also affects producer prices, and even export sector producer prices, which are sharply up.

I would say that policymakers have fallen into two "Econ 101 simpleton" type errors here. The first is to think that since part of the objective is to raise nominal GDP to reduce debt to GDP, and since GDP is falling, raising the price level might help (I would call this the "fools gold" discovery), and the second is to imagine that since exports don't attract VAT, the impact is relatively benign, without stopping to think the the VAT hike also acts on inputs, and especially in an economy which suffers from chronic price and wage rigidity issues like the Greek one.

If a first year student had sent me these kind of arguments in a term essay, aside form awarding a "fail", I think would recommend to the person that they would perhaps be better off studying another topic, physics maybe, since the demonstrated aptitude for applied macro economics would be very low indeed. Could it be that bondholders who normally understand quite a lot more than many imagine about how economies work are also noticing this, hence their growing nervousness.

The incredible result of the application of this very short sighted policy is that in addition to the fact that Greece started out with a serious competitiveness issue with its most competitive EuroArea peers, like Germany.....

it has even hadits virtual currency revalued against the EuroArea average since entering the IMF sponsored programme, which is the exact opposite of what we need to see.

Export Lethargy Feeds The Industrial Output Slump

As a result we are seeing no evidence of a Germany-type resurgence in export activity.

And in fact even though the trade deficit has reduced somewhat, it still remains a trade deficit.

Given the fact that domestic demand is falling, while exports stagnate, Greece's industrial sector is still in a sharp and continuing contraction.

A contraction which continued and even accelerated slightly in October, according to the most recent PMI reading.

Construction activity is in "freefall", as can be seen from the drop in cement output.

and the decline will surely continue, as new building permits continue to fall.

And private construction activity continues to drop.

The net result of the economic contraction and a credit crunch is, of course, that while other consumer prices rise, house prices are now falling, giving us just one more reason why Greeks are starting to feel a lot less wealthy than they used to feel. Evidently, to kick start the economy again the fall in land and property prices needs to be brought to a halt. This is where the traditional devaluation strategy helped a lot, since you could stop the fall in nominal prices at a stroke, but the Greeks are helpless in this case, and it is rather alarming to find that there is no discussion of this key issue at the policy level, and just talk about how structural reforms will put everything right.

Employment Falls And Unemployment Surges

The man and woman power is there to rebuild the economy, as ageing hasn't yet reached the point where the labour force will start to shrink. Indeed at this point it is still rising.

But, of course, employment is now falling.

And thus, logically, unemployment is rising, and is currently something over 12%.

And With The Fall In Employment Revenue Comes Under Pressure

And with the rise in unemployment, there is a fall in incomes, and thus income tax revenue is falling, putting yet more pressure on the deficit.

At the same time, and despite a 5% increase in VAT rates, returns on the tax are also not rising as hoped.

A Contraction Which Feeds On Itself?

The Greek fiscal deficit is now falling, but after the huge upward revision in the 2009 figure, getting it down towards this years 9.4% target is a more or less Herculean task, which will involve far more fiscal effort than was previously anticipated, and with the fiscal effort more economic contraction. In addition, the finance ministry recently reported that while Greece's central-government deficit narrowed by 30% in the first 10 months of this year, this still fell short of the targeted narrowing of 32% due to lower than anticipated revenue returns.

Finance ministry data show that the Greek central government took in 41.0 billion euros in revenue in the first 10 months of 2010, just 3.7% more than it did in the same period of 2009. The deficit-reduction plan hammered out with the EU and the IMF in May called for 13.7% growth in such revenues for 2010 as a whole. This implies that to meet the target, Greece must receive 14.1 euros billion in November and December, which is highly improbable given that to date this year the Greek government has only once had monthly revenue above €5 billion, and that was in January.

On the spending side things have gone better, and targets are being met. Indeed over the summer the Greek government put forward a revised plan that compensates for the lower revenue with deeper spending cuts. But even meeting the lowered target of €52.7 billion would require a 30% jump over last year's revenue for the last two months of the year, and this is well nigh impossible.

As a result of the revenue shortfalls and the revision in the 2009 deficit, Greece still looks to be well short of the 7.8% of GDP deficit originally aimed for. Current estimates are for a shortfall this year of something like 9.4% of GDP. In order to try to soothe market fears in this unsettled environment the Greek government last week unveiled a further austerity plan for 2011 involving an addition 5 billion euros in cuts, with the objective of cutting public deficit to 7.4% of GDP by the end of next year. Apart from the fiscal effort involved the new budget will almost certainly involve a stronger economic contraction than previously anticipated - and indeed the Greek government have already revised their forecast to 3% from the previous expectation of a 2.6% shrinkage.

The problem is, that Greece is in danger of a counterproductive downward spiral here, since the revenue shortfall is at least partially the result of the existing budget austerity, which has simply helped to squeeze an already weak economy. The expected sharp contractions in GDP this year and next, will weighing heavily on revenue from income and sales taxes. Cuts to public-sector paychecks that went into affect this summer, for instance, have certainly helped contribute to a fall of about 10% in retail sales in August and September, and continuing unemployment rising above 12% will only add to the banking sectors bad debt problems.

You Need To Attack The Competitiveness Issue, And Not Just The Fiscal Deficit One

In my opinion the IMF are making a fundamental mistake in relying almost exclusively on structural reforms. "It has to come through structural reforms," Mr. Thomsen said, adding that he expected those reforms to be discussed at the next visit by the delegation early next year. "It cannot come through higher tax rates, that's not good for the economy, and it cannot come from more wage cuts because that is not fair."

The are right that more taxes and less salaries without corresponding price reductions don't solve the problem, but Greece needs to do something radical (like a sharp internal devaluation) to restore competitiveness rapidly. Pushing the issues out to 2020 is no solution, and it is hard to imagine Greek civil society will accept the levels of unemployment and social dislocation that are being produced for such a lengthy period of time.

Estimates of the future path of Greek debt vary a lot, and their is considerable uncertainty involved in any estimate. The IMF currently forecast that the debt will peak at just under 145% of GDP in 2013, but I think we can regard that as an estimate at the lower end of the range.

Despite the fact that George Papandreou's government has been widely praised for enforcing draconian austerity measures, the country still has the largest debt-to-GDP ratio in the EU, which involves a debt mountain of something like 330 billion euros - only 110 billion of which will be funded by the EU-IMF rescue programme. That is to say, private sector bondholders will still have something like (at least) 220 billion euros of exposure to Greek debt come 2013.

Greece's whopping current account deficit has reduced to some extent since the 2008 15% of GDP high, but the level is still quite large.

More importantly the IMF do not forsee Greece running a current account surplus at least before 2015. Indeed they imagine that Greece will still have a current account deficit of 4% of GDP come 2015. Which means that far from paying down their external debt, Greek indebtedness (absent restructuring) will continue to rise over the whole period. According to Greek central bank data, the country had a net external investment position of 199 billion euros in 2009, or put another way, net external debt was something like 110% of GDP.

At the end of last week, risk premiums on 10-year Greek bonds over their German equivalents were still timidly nosing above 1,000 basis points, a level many consider to be the market signal that default is likely. And this despite the International Monetary Fund having announced the same day that the Greek reform programme is “broadly on track”.

And then there is the return to the financial markets issue. Finance Minister George Papaconstantinou has repeatedly said the country would return to bond markets when the time was right sometime in 2011. This looks increasingly like wishful thinking, especially since the 2009 deficit revision by Eurostat, while the less than anticipated revenue performance means that Greece has already missed its first fiscal consolidation target. Such a lapse may convince inspectors from the EU and the IMF, but it is unlikely to cut too much ice with ultra conservative fixed income market participants.

And, as Nick Skrekas points out in the Wall Street Journal, the numbers simply don’t add up. Greece has to raise €84 billion to repay interest and principle over the next three years, even assuming the force of the economic contraction doesn't mean even more missed deficit targets . Add to that an additional €70 billion for each of 2014 and 2015 in repayment of EU-IMF loans, and the calculation equals an unavoidable default, which is what the markets are signalling with there 1,000 to the sky is the limit spread on Greek 10 year bonds over bunds.

Even in the pre-crisis days, Greece couldn’t realistically raise more than about €50 billion a year from markets that trusted it. And market participants know the ‘troika’ is being unrealistic in its expectations. Lack of conviction in the bond markets that Greece can survive without a default is creating a vicious cycle that keeps prospective borrowing costs elevated and thus makes eventual repayment even more unlikely. And round and round and round and round we go.

In this sense the troika’s earlier inflexibility over the repayment postponement issue has been entirely self-defeating. The delay in letting the markets know that extension was a possibility is rumored to have been in part due to the German government's worries about what the reaction inside Germany would be to the news. Evidently borrowers are going to be able to kick the can a lot harder and a lot further down the road than previously imagined. Indeed only today Ireland is seemingly to get money over a nine year term, which makes it hard to see how exactly the European Financial Stability Facility can be wound up in 2013 as previously planned - indeed the way things are shaping up it looks like 2013 could be the year when it really gets going.

Which, as John Dizzard notes in the Financial Times, would seem to create a new potential moral hazard problem, which is that if the funds in the pot are going to be limited, and if potential costs going forward are likely to be high, then we could see a rush to get in (before the funds are all used) with few in any hurry at all to leave. Giving Spain the prospect of 350 billion euros (or thereabouts) over seven and a half years mights seem very tempting, but it is unlikely that those in Rome would be happy to pay rather than join the queue standing next to the soup pot.

So, what this all boils down to is, that along with the EU and IMF we can be in no doubt: the reform programme evidently is on track. The only issue which seems to divide everyone - and especially those office-bound Fund employees from their more financially savvy market-participant peers - concerns the exact name of the station towards which the train in question is heading.

Thursday, October 28, 2010

Has the Market Finally Gotten it on the Eurozone Periphery?

By Claus Vistesen: Hull

Update: I was so caught up with Ireland today that I didn't notice how Greece also wants its part of the limelight. But fear not; Joseph Cotterhill from Alphaville delivers the goods as Greek spreads to the German benchmark rose above 10%. Basically, it is a mess at the moment in Greece with one of the biggest risks that the political balance is also shifting. Most remarkably however was the comments made by the Finance Minister Papaconstantinou that growth rate this year would be -4.0 and -2.5 to -3.0 in 2011. Add to this ongoing deficits (which will of course be smaller due to the contraction) and you are looking at an overall debt level that does not look too nice at all. Basically, the 2009 deficit is likely to be revised to 15% of GDP by the EU commission according to Alphaville and the IMF puts the 2010 deficit to around 7%. Now, figures are scarce here but wikipedia puts debt to GDP at 115% in 2009. So, with let us say a 5% deficit in 2011, a nominal growth rate of -2.5% and an initial debt level of 115% (just to play nice) my calculations suggest that Greece will be facing a debt to GDP level of some 130% at the end of 2011, a number which naturally will grow as we move on.


Popular wisdom has it that markets are always right or, more appropriately; that if you find your self on the wrong side of the market consensus the best cause of action is to join the ranks less you want to be rolled over by steamroller. However, it may take some time before the market corrects to the underlying fundamentals or so, at least, I will argue.

Last time I wrote on Ireland I noted how the country's latest move to emphasize its strong cash position (as well as the fact that it announced the intention not to go to market to seek financing) was a wink to EU policy makers that either the current plan works or Ireland will need funding help. Private market funding at current and future expected rates is not an option and the really important question is whether the interest rates charge by some form of European SPV would also be consistent with a recovery or simply another debt spiral. I have my doubts here.

Indeed; with a the running deficit to GDP of 32% in 2010 it is absolutely necessary that Ireland addresses this as a first priority. No matter how much cash you have lying around or how much you expect to be able to get from a coordinated relief program (essentially borrowing with low rates and long maturity), the failure to react now would mean that the time path of public debt would prove instantly unsustainble as we moved into 2011 and 2012

However, markets don't seem to be very comfortable with the prospects of very strong austerity measurse in Ireland.

Quote Bloomberg

Bond investors are losing faith in Ireland’s plan to lower the deficit as spending cuts threaten to undermine economic growth, reducing government revenue. Irish 10-year bond yields climbed within 50 basis points of the 454 basis-point record spread, set Sept. 29, relative to similar-maturity German bunds. Portugal’s spread fell about 1 percentage point against the German benchmark in the past month, the Greek-German yield gap narrowed 102 basis points and the Spanish spread was close to the lowest level since Aug. 10.

It is important to understand the underlying message here. What drives the worry is not so much the debt and deficit itself, but more so that the severe austerity measures needed to restore the evolution of debt will derail the economy and thus become counterproductive. Indeed, this is the main issue which most OECD economies grapple with at the moment.

But surely, it is not easy being Ireland at the moment. On one day, spreads climb because you are trying to plug the hole in the budget as you try to salvage a broken financial sector and the next spreads climb on growth fears as you introduce austerity measures in an attempt to correct the deficit incured in the first place.Look up the old proverb of being stuck between a rock and a hard place and you will find the European Periphery as a chief example.

What is interesting in particular are the comments extracted by Bloomberg from various fixed income portfolio managers across Europe. They seem to me to be getting closer to a does not compute moment of their own (all quotes are gathered by Bloomberg). Firstly, Dermot O’Leary, chief economist at Goodbody Stockbrokers simply turns the focus upside down and argues that now, surely, growth is the most important goal for Ireland.

“With the scale of consolidation now known, the department’s strategy for returning the economy to growth” could “now be described as more important than the consolidation measures,”

I wonder whether he would change his mind if the black hole of Anglo Irish takes the 2010 deficit/GDP figure to 40% (or perhaps 50%?). But there are other much more fundamental issues being raised; for example by John Fitzgerald a member of the central bank board.

The risk is “the medicine is too severe so that, like chemotherapy, it puts the patient into decline,”

Indeed, this is a risk and one which I (and others) have been banging on about the last 2 years, but the one I really liked was the comment by Ralf Ahrens from Frankfurt Trust and the simple yet crucial question;

“There is this central question of where does growth come from.”

Well, well. Aren't we coming full circle here?

Allow me to repeat three questions I posed recently in relation to the ongoing efforts to solve the the crisis in many European economies.

  • How do you correct external competitiveness deficiency from within a currency union at the same time as implementing fiscal austerity without risking debt levels to spin out of control?
  • How long should Southern Europe and Ireland endure deflation relative to the core to restore external competitiveness (will Germany accept a lower external surplus as result)?
  • How might a sovereign restructuring in a Eurozone economy play out?

The first question is really the main issue at hand. In the absense of nominal currency devaluation you need to impose wage restraint and deflation in order to correct a large external balance. As this large external imbalance is reflected in a large domestic debt level there is a real risk that if the entire correction must come from the domestic price level, the level of debt in itself will spin out of control which then manifests itself in either large scale private sector defaults or default on the sovereign level.

The main message here is simple macroeconomics. If you combine deflation and negative nominal growth rates over a prolonged period of time and given an already elevated debt level; your overall level of debt relative to the value of your activities (GDP) quickly become unsustainable.

So how do correct then? Well, not without a little help from your friends which brings us to the second question.

Consequently, this is not only about the European periphery suffering, it is about them suffering more than everyone else. Indeed, the recent ascent of the Euro is no good for them in so far as goes competitiveness outside the Eurozone and even inside Europe, it is starting to look like everybody's race to the bottom in terms of on whose back intra-Eurozone imbalances are supposed to correct. Naturally, a steady depreciation of the Euro would, strictu sensu, be welcome news for Greece, Ireland et al. Yet, this seems far off at the moment with the Fed doing the printing and the ECB reluctant to add further stimulus. On the concrete question of time, you just need to slice up the effects of say, a 30 % nominal devaluation (e.g. against the Euro or USD) which is the likely alternative scenario, I think, if any of the most troubled Eurozone economy had their own currencies. It then means that we would need to see a prolonged period of relative deflation to Core europe.

This however would in itself be problematic since 5-10 years of slow pain would almost certainly result in a Japan type lost decade, but also be almost impossible from within the Eurozone (i.e. politically). So by proof of elimination we reach question three. Indeed, PIMCO's El-Erian recently argued that Greece is likely to default within 3 years and that this need not be cataclysmic. I fully agree.

It is impossible to do any form of calculation here since we don't have any numbers that are coherent, but surely I would think that something along the lines of a 30% haircut on the principal and a notable extension of maturity is a likely result (but really, I have no idea!). The alternative would be that the rest of the periphery follows Ireland's example and simply leave the private market (although China et al. have indeed been fishing lately) and thus, they would have to be capitalised slowly from within an intra Eurozone structural fund (or through outrigth monetization by the ECB, but this is not going to happen I think).

In the event of restructuring, big the question of the hole left on the balance sheet of Eurozone debt holders of peripheral bonds (let us think about foreign holders later). A couple of potential solutions have already been put forward.

Leaving aside the Structural Fund which is not supposed to recapitalise private entities (at least not yet) it would mean that those banks either would have to enter the market to recapitalise, be recapitalised by their domestic governments (a deal which could form part of the default), or simply tranfers bonds at par to the ECB which tend would have to take the hair cut on its balance sheet.

At the end of the day, this kind of rhetoric is still seen as fearmongering and disruptive in the Eurozone collective since there is still a strong sense of resolve around the fact that no sovereign in the Eurozone may be allowed to default/restructure on its debt. As such, you could argue that one glaring omission in my analysis is that I don't consider the costs of default. Well, they would naturally be substantial not only for the individual economies but for the Eurozone itself. However, when you run even a rudimentary simulation of the likely numbers it is pretty easy to see how this cannot go on. There is no exogenous source of economic growth that will help the periphery move in to a virtuous circle, there is only one big vicious one in which more austerity brings lower growth and deflation which in turn affects the level of debt to GDP.

I admire resolve and I even believe that it is merited, but this is only to the extent that Germany (and France) are willing to assume their part of the bill (which will be very big) or to the extent that the ECB decides to employ wholly new and Fed-like policy tools.

Absent this and leaving aside the question of whether Germany and France realistically would be able to foot the bill at all, the only question is if the markets are starting to get it, when will the shoe drop on the level of macroeconomic policy making?

Sunday, October 17, 2010

Mr Zapatero Said What..........?

by Edward Hugh: Barcelona

Spain's Tinsa Price Index was out last week, and showed Spanish property prices fell again in September, and at an accelerating rate. As Tinsa point out in their report, both "Metropolitan Areas and municipalities on the Mediterranean Coast," whose rates experienced a significant drop from the previous month, have contributed decisively to this steep decline".

In fact, looking at the chart the other way round, prices have now fallen some 18% from their December 2007 peak.

The strange thing is that the latest Tinsa data contrast sharply with the most recent finding of Spain's National Institute of Statistics (INE) on the subject, since they suggest in their latest report that Spanish property prices actually rose in the second quarter (quarter-on-quarter) (and for the first time in the best part of 3 years), but this finding rather than reassure us that all is well (and as it should be) only serves to cast further doubt on the ability of the INE to maintain adequate statistics on the state of the Spanish economy, or at least to interpret the data they collect. This latest piece of statistical wizzardry lead Spanish property expert (and author of Spain Property Insight blog) Mark Stucklin to say "If you believe that, you’ll believe anything". Frankly, I'm inclined to agree with him.

Of course, it has become rather fashionable to question INE data interpretation of late (and I personally have had my problems with the seasonally adjusted employment numbers - in fact see these collected screenshots of the the backward revisions that were going on in the data as evidenced by Eurostat monthly reports) but this latest "faux pas" does make you want to ask "can't they get anything right"? In fact the Statistics Office house-price-data, is full of incredible and eye catching details, like the suggestion that new build sale prices only peaked in the third quarter of 2008, following which they only fell back 7.77% from peak, before taking off again, if we are to accept the official data version of things. So this must have been the "bottom" that Mr Zapatero refered to in his CNBC interview (see below). And this, as Mark Stucklin notes "despite a glut of up to 1 million newly-built homes, and discounts of up to 20pc or more on any developer’s price list you care to look at". So is this how one of the greatest housing busts in living history ends, with a whimper and not a bang? Somehow I doubt it.

Naturally, I'm sure its a pure coincidence that this latest "surprise price reversal" data came out just before Jose Luis Rodriguez Zapatero went to New York to kindly inform all concerned that the Spanish property market is now on the mend. In an interview with CNBC (see this official Moncloa transcription of the interview if you have any doubt), Prime Minister Zapatero repeated the INE claim, stating that house prices are beginning to rise in some areas, though not, he admitted, in the case of holiday homes. “In fact, in the last 2 to 3 months, we have seen that prices are not only not falling, but even rising in certain parts of Spain, where people buy their first home,” he told CNBC's Maria Bartiromo. This, he argued, shows that “demand appears to be on the rise.”

MS. BARTIROMO: Are you expecting real-estate prices to continue coming down? Have they hit the bottom or not yet?

PRIME MIN. ZAPATERO: I think that the price of housing has hit the bottom. It won't go down any more. For the past two or three months, what we see is that not only has it not dropped. But in certain parts of Spain, the price of housing has gone up. This is especially the case in those areas of -- not where people are buying their second house, if you like, with the prices there have still gone down a bit, but rather where they're buying their first, there the prices have gone down in the housing sector. So in general the prices have been stable recently, and they've even been increasing. So demand seems to be ticking up again.

Now, as that posse of irate INE defence vigilantes who may come chasing after me on this will no doubt tell you, the methodology they use is different from the Tinsa one, since it based on registered Notarial transaction prices, while the Tinsa index is based on asking prices, but come on, house prices rising again in Spain? Which world are we living in?

Of course, there could be another explanation for this seeming discrepancy (apart from fudging the numbers that is) and that would be that many of the actually new build transactions are not real transactions at all, but rather paperwork ones, as the banks move over the developers unsold property onto the books of their special purpose subsidiaries, and don't mark down the price since they prefer not to show losses. Then, of course, the very same subsidiary offers the property for sale at a sizeable discount (and it shows up with the Tinsa index as an asking price), but since there are very few real new-build sales at the moment, these number never show up back in the notaries office, where all is quiet and orderly.

Sure, the data show that new house sales "seem" to have bottomed, and even picked up a bit (see chart below), but talking to developers and estate agents out on the street, this doesn't seem to be the result of any real pick up in end user demand. It is more a question of banks responding to pressures from the Bank of Spain by moving their properties "out of sight" (if not out of mind). Meanwhile, the typical Spanish buyer is adopting a watch-and-wait approach, and will need a lot of convincing that they really have stopped falling before they move back in. Even the "experts" employed by the EU Commission are not convinced either, since they just published a report stating that Spanish property prices were still 17% too high.

But if you want one, there is something more like a smokin gun out there which should tell us that this whole Spain property market recovery story is a bit strange, and that is the Bank of Spain data for total mortgage lending. This has hardly moved since the start of 2009 (see chart below) so it is far more easily reconcilable with the properties being transfered over to bank subsidiaries (complete with their "developer" mortgages) story, than it is with one of rising sales and rising prices.

More than the house price story itself, which is hardly pleasing to the eyes, what I find most worrying is the way the Spanish administration seems to be boxing itself into a corner with its use of data. During the interview. Mr Zapatero also said the following in a response to a question about the outlook for the Spanish economy: "Well, our estimate is that we won't have any more quarters where growth will go down. We think that growth will continue to improve, and this will also improve confidence in the Spanish economy". But none other than Bank of Spain Governor Miguel Angel Fernandez Ordoñez recently asserted that the Spanish economy had visibly weakened in the third quarter, and the data we have certainly seem to back him up. And the fourth quarter outlook looks even worse. So which is it, will Mr Zapatero be able to eat humble pie, or will an army of bank analysts and hedge fund investors end up spending the whole xmas period going through all the Spanish data with a fine toothcomb? Mr Zapatero also says: "What's happening is that our plans are being fulfilled to the letter". This reminds me of other statements from other national leaders in other times. Would that those beyond the confines of his own small closed inner circle could find themselves able to agree with him when he makes such an assertion!

Saturday, October 16, 2010

An Unusual But Interesting Argument Which May Help To Understand Why QE2 Is Now Almost Inevitable

by Edward Hugh: Barcelona

For reasons which aren't worth going into now, I'm reading through a recent report by Deutsche Bank Global Markets Research entitled "From The Golden To The Grey Age" this afternoon. The report (all 100 pages of it, many thanks to researchers Jim Reid and Nick Burns who produced the thing) looks at the extent to which a variety of macro indicators - like GDP growth, inflation rate, equity yields, etc - may have been influenced by demographic forces over the last 100 years or so. It is certainly one of the most systematic reports of its kind I have seen, and well worth losing a Saturday afternoon to read.

But in the middle, there is an argument which caught my eye, and I thought it worth reproducing. Basically the starting point is this chart, which if you haven't seen by now (or something like it) I'm not sure where exactly you've been during the last 2 or 3 years.

Obviously, just the most cursory of glances at the thing should lead even the most untrained of eyes to get the point that what is going on around us is not some passing phenomenon, and that there are deep structural factors at work.

As our DeutscheBank researchers put it:

As can be seen (from the above chart) there was a step change in the US economy’s indebtedness from the early 1980s onwards and then an additional one in the late 1990s/early 2000s. A similar picture is apparent across most of the Western World.

Basically from the early 1980s to the onset of the Global Financial Crisis the economy added on more debt every year and business cycles were extended as a result. Indeed the Fed and Central Banks around the world were afforded the luxury of operating in a secular falling inflation regime (globalisation) that allowed them to cut rates, further allowing the accumulation of debt, every time the economy may have naturally been rolling over into a normal recession consistent with those seen through history. This debt accumulation undoubtedly helped smooth the business cycle and contributed to the period being known as the ‘Great Moderation’. This period came to a spectacular end with the onset of the crisis and it is possible that going forward we will revert to seeing business/credit cycles more like they were prior to the ‘Great Moderation’.

Now here comes the clever part. Our researchers then go on to take a look at the the average and median length of the 33 business cycles the US economy has seen since 1854. For the overall period they found the average cycle from peak to peak (or trough to trough) lasted 56 months (or 4.7 years). However, the averages are boosted by an occasional elongated "superbusiness cycle", and thus the median length is a much smaller 44 months (3.7 years). As they comment, such numbers must look very strange to those who have only ever analysed business cycles over the last 25-30 years. Within these 33 cycles the contraction period lasted 18 months on average or 14 months in terms of median length. This equated to the economy being in recession 31% or 32% of the time depending on whether you look at the averages or the median numbers. Taking just the period before the “Great Moderation” the average US cycle lasted 5 months less at 51 months (or 4.3 years) with the median at 42 months (3.5 years). Over this period the US economy was in recession 35% and 36% of the time respectively depending on whether you look at averages or the median.

Now we used to think that all of that was behind us, but then we used to think that the "Great Moderation" had gotten things under control, and not simply temporarily extended the cycle length by facilitating long-term-unsustainable levels of indebtedness. So in fact, given that, as they say some sort of cycle or other has been with us since at least biblical time, what we might now expect are more "normal" cycles (in historical terms), which put a little better means shorter ones with more frequent recessions.

"Given all we know about the ‘debt supercycle’, it is likely that the onset of the Global Financial Crisis ended the “Great Moderation” period. Unless we find a way of continually adding more debt at an aggregate level in the Developed World it is likely that we will see much more macro volatility and more frequent business cycles going forward. Given the fact that Developed World Government balance sheets are under pressure, and given that interest rates around the Western World are close to zero, the post-crisis ability to fine tune the business cycle is extremely limited. We may need to put an immense amount of faith in the experimental force of Quantitative Easing to deliver economic stability. This will be an experiment with little empirical evidence as to how it will turn out. For now the base case must be that we revert more towards business cycles more consistent with the long-term historical data".

So then our authors do their calculations concerning the average length of US cycles since 1854 in order to make a rough estimate of when the next few US downturns will start, as illustrated in the following chart.

Now, without dwelling on the gory details, if we look at the spread between the upside, median, and downside cases, we could pretty rapidly come to the conclusion that the next US recession has a high probability of starting sometime between next summer, and the summer of 2012 - which, as you will appreciate, isn't that far away. I am also pretty damn sure that Ben Bernanke and his colleagues over at the Federal Reserve appreciate this point only too well, and hence their imminent decision on more easing, since a recession hitting the US anytime from next summer will really come like a jug of very icy water on that very fragile US labour market, not to mention the ugly way in which it might interact with the US political cycle.

I think the mistake many analysts are making at this point is basing themselves on some sort of assumption like, "if the recession was deep and long, then surely the recovery should be just as pronounced and equally long", but, as the DeutscheBank authors bring to our attention, business cycles just don't work like that.

Now, why I think this is an interesting argument is that the starting point for looking at the recovery is rather different from the norm, in that instead of peering assiduously at the latest leading indicator reading, they do a structural thought experiment, and work backwards from the result. Now, one thing I'm sure Ben Bernanke isn't is stupid, so it does just occur to me that either he, or someone on is team, is well able to carry out a similar kind of reasoning process.

Watch Out, Here Comes The QE2

In fact, it would be an understatement to say that the forthcoming QE2 launch is causing a great deal of excitement in the financial markets. As the news reverberates around the world, it seems more like people are getting themselves ready for some kind of "second coming". Right in the front line of course are the Europeans and the Japanese, and the yen hit yet another 15 year high (this time of 81.11 to the dollar) during the week, while the euro was up at 1.4122 at one point. Greeks, where are you! Can't you engineer another crisis? We need help from someone or we will all capsize in the backwash created by this great ocean liner as it passes.

But joking aside, a weaker USD is going to be both the natural and the intended consequence of the coming bout of additional QE by the Fed, and it will have a strong collateral effect on the already weaked and export dependent economies of the EuroArea and Japan.

With this prospect as the background, it should not come as a surprise that talk of currency wars and competitive devaluations is rising by the day. Japan only last week threatened "resolute action" against China and South Korea, Thailand has placed a 15% tax on bond purchases by non resident investors, and central banks from Brazil to India are either intervening to try and keep their currency from rising too fast, or threatening to do so.

And the seriousness of the situation should not be underestimated. Many have expressed disappointment that the recent IMF meeting couldn't reach agreement, and hope the forthcoming G20 can do so. But really what kind of agreement can there be at this point, if the real problem is the existence of the ongoing imbalances, and the inability or unwillingness of the Japan's, Germany's and China's of this world to run deficits to add some demand to the global pool. Push to shove time has come, I fear, and if this reading is right then it is no exaggeration to say that a protracted and rigourously implemented round of QE2 in the United States could put so much pressure on the euro that the common currency would be put in danger of shattering under the pressure. Japan is already heading back into recession, as the yen is pushed to ever higher levels, and Germany, where the economy has been slowing since its June high, could easily follow Japan into recession as the fourth quarter advances.

Indeed, I think we can begin to discern the initial impact of the QE2 induced surge in the value of the euro in the August goods trade data. The EuroArea 16 have been running a small external trade surplus in recent months, and to some extent the surplus has bolstered the region's growth. It is this surplus that is now threatened by the arrival of the QE2. The first flashing red light should have been the news that German exports were down for the second month running in August, but now we learn from Eurostat that the Euro Area ran a trade deficit during the month.

"The first estimate for the euro area1 (EA16) trade balance with the rest of the world in August 2010 gave a 4.3 bn euro deficit, compared with -2.8 bn in August 2009. The July 20102 balance was +6.2 bn, compared with +11.9 bn in July 2009. In August 2010 compared with July 2010, seasonally adjusted exports rose by 1.0% and imports by 1.8%".

Basically the eurozone countries had been managing to run a timid trade surplus (see chart below, which is a three month moving average to try and iron out some of the seasonal fluctuation) and this had been underpinning growth to some extent. Now this surplus is disappearing, and with it, in all probability, the growth. Maybe we won't get a fully fledged "double dip" in the short term, but surely we will see a renewed recession (and deepening pain) on the periphery and at the very least a marked slowdown in the core.

In fact the current situation is extraordinarily preoccupying. We are now in the fourth year of the present crisis (however you choose to term it, the second great depression, the very long recession, or whatever) and there seems to be no sustainable solution in sight. The underlying problems which gave birth to the crisis are excessive debt (both private and public) and large global imbalances between lender and borrower countries, and neither of these issues has so far been resolved, nor are there proposals on the table which look capable of resolving them.

And unemployment in the United States (which is currently at 9.6%, and may reach 10% by the end of the year) is causing enormous problems for the Obama administration. The US labour market and welfare system are simply not designed to run with these levels of unemployment for any length of time. In Japan the unemployment rate is 5.1%, and in Germany it is under 8%. So people in Washington, not unreasonably ask themselves why the US should shoulder so much extra unemployment and run a current account deficit just to maintain the Bretton Woods system and the reserve currency status of the US Dollar.

My feeling is that the US administration have decided to reduce the unemployment rate, and close the current account deficit, and that the only way to achieve this is to force the value of the dollar down. That way it will be US factories rather than German or Japanese ones that are humming to the sound of the new orders which come in from all that flourishing emerging market demand.

I think it is as simple and as difficult as that.

The problems created by the way the crisis has been addressed now exist on a number of levels. In emerging economies like Brazil, India, Turkey and Thailand, ultra low interest rates in the developed world are creating large inward fund flows which are making the implementation of domestic monetary policy extremely difficult, and creating sizeable distortions in their economies.

At the same time, a number of developed economies like Spain, the United States, the United Kingdom became completely distorted during the years preceding the crisis. Their private sectors got heavily into debt, their industrial sectors became too small, and basically the only sustainable way out for them is to run current account surpluses to burn down some of the accumulated external debt. Traditionally the solution to this kind of problem would be to induce a devaluation in the respective currencies to restore competitiveness, but in the midst of an effectively global crisis doing this is very difficult, and only serves to produce all sorts of tensions. As Krugman once said, "to which planet are we all going to export".

At the same time, two of the world's largest economies - Germany and Japan - have very old populations, which effectively means (to cut a long story short) they suffer from weak domestic demand, and need (need, not feel like) to generate significant export surpluses to get GDP growth and meet their commitments to their elderly population. The very existence of these surpluses also produces tensions, and demands for them to be reduced. But this is just not possible for them, and Japan is the clearest case. For several years Japan benefited from having near zero interest rates and becoming the centre of the so-called global "carry trade", which drove down the currency to puzzling low levels, and made exporting much easier. Large Japanese companies were even expanding domestic production and building new factories in Japan during this period (a development which had Brad Setser scratching his head at the time, trying to work out how the yen could have become so cheap).

Then the crisis broke out, the Federal Reserve took interest rates near to zero, and the United States became the centre of the carry trade. The result is that every time the Fed threatens to do more Quantitative Easing the yen hits new 15 year highs, even while the dollar continues its decline, with the result that Toyota are having a change of heart, and are now thinking of closing a plant in Japan to move it to Mexico. The present situation is just not sustainable for Japan, which is basically being driven back into what could turn out to be quite a deep recession.

Unfortunately I think there is no obvious and simple solution to these problems. As we saw in the 1930s, once you fall into a debt trap, it can take quite a long time to come out again. You need sustained GDP growth and moderate inflation to reduce the burden of the debt, and at the present time in the developed world we are likely to get neither. In the longer term, the only way to handle the presence of some large economies which structurally need surpluses is to find others who are capable of running deficits, but this is a complex problem, since as we have seen in the US case, if the deficit is too large, and runs for too long, the end result is very undesireable. Basically the key has to lie in reducing the wealth imbalance which exists between the developed and the developing world, but this is likely to prove to be a rather painful adjustment process for citizens in the planet's richer countries, so policy makers are somewhat relectuntant to accept its inevitability.

Basically, the structural difficulty we face is that all four major currencies need to lose value - the yen, the US dollar, the pound sterling and the euro - and of course this basically is impossible without a major restructuring of what has become known as Bretton Woods II. The currencies which need to rise are basically the yuan, the rupee, the real, the Turkish lira etc. But any such collective revaluation to be sustainable will need to be tied to a major expansion in the productive capacity of the economies which lie behind those currencies.

In fact, the failure to find solutions is increasingly leading to calls for protectionism and protectionist measures. The steady disintegration of consensus into what some are calling a "currency war" is, as I said above, another sign of this pressure. On one level, the move to protectionism would be the worst of all worlds, so I really hope we will not see this, but if collective solutions are not found, then I think we need to understand that national politicians will come under unabating pressure from their citizens to take just these kind of measures. The likely consequence of them succumbing to this pressure, which I hope we will avoid, would be another deep recession, possibly significantly deeper than the one we have just experienced. And, not least of the worries, the future of the euro is in the balance at the present time.

The structural imbalances which we see at the global level, between say China and the United States, also exist inside the eurozone, between Germany and the economies on the periphery (Ireland, Portugal, Spain, Italy, Greece). These latter countries failed to take advantage of the opportunities offered by the common currency to carry out the kinds of structural reform needed to raise their long run growth potential, and instead they simply used to cheap money available to get themselves hopelessly in debt. At the same time the crisis has revealed significant weaknesses in the institutional structures which lie behind the monetary union, weaknesses which go way beyond the ability of some members to fail to play by the rules when it comes to their fiscal deficits. Steps are now being taken in a night-and-day non-stop effort to try to put the necessary mechanisms in place, but it is a race against the clock, and it is not at all guaranteed that the attempt will be succesful, especially if the volume of liquidity about to hit the global financial system drives the euro onwards and upwards beyond supportable limits.