A Europlan that Works

Winston Churchill once remarked that "American can always be counted on to do the right thing... after they have exhausted all other possibilities." While the veracity of this statement is certainly up for debate, it seems  to apply to European policymakers in today's context.

Over the last 18 months a litany of ineffective plans have been drafted and implemented to deal with the sovereign debt crisis. Leaving various nuances aside, these plans are pretty effectively summed up by the following: (1) Provide country X with Y billion euros in loans at below-market rates, (2) force austerity on country X, (3) declare that country X is illiquid rather than insolvent and reiterate commitment to no bankruptcies in the euro area (4) on the basis of illiquidity rather than insolvency, have the ECB purchase country X's bonds. Keen minds in financial markets saw through each of these plans (Macro Man has offered a concise analysis of the failings of each plan), and the market disruptions they were designed to end always re-emerged.

The most recent bout of market instability differed from those which preceded it in that it posed an immediate existential threat to the European banking sector. This seems to have finally woken European policy makers up to the scale and severity of the problem. A series of meetings (and subsequent statements/announcements), as well as various leaks have offered observers a glimpse of the plan being negotiated. It appears to include the following:

1. A forced Greek default, with a haircut of 40-50%.
2. A commitment that no other countries will be allowed to default (this will require either a larger EFSF or more bond purchases by the ECB to be credible).
3. Bank recapitalizations. There is to be a new round of stress tests including a much harsher set of assumptions surrounding sovereign debt valuations. Where the estimated 200 billion euros necessary to get all European banks to the targeted 9% tier 1 capital under the stressed scenario will come from is to be determined, but it seems that there are enough good credits in Europe to raise the money.

The current expectation is for the final details to be ironed out by the end of the meeting of the G20 on November 3-4. Should the plan emerge as a credible version of the points above, I would consider it sufficient to contain the European sovereign (banking) crisis for a considerable period of time.

It is important to point out that the plan, in the form outlined above, would not address the longer-term structural issues I outlined in my earlier post. However, it would mitigate the more immediate threat, giving policy makers time to make the necessary adjustments to the legal structure governing the euro area (I am not particularly optimistic that the necessary changes will be made, however that is a discussion for another day).

Chalk One Up for the Good Guys

Raj Rajaratnam (of Galleon Group fame) got what he had coming today.

11 years in federal prison - the longest sentence for insider trading in history. Plus a $10 million fine to boot; pile that on top of his lawyer fees.

He deserves it. He operated a huge network of executives and analysts who routintely exploited insider information for profit. Not that I consider insider trading particularly out of the ordinary, but I like to believe that most shops haven't made it as large a part of their day-to-day business practice as Galleon did.

This is important. The investigation that led to this trial was the first time that wiretaps were used in an insider trading case. Talk about a game changer. The possibility Big Brother listening in on your phone calls will make networks such as Raj's considerably harder to operate moving forward. And that's the really determined people. There will be a lot of others who will simply stop trading on tips for fear of prosecution. This will lead to fairer markets going forward.

Kudos to the investigators and the prosecutors.

Why the Euro Doesn't Work

Currently there are two existential problems in the euro area. The first is a relatively recent development and must be dealt with immediately, while the second has been building for about a decade and requires longer-term solutions:

1. The positive feedback loop between insolvency in the European periphery and stresses in the European banking sector.
2. The long-term structural divide between unit labour costs in the north and the south of Europe.

Let’s start at the beginning – ironically the second problem above. Before anyone gets pedantic, I realize that what follows quite a stylized story (ie short on details) but I am simplifying for the sake of clarity.

Before the nations now known rather pejoratively as the European periphery joined the euro area, their workers were kept competitive with those industrious Germans through a regime of flexible exchange rates. For example, if the Portuguese were not innovating as quickly as the Germans, the Portuguese escudo would depreciate against the German mark, making Portuguese products relatively cheaper (all else equal) and thereby allowing the Portuguese to compete with the Germans in international trade.

When the euro was introduced, this mechanism disappeared and the European periphery rapidly lost competitiveness with the core.

Seems like a raw deal right? Well not entirely. The upside for these chronically uncompetitive countries was that, despite all of structural differences between the economies, the bond markets began treating debt issued by any European government as essentially the same credit (assuming an implicit mutual guarantee). This allowed these countries to fill the gap created by the erosion of their domestic private sector with government spending financed by cheap debt issuance.

This was all good until it wasn't. Once people woke up to state of the sovereign finances in these countries (initially just Greece), they rushed for the exits. With European policymakers refusing to take bold action to resolve the crisis, it spread and evolved to the point where we stand now - uncomfortably close to the abyss.

The next post will describe in more detail why policy fixes introduced have been insufficient, and detail the policy prescription necessary for Europe to extricate themselves from the mess they have found themselves in.

Note: I have not included Ireland in this discussion because I consider both its path to fiscal ruin and the steps to recovery be considerably different from the nations detailed above.