“It is time for a breakthrough to a new Europe,” German Chancellor Angela Merkel said on November 9th.  “That will mean more Europe, not less.” Merkel wants a stronger fiscal union with strict controls on eurozone national budgets.  Yet to date EU fiscal policy, such as it is, has meant ill-considered pro-cyclical spending programs – as shown in the graphic above.  Greece was and is a large recipient of EU transfers, yet those transfers collapsed by 1.3% of Gross Domestic Product (GDP) after it was forced to cut back on its contributions to EU-subsidized projects in an effort to slash government spending.  This additional fiscal squeeze hurt growth; Greek GDP fell an annual average of 3.5% in 2009 and 2010.

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Imagine life insurance contracts that wouldn’t pay off if officials declared heart attacks to be “voluntary.” Welcome to the world of sovereign credit default swaps, or CDSs.  When the Greek debt deal was announced on October 27, the eurozone leadership insisted that the banks were taking a 50% write-down “voluntarily,” meaning that Greek CDS contracts would not be triggered.  This was done to protect official creditors like the ECB and IMF, to avoid rewarding speculators, and to prevent possible financial contagion.  In response, Greek CDS prices plunged 20 percentage points.  Policymakers didn’t seem to care, but they should.  Those who bought CDSs believing that they were prudently insuring their bond holdings now face unexpected losses.  Sovereign CDSs have lost so much credibility that the troubled investment bank Jefferies felt it necessary to state publicly that it was not using them.  This credibility loss has spread to other sovereign CDSs, as shown in the bottom part of the figure above: the correlation between PIIGS debt spreads and CDS prices has plunged, indicating that CDSs are no longer viewed as reliable sovereign credit risk insurance.  Using CDS prices as a measure of default risk is now like setting your watch to a defective clock.  Yet the market is unlikely to die owing to Basel III bank capital regulations, which still treat CDSs as meaningful offsets against certain types of sovereign credit exposures.  This gives banks a perverse incentive to hold them just to reduce their capital requirements.  Given the permanent political distortion that Europe has introduced into the sovereign CDS market, it would be best now if the market could simply be shuttered.

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On September 21st the Fed announced that it would be selling $400 billion in short-term Treasurys and buying $400 billion in longer-term Treasurys to replace them – a maneuver titled “Operation Twist.” Atlanta Fed president Dennis Lockhart explained what it would mean for the economy: “It means lower interest rates – a lower cost of borrowing – across a whole spectrum of loan maturities.” Is he right? Well, China, Russia, and Brazil have conducted their own version of Operation Twist over the past several years, replacing roughly $330 billion in short-term Treasurys with long-term ones. The 10-year Treasury rate went sideways over that period, as shown in the figure above. Whereas the BRIC* Twist may have put some modest downward pressure on longer-term rates, other factors overwhelmed it. Don’t expect much from the Fed’s similar-sized version.

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The eurozone leadership is finally coming around to accepting that a major continent-wide bank recapitalization program is necessary.  Germany wants each country to take care of its own banks.  This approach could buy time, but it won’t work for long.  National bank backstops are untenable in a common currency area, as each sovereign has its own credit risk profile.  Depositors will simply flee toward the better backstops.  This can already be seen in the correlation between bank deposits in Germany and the PIGS (Portugal, Ireland, Greece, and Spain).  Before the financial crisis, those deposits were tightly correlated, as shown in the graphic above, but over the past two years the correlation has flipped – deposits are fleeing the PIGS and flying into Germany.  A stable eurozone banking system will require a unified regulatory, resolution, and rescue regime. Read more »

Chinese Premier Wen Jiabao recently hinted teasingly that China might buy more risky-country European debt; a “helping hand,” he called it.  Yet even if China follows through, it is unlikely to increase its intended purchases of European debt but rather just change the composition.  China’s euro purchases have increased dramatically over the past two years (we estimate these to be ¾ of reserves purchased in excess of the change in China’s U.S. asset holdings).  Most of this can be presumed to have been invested in German bunds, Europe’s closest thing to U.S. Treasurys.  Chinese euro purchases over the coming twelve months equivalent to those of the previous twelve months could cover the entire 2012 net financing needs of Portugal, Ireland, Italy, Greece, and Spain (PIIGS), as the figure above shows.  Every euro China invests in new PIIGS debt, however, can be expected to come at the expense of bunds.  Such a diversion would push up German interest rates—precisely what Germany wants to avoid by resisting eurobond issuance—without giving Germany any greater say over eurozone fiscal policies.  Chancellor Merkel therefore gains little, if anything, in making political concessions to secure Wen’s “helping hand.”

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