The politics of the Maastricht convergence criteria

http://www.voxeu.org/index.php?q=node/3454

Some countries “got in” just because of political considerations (what a shock!). Same countries better be careful as public attitudes and politics change in good old Europe. Ireland, Greece, and Austria, are you listening?

Of course, politics may change again. Even Germany is expected this year to violate the 3% limit on public deficit to GDP. Nevertheless, repeat offenders better prepare themselves for a trip to the woodshed.

It was an unintended side effect of the Cold War. The Marshall Plan ended up with Europe having lots of dollars some of which ended up in the Soviet Union. For obvious reasons, the Soviets were worried about holding dollars in American banks.

The huge amount of dollar-euro swaps may have something to do with the “dollar hegemony conspiracy theory.” Suppose you are a Spanish oil company, you want to buy crude oil in six months, but you want to do it in euros. What do you do to avoid currency fluctuations? You buy a dollar-euro swap.

Yes. Still, what’s new? Since some European banks did all this almost riskless arbitrage and got badly burnt, we have come down to earth, This looks like a hornet’s nest where desparate banks will not be looking for honey temporarily. There were (and still are) far too many financial institutions and too little capital to keep them all solvent while their industry is going through a shakeout.

The thing about shake outs is that it eliminates the weak. Where is that happening now, when every bank gets bailed out? Financial services where firms act as principals with the tacit backing of the government (too big to fail) are still around and we have just witnessed yet another instance of political impotence to tame this stupid industry. The eurodollar market was once the typical example of an unconstrained deposit multiplier system. Then Basle I came along, the banks found ways around it, governments looked the other way while the investment banks sold yield machines to German public sector banks
(uncontsrianed again, off balance sheet) consiting of a conduit, toxic assets and commercial paper placement facilities. NOw there is a bit of a problem, some shake out but also a lot of real economy shrinking. Our political system cannot afford to antagonize major constituencies so the sore is bandaged and deodorized for a while.

The eurodollar market (that is the market in US instruments without a US resident actually borrowing or lending) has been around for some 40 years now and was once the unintended consequence of US regulation. The lower interest rates are, the lower the US political risk (of confiscation) and the less not quite legal money is held in USD, the more USD is held at home.

Were you surprised by the existence of a large stash, or about the size of the stash? (assuming the numbers have any meaning). If you believe the US should have control, promote regulation (and get smuggling plus other forms of crime). If you do not, pay no attention.

No there isn’t. The banks exposures to CDS’s is a few billion, and it’s not the big problem. At this point CDS’s and derivatives are minor problems. Going back to the forest fire analogy, CDS’s and derivatives are what set off the forest fire, but now that everything else is burning, it’s not too useful to focus on what started the fire except for historical reasons.

Also the place that started the fire is the first place that got burned to ashes. CDS’s and synthetic CDO’s have been written down to the point that they are a minor problem right now.

The big problem are ordinary loans. Also I think everyone “passed” the stress tests. But there is still a huge difference between the picture of health and barely alive.

Europe indirectly benefits when the US bails out AIG, but then the US benefits when Europe bails out RBS, so I think in the end, everyone is more or less even.

D Gross: It is interesting how so many factors came together to create the current crisis.

Yes and no. If you light a match in a room full of dynamite, it’s interesting to watch which particular sticks go off first, but tracking down exactly what explodes may make you lose track of the big picture.

The basic cause of all this is that you had a complex coupled system that was highly leveraged, in which a failure at one point would cause a domino effect.

By process of elimination, I’d say it was the Arabs. There are four big players in the world. The US, Europe, China, and the Middle East. It’s not the US and Europe. China is heavily dollar exposed, so that leaves the Arabs.

There’s no one else I can think of with with large dollar holdings that want euros. It makes sense if you have Arabs with dollars that want to invest in Europe, and then Europeans with euros that want to invest in the United States, and the United States with large trade deficits due to oil that were paying the Arabs.