A matter of certainty

After negotiating a sizable haircut on Greek debt and pushing through an expansion in the EFSF we have seen markets rally.

The current crisis has very much been one of people wondering “who the hell will bear the burden of default”.  The closer we get to solving that question, the closer we get to putting this junk behind us.

I don’t like how people are calling these things “buying time” – in reality there just needs to be a clear set of policies set down, and a clear lender of last resort for the regions banking sector.  Get those things in place and the crisis will get the hell out.

There has been progress this month, but the international situation is still pretty weak.

If Europe’s bank don’t trust themselves, why would anyone else?

Quite. (ht Marginal Revolution)

The issues in Europe remain the most concerning thing for me at the moment – the US has a large drought and a weak patch, but at least we don’t have to ask if their central bank has the ability to always act as a lender of last resort.

The fact that there is no central fiscal authority in Europe, and the fact that people are unsure whether they can trust the ECB in a worst case scenario, makes matters difficult over there.

My concern for NZ comes from the same place they always do during these financial crises: will it lift the cost of funding (which is happening in part – albeit at a time when additional credit remains cheap) and lower export commodity prices (which hasn’t happened).  With a stagnant Europe NZ can do fine, but if they lose the plot we will not be left unharmed.

Update:  For future reference (as I often use these types of posts when I’m going back to look at history – it is amazing how useful blogging has been in this context), growing issues regarding German’s willingness to bail out the region (following election defeats for the incumbent) are a major driver of increasing uncertainty at this point in time.  Also note that the decision to start suing US banks now, in the middle of a crisis, isn’t particularly helpful.

Irish and Greek crises: Why is NZ different?

This post from Marginal Revolution has moved me from thinking to writing.

On the surface there appears to be a lot in common with the Irish, Greek, and NZ economies.  All three have high net foreign liability positions, liabilities are highly concentrated through banks who are borrowing overseas, all three have experienced some form of housing boom and lift in consumption, and finally all three appeared to have a relatively strong fiscal position before the GFC before moving into fiscal deficits after the shock.  And yet (so far) while the Irish and Greek economies and banking systems have collapsed, New Zealand’s has been fine.

There are two major differences that have helped reduce the implied risk on our debt, making New Zealand much less likely to experience a bank run:

  1. Our banking system is primarily foreign owned (Eric Crampton expands on why this is a good thing),
  2. We have a freely floating exchange rate – combined with having much of our debt denominated in NZ$ this is useful.

These are important points to recognise.  While many commentators are saying we should “peg” our dollar and set up more domestic ownership of banks GIVEN the risks associated with the GFC, I tend to reach the opposite conclusion – namely, the reason why we haven’t suffered as much as these countries has been largely the result of our free floating exchange rate and the fact that a larger economy has a large stake in our banking system.

The terms of trade boost and our proximity and exposure to Asia has also helped, but I would say that the Greek and Irish crises give us a reason to hold onto the status quo – not to chuck it out!

Sovereign debt is a different beast

So it seems the ECB is going to go out and buy government bonds.  I don’t quite agree with this description of what is happening to be honest:

“They are not cranking up the printing presses,” said James Nixon, co-chief European economist at Societe Generale SA in London. “This is a much more targeted, surgical approach. They buy the duff stuff that no one in the market will touch.”

The point is to buy stuff that would otherwise be good, but is only struggling because of the crisis – not to actually buy duff stuff.  The intervention is supposed to prevent a run on good assets – not to keep bad assets in business.  Of course, in practicality they will have to buy some duff stuff, but saying that this is the goal is an exaggeration.

Still, this isn’t my main point.  My main point is that sovereign debt is a different beast to private debt.  If the ECB starts buying up government bonds, and there is no plan to get government budgets under control in the medium term, then the result is high levels of inflation – and probably the collapse of the Euro Zone.  The second point doesn’t concern me – the first point does.

With private debt we had a response when effective interest rates exploded upwards.  Will we get the same response from domestic governments in Europe?  I don’t know.

EU preparing to protect currency, fight off “wolfpack”

The EU has decided it arbitrarily needs to protect the value of the euro.  Specifically:

We now see herd behavior in the markets that are really pack behavior, wolfpack behavior

Relevant picture:

Shirt source.

My question as a New Zealander who has experience the vicious swings in currency myself – why protect the value of the euro?  The euro is falling to help buffer the painful adjustment Europe is about to go through given their banking crisis, and they want to waste money trying to prevent this?  I don’t understand. Note: Krugman seems to feel a similar way.

Prior moral hazard and the credit crisis

Were inextricably linked.  A quote that illustrates this to me strongly came from a Bloomberg article today.  The ECB decided to tell the countries that have high soverign debts to go to hell, and now that they aren’t going to take on the risk themselves private investors aren’t willing to and are selling.

This makes sense, previously people purchased the junk on the basis that someone else would pay for it – high return low risk!  Now that they have to face the real risk profile they are like “f**k that”.  However, Bloomberg (or at least David Kovacs) stated:

The reason the market is horrified now is Trichet said it’s not even being discussed. Smart investors are basically selling risk(y) assets

No s**t.  An asset appeared low risk, and now it is high risk, and the expected return is (at most) unchanged – so the risk adjusted return is lower.  No wonder they want to sell.

Now we are in a crisis, and if there is a run on good quality debt because of concerns we have to do strange things – sure.  But we need to come up with a system that rips this moral hazard out of the system.  It is the moral hazard that helps to drive crisis after crisis ultimately.