OK, settle down. This post isn’t as wonkish as the title makes it out to be.
France will now be motivated to “do something” if for no other reason than they probably don’t want the Germans to get all the credit for acting. So will Italy. And possibly Switzerland, Belgium, the Netherlands, Denmark, Luxembourg and the Nordics as well. Did I leave anyone out?
Here’s the crux of the matter: if the governments over there decide to do this, OK fine. Do it. It’s your country. But the problem of structural reform doesn’t go away. The total level of total sovereign risk in the system does not go away, either. Because, as the First Law of Thermodynamics says:
The increase in the internal energy of a system is equal to the amount of energy added by heating the system minus the amount lost as a result of the work done by the system on its surroundings.
Another way if saying it: energy is neither created or destroyed. It is merely transferred from one state to another.
My corollary: The same applies to the level of risk in the financial system.
I remember a speech Tim Geithner gave when he was President of the New York Fed. It was at the first Credit Markets Symposium hosted by the Richmond Fed. I want to pull out a particularly telling passage:
The rapid growth in these new types of credit instruments is, of course, a sign of their value to market participants. For borrowers, credit market innovation offers the prospect of increased credit supply; better pricing; and a relaxation of financial constraints. For investors, new credit instruments bring the prospect of broader risk and return opportunities; the ability to diversify portfolios; and increased flexibility. And for lenders, innovations can help free up funding and capital for other uses; they can help improve credit risk and asset/liability management; and they can improve the return on capital and provide new and cheaper funding sources.
By spreading risk more broadly, providing opportunities to manage and hedge risk, and making it possible to trade and price credit risk, credit market innovation should help make markets both more efficient and more resilient. They should help make markets better able to allocate capital to its highest return and better able to absorb stress. Broad, deep and well-functioning capital markets complemented by strong, well-capitalized banks, able to provide liquidity in times of strain, make for a more efficient financial system: one which contributes to better economic growth outcomes over time.
Oh yes he did. He said it and I saw him say it. It was one of the dumbest things I had ever heard. It tells you what he thought: by breaking down and repackaging credit risk, we had slayed the risk dragon. Kind of like saying he found the fountain of youth or the key to turning lead into gold. It’s hocus pocus and alchemy. The actions in Spain and Germany tell me they’re still using the same line of thinking. That if we transfer the risk and repackage it somehow, the problem will just float away into the ether… How is that working out for us?
Does this buy some time? Perhaps, but it doesn’t buy as much as it used to. All the countries involved will have to race against the clock to get their financial houses in order. Or more specifically, the time will be needed for Eurozone banks to get their balance sheets in order. And there’s tremendous risks in the GDP forecasts of these countries not even being in the ballpark, as Greece has shown with consistent misses to the downside with respect to its GDP.
So let’s think of the scenario this paints: a central bank that has no printing press per se will be backstopping sovereign debt of all stripes on the European continent, paying at or near par for the govies that get pledged as collateral. But the macro fundamentals are shaky at best which means the ECB will be overextending cash for the sovereign debt that gets pledged. What would that mean? It would mean the ECB would “fall on the grenade” from a credit risk perspective. At that point, what good would it be for a central bank to backstop bonds where credit risk is increasing, possibly putting its own balance sheet at risk? Trichet and the ECB are responsible for defending the Euro. They could have avoided a lot of this by kicking Greece out and thereby giving the Eurozone banks with significant exposure to Greece and its banks a clear signal that they need to be winding positions down (and yes, taking a few lumps along the way).
See, I don’t think there’s a panacea to this situation. There’s no silver bullet that will make this go away. This is all about how we choose to take our lumps. Do we choose to get it over with quickly, albeit with significant severity, or do we choose to prolong ripping the band-aid off, choosing to pull e v e r so g e n t l y, and robbing everyone of the most essential ingredient in a recovery: time? That’s the question before us all now.
Just like in every other crisis… It’s just a question of whether or not we learned the lesson yet.
So… have we?