Sat Apr 16th, 2011 at 06:14:23 AM EST
Portugal's blood was not yet dry on the maws of the hyena pack when our old friends the economy editors of the Frankfurter Allgemeine Zeitung announced that Spain would be next.
Eurointelligence Daily Briefing: "We will continue to monitor very closely" (8 April 2011)
After Portugal, who is next?
Frankfurter Allgemeine Zeitung's Werner Mussler has an interesting comment on the consequences of Portugal's rescue demand. According to the Brussels correspondent the next in line is the first really big Euro economy: Spain. Economically the country is in better shape than Portugal, he concedes. But unemployment is rising, growth perspectives are bad and the Spanish banks are heavily engaged in neighbouring Portugal. "The risk of contagion has not diminished with the Portuguese appeal for help", Mussler concludes. "And the EFSF is not sufficient to satisfy a potential Spanish request".
(link to FAZ, in German, added)
The signs for Spain are ominous. Not only are Spanish politicians and commentators (see El Pais calling Portugal's defeat The Final Rescue) publicly reassuring themselves that Spain is Not Portugal (have I not heard that one twice before?) but during the last week the Financial Times, Trichet, Merkel and the European Commission have all praised Spain's policy adjustments over the past 9 months. But most serious of all is the open consensus that Spain is too big to fail as the European Financial Stability Fund is too small for a possible "rescue" of Spain.
There is nothing more dangerous in financial markets than the belief that something cannot happen. To illustrate this, here's a battle story recounted by Nassim Taleb in his 1996 technical book Dynamic Hedging
A trader who survived the EMS (European Monetary System) breakup of 1992 recounts the following. In the events leading up to the turmoil of September 1992, he had to execute a large option order in Sterling versus German marks for a customer. He needed to buy quantities of out-of-the-money puts on the sterling, calls on the mark, struck 10% outside the official government band. The customer was a conspiracy theorist fund manager who believed in the imminent breakup of the monetary order. He belonged to the small coterie of traders who took on the Bank of England later that month.
The trader, being risk-averse, decided to do what most of his headache-free peers do: call a large market-maker, add on a margin, and earn the difference. He called two of the largest option dealers in the world asking for their selling price and received the following answers:
W was a former pit trader surrounded by pit traders. He is now the head of worldwide foreign exchange for a large bank. The second dealer, B, was a graduate of a prestigious European school of Engineering. He is now back to Engineering and other precise activities after his desk was decimated by disastrous losses in September 1992. After all, in the physical world, barriers are barriers, bridges are bridges, and horses are horses.
- W, based in the United States, and a former CME pit trader, told him that they were reluctant to show a price "because the strike is outside the band" and the options were "too risky". They would accommodate him if necessary, but at a very expensive implied volatility and only for a moderate amount.
- B, based in Europe, literally laughed at him. "But Zey are outside the band, if I am not mistaken," he was told. "How many do you vant? I can sell you all you need. You should give your money to charity instead".
frongpaged - Nomad
The situation in the Eurozone is ripe for a repeat of the events of 1992.
The UK's prime minister and cabinet members tried vehemently to prop up a sinking pound and withdrawal from the monetary system the country had joined two years prior was the last resort. Major raised interest rates to 10 percent and authorised the spending of billions of pounds to buy up the sterling being frantically sold on the currency markets but the measures failed to prevent the pound falling lower than its minimum level in the ERM.
The Treasury took the decision to defend Sterling's position, believing that to devalue would be to promote inflation. On 16 September the British government announced a rise in the base interest rate from an already high 10 to 12 percent in order to tempt speculators to buy pounds. Despite this and a promise later the same day to raise base rates again to 15 percent, dealers kept selling pounds, convinced that the government would not stick with its promise. By 19:00 that evening, Norman Lamont, then Chancellor, announced Britain would leave the ERM and rates would remain at the new level of 12 percent (however, on the next day interest rate was back on 10%). It was later revealed that the decision to withdraw had been agreed at an emergency meeting during the day between Norman Lamont, Prime Minister John Major, Foreign Secretary Douglas Hurd, President of the Board of Trade Michael Heseltine and Home Secretary Kenneth Clarke (the latter three all being strong pro-Europeans as well as senior Cabinet Ministers), and that the interest rate hike to 15 percent had only been a temporary measure to prevent a rout in the pound that afternoon.
It is, in fact, impossible for a monetary authority to prop up its overvalued currency indefinitely, as that requires buying its own currency with foreign reserves, which are by definition finite. The only monetary authority which could have preserved the ERM was the Bundesbank, since the DM was in fact overvalued (when a majority of the currencies in the ERM including the Lira, Sterling and the French Franc are all near the bottom of their exchange-rate band with respect to the DM, one has to conclude that maybe the currency that needs corrective action is the DM) and a monetary authority of a fiat currency can always lower its value by buying foreign currencies with newly created money. However, the Bundesbank was engaged in a fight to contain the inflationary pressures from the 1:1 conversion of East German Marks to DM. In any case, the Bundesbank saw that it was being asked to act as EU central bank and issue DM to help "irresponsible others" and would likely have refused even in the absence of perceived inflationary tendencies. See this third-person account by the Bundesbank
Crises in the ERM. In 1992, investors lose confidence in the stability of the pound sterling, in particular, and then, in 1993, in the French franc, resulting in speculative selling of the pound and franc; in 1992, the United Kingdom and Italy leave the ERM; in 1993, the fluctuations margins around the bilateral central rates are expanded sharply. The Bundesbank with its commitment to price stability had refused to lower interest rates massively. The partner countries are forcibly reminded of their responsibility for their currencies; the process of convergence needed for monetary union is strengthened.
Now, there is an interesting detail about the 1992 events which is very relevant to our current predicament in 2011:
On Monday, October 26, 1992, The Times quoted Soros as saying: "Our total position by Black Wednesday had to be worth almost $10 billion. We planned to sell more than that. In fact, when Norman Lamont said just before the devaluation that he would borrow nearly $15 billion to defend sterling, we were amused because that was about how much we wanted to sell."Further
Soros said he had been confident that the German Bundesbank wanted devaluations in Italy and Britain, but not in France. I felt safe betting with the Bundesbank. The Bundesbank clearly wanted the lira and pound devalued, but it was prepared to defend the franc. In the end, the score was Bundesbank, 3-nil; speculators, 2-1. I did even better than some others by sticking to the Bundesbanks side.
Note here, that the Bundesbank was politically prepared to defend the Franc, but not Sterling or the Lira. Ask yourself, does it look like Germany is prepared, politically, to defend Spain
from debt speculators? Come to that, would it be prepared to defend France any longer?
The European Union has failed to contain the ongoing sovereign debt crisis in large part because both the European Central Bank and the Member States (individually and collegially as the European Council) have refused to provide unlimited support to government debt when it came under attack, and have even telegraphed the amount of the exposure they were willing to take to deal with the problem. You cannot bicker about the amount of capital available to the European Financial Stability Mechanism and tell the markets in inequivocal terms that this or that precise amount is as far as you're willing to go to defend a financial position from attack, and expect them not to be "amused" like Soros in 1992. If Soros could muster £15bn in 1992, who can seriously claim that international speculators cannot put together 400bn in 2011 given a period of a year and a string of targets to place a succesion of ever larger bets? Another sign of limited intervention is the ECB's obsession with "sterilizing" any bond purchases made (adding up to 77bn at latest count) and the fact that these purchases are always too little, too late due to pressure from inflation hawks within it.
So, I am pretty confident things will come to a head with Spain within three months. Speculators are recouping their gains from the successful attack on Portugal, and can start to amass a war chest to go after Spain. They even have estimates of the amount of money they need, since everybody and their grandmother has been speculating about the amount that a "rescue" of Spain would require. Success is assured, since everyone agrees that the required amount exceeds the resources that the EFSF is politically allowed to commit. In Wolfgang Munchau's words, total überfordert
Usually I stay clear of connotation-rich German words that have no real equivalent in other languages. Their purpose is to obfuscate. But there is one that describes the eurozone's crisis management rather well. It is überfordert. The nearest English translation is "overwhelmed", or "not on top of something", but those are not quite the same. You can be overwhelmed one day, and on top the next. Überfordert is as hopeless as Dante's hell. It has an intellectual and an emotional component. If you are it today, you are it tomorrow.
Yes, sometimes (as in metaphysics) you need to use German words; and yes, when the Eurozone is a smoking ruin 3 months from now, the European political and economic policy class won't know what hit them. Take France's finance minister Christine Lagarde: Ireland aid sufficient, confident on Portugal
(Reuters, Nov 29, 2010)
"Europe is difficult to understand for the markets. They work in an irrational way sometimes," Lagarde told RTL radio.
It appears that the difficulties in comprehension are mutual, since European economic policymakers don't seem to understand markets either. In fact, their being "confident" in a country in the aftermath of another's "rescue" seems to be a good 3-month leading indicator of trouble. That doesn't bode well for Spain.
The evidence that the people in charge have no idea what they're contending with is ample. From the Spanish government believing that the problem is one of communication with the investors who just cannot see how virtuous the Spanish fiscal policy is and will be swayed by the Spanish treasury setting up an English-language website to explain the adjustment programme; to ECB council members declaring themselves surprised that the markets haven't been shocked and awed by the announced maximum size of the EFSF; to the politicians who on the one hand proclaim that they will do everything necessary to "save the Euro" while at the same time putting limits to their resource commitment, pandering to xenophobic populists at home, or protecting insolvent banks.
Politically, not only is the European Union over its head, but the positioning on the sovereign debt crisis has been full of moral overtones - economics as a morality play on debt. The whole thing is likely going to end up in an assertion of the moral superiority of the Protestant North of Europe over their inferiors, be they Catholic or Orthodox.
As for timing, I suspect the final crisis of the Euro will be within a couple of weeks of the publication of banking stress test results in June of 2011. If the results of the stress test are bad for the German banks, expect the speculative attack on Spain to be before the publication of the stress test results; if the results are favourable for German banks, the attack will come after. But it will come.