By now, you have figured it out - I am a big fan of my old UofC professor, John Cochrane. And in this latest article (here
) he delivers even more real common sense.
"Conventional wisdom says that sovereign defaults mean the
end of the euro: If Greece defaults it has to leave the single
currency; German taxpayers have to bail out southern governments
to save the union.
This is nonsense. U.S. states and local governments have
defaulted on dollar debts, just as companies default."
Cochrane is correct. Orange County, CA - size ca 1/2 Ireland - has defaulted before and so... no end to the State of California or to the Feds and, crucially, no bailout. New York went bust in 1975, Cleveland in 1978. Fitch did a study in 1999, updated in 2003, that shows 2,339 cases of municipal bonds defaults in the US for 1980-2002 totaling USD32.8 billion. And guess what: no bailouts and yet the dollar still exists. Fitch estimated cumulative default rate for 1980-1986 issuance of 1.5%m cumulative default rate for 1987-1994 issuance of 0.63%, average recovery rates were around 63-64%, consistent with standardized CPD pricing practice of 40% haircut. This is not to say that defaults are costless or easy, but there is no ex-ante intrinsic reason for the common currency to implode were a country like Greece - expected by all to default - to restructure its sovereign debts.
"Bailouts are the real threat to the euro. The ECB has been buying Greek, Italian, Portuguese and
Spanish debt. It has been lending money to banks that, in turn,
buy the debt. There is strong pressure for the ECB to buy or
guarantee more. When the debt finally defaults, either the rest
of Europe will have to raise trillions of euros in fresh taxes
to replenish the central bank, or the euro will inflate away."
Correct again: latest LTRO allocation of €489bn this week, with €235bn of this being lent in excess of the banks covering shorter-term ECB debt is the case in point. ECB's hope is that the banks - already sick from overloading with low quality sovereign debts on their balance sheets - will use €235bn to buy more
sovereign debt. This, of course, will help ECB to cut back its own purchases of Government bonds and to, thus, pretend that 'the market' for sovereign debt in Europe is somehow being repaired. The madness of this 'solution' is that it creates even greater link between ECB, banks and sovereign debt - the very cause of the crisis contagion. You can see an excellent, albeit a bit politically-correct piece on this in the Economist (here
And to correct for the 'politically correct' bit - here's my view of LTRO: In a nutshell, the ECB will lend the banks unlimited money at 1% so they can buy PIIGS+Belgian+French debt making 2-6% margin as pure profit and benefiting from capital gains in the process. As bonds prices firm up on the back of these purchases, banks collateral deposited with ECB will also improve in value, allowing them to borrow even more. This positive correlation between banks borrowings from ECB and their profits gains will continue until in 3 years from now the entire pyramid collapses - the banks will have to repay ECB funds, prompting massive sales of bonds. And in the mean time, there will be no lending in the real economy, as banks funding will be tied into financing Government spending and banks will continue to deleverage out of real assets. This makes LTRO an equivalent of an RX to a drug addict for unlimited supply of free opiate.
As Cochrane puts it:
"Sovereign default would damage the financial system,
however, for the simple reason that Europe has allowed its banks
to load up on debt, kept on the books at face value, and treated
as riskless and buffered by no capital. Indebted governments have been pressuring banks to buy more
debt, not less.
As banks have been increasing capital, they have
loaded up even more on “risk-free” sovereign debt, which they
can use as collateral for ECB loans. The big ECB “liquidity
operation” that took place yesterday will give banks hundreds
of billions of euros to increase their sovereign bets. Bank
depositors and creditors have figured this out, and are running
for the exits.
...By stuffing the banks with sovereign debt, European
politicians and regulators are making the inevitable default
much more financially dangerous. So much for the faith that
regulation will keep banks safe."
"More fiscal union hurts the euro. Think of Poland or
Slovakia. ...A common currency without a fiscal
union could have universal appeal. A currency union with a
bailout-based fiscal union will remain a small affair."
"Europeans leaders think their job is to stop “contagion,”
to “calm markets.” They blame “speculation” for their
troubles. They keep looking for the Big Announcement that will
soothe markets into rolling over another few hundred billion
euros of debt. Alas, the problem is reality, not psychology, and
governments are poor psychologists. You just can’t fill a
trillion-euro hole with psychology."
"The euro’s fatal flaw then wasn’t to unite areas with
differing levels and types of development under one currency. ...Nor was
it to deprive governments of the ephemeral pleasures of
devaluation. Nor was it to envision a currency union without
Banking misregulation was the euro’s fatal flaw
[emphasis is mine]. Sovereign
debt, which can always avoid explicit default when countries
print money, doesn’t remain risk-free in a currency union. Yet
banking regulators and ECB rules continue to pretend otherwise.
So, by artful application of bad ideas, Europe has taken a
plain-vanilla sovereign restructuring and turned it into a
banking crisis, a currency crisis, a fiscal crisis, and now a
"When the era of wishful thinking ends, Europe will face a
- It can have a monetary union without sovereign
defaults. That option means fiscal union, accepting real German
control of Greek and Italian (and maybe French) budgets. Nobody
wants that, with good reason.
- Or Europe can have a monetary union without fiscal union.
That would work well, but it needs to be based on two central
ideas: Sovereigns must be able to default just like companies,
and banks, including the central bank, must treat sovereign debt
just like company debt.
- The final option is a breakup, probably after a crisis and
inflation. The euro, like the meter, is a great idea. Throwing
it away would be a real and needless tragedy."