Macroprudential Follies and Monetary Policy

In a recent article in Project Syndicate Barry Eichengreen appears to criticize the former Fed Chair Alan Greenspan, for expressing doubt that policymakers can reliably identify bubbles, and are generally uneasy about managing asset prices. He writes:

To be sure, central bankers cannot know for sure when asset prices have reached unsustainable heights. But they cannot know for sure when inflation is about to take off, either. Monetary policy is an art, not a science; it is the art of taking one’s best guess. And, as the 2008-2009 crisis demonstrated, merely cleaning up after the bubbles burst is very costly and inefficient.

Eichengreen’s argument, is in fact, part of a post-global-financial-crisis discourse on macroprudential policy. Many  interventionists argue for financial regulation that would be  specifically  designed  to mitigate systemic risks to the financial system as a whole. According to macroprudential regulation’s proponents, monetary policy historically has failed as policy changes have resulted in blunt outcomes i.e., the monetary policy actions in either directions have resulted in a broad sweeping measure for the whole economy that does not properly address the issues specifically feeding financial instability. Thus, they argue that the recent financial crisis was created by a supervisory gap, as various sectors of the financial system often fall under the responsibility of different authorities, making it difficult to conduct a thorough analysis of systemic risk. As a result of these debates, in recent years, a number of new institutions have been popped out to preserve financial stability such as the European Systemic Risk Board in the EU and the Financial Stability Oversight Council in the US.

At the same time, central banks are now assuming an important role in this regard, to the extent that in a recent speech, Governor Daniel Tarullo, a member of the Board of Governors of the Fed, has stated: “I feel secure in observing that we are all macroprudentialists now. The imperative of fashioning a regulatory regime that focuses on the financial system as a whole, and not just the well-being of individual firms, is now quite broadly accepted.” Mario Draghi, President of the European Central Bank has also argued that “As you know, the [Single Supervisory Mechanism] Regulation gives the ECB the power to apply stricter macroprudential measures than the national authorities if it deems them necessary. We can also advise on the calibration of instruments. This goes some way towards insuring against an inaction bias at the national level, thus improving the prospects for a more stable euro area financial system.” As well, the Bank of England has been assigned full responsibility for macroprudential policy.

In 2008 chairman of the House Committee on Oversight and Government Reform, Henry A. Waxman of California, asked Mr. Greenspan: “You had the authority to prevent irresponsible lending practices that led to the subprime mortgage crisis. You were advised to do so by many others. Do you feel that your ideology pushed you to make decisions that you wish you had not made?” Mr. Greenspan conceded that:

“Yes, I’ve found a flaw. I don’t know how significant or permanent it is. But I’ve been very distressed by that fact. (…) Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief.”

Unfortunately, it appears that this testament has caused an irreparable damage to confidence in the market’s self-equilibrating potentials. Instead authorities have espoused a partial preference for the risk-management and credit-allocation skills of a few central bank officials. The macroprudential regulation has been justified by arguing that Chairman Greenspan’s 1994 hypothesis, put forward in front of House Subcommittee on Telecommunications and Finance, to the effect that “There is nothing involved in federal regulation per se which makes it superior to market regulation,” is proved to be wrong. Also misguided was his argument for removal of the legislative barriers that prohibited the straightforward integration of banking, insurance and securities activities, when he concluded that:

“In virtually every other industry, Congress would not be asked to address issues such as these, which are associated with technological and market developments; the market would force the necessary institutional adjustments. Arguably, this difference reflects the painful experience that has taught us that developments in our banking system can have profound effects on the stability of our whole economy, rather than the limited impact we perceive from difficulties in most other industries.”

In fact, governments across the world begun to introduce macroprudential regulations in the form of more stringent capital requirements, requiring financial institutions to value their assets more conservatively, asking them to hold more liquidity buffers, placing constraints on risk-taking, enforcing more stable funding restrictions and requiring improved provisions to protect against bad and toxic loans. According to Christian Noyer, Governor of Banque de France, there is a consensus over broad outlines of macroprudential regulation that

First, it involves adding a macroeconomic perspective to the supervision of the financial system, which up till now has only really been addressed from a “micro” standpoint. As the crisis has shown, financial stability does not depend solely on the soundness of the individual components that make up the financial system; it also depends on complex interactions and interdependencies between these components.

Implicit, in Noyer‘s argument is the unsubstantiated claim that even those economies that their financial system were composed of sound micro components suffered from financial instability. This is not true. Canada is perhaps the only country that can legitimately claim that its financial sector was robust at micro level, and as it was expected its economy fared quite well during the global financial crisis. In the words of Mark Carney the governor of the Bank of Canada at the time “the core lesson we learned from those difficult years was the importance of coherent, principle-based policy frameworks.” These frameworks discipline policy-makers and enhance credibility. In the words of his predecessor David Dodge:

Canadian financial institutions took a more cautious approach to financial innovation at some cost to their short-term growth and profits relative to more leveraged foreign competitors, relied relatively less on wholesale funding and kept relatively more liquidity. In part, this stemmed from more stringent, coordinated and effective regulation and supervision in Canada, which provided the right incentives to financial institutions. (…)
Our system of principles-based regulation should continue to serve us well, even more so in a context where most national regulators elsewhere will not conform to the detailed, uniform international standards. What is required here in Canada is a high degree of cooperation between regulators and financial institutions to achieve stability goals. In the past, such cooperation in designing principles-based regulation has strengthened the Canadian system. We should not lose that advantage as we move forward.

It is important to note that in principle-based policy frameworks monetary policy would be dealing with the monetary policy goals and would not allow macroprudential considerations to contaminate  the transmission mechanism and distort the economic structure. Mr. Noyer ‘s second characteristic of macroprudential policy is that:

“it is preventive. Its aim is precisely to prevent the formation of financial imbalances, procyclical phenomena or systemic risks by limiting excessive growth in credit and in economic agents’ debt levels, and increasing the shock‑absorbing capacity of financial institutions or structures ex ante.”

The argument again assumes a number of untenable implicit assumptions; namely that authorities possess reliable measures of excess or systemic risk, the macroprudential policy makers are themselves experts in detecting and interpreting economic signals, the lag structure of the policy impacts are known and stable, and the policy actions can be precisely calibrated so that they will be efficacious in damping excesses while not unnecessarily reducing well-underwritten credit flows in the economy. In this regard the Bank of Spain’s assessment of the Spanish macroprudential experience shows that virtually none of these conditions are satisfied. That assessment reads:

Dynamic provisioning is not the macro-prudential panacea, since the lending cycle is too complicated to be dealt with using only loan loss provision policies. Indeed the Spanish experience shows that even well targeted and calibrated instruments cannot cope perfectly with the narrow objective for which they are designed, among other things because the required size to fully achieve its goals would have inhibited and distorted financial and banking activity.

 Of course, no proof exists to show that government regulators are more able than private investors at predicting which individual investments are justified and which are folly. The cost of macroprudential regulation in the name of financial stability has been a confused monetary policy that has caused a delay in return to equilibrium, increased uncertainty and a slower economic growth.

In a world that agents can innovate to take advantage of arbitrage opportunities, there would be no reasons for believing that macroprudential policies can have any impact on financial stability. In fact, if regulations were of any use the old Soviet Union would have been a success story, or today’s China’s financial markets would be the most stable in the world. The arbitrage possibilities generated by these regulations leads to financial innovations that would work against those policies annulling their impact. The evidence does in fact already present itself in the form of a shift of financial activities toward less regulated shadow banking system.

Moreover, to assume that macroprudential policies are of any impact must be based on the postulate that economic system can be represented by a stable model and that authorities have already discovered that model. Otherwise, in a fast changing world, in which parameters of taste and technology are responding to new scientific and digital advances at an ever increasing speed no financial authorities have any clue about the nature of an evolving transmission mechanism, the lag structure and the specification of an adequate model.

As Paul Kupiec has argued macroprudential policies will not have a significant impact and thus will not succeed. In fact, his study co-authored with Yan Lee of the Federal Deposit Insurance Corp. and Claire Rosenfeld has found that increasing a bank's minimum capital requirements by 1% will decrease bank lending growth by a paltry six one-hundredths of a percent. As he reported in the Wall Street Journal: There is not much evidence that these policies prevent financial bubbles. But there is great risk in allowing a small group of unelected technocrats to determine the allocation of credit in the U.S. economy.

Furthermore as many analysts have noted the propaganda surrounding macro-prudential regulation or supervision creates a false sense of security and stability. A central bank that is now playing too large a role in the economy in order to stabilize successfully the industrial, construction, and the other goods and services sectors, as well as the labour market, will have more difficulty communicating its monetary policy stance. It’s hard to believe that central banks models and expertise are adequate for executing various goals when the issues in each one of these sectors are complex and are impacted by various technological and competitive factors. The lines between discretion and rules for two sets of monetary and macroprudential would criss-cross and creates a very confusing lag structure for any signal extracting model.

There is no reason to believe that the principal- agent problem is not applicable in this case. In other words, it can be hypothesized that central banks as agents may not be supportive of market mechanism to stabilise independently. A regulated environment maximises the returns to agents in this framework as it entails more secure job prospects because of the needs for intense monitoring of capital and liquidity ratios, continuous inspection of the impact of various restrictions on banking practices, and conduct of periodic stress tests. The increased uncertainty will cause a surge in speculative activity in capital-asset markets which would exasperate the situation and boost the need for macroprudential regulation perpetuating the favourable job prospects of the agents.

Will the Fed raise rates in September?

 In my estimation Fed can not risk rising rates in such  critical times and therefore it won't. A rising rate at current market conditions one month before October, that historically is associated with a stock market correction, could be the psychological trigger that would disturb the current fragile local equilibrium, pushing the US and the whole global system along a path towards instability and a full-fledged financial crisis exhibiting a collapse of investment, debt deflation, and thus leading to insolvent debtors and a weaker banking system – that would be 1937 all over again!

I am not of course a fan of current zero interest rate policies, and I believe these policies have distorted not only the US and European economies, but also the global economy.   The Fed indeed has created a catch 22 situation; as higher rates are needed badly, but any action towards raising rates would be extremely destabilizing. This is why I have been calling for an emergency global finance conference similar to the Brussels conference that took place   between the 24th of September and the 8th of October 1920.  That international conference was called

“with a view to  studying the financial crisis and looking for the means of remedying it and mitigating the dangerous  consequences arising from it.”

Such a sharp focus on financial crisis is needed for any new conference that would be dealing with the current situation in order to find a sustainable long-term solution.  In other words, none of the unrelated questions such as geopolitical crisis, human rights or environmental concerns need to be discussed in this conference, and its sole purpose should be a search for restructuring of global finance.  To arrive to an accurate assessment the Brussels conference secretariat asked the participant countries, and their financial institutions to submit latest data on currency, public finance, international trade, inflation and so on, which is an obvious prerequisite.

       

Like the current crisis, as Gustav Cassel, the great Swedish economist, argued the main responsibility for the 1920s financial crisis was the policy actions by various countries, which could only be remedied by an internationally coordinated return to stable currencies.  It is of note that, such a return in Cassel’s framework was not predicated on a return to the gold standards. He also strongly dismissed the possibility of arbitrarily fixing exchange rates and instead advocated a global exchange rate regime based on the theory of Purchasing Power Parity PPP, which would have linked fluctuating exchange rates to the prices paid for a common basket of goods and services in the regions that participated in international trade, such that the same price level would have been maintained for that common basket in every region.

     

Although Cassel correctly diagnosed the dangers of deflationary policies for the future prospects of economic growth and social stability, he warned that:

“As the internal value of a currency exclusively depends upon its purchasing power over commodities, a stabilization of this value can clearly only be attained by an adequate restriction of the supply of means of payment. The character of this restriction depends, of course, on the character of the means of payment used in the country. If they are supplied by the State as a paper money issued by the Government directly or indirectly for covering their expenses, the stabilization of the monetary standard clearly requires the stopping of further arbitrary creation of such money. This is so obvious that it is not necessary to waste many words on it”.

   Unfortunately under today’s “currency wars” conditions, with the slowdown in China, and Europe’s debt crisis, as well huge debt build up by consumers and states the normalization of monetary supply in any single country, as an isolated and uncoordinated action, would be a recipe for disaster.  

UK Competitiveness Outlook is Gloomy!

In its first budget, the new Government of Prime Minister David Cameron has eased markedly its intended austerity measures that had been pencilled in by the previous Coalition. However, the new relatively less intense tightening is still financed by welfare cuts, net tax increases and three years of higher government borrowing. Chancellor Osborn has delayed the expected return to a budget surplus by a year to 2019-20, sugar coating this delay by promising a slightly bigger surplus in the medium term. Chancellor’s introduction, from April next year, of a £7.20 an hour National Living Wage, rising to £9 an hour by 2020 outshone the opposition’s election pledge for an £8/hour minimum wage by 2020.

Does this budget change the trajectory of the British economy towards a more dynamic and competitive path? To explore this question let’s have a look at the current state of the economy. The UK independent Office for Budget Responsibility, OBR’s estimate of the margin of spare capacity in the economy is 0.6 per cent of potential output in 2015-16 and OBR expects this ‘output gap’ to close in 2018-19. However, these estimates may be hiding the fact that because of businesses’ utilization of contingent capacity the gap has been underestimated. This is because in planning for capacity during uncertain times businesses usually postpone their irreversible component of investment and utilize intensive margin production processes. As a result of this focus on short-term capacity corresponding to existing cost structure the longer-term capacity signals will be hidden. This reading is validated by the Bank of England’s August Inflation Report that reports:

Companies using their existing capital and labour more intensively will increase measured productivity but there is a limit to how far companies can do this without putting excessive upward pressure on their costs. Survey measures suggest that, having increased since 2013, capacity utilisation picked up a little in 2015 Q2, and is close to or perhaps slightly above past average levels.

Consistent with Ben Bernanke’s option price of waiting it would be quite rational for businesses to postpone their strategic investment plans at times of currency wars and global volatility, and focus instead on their contingent capacity limits. Thus, business surveys instead of picking up reports of capacity utilization rates relative to the long term capacity associated with the firm’s minimum long-term average costs would detect signals of capacity tightening due to delays in implementation of irreversible phases of investment. This observation can also be validated by indicators such as investment profile and productivity growth. Note that productivity growth — defined as the rate of change of output minus rate of change of hour worked — will rise when investors invest to expand the production possibility frontier which usually would  reduce their cost structure through adoption of new innovative technologies. The fact that growth in the UK productivity has been subdued in the past eight years is a clear indication that British investors are still quite hesitant to invest strategically to enhance competitiveness.

The chart below, based on the OECD data, shows the widening gap in capital formation between the UK and the United states, particularly since the recent big recession which can explain why productivity growth in Britain has been so low.

As the following chart shows, ONB predicts that investment as a share of GDP, which was hovering around 11% in recent quarters will increase to about 13% by 2018. However, the latest data show that business investment growth slowed in the second half of 2014, thus in a backdrop of heightened uncertainty the ONB predication may prove rather optimistic. Nevertheless, even if its prediction comes to pass the amount of investment would not be sufficient to remedy the loss of competitiveness of British industries, which are in need of a drastic restructuring in response to the imperatives of the new technological advances such as in internet of things, mobility, 3-D technologies, and smart raw materials, to name a few.

Moreover, the Bank of England’s Agents’ Summary, depicted in the following chart, indicates only moderate investment growth and it is not clear as to whether the new investment would be aiming at expanding the production frontier and increased competitiveness or will still be focused on a tactical reversible investment, such as repair and marginal upgrading of the existing technology along pursuing a path of intensive margin production process.

As already mentioned such moderate investment growth would not be sufficient for the needed restructuring and the crucially necessary enhancement of British competitiveness. The chancellor’s strategy to rejuvenate manufacturing and exports by new trade deals cannot succeed in the absence of investment that would be geared toward enhancing competitiveness. His fast-track visa system for wealthy Chinese investors would be ineffective, if the new investments just move towards real estate instead of new technology. In order to halt the persistent decline of the UK export market share, depicted in the following chart, a significant rise in investment would be prerequisite.

A participation in the current currency war, even when British pound has appreciated 20% on a trade-weighted basis since March 2013, would not be an option. As it would either worsen the public sector net borrowing (depicted in the chart below), or further reduce the effectiveness of monetary policy, and exacerbating household high level of debt (the next chart below). Of course, one needs to be reminded that that the Bank of England has maintained the stock of purchased assets financed by the issuance of central bank reserves at £375 billion, and will reinvest the £16.9 billion of cash flows associated with the redemption of the September 2015 gilt held in the Asset Purchase Facility. At the same time the Government’s spending is expected to be £83.3 billion higher in total over the current Parliament relative to the previous Coalition budget. Thus, more easing will add to the distorting imbalances.

Alpha, Beta, and Beyond -- A comment on "smart beta'

 

In a recent Project Syndicate article Dr. Roubini argues:

 [M]y economic research firm has a quantitative model, updated every three months, that ranks 174 countries on more than 200 economic, financial, political, and other factors to derive a measure or score of these countries’ medium-term attractiveness to investors. This approach provides strong signals concerning which countries will perform poorly or experience crises and which will achieve superior economic and financial results. 
Weeding out the bad and the ugly based on these scores, and thus picking more of the good apples, has been shown to provide higher returns with lower risk than actively managed alpha or passive beta funds. And, as the rankings change over time to reflect countries’ improving or worsening fundamentals, the equity markets that “smart beta” investors choose change accordingly.

The claim goes beyond the pale, and is absolutely stunning. It is hard to imagine that alphas and betas are not time varying parameters. In fact, studies by Blume; Hawawini, Michel, and Corhay; Levy and others have shown that stock betas can change drastically over two succeeding periods, and some have argued that linear estimators of beta are unrealistic estimates. Thus, one wonders, about the validity of any “smart” (or “enhanced”) beta strategy that can at any specific period pick up the true betas. It has always been a puzzle to many as to how some serious people look at betas and alphas as ex ante criteria for portfolio selection. Is it not reasonable to believe that the intrinsic value of any stock is derived from the firms’ competitiveness characteristics and the market fundamentals for the underlying goods or services that are represented by various stocks? 

Based on the ex post data any econometric technique  can always identify some alphas and betas that appear to have superior characteristics supported by an array of statistical measures attesting to the explanatory power of the regression.  Such models may capture part of the impacts of the real market fundamentals, say a rightward shift of demand curve for the underlying goods and services, or a shift of the cost structure of the firm producing those goods and services, and so on. The data may also contain some memory, due to various lags that can be captured be the estimated equations. However, if a portfolio manager shows you a selection of stats (and there are hundreds of those; R-squared, P-tests, LM, DW, BP, F to name a few) that appear to suggest some superior predictive information content, then one really needs to ask why the investment manager is prepared to share such a valuable information for a small fee, instead of attempting to corner the market!

This is neither a rehash of efficient market hypothesis, nor an argument derived from the possibility of black-swans. It is a subtle recognition of the nature of risk and uncertainty in its Knightian framework. In other words, the expected return from a portfolio is not the same as the expected return from casting of a number of fair dice. The distribution outcomes from casting of a die can be detected by a repetitive casting process and thus the volatility of returns can be formulated as a Knightian risk. However, this is not the case for the expected return of a stock, because each return would be derived from a specific demand-supply configuration for the underlying stock’s goods and services and the position of the short-run average cost of the company producing them at a particular time. This does not lend itself to a repeated sampling. Moreover, we are seldom in an idealistic case of perfect competition, in reality various strategic pricing and capacity decisions together with logistical constraints would also play important roles. Thus, the underlying distributions of the expected betas are unknown –Knightian uncertainty. Can one resort to time series analysis of say cointegration type? Simply because of the unavailability of long enough data (i.e., degrees of freedom restraint), difficulties in detecting of the order of integration and a host of other technical issues that are well known to practitioners that option too would be impractical.

Read more at https://www.project-syndicate.org/profile/551891a0bc1f570d68f3eac8#6VwyDPZ00gQdq8WH.99

In Defense of Varoufakis -- A comment

Mr El Erian’s defence of Yanis Varoufakis is accurate, elegant and powerfully articulated. Yet I wish he would provide an answer to the following crucial question: Do German, French and Dutch banks have sufficient wherewithal to stand the adverse impacts of liquidity shocks that would be the inevitable outcome of a Greek debt relief? 

In fact, recall that since the inception of the euro in 2001, mainly through leveraging of their equity capital, these banks bought an astronomical amount of Greek, Portuguese, Spanish and Italian sovereign debts. It is true that, the “troika” of the European Central Bank, the International Monetary Fund and the European commission has simply replaced the banks and the hedge funds as Greece’s creditors of her €300 billion debt, and it is also true that private investors are not now heavily exposed to Greek assets. But private banks are still holding astronomical debts of the other fragile European states. 

Some economists assume that governments and international institutions are strong enough to cope with a Greek default. But are they strong enough to cope with any deterioration of Portuguese, Spanish, Italian and French finance? Such simplistic assumptions about the possibility of a trouble-free Greece’s debt relief ignore the fact that tax payers of Northern European countries are well aware of their implied tax burden and will not be prepared to allow these public institutions to just create paper money to save these unsustainable debt dynamics. The result would be an inevitable freezing of credit which would again adversely affect the European banks and with some lags its ripple effects will reach the North American shores. 

As the ECB’s financial stability report, released this May, has stated “A continuing legacy from the sovereign debt crisis is a large and, in some countries, still increasing stock of non-performing loans. Further progress in removing impediments to the supply of bank credit – including faster NPL resolution – is necessary to improve credit conditions, which should be also supported by the ECB’s targeted monetary policy measures.” 

The fragile stability of the system has only been maintained by a rather artificial prolonged surge in global financial markets since 2013, emanating from an extraordinary loose monetary policies in advanced economies. These measures have temporarily reduced stress and fragmentation in euro area sovereign bond markets resulting in very low term premia. But as the ECB report points out “Clearly, any implied deviation from long-term norms might very well prove to be transitory, so that it is important that investors have sufficient buffers and/or hedges to cope with any prospective normalisation of yields over the years ahead, either from global or from euro area-specific changes in financial risk sentiment.”

It appears to me that the window of opportunity for a global coordinated action for restructuring international finance is closing fast. When the time for a disorderly adjustment arrives, perhaps by this October, central banks will not be in a position to clean to the mess. Now is the time to pre-empt the upcoming crisis. 

Read more at https://www.project-syndicate.org/profile/551891a0bc1f570d68f3eac8#D01tvoxY4bhKfxkZ.99

How should the Greek debt crisis be resolved?

On July 29th, two days from now, Greece will begin her deferred discussions over a third bailout of €85bn when prime minister Alexis Tsipras of the governing Syriza party will  meet again  the emissaries of the dreaded troika the European Commission, European Central Bank and International Monetary Fund in Athens. He has already capitulated to demands of Germans, after being threatened to be forced out of the eurozone in his previous talk, to repay the debt of almost $339 billion, which the International Monetary Fund now says that there is no way that she can reasonably pay it back – and this is, of course, after years in which the IMF, as part of troika, was a stern advocate of tough austerity policies.

There is no doubt that the Greek economy, which according to the World Bank data, has experienced a dramatic decline in the GDP of nearly 30 percent, from $354 billion in 2008 to $242 billion in 2013, after five years of austerity, recession and soaring unemployment with an overvalued currency, can ever hope to repay even a fraction of her debt. The country’s ex-finance minister Yanis Varoufakis has recently revealed that eurozone leaders demanded that Greek public assets be transferred to a Treuhand-like fund – that would be based in Luxembourg, and under the supervision of the Germany’s finance minister, Wolfgang Schäuble, would complete the fire sales within three years. According to him the new Geek finance minister Euclid Tsakalotos, were able to extract some concession from the troika so that the fund would be managed from Athens and that the sales could extend to 30 years.

It is important to be reminded that in 1980, Greece was among the less well-off member countries of the EU. Moreover, from 1980 to 1997, the annual GDP per capita growth rate in Greece was only 0.56%, the lowest among all future eurozone countries. This was mainly due to its undisciplined fiscal policy, reflected in an average annual deficit of almost 9% of GDP over the 1980-97 period. Thus, it was only natural that, she became the third most indebted country in the EU with the increase of the public debt to GDP of over 70 percentage points in 1997 (only Belgium and Italy were then worse), and when it joined the eurozone in 2001, its debt-to-GDP had climbed to around 99% . The situation exacerbated even more after she joined eurozone, as over the 2000-2008 period it surged to 109%, because as a new member she was able to borrow at interest rates that were applicable to a country like Germany. Of course, the onset of the 2008 financial crisis put an end to the lax fiscal policy, as credit conditions tightened drastically.

 A combination of downsizing fiscal policy and collapse of bank credit, created a severe crisis of confidence in the banking sector amidst of a rapidly worsening recessionary conditions. Fearful of banks ’insolvency and Grexit, many savers, including Greek businesses withdrew their bank deposits and transferred their funds to banks abroad. Withdrawals in recent weeks have averaged €200-250m ($218 -273m) per day, and when the talks between the Greek government and its Eurozone and international lenders were on the verge of collapse, they surged to €400m ($436m). The torrent of deposits out of Greece’s paralyzed banking system has forced Prime Minister Tsipras to accept the terms of the nation’s creditors. The banking turmoil has pounded an already feeble economy and lenders demanded urgent injection of new funds, potentially from the European Stability Mechanism bailout fund.

 It is of note that as the BIS data reveals the first bailout of 110 billion euros ($120 b), from the European Union and the International Monetary Fund, agreed in May 2010, was mostly used to save the German, French and some other foreign banks, by reducing their exposure to Greek public-sector debt. Perhaps only close to 17% of the first bailout money were allocated to prop up the Greek financial intermediaries.

 The same was the case in the second bailout, which was arranged by the end of April 2012, after the IMF declaration in June 2011 to the effect that Greek debt was still unsustainable and there was a need for a further injection of between 70 to 104 billion euros. In the second bailout, as part of a private debt restructuring, with an additional 64 billion euros pledges of the EU and the IMF, the Greek debt was reduced by 52% to a level of 107 billion euros, with some creditors assuming about 65% haircut. In an effort to compensate her banks which had suffered disproportionate losses from the restructuring, Greece was allowed to borrow 25 billion euros from the European Financial Stability Facility in April 2012. This recapitalization helped her fragile banks, inflicted with toxic balance sheets, to tap the credit markets again, although they depended completely on emergency liquidity assistance from the ECB, set at 89 billion euros.

The still uncertain deal of today has been vehemently criticized by many as a sign of “The Return of the Ugly German”, as characterized by the former Foreign Minister and Vice Chancellor of Germany Joschka Fischer. According to him”

“For the first time, Germany didn’t want more Europe; it wanted less. Germany’s stance on the night of July 12-13 announced its desire to transform the eurozone from a European project into a kind of sphere of influence. Merkel was forced to choose between Schäuble and France (and Italy).

(…)

Schäuble’s position has thrown into sharp relief the fundamental question of the relationship between Europe’s south and north, his approach threatens to stretch the eurozone to the breaking point. The belief that the euro can be used to bring about the economic “re-education” of Europe’s south will prove a dangerous fallacy – and not just in Greece. As the French and Italians well know, such a view jeopardizes the entire European project, which has been built on diversity and solidarity.”

Germany has been the big winner of European unification, both economically and politically. Just compare Germany’s history in the first and second halves of the twentieth century. Bismarck’s unification of Germany in the nineteenth century occurred at the high-water mark of European nationalism. In German thinking, power became inextricably associated with nationalism and militarism. As a result, unlike France, Great Britain, or the United States, which legitimized their foreign policy in terms of a “civilizing mission,” Germany understood its power in terms of raw military force.

Even the prominent German philosopher Jürgen Habermas, has weighed in the debate in an interview with Guardian criticizing Angela Merkel and arguing:

“I fear that the German government, including its social democratic faction, have gambled away in one night all the political capital that a better Germany had accumulated in half a century.”

The European Economic Community, established by the Treaty of Rome in 1957, from its inception was inherently an “economic” union. Thus, it’s ironical that most critics look at the resolution of crisis as a political challenge and they do not offer an alternative economic solution for Germany to adopt.

In fact, Joschka Fischer’s ascription of *the economic “re-education” of Europe’s south* as the main German motive is a re-hashing of Yanis Varoufakis thesis that:

 Based on months of negotiation, my conviction is that the German finance minister wants Greece to be pushed out of the single currency to put the fear of God into the French and have them accept his model of a disciplinarian eurozone. 

It is economically unrealistic to expect that Germany, Finland, Austria, the Netherlands’ tax payers would be prepared to assume the financial rescue of Portugal, Spain, Italy and France. It is certainly true that these countries have benefited from a lower exchange rate that was made possible by the inclusion of the Southern Europeans in the eurozone, but the union do not have an interstate wealth redistribution mechanism, and in any case the cost of such a hypothetical rescue far outweighs the compounded benefits accrued to the Northern European members . In this light it is clear that the expected deal will not solve anything, and as François Heisbourg, in his article in Financial Times has argued:

Unfortunately, by having avoided what they loathe — debt forgiveness — the Germans may now be hoist with their own petard. Adding billions to Greek debt, enforcing pro-cyclical pension cuts and tax increases in the middle of renewed recession, and positing as in 2011 a €50bn privatisation programme: this is as unlikely to work now as it was in the past. Now it has acquired the formal status of plan B,

Grexit is likely to come back. France would then be faced with an impossible choice: to flow with the German-led tide of Grexit, clearly as a subordinate, or to fight a losing battle to prevent a country from being forced out of the European family. Even Franco-German co-management may not be up to striking a workable compromise. The change behind the scenes is that the Paris-Berlin bond can no longer take strength from the shared project of European integration: France’s 2005 rejection of the proposed EU constitution was a turning point. The relationship has instead become utilitarian and as a result the EU’s days of ever closer union may be at an end.

The deal that is being negotiated will just postpone the reckoning time for current imbalances  for a short while until repaying its creditors becomes an insurmountable undertaking again. Greece won’t get her desired debt relief along the line of a Brady-type rescue package and her creditors will demand more austerity, through fiscal tightening taxes which once again create vicious feedback loops and exacerbate her predicament.

Yet an exit from the eurozone is not a realistic option either, because nobody want to deal with a Drachma that would fluctuate violently in an uncertain political environment where it cannot act as a means of payment, store of value, or any other functions of money. Eurozone is not an optimal currency area, because the economic structure of member countries are not similar. Greece and other Southern Europeans need a much lower exchange rate, which is opposite to Germany’s purchasing power parity requirements manifested by her considerable trade surplus. So why Berlin insists on austerity charade?

The reason, as I have suggested in other fora in the past, is that “this is not a Greek financial crisis but German and French banking crisis.”  While $107 billion dollar Greek  debt to European banking sector appears manageable, even a rather modest money multiplier inflate that amount to a quite frightening level. In fact, since the inception of the euro in 2001, the German, French, and Dutch, banks bought a huge amount of Greek, Portuguese, Spanish and Italian sovereign debts by leveraging their equity capital—this was European version of the US subprime mortgage fiasco. Thus, the balance sheets of these banks, levered up in some cases by forty to one or more, is in a very fragile state. The stability of the system has only been maintained by a rather artificial prolonged surge in global financial markets since 2013, emanating from an extraordinary loose monetary policies in advanced economies. In the words of a December 2014 BIS report, “ample monetary stimulus fueled investors' risk appetite and boosted a search for higher-yielding assets”.

In fact, ECB’s financial stability report, released this May, acknowledges this fragility in a ‘bankspeak’ style :

Monetary policy actions of the ECB, both conventional and unconventional, have clearly reduced stress and fragmentation in euro area sovereign bond markets throughout the last years. In many Member States, long-term bond yields stood at historically low levels in mid-May, and intra-euro area spreads narrowed substantially, also resulting in very low term premia. Clearly, any implied deviation from long-term norms might very well prove to be transitory, so that it is important that investors have sufficient buffers and/or hedges to cope with any prospective normalisation of yields over the years ahead, either from global or from euro area-specific changes in financial risk sentiment.

(…)

Amid some signs of compressed risk premia, the risk of relatively low market liquidity becoming a potential amplifier of stress remains. Broad market liquidity measures for secondary fixed income markets indicate a deterioration of conditions. While bid-ask spreads have fallen considerably from their crisis peaks, turnover ratios show a steady decline across most market segments and the average deal size traded on the largest inter-dealer trading system for euro area government bonds has fallen sharply. Complementing these data-based signals, market intelligence also indicates reduced confidence among large banks with respect to their ability to make markets during periods of stress

(the emphasis are mine) In its identification of the second risk ECB states:

Euro area banks continue to be challenged by relatively weak profitability. Although profitability improved somewhat, on average, in 2014, thanks to lower funding costs and a moderate decline in loan loss provisions, euro area banks continue to lag behind most US peers and European banks outside the euro area. Subdued profitability prevailing over the past few years has been driven by a confluence of factors, including bank-specific characteristics, banking sector structures and cyclical developments. The profitability of euro area banks remains characterised by substantial cross-country heterogeneity. (…) Euro area banks’ profitability will benefit from the ECB’s expanded asset purchase programme as it supports nominal growth, improves asset valuations and effectively rules out debt deflation. These benefits notwithstanding, net interest margins are expected to remain under pressure as a result of the low interest rate environment and flattening yield curves. Bank profitability might therefore be squeezed further if banks cannot compensate for this by increasing loan volumes and/or reducing credit risk.

Thus  it was this vulnerability of the eurozone's banking sector that has motivated Berlin and Paris to create a semblance of deal, no matter how unrealistic it is.  In this regard it is of particular interest that there has been a very clear statement about the need for an speedy resolution of non-performing loans.

A continuing legacy from the sovereign debt crisis is a large and, in some countries, still increasing stock of non-performing loans. Further progress in removing impediments to the supply of bank credit – including faster NPL resolution – is necessary to improve credit conditions, which should be also supported by the ECB’s targeted monetary policy measures. The resolution of systemic NPL problems requires a comprehensive strategy that encompasses necessary improvements in the operational environment and the selection of appropriate resolution strategies. In this respect, it can be concluded that tailored approaches – based on a thorough understanding of the country-specific dimensions of the NPL problem – that are driven as much as possible by the private sector may be most appropriate. The efforts to resolve the stocks of NPLs in parts of the euro area should be carefully designed so as to avoid an undue negative impact on bank capitalisation and to minimise moral hazard.

So is there a solution? As I have repeatedly argued the global financial system is in dire need of a serious coordinated effort to restructure its international flow of funds based on a modern version Purchasing Power Parity criteria, similar to what Gustav Cassel suggested in Brussels conference in the interwar period. Today's extraordinary inflated level of leverages must be deflated in an orderly fashion. While some financial institutions with high leverage ratios may face the risk of insolvency, the risk would be far more manageable in a newly restructured sound international system relative to the existing messy and uncertain situation. We  need an urgent international conference to tackle this very important issue.

China markets rout resumes with 8.5% Shanghai sell-off -- as expected!

As I did predict  in my previous post, Chinese shares fall  more than 8% despite an unprecedented state rescue efforts to prop up valuations.

Some annalists have argued that an abrupt halt in state support was the main reason for the latest fall, expressing concerns about the lack of resolve by Beijing’s authorities to stave off a deeper crash, I   beg to differ.

As I've argued in my previous post the crash was unavoidable, because no justifications could be offered from the real side of economy for the surge of stock prices earlier this year.

 These record one-day drops since 2007 in major indexes, after three weeks of relative calm, once again demonstrate that policy interventions in equity markets would be ineffective if they're not firmly grounded on the economic fundamentals.