25IQ

The Eurozone is going to shrink in my view. That will come about as the electorate in key countries puts politicians in place that are willing to embrace default or the politicians in place embrace default.  Senior bondholders/foreign banks are going to take bigger haircuts than the market prices in right now.

“…There are very powerful arguments to support the default view, and the strongest argument against it, from Ireland’s perspective, evaporated last week – that argument was that any default on bank bonds would cause lenders to stop giving money to the Government to fund its deficit. That has now happened anyway. It is no longer in Ireland’s narrow national interest to prevent senior bondholders from suffering the consequences of their own bad judgement. …  the consequences of weaning Ireland’s banks off cheap ECB money simply transfers the problem. Support for the banks will have to come from the bailout fund, which, in theory, will offer cash at a much higher rate of interest. If a large part of the ECB funding were to be refinanced at a much higher interest rate, the State’s total debt burden (Government and banks) would become unmanageable.http://www.irishtimes.com/newspaper/opinion/2010/1126/1224284180165.html?via=mr

“… In early 2009, a joke was making the rounds: “What’s the difference between Iceland and Ireland? Answer: One letter and about six months.” This was supposed to be gallows humor. No matter how bad the Irish situation, it couldn’t be compared with the utter disaster that was Iceland.

But at this point Iceland seems, if anything, to be doing better than its near-namesake. Its economic slump was no deeper than Ireland’s, its job losses were less severe and it seems better positioned for recovery. In fact, investors now appear to consider Iceland’s debt safer than Ireland’s. How is that possible?

Part of the answer is that Iceland let foreign lenders to its runaway banks pay the price of their poor judgment, rather than putting its own taxpayers on the line to guarantee bad private debts. As the International Monetary Fund notes — approvingly! — “private sector bankruptcies have led to a marked decline in external debt.” Meanwhile, Iceland helped avoid a financial panic in part by imposing temporary capital controls — that is, by limiting the ability of residents to pull funds out of the country.

And Iceland has also benefited from the fact that, unlike Ireland, it still has its own currency; devaluation of the krona, which has made Iceland’s exports more competitive, has been an important factor in limiting the depth of Iceland’s slump….”  http://baselinescenario.com/2010/11/17/the-debt-problems-of-the-european-periphery/#more-8268

These probabilities of default  as expected by the market are still too low:

the probability that CDS spreads assign to a default of Italy in the next five years (around 12.7%) is significantly lower than that of Ireland (34%) and Portugal (28%). http://www.nakedcapitalism.com/2010/11/guest-post-will-the-irish-crisis-spread-to-italy.html

Nov. 26 (Bloomberg) — The cost of insuring Portuguese, Irish and Spanish government debt against default rose to records based on closing prices, according to CMA. Credit-default swaps on Portugal rose 31.5 basis points to 507.5, Ireland increased 19 basis points to 599.5 and Spain climbed 21 basis points to 320.5.  http://www.businessweek.com/news/2010-11-26/portugal-ireland-spain-credit-default-swaps-rise-to-records.html

Irish police estimate 20,000 people took to the streets of Dublin as bailout talks focus on the interest rate charged to Ireland and the fate of senior bondholders. A finance ministry spokesman said the rate will be “sustainable” after state broadcaster RTE reported that nine-year loans from the EU and the International Monetary Fund may cost as much as 6.7 percent.  … 

“One possible scenario is that the financial package for Ireland could include an element of restructuring affecting senior debt,” Fitch Ratings said in a statement yesterday. “Fitch has no visibility of this matter but notes that such a restructuring could have wider implications for the euro area.” …EU and IMF officials are taking legal advice on how senior bondholders can share the cost of the rescue without triggering lawsuits, the Irish Times said yesterday, without saying where it got the information.

http://www.bloomberg.com/news/2010-11-26/ireland-races-to-secure-weekend-aid-deal-amid-bank-debt-concern.html

Shares of European banks which hold the debt of Irish banks tumbled on Friday on reports that they could be forced to share in the cost. Britain’s Royal Bank of Scotland and Lloyds Banking Group tumbled 5.3 and 4.4 percent respectively, while Spain’s top bank, Santander, fell 3.7 percent. http://www.reuters.com/article/idUSLDE6AO0HG20101127

Ireland’s debt is “massive,” says Sean Egan, managing director at Egan-Jones. After the latest bailout, Ireland will have €220 billion of debt along with €400 billion of bank guarantees. That equates to €135,000 per person. By comparison, the French have debt of €23,000 per person. Ireland’s government also plans €15 billion ($20.53 billion) in spending cuts and tax increases, even as its gross domestic product fell 1.2% in the seasonally adjusted second quarter and its debt as a percentage of GDP rose to 77.4%. Its deficit-to-GDP is the highest in the European Union at 14.30%, and it’s expected to rise in the months ahead as the government continues to repair its damaged banking system. To date, the government has injected roughly €22 billion in capital into the banks…. its unemployment rate is 13.6%, http://online.barrons.com/article/SB50001424052970204374404575630840242907612.html?mod=BOL_twm_mw

There were big falls in the price of senior Irish bank debt at home and abroad. AIB’s 5.625 per cent senior debt due in 2014 fell to 73 cent, a 5.2 per cent drop. Similarly, Bank of Ireland’s 4.625 per cent senior notes maturing in 2013 saw a drop of four cent on the euro, or 4.8 per cent, to 81 cent. According to one London trader, any move to compel bondholders to take a haircut could have long-term implications for Ireland’s ability to enter international markets for years to come, as the Government had explicitly guaranteed the senior debt of the Irish banks in September 2008 under the guarantee. “Ireland guaranteed its bank debt two years ago, much to the annoyance of other countries . . . if it was to renege on that debt, it could find itself in the situation faced by Argentina, which still can’t enter international markets because of its default.”  http://www.irishtimes.com/newspaper/ireland/2010/1127/1224284259127.html

More thoughts:

“… The public debt can be contained in two ways. The first and preferable option is that the state never nationalizes private bank debt as Ireland has done.  For Ireland, this opportunity has probably passed, but other countries should be warned not to make the same mistake. Kazakhstan’s refusal last year to bail out its major banks, despite strong demands from the senior creditors of these banks, has proved a far more successful path.  Banks can and should go under if they have failed. The state should only defend small and medium-sized depositors.

If the state has taken on too large debt, sovereign default is the natural outcome. In their excellent book This Time Is Different, Carmen Reinhardt and Kenneth Rogoff argue that 90 percent of GDP is the highest sustainable level of public debt for a developed country. This limit is not absolute, but there is little reason to believe that Greece and Ireland would belong to the exceptions. As Germany and France so sensibly, though perhaps not very cautiously, have argued in public, the EU needs a facility for sovereign debt default.  http://baselinescenario.com/2010/11/17/the-debt-problems-of-the-european-periphery/#more-8268

In a nutshell, we’re watching the most pitched, highest-stakes, most determined battle between politics and finance which has been staged. I am expecting finance to win. It’s not just about PIGS and the future of the eurozone, it’s settling a very general question about the relative power of politics and finance.  Either way, it is an event of momentous importance. http://www.marginalrevolution.com/marginalrevolution/2010/11/the-war-of-politics-and-finance.html

Taleb: “connectivity and operational leverage are making cultural and economic events cascade faster and deeper”. http://www.economist.com/node/17509373?story_id=17509373&CFID=149238396&CFTOKEN=89583226

The question is whether the Eurocrats can beat back the speculators. I find the whole situation much too complex. I can only come up with a list of things that I wish I knew.

1. What is the true state of the large European banks? In particular, if, they had to write down the principal on the debt of the PIGS by, say, 15 percent, which banks would still be solvent?

2. What does the option for inflating away European debt look like? How would the cost of that inflation be distributed? Can the inflation take place within the context of the euro, or does it require that some countries leave the euro?

3. Does a crisis create an opportunity for governments to make radical changes to the welfare state, or is that still not possible?

4. Suppose that governments have to choose between preserving their banks and preserving high levels of spending on public employees and retirees. Which choice is better for the economy? For political survival?  http://econlog.econlib.org/