EMU break-up risks global deflation shock that would dwarf Lehman collapse, warns ING

Another great story from Telegraph by Ambrose Evans-Pritchard:

A full-fledged disintegration of the eurozone would trigger the worst economic crisis in modern history, devastate every country in Europe including Germany, and inflict a deflationary shock on the US. There would be no winners, warns the Dutch bank ING in a new report "Quantifying the Unthinkable".

"Complete break-up would have effects that dwarf the post Lehman Brothers collapse. Governments would find themselves having to bail out banks again, worsening already fragile government finances. The risk of at least a temporary break-down in payments systems would be enormous, " said the report by Mark Cliffe, Maarten Leen, and Peter Vanden Houte.

"Initial trauma is sufficiently grave to give pause for thought to those who blithely propose EMU exit as a policy option," it said, a rebuke to those German politicians and economists who have talked openly of shaking out weaker members.

The new Greek drachma would crash by 80pc against the new Deutschemark. The currencies of Spain, Portugal, and Ireland would fall by 50pc or more, causing inflation to soar into double-digits. "The impact is dramatic and traumatic," it said.

ING has attempted to unpick the complex consequences of break-up scenarios, concluding that even a surgical exit by Greece alone would hurt everybody, and be suicidal for Greece. Both weak and strong states would suffer violent downturns if EMU unravelled altogether, though each in very different ways. "In the first year, output falls by between 5pc and 9pc across the various former member states," it said.

The German sphere would face a "deflationary shock". The US dollar would rocket to 85 cents against the euro equivalent, with a "temporary overshoot" to near 75 cents. This would tip the US into acute deflation, threatening North America with a double-dip recession. East Europe would contract 5pc in 2011 alone.

Safe-haven flows to core debt markets would drive down yields on 10-year US, German, and Dutch bonds to near 0.5pc, by far the lowest ever. Club Med yields would decouple brutally, rising to between 7pc and 12pc, "capital controls, notwithstanding."

This is the picture of a world falling apart. It is an outcome that Angela Merkel, the German Chancellor, now seems determined to avoid, after dragging her feet over the Spring. The Bundestag has backed Germany's share of the €110bn rescue for Greece, and the €750bn EU-IMF bail-out for future casualties should they need it. The Bundesbank has lifted its de facto veto on purchases of Club Med bonds by the European Central Bank.

Yet markets have failed to stabilise. Spreads on 10-year Greek bonds are still 750 basis points over Bunds. Investors clearly doubt whether the Greek austerity policy of wage deflation can ever work, or whether EU states will back their words with money, or both. The spreads are 285 for Portgual, 272 for Ireland, and 213 for Spain.

The markets perhaps sense that the bail-out battles in Germany are not yet over. There are four complaints lodged at the German constitutional court arguing that the rescues breach EU treaty law and therefore German basic law. While the court has refused an immediate injunction to block aid, it has not yet ruled on the cases.

A group of five professors has just expanded its original complaint against the Greek rescue to cover the EU's €440bn Stability Facility, describing the methods used to ram through the measures as "putschist" and anti-democratic. "This course is leading Germany to ruin," they said.

Germany's Centre for European Politics in Freiburg has joined the fray with a report arguing that the use of €60bn of EU money under Article 122 of the Lisbon Treaty to support the rescue package is illegal. "It is a complete violation of our constitutional law and the judges at the court will have to say so if a case reaches them, even though they are afraid of the economic consequences," said the author, Dr Thiemo Jeck. Bavarian politician Peter Gauweiler aims to file a fresh case along these lines.

ING's global strategist Mark Cliffe said any Anglo-Saxon Schadenfreude at a euro break-up would be short-lived. The UK economy would shrink by 4.5pc from 2011-2012. "It would be a very unpleasant experience," he said.

Safe-haven flows pouring into Britain would drive sterling through the roof. Eurozone demand for UK exports would contract viciously. Pension funds would suffer fat losses on eurozone assets. UK lenders would face havoc again though a web of cross-border linkages.

The Dutch bank does not make any judgement on the merits of EMU, or on whether it is an 'optimal currency area', nor does it explore half-way options such as a split into a hard Teutonic euro and a weak Latin euro.

The report said break-up talk is "no longer just a figment of fevered Anglo-Saxon imaginations". It has spread into top policy-making circles in the eurozone and must now be analysed as a serious tail-risk. A survey of 440 heads of global banks and companies by RBC Capital Markets found that 50pc expect at least one country to leave EMU by 2013, and a quarter expect a complete collapse.

ING said heavily indebted states such as Greece would not gain relief by escaping EMU and devaluing since their debt burden would remain, even if government bonds are switched into the new currency. This is a controversial point. If Greece devalues and defaults as well, the calculus is different. Many big bust-ups entail both, such as the Argentine crisis in 2001. Some Argentines argue that their trauma proved cathartic, pulling the country out of a destructive downward spiral.

If Greek, Portuguese or Spanish leaders ever start to ask their own Argentine questions as austerity grinds on, and unemployment grinds higher, events will run their ineluctable political course regardless of the greater risks.

INGBank Global Economics 20100707

Fishing at a Paradox. No Toil, No Thrift, No Fish, No Paradox.

The Aleph Blog:

Aggregation of economic variables is required for macroeconomic modeling. One of the largest problems with macroeconomics is whether that aggregation makes sense, or conceals a more dynamic and diverse economy.

The paradox of thrift as proposed by Keynes assumes that all saving is similar. People invest excess monies in some simple depositary instrument that earns interest. As people panic over bad economic activity, they save more, driving interest rates lower. But wait. What if they don’t place their money in depositary instruments? What if they pay down debt, whether secured or unsecured? In that case, banks will find themselves more willing to lend, as the surplus/assets ratio rises. The liquidity crunch at the banks will lessen. Or, people may save in a different way, by:

• Buying gold, commodities, or non-perishable consumables
• Enhancing their homes, cars, etc., making them cheaper to operate, or giving them longer lifespans
• Investing in foreign debt instruments

Saving can take many forms, some of which may look like consumption or investment. The main idea is to direct your excess assets to the place that will give you the best long term benefit.

Even corporations will want to save during a tough environment. Building up cash balances gives flexibility for the future, and gives options to buy assets cheaply if competitors crater. Some firms even borrow long-term to have cash on hand. It’s a negative arb, but it gives the firm flexibility. But even firms may have alternative ways to save:

• Investing in labor-saving or waste reducing technology.
• Stockpiling needed nonperishable commodities, or locking in long-term supply agreements, at attractive prices.
• Retiring stock or debt through buybacks at attractive prices.

Saving need not be in money markets or banks. There are many ways to save, and there are always alternative uses for money. Each economic actor has to find the most fitting savings method for his needs.

Now, recently I ran across a paper called The Paradox of Toil. The abstract:

This paper proposes a new paradox: the paradox of toil. Suppose everyone wakes up one day and decides they want to work more. What happens to aggregate employment? This paper shows that, under certain conditions, aggregate employment falls; that is, there is less work in the aggregate because everyone wants to work more. The conditions for the paradox to apply are that the short-term nominal interest rate is zero and there are deflationary pressures and output contraction, much as during the Great Depression in the United States and, perhaps, the 2008 financial crisis in large parts of the world. The paradox of toil is tightly connected to the Keynesian idea of the paradox of thrift. Both are examples of a fallacy of composition.

This paper does the same simplifications that Keynes did to produce his paradox of thrift. There is only one type of labor. Well, certainly if everyone does the same thing, there are diminishing marginal returns to scale. Big deal.

But labor is different. We have the ability to choose different firms to work at. Not all work is equal, and there are often better and worse opportunities available for labor. Recessions occur partially because capital and labor are misallocated. Look for the firms that are showing promise in the recession, and angle to work for them.

But beyond that, workers have one more option: work for yourself; start your own firm. Find a problem that irritates many, and solve it. Create a product or service that meets the needs of many. In a deflationary environment that might mean finding a cheaper way to do things. But it could be creating a new product that meets needs that people or businesses did not know they wanted. Go for a Blue Ocean Strategy.

The best businesses are often created in recessions. Flip the paradox of toil, and work many hours for yourself and your ideals.

Summary

I don’t believe in the paradox of thrift or the paradox of toil. They are bogus results of oversimplified models that do not reflect reality. As an investor and an economic historian, I know of many times where massive amounts of money were allocated to a single asset class or a single sector of the market. If everyone follows a mania strategy, whether due to greed or panic, I can guarantee that there will be a bad result.

• The dot-coms of the late ’90s
• The one decision stocks of the ’60s.
• Gold in the ’70s.
• Railroads in the late 1800s.
• Buying stocks in the 1920s.
• Selling stocks in the 1930s.
• Selling bonds in the early ’80s.
• The mercantilist era — exporting cheaply to get gold, then getting less in return when liquidating the gold.

I could go on to various manias in earlier eras, less well-known manias, or individual stocks, but that wouldn’t help make my case any more than I have already. The main point is the same. Anytime everyone does the same thing, it is foolish. It would be stupid for everyone to save using T-bills, or sell their excess labor to agricultural day labor.

I trust intelligent people to seek their best advantage in the markets. That does not mean that foolish people will not get hosed. That’s the nature of being foolish. But bright people see recessions as a time to reorient and look ahead, to see what the new economy will want, and ignore what the old economy wanted.

So, I don’t see any value in:

• Stimulus programs that don’t produce economic value. If it only pays a wage, that is destructive. For stimulus to be effective it must produce infrastructure that lowers the costs of the economy. Think of all the useless projects built in Japan.
• Paying extended unemployment benefits. Additional consumption today, plus debt tomorrow is a recipe for economic lethargy.
• Running large deficits. If the money is not being spent on something that will produce future growth, it is a loss.
• Bailouts of large financial institutions. We have too many of those.
• Housing tax credits. We have too many houses.
• Bailing out auto companies. Too many autos are made in our world today.
• Bailing out the GSEs. They are deadweight losses. Let them die, and let the senior bondholders feel the pain. Let the junior bondholders be wiped out.
• Monetary policy that steals from savers, thus depriving the private capital markets of a supply of private capital for productive investments, rather than the government absorbing most of the capital at low rates, and wasting the money on less productive projects.

Don’t listen to the fools that insist that we must run huge deficits and run a loose monetary policy. A “big bang” would be preferable to the “Chinese water torture” that we are now undergoing. Far better to take a short dose of sharp pain, where asset prices fall, some more banks fail, and bad debts are purged from the system, than to endure another lost decade, where the ability to employ capital productively is difficult.

As it is, we are pursuing the Japan solution to our overleverage. They have had two lost decades, and are starting on their third lost decade. Is that what we want?