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Read this Der Spiegel "Imagining the Unthinkable"

Are the Germans in denial about the Euro? According to this must read Der Spiegel article, no.

• Investment experts at Deutsche Bank now feel that a collapse of the common currency is "a very likely scenario." 

• German companies are preparing themselves for the possibility that their business contacts in Madrid and Barcelona could soon be paying with pesetas again. 

• According to Credit Suisse, the market leader in Europe's largest economy [Deutsche Bank] ..., would face such heavy loses that it would suffer a capital shortfall of €35 billion.

• IT systems are being prepared for a Europe with multiple currencies.

• Economists with the Dutch bank ING have calculated that in the first two years following a collapse, the countries in the euro zone would lose 12 percent of their economic output... It would make the recession that followed the bankruptcy of investment bank Lehmann Brothers seem like a minor industrial accident by comparison.

• The German Finance Ministry's prognosis is even grimmer than that of the ING experts. According to their scenarios, in the first year following a euro collapse, the German economy would shrink by up to 10 percent and the ranks of the unemployed would swell to more than 5 million people. The officials were so horrified by their conclusions that they kept all of their analyses under lock and key, for fear that the costs of rescuing the euro could spin out of control.

• According to a scenario by the major Swiss bank UBS, if the financial risks resulting from the decline in exports, the necessary bank bailouts and the company bankruptcies are added together, the total cost to the German economy could amount to a quarter of Germany's gross domestic product -- well over €500 billion.

• Through this internal payment system in the euro zone, the Bundesbank has accumulated about €700 billion in claims against the central banks of countries like Greece, Spain and Italy. This is more than five times the Bundesbank's own capital.

Given these prominent German and Dutch prognostications, how could German leaders allow the Euro to fail? After all, they must know this information. I think that is explained earlier in the article...

• They [Southern Europe] would prefer to have the money without conditions. But the German government is unwilling to accept this, which puts Europe at its next impasse. Furthermore, the rescue strategists' resources are limited.

• But now even the ECB has largely exhausted its resources. It has already bought up so much of the sovereign debt of ailing countries that any additional shopping spree threatens to backfire, causing interest rates to explode instead of fall.

• The question is whether the economy in Southern Europe will recover before the euro rescuers' tools are exhausted, or whether it will be too late by the time the recovery arrives.

• It's a question of growth and the economy, but also of character. How willing are the Spaniards and Italians to accept reforms and hardship, and how willing, on the other hand, are the donor countries of the north to provide assistance and make sacrifices?

I would dispute some of these points, but what I think doesn't matter. Based on this, it sounds like German leaders have already accepted that the Euro will break apart. But the date of failure sounds distantly dependent on future periphery economic performance and political reforms, and has nothing to do with German decisions.

I too, think the break-up of the Euro (if not in name, then significantly in composition) is inevitable. But preparations must be made immediately for an orderly and amicable division. I don't hear any of this, only defiance and a bunker mentality (no double entendre intended).

If Germany has already accepted the break-up of the Euro, then at this Thursday's summit Germany will offer disingenuous solutions, which will be both impossible politically and inappropriate for the immediate market problems. The purpose will be to give the appearance of German support for the currency union, while in fact having confidence that it is doomed. This strategy will enrage other participants, and probably not just Southern Europe. And it will frighten markets whose hopes hang from increasingly dubious expectations of government and central bank rescue.

The begining of the Euro's end could be within a week. And that photo of Draghi being presented with a Prussian spiked helmet will go down in infamy.

An Alternative to Blame within the Eurozone

Nationalism and stereotypes have created a breakdown in communication within the Eurozone. Each side tells monologues of how they are the victim of so-and-so's vice of gluttony, greed, sloth, wrath, or envy. Perhaps some truth, but they are all guilty of pride. In this environment, an orderly resolution of the debt crisis is impossible.

I believe they need to share a non-judgemental historical explanation of the crisis. From that standpoint it is much easier to agree on mutual solutions. Here's how I would explain the development of the crisis - with no blame attached. As is usually the case, unsustainable virtuous cycles (low interest rates & trade imbalances) become vicious cycles.

Low Interest Rate Cycle:

1. Euro adoption caused periphery interest rates to fall in expectation of tighter monetary policy from the ECB than than they had from their individual periphery central banks.
2. The ECB lowered their benchmark interest rate from 4.75% in 2001, down to 2.0% in 2005. This was stimulative for Germany's 1% real GDP growth for that period, but was inflationary for Irish (21%), Greek (17%), and Spanish (13%) growth.
3. High perhiphery growth rates caused markets to underestimate long-term credit risk and price the periphery at the same low interest rates as the core.

Trade Imbalance Cycle:

1. The Euro gives periphery consumers a stronger currency, which makes imports from the core cheaper and creates years of trade deficits with the core.
2. Low interest rates and high inflation create a very favorable environment for real estate investment in the periphery.
3. Domestic investment is directed towards real estate and away from manufacturing, which makes the periphery even less competitive in manufacturing.
4. Higher inflation in the periphery causes employee compensation to rise faster than in the core, which makes the periphery even less competitive in manufacturing.
5. Core nations accumulate huge trade surpluses in the form of periphery IOU's, which they invest in perhiphery banks and core bank subsidaries in the periphery, where it is often invested in an asset with outstanding returns - real estate.

Imbalances Find Equilibrium:

1. Trade imbalances created poor private investment choices in the periphery, particularly in a real estate bubble. This threat was not recognized until the US financial crisis forced tighter credit and more appreciation of asset bubble risk.
2. As collateral prices fell, periphery banks became insolvent. Core nations withdrew their short-term lending to periphery banks. Large depositors fled perhiphery banks.
3. Sovereign and ECB lending replaced the private debt to periphery banks, which allowed core banks to recover some (but not all) of their periphery investments.
4. Employment and production rapidly fell in the periphery as private credit, consumption, investment, and government spending all fell.
5. The expense of bank bailouts and a shrinking tax base caused higher borrowing costs for periphery nations, which in trun caused even more fear of sovereign default.

The above is Christmas past and present, and what we should acknowledge it (though details vary from nation to nation). Below is Christmas future...

Resolution:

1. Widespread insolvency causes high interest rates, deflation, and cessation of trade (the opposite of virtuous cycle that started the debt crisis).
2. Core economies are dependent on trade, which plummets and rapidly shrinks their economy.
3. Large periphery sovereign(s) default and/or leave the Euro, which causes core banks to be insolvent (including some of largest banks in world). Core bank losses exceed their host's GDP.
4. After the first major nation withdraws from the Euro, there is a run on the ECB as other members threaten to leave the Euro to avoid the larger share of losses from ECB and Target 2 debts.
5. Core nations become insolvent due to smaller tax revenues and large bank bailout costs.
6. Ironically, the remaining core nations instruct the ECB to print trillions in Euros to prevent systemic collapse. 

The resolution section could be completely different, if the Euro members realize that blame will lead to mutually assured destruction - including for the core. The downside can be avoided with generous debt restructuring, ECB debt purchases, heterodox ECB money creation, and the orderly end of the Euro. The Euro never made sense. Europeans don't have enough common identity to be willing to help each other during times of economic crisis - particularly for the long run. In this case accepting a sad truth is better than believing a comfortable lie.

The US dollar works because the states share government revenue and spending between each other with ignorance and impunity rather than avarice and antagonism. I believe that a common currency across the Anglo nations would be more successful than within the Euro, because the people of the US, Canada, UK, Australia, and New Zealand share more in common culture than within the Eurozone. But no one is advocating an Anglo-wide currency because it is a silly idea (even between closer trading partners like the US and Canada or Australia and New Zealand). We all do fine with our own floating currency, thank you very much. And we don't want an even more behometh and remote central government.

Eurozone members should plan an orderly break-up of the Euro, and then hopefully focus more on wealth and less on money. May they have the wisdom to know the difference.

Timing a Crisis

I remember that the US financial crisis slowly developed for more than two years. Here's my recollection, of key events both from personal experience and news accounts.

• 4/2006 - I see data on new purchase contracts, Florida house prices are falling.
• 6/2007 - First payment and early defaults are so high on subprime and option ARM's that warehouse lines and originations start to collapse.
• 3/2008 - I hear anxious conversations from a broker dealer that they are hedging and/or severing transactions with Bear Stearns. (I then realized the problem was much bigger than mortgages).
• 9/2008 - Fannie & Freddie are put into conservatorship.
• 11/2008 - Lehman files bankruptcy. There is a run on money markets. Private lending stops.

What is surprising in retrospect is that it took 31 months from the first sign of distress until the apex of panic. For the first two years, most of the public and even financial experts were oblivious to the danger that already existed. Who would have expected money markets to be the achilles heal of a mortgage crisis?

In retrospect we tend to think of a crisis occuring at a single point in time due to a single catalyst. In reality a crisis can build for years, and the particular catalytic event (if any) is never forseen. That's what makes shorting so scary, because you can't time fear. Conversely, the fact that a systemic problem hasn't lead to a panic yet should not give us confidence that it won't happen in the future.

It is surreal how quickly we have reinvented history in our rememberence of the recent financial crisis, perhaps as a concious effort to not learn anything from it, and to protect the existing system. And so it is in Europe as well, even before their panic.

Debt Solution

Most of the economic problems in the developed world are due to high levels of private debt that purchased overpriced speculative assets. Many will add their own spin to blame somebody for it (governments, central banks, banks, lazy people, greedy people, etc.). If blame were a solution then our economies would have long ago recovered. 

There are several common reactions to a debt crisis:

1. Lower interest rate and/or extend term.
2. Forgive the borrowers.
3. Liquidate the borrowers.
4. Lend the creditors money from the government and/or central bank.

The traditional workout is the rate/term. Because of the fear of moral hazard there is a maddening amount of bureacracy and time to make sure the borrower really deserves/needs it. If the rate reductions do occur, they are often just enough to delay the default rather than cure.

The rate/term workout is increasingly forgotten in our politically polarized world, where many want to liquidate in order to punish the debtor, or forgive in order to punish the creditor. The problem with either ideology is that it would not only destroy most banks, but also destroy credit markets and collateral values for decades. For example in the mortgage industry ruthless foreclosures lead to a vicious cycle of falling house prices, more negative equity, and more defaults. And debt forgiveness would make lenders very reluctant to lend in the future. 

Since rate/term, liquidation, and forgiveness don't work on a large scale, debt crises soon end up with the delay tactic of lending from the government/central bank/IMF. Swapping one debt for another debt may solve short-term liquidity problems, but it isn't a cure unless the borrower's capacity to pay improves through income growth or collateral appreciation. Unfortunately, neither of those is likely in a balance sheet recession.

A controversial fourth way would be for the central bank to purchase bad debt after it has followed a stipulated restructuring. The restructuring itself would be traditional, the novel part is for the central bank to commit to purchase the restructured debt as a commodity. This gets quantitative easing directed to the heart of the solvency debt problem, rather than pushing more liquidity into excess bank reserves (which are at the central bank rather than flowing through the economy).

Eligible debt would be defined as debt that the market will not refinance (or requires an excessive premium to do so). The central bank would set restructuring policies that place costs on both the lender and borrower (contrary to popular opinion, both are often to blame for bad loans). Restructuring rules would generally be:

1. Interest rate is reduced to the rate for best credit.
2. Fixed-rate debt becomes floating rate indexed to 1-month risk free rate.
3. Lifetime interest rate ceiling is set to prevent large future rate shock, but borrower bears some interest rate risk (likely when economy recovers).
4. Principal reduction is possible, but discouraged.
5. For secured debt where the borrower has the capacity to pay (is current), the amortization term is shortened so that they pay down debt and achieve positive equity sooner.

The central bank gets creditors to realize their losses through large interest rate reductions to the borrower, and in return the central bank can directly subsidize a specific portion of those losses by paying up for the restructured assets in order to make the deal work. This quickly cleans up bank balance sheets and borrower income statements so that consumption, lending, and investing can increase at a normal pace.

The central bank would have no recourse to the government or bank that sells the restructured debt, so that the central bank would bear the full credit risk. However credit losses should be small if the restructuring works at a macro and micro sense. This approach could be applied to consumer, commercial, or government debt. Consumer and commercial restructured debt would be securitized for easy sale and administration for central banks.

Such purchases by central banks have many advantages:

1. Immediate, large reduction in borrower payments will stimulate consumption.
2. Removal of bad assets from balance sheets will increase bank capital and lending.
3. Higher consumption and easier credit will increase investment and absorb high savings.
4. By the central bank stipulating the restructuring terms it removes lengthy means testing and negotiations between the creditor and debtor.
5. Collateral values are supported by reducing liquidations and accelerating amortization.
6. By indexing restructured debt to short-term rates, central bank and/or markets can easily constrain consumption if inflation becomes a problem.

On the other hand, there are several possible problems with this proposal:

1. Central banks take credit risk, which is scary from a political perspective.
2. It could create inflation.
3. Moral hazard because banks think they will be bailed out in the future.

None of these objections are unique to this policy. Right now the ECB is holding lots of dubious assets as collateral; they take credit risk but won't admit it. And any policy that is stimulative could create inflation; but in a deflationary environment can't the central bank create money without much inflation? As far as moral hazard, we've amazingly already made government bonds subordinate to senior bank bonds in many situations.

In 2008 I would have thought this proposal was insane, but conventional policies haven't worked in the past 5 years of recession. Huge problems are building in Europe and China. The time for radical intervention is approaching, because what is the point of a healthy central bank at the expense of a destroyed economy? 

Too Much Saving?

Are the households of surplus nations (i.e. China, Japan, Germany) the ones that are saving so much, or is it more their businesses? It tends to be the latter. Are they are scared by previous economic or war traumas, do their tax laws favor savings over debt, do low interest rates exacerbate savings rates, or perhaps it is just cultural? I don't know the answer.

My guess is that savings is culturally more valued in geographies with harsh winters, because people learned that they had to stockpile food, fuel, and seed to survive. Savings did not equal a contemporaneous investment, but was hoarding for the certain future dearth. But there's more to it than that.

Many people view savings and debt as moral issues; savings is good and debt is bad. Never mind that if debt is a vice then it is only possible through the action of the saver (therefore savings must be bad?). Savings could be directed to equity investment rather than debt, but in spite of our capitalistic propaganda, most stock trading is speculation after the IPO. Ironically, higher stock prices enable corporate investment mostly by supporting a higher debt burden.

The problem with corporations is that they don't consume goods and services (except for executive perks), instead they invest their money. The same goes for state owned enterprises and central banks. If we ask them to consume then we are asking them to violate their charters. Corporations will invest in their business if either they have a technological breakthrough that allows them to expand their market, or if their market is organically growing (uncommon now). Typically one can expect markets to gradually expand simply through population growth and inflation - but Europe and Japan have neither (is a low inflation target incompatible with a declining population?). Nor has either invented new must-have consumer goods. So they have little internal corporate investment, and what they had was for Chinese capital equipment export (now gone).

Fortunately our modern financial system enables savings to immediately be transformed into an investment in the winter rather than waiting for spring. Unfortunately in the past decade bank loans and bonds have tended to invest savings into assets for speculative price appreciation rather than an investment to increase productivity. The inevitable resulting losses perversely create an incentive for more saving, but less investment. If we can't find more household consumption or corporate investment, then we need more shared investment (education, infrastructure, technology) to absorb savings.

A fascinating alternative is that we need less savings. We now produce so much food with 2% of the work force, and so many goods with 8% of the work force that we are obese and trip over our cluttered possessions. Goods no longer cost much, though assets (including land) do as we bid up their scarcity through our mal-investments. We need not save for the cold season, and in the Western world we have government pension provisions for old age. Relatively speaking, we don't need much savings, (but we are told that saving is wise and moral).

I think most households desire future income more than the savings themselves. But if we all buy annuities, then we just increase demand for scarce assets through an intermediary. One solution would be to change the tax law to incentivize corporations to pay out their profits in dividends rather than their current practice of hoarding their savings in high grade paper or equity buybacks (at yields below their core business operations). By turning most public companies into yield producers, the companies themselves become high quality assets for investment rather than hoarders of savings and scarce high quality investments.

The False Hope of Emergency Lending

Central banks can lend money at low interest rates to nations, either directly or indirectly (through banks, special funds, or international agencies). Markets love this stuff because they think that it is inflationary (in particular, asset prices), and that the poor country is saved. However both are usually false.

Emergency lending can only works if it isn't done at the last minute. Replacing more expensive debt with cheaper debt is nice because it reduces interest expenses (and therefore future borrowing costs), and it increases the liquidity (reducing the chance they will run out of cash). But remember, that the money we are seeing in Europe isn't a gift - it is still debt to be repaid.

If you wait until the market fears immenent default, then households and consumers hoard cash rather than consuming or investing. Which is to say tha that economic activity slows and tax revenue falls. It may also create deflation rather than inflation, since people hoard currency (including in another nation) rather than goods or assets. In order to counteract this hoarding one would have to lend so much money, so cheaply, that everyone knows the government is solvent (not merely liquid) for years to come.

But that isn't what happens. Emergency funds are dispensed in the same way that someone's head is held underwater until the moment that they are about to drown, then they are let up momentarily for one gasp of air, and then plunged underwater again.

Someday the markets will figure out that emergency lending isn't helping the debtor. In the meantime, the only one that it does help are the creditors (often banks and insurance companies), who get their risky private debts repaid through the expense of central banks and taxpayers issuing the new debt.

By now, the economies of many troubled nations are so screwed up that their debts are uncollectible because their tax base has been wrecked, and they weren't doing great beforehand. The only solution is a workout (a.k.a. 'default' to creditors) - unless one wants to hope that Prince Charming gives the money to the nations, rather than lending it. But neither Mario nor Angela look like the giving or forgiving type.

Think the Unthinkable

It used to be unthinkable that the Euro would break-up. Now the common question is not if, but when and how much. 

Another unthinkable is that China's economy will not only slow, but will shrink significantly. Even more unthinkable is that the Politboro's power will be challenged. The economic news from China looks to have turned into a vicious negative cycle. Yes, there is still hope by many that the government will manage a recovery, but I doubt that hope will survive the year. When hope is lost, it is difficult to regain and most stimulus projects become impotent because consumers don't consume and investors don't invest no matter how big the government incentives are. My crystal ball isn't clear enough to see if China's political system is overthrown; I doubt it, but again, it is thinking the unthinkable.

And so two of the largest economies in the world will retreat for a decade or two. Perhaps the US will become like Japan and have 25+ years of zero growth, zero inflation, and constant deficits. And who knows what will become of Japan - can they borrow forever? We study Greece too much and Japan too little.

Looking back, we will ask why it happened, and how it could have been avoided. The old self rightous vices of debt and sloth will be trotted out, with perhaps a bit of avarice and gluttony too.

But it was all avoidable, if we followed a few simple rules:

1. Bad debts are the responsibility of the lender more than the borrower, and are not the unlimited liability of the government or society. Our bailouts to date have benefitted the creditor more than the debtor, and in so doing create lenders with money who won't lend, borrowers who can't consume, and businesses who won't invest. Gradually liquidate insolvent lenders, and encourage new capital to new lenders.
2. Never give up your currency. It is your sovereignty. Don't share or peg currencies because it creates long-term inbalances that end in distaster.
3. Corruption destroys the state. It creates terrible investment decisions and breeds contempt and hopelessness. Corruption is obvious in Greece and China, but more shadowy in the West; particularly in the US where Congress spends most of its time asking for campaign contributions.

In the past decade the world has made many bad investment decisions. In almost every instance the loss is borne by taxpayers, the creditors are indirectly bailed out, and the debtors are slowly destroyed. This will be exacerbated in the future by global deflation.

Here in North Carolina, a recent vote on banning same-sex marriage brought guidance from this Leviticus 20 scripture, "If a man lies with a man as one lies with a woman, both of them has done what is detestable. They must be put to death, their blood will be on their own heads."

I don't want to live in a theocracy, but I wish equal attention was given to Leviticus 25, in particular: "If any of your fellow Israelites become poor and are unable to support themselves among you, help them as you would a foreigner and stranger, so they can continue to live among you. Do not take interest or any profit from them, but fear your God, so that they may continue to live among you. You must not lend them money at interest or sell them food at a profit." 

It sounds to me like the Bible directs an interest free work-out on hardship borrowers (read the whole chapter and you will see details on foreclosure and redemption rules). Maybe we should pay more attention to the passages that direct us to help each other, and less on the those that direct us to stone each other. Let's think the unthinkable.

End the Euro Now

A common currency is impossible across nations that don't share government spending,taxes or labor. The Eurozone isn't the United States of Europe because Germans would rather destroy Europe for a third time than pay money or forgive debts of Mediterraneans. Compare that to taxpayers on the East and West coasts of the US, who send large amounts to the Southern and Midwestern US without concern (or even knowledge). It is as simple as identity, Germans and Spaniards think of themselves as Germans and Spaniards, not as Europeans (indeed, not even all Spaniards would identify as Spaniards).

Periperal nations need to create their own floating currencies, with independent central banks that have clear instructions. And they need to let their banks fail - including allowing bond holders and foreign depositors to lose money, but they must also capitalize new banks to replace the old. With every institution that is destroyed they must immediately have a new and improved institution to replace it.

Europe continues to save banks, governments, and a currency while economies and even the fabric of society are destroyed. It is a terrible trade off.