Odds Of A Country Leaving The Eurozone Collapse

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Citi’s call for Greece exiting the EMU in the next 12 to18 months with a 60% probability (see discussion) looks even more out of sync with current expectations. The latest survey from Barclays shows that 70% of investors do not expect any nation to drop the euro next year. This chart shows how responses changed over time.

After all, the Eurozone leadership pulled all the stops out in order to prevent EMU’s breakup. That included bringing in the full force of the ECB in the name of fixing the “monetary transmission” (see post) in order to provide central bank funding to periphery governments.

The betting markets seem to agree. In fact Intrade odds are 77% that no nation will exit the union next year. With Greek debt nearly converted to “zero coupon perpetual bond” (see discussion), the probability of near term default and/or exit has collapsed.

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2012 Was A Historic Year In Monetary Policy — And It Just Had The Perfect Ending

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2012 has been a historic year in monetary policy.

Here are the big events:

  • The ECB came into its own. The monetary structure of the Eurozone has been flawed from the get-go, but the sovereign debt crisis that started in 2009, really drove home the fact that the nations in the currency bloc were weak due to the fact that unlike other countries, they did not have “their own” currency or central bank to back them up. Everyone recognized that the only way the crisis could end would be for the entity with unlimited money — the ECB, because it has a printing press — to get in there as a lender of last resort. That’s what the ECB is now doing, with its promise to buy bonds of countries that request it, on condition of reform.
  • The FED changes the goalposts. At the beginning of 2012, there was no active QE program, and the only promise was to keep rates low through 2014. Then over the summer, the Fed changed the game, with its announcement of QE-open ended, a promise to keep buying bonds until the economy improved. There would be no cap. Then at its last meeting, it adopted “Evans Rule” a promise to keep money easy until unemployment hit 6.5% or inflation projections hit 2.5%, meaning that for the first time, the Fed was really offering guidance and expectations management, an approach long favored by academics.
  • Michael Woodford endorse Nominal GDP Targeting. This August at the Jackson Hole conference, Michael Woodford, one of the world’s most pre-eminent monetary policy economists basically came out in favor of an approach where the Fed targeted a specific level of economic output. This was a huge endorsement of a buzzy idea, and it’s likely one reason that the Federal Reserve has moved so fast to attach specific goals to its easing.
  • The Bank of England’s big poach. In what is (hopefully) a sign of things to come for the monetary policy world, the BOE poached Mark Carney from the Bank of Canada. Carney is considered the world’s best central banker, and now he has a huge stage, and a huge challenge (a weak economy, a gangly banking system, a government with tons of debt, etc.). It will be good for the world economy if tests can rise up from smaller central banks, and be applied globally.
  • Abe wins! Just capping it off now, Shinzo Abe has won the election on Japan, and he’s run on a platform of forcing the Bank of Japan to do more easing. His first priority he says: Defeat deflation!

For more on today’s big Japanese election, see here >

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EICHENGREEN: Keep The European Union, Scrap The Euro

German Chancellor Angela Merkel Greek Prime Minister Antonis Samaras

Europe’s crisis has entered a quiet phase, which is no accident.

The current period of relative calm coincides with the approach of Germany’s federal election in 2013, in which the incumbent chancellor, Angela Merkel, will be running as the woman who saved the euro.

But the crisis will be back, if not before Germany’s upcoming election, then after. Southern Europe has not done enough to enhance its competitiveness, while northern Europe has not done enough to boost demand.

Debt burdens remain crushing, and Europe’s economy remains unable to grow. Across the continent, political divisions are deepening. For all of these reasons, the specter of a eurozone collapse has not been dispatched.

The consequences of a collapse would not be pretty. Whichever country precipitated it – Germany by threatening to abandon the euro, or Greece or Spain by actually doing so – would trigger economic chaos and incur its neighbors’ wrath.

To protect themselves from the financial fallout, governments would invoke obscure clauses in EU treaties in order to slap temporary controls on capital flows and ring-fence their banking systems. They would close their borders to stem capital flight. It would be each country for itself.

Would the European Union survive? The answer depends on what one means by the EU. If one means its political organs – the European Commission, the European Parliament, and the European Court of Justice, then the answer is yes. These institutions are now a half-century old; they are not going away.

As for the single market, the EU’s landmark achievement, there is no question that a eurozone breakup would severely disrupt its operation in the short run. Trucks would be halted at national borders. Banking and financial systems would be balkanized. Workers would be prevented from moving.

But what would happen then? There has always been a debate about whether it is possible to have a single market without a single currency. Critics of the euro have always asked: Why not?

Under this scenario, the Single European Act, signed in 1986, would remain in place. Member states would be obliged to restore free movement of goods, capital, services, and people – the EU’s “four freedoms” – as quickly as possible. Given the clear benefits that Europe has derived from the single market, they would have every incentive to do so.

Proponents of the single currency object that if Europe has separate national currencies, it will have separate banking systems, each with its own lender of last resort. So much, then, for a single market in financial services, or for harmonizing regulation and removing trade barriers behind the border.

Free trade in goods and free movement of capital and labor would not survive the euro’s collapse, these diehard Europhiles warn. We may yet find out if they are right.

And what about the acquis communautaire, the body of law that enshrines member states’ obligations not just in terms of economic policies, but also in terms of democracy, the rule of law, and fundamental human rights? The intent of the acquis is not simply to make Europe more prosperous, but to make it more civilized.

Spain, Portugal, and Greece had to establish functioning democracies before applying for EU membership. Even now, Hungary and Romania feel peer pressure and face sanctions from their EU partners when they engage in dubious electoral practices, compromise their courts’ independence, or discriminate against minorities.

The cooperation needed to make that peer pressure effective might conceivably survive the euro’s collapse. But finger-pointing about which country was responsible for Europe’s damaging financial disruption would make it difficult for the members to maintain a common front. It seems likely that the acquis would lose much of its force.

A final way of thinking about the EU is as the “ever closer union” referred to in the Treaty of Rome and echoed in the Maastricht Treaty. “Ever closer union” means an EU that moves ineluctably from economic and monetary union to banking union, then to fiscal union, and finally to political union.

This is what European leaders had in mind when they created the euro. They hoped that establishing a monetary union would generate irresistible pressure for the creation of an EU that functioned in all respects as a cohesive economic and political bloc.

Europe’s leaders were right about the pressure. Monetary union without banking union will not work, and a workable banking union requires at least some elements of fiscal and political union. But they were wrong about the irresistible part. There is no inevitability about what comes next.

Europe can either move forward, toward deeper integration, or it can move backward, toward national sovereignty. Its leaders and, this time, its people need to decide. It is on their decision alone that the future of both the euro and the EU depends.

 

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The Market Rally Is Based On Some Pretty Shaky Assumptions

The stock market has been kept afloat only by an expansive Fed and the widespread expectation that the administration and congress would have the sense never to let the nation actually go over the fiscal cliff.  As the old saying goes, however, hope is not a strategy, and this optimism is not supported by the recession in some major economies and the economic slowdown elsewhere.

Despite all the chatter about yesterday’s Fed meeting, it was certainly no game changer.  As expected, the Fed will buy $85 billion per month of mortgage-backed securities and Treasury securities , basically a continuation of previous policy.  It also announced its intention of keeping short-term rates near zero at least until the unemployment rate dropped to 6.5%.  Separately, the Fed’s newly issued economic projections estimated the unemployment rate dipping to 6.0% to 6.5% by 2015.  While this is the first time the Fed has set an actual unemployment target, it had already promised to keep rates down until 2015, meaning that the overall policy remains about the same as before.

Some pundits have already dubbed the policy QE4.  So far each successive QE has been less effective than the last, a pattern we expect to continue.  As we have previously stated, the Fed has used all of its conventional tools and lot of new ones, resulting in a huge increase in the Fed’s balance sheet.  So far, however, the transmission mechanism between the creation of excess reserves and a robust economy has broken down, as the excess reserves have not resulted in a commensurate increase in the money supply.  Similarly, the increase in the money supply that did take place has not resulted in a strong economic recovery.  In addition the new methods implemented by the Fed have never been tried before and have the potential to lead to unintended negative consequences.  

As for the fiscal cliff, most of what we know about the negotiations is public posturing by both sides as they seek to avoid blame for any failure and convince their followers that they fought as hard as they can.  Although it is possible that more progress is being made in private negotiations, we don’t know that.  The market is assuming that a settlement is likely by year-end, and has run up on that hope.

While we don’t know what is going to happen, doing a deal may be far harder than it seems.  Obama and Boehner probably could agree to something if it was just up to them, but that is not the case.  Both of them must satisfy their relative bases in order to put together enough votes in both parties to pass the House.  Furthermore, in the past Boehner has insisted upon getting a majority of his own party in addition to an overall majority in the House.  As we write, it appears that a 5:00 PM meeting today between the President and the Speaker has not resulted in any more progress.

More importantly, as we have emphasized in recent comments, even a settlement will result in austerity—-less austerity than no settlement at all, but austerity nevertheless.  Any combination of lower spending and higher taxes means fiscal tightening at a time when Fed policy is becoming more ineffectual and the economy is slogging along at less than 2% growth.  In addition, as we have previously pointed out, both the Eurozone and Japan have entered recessions while the growth rate in the BRIC nations is slowing down.

In a broader context, the U.S. economy is being held back by high household debt levels and low savings rates, a problem that is not cured by either a fiscal cliff settlement or more ease by the Fed.  In our view the market has gone about as far as it can go on some shaky assumptions.  The downside risk is substantial. 

SEE ALSO: JACK BOGLE: Here Are The 6 Books That Every Investor Must Read

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EU Leaders Green Light The Greek Bailout

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BRUSSELS (AP) — Greece’s euro partners agreed Thursday to hand over the next disbursement of the country’s bailout loans that will prevent it from going bankrupt and potentially trigger more turmoil in financial markets.

The cash-strapped country will get a total of €49.1 billion ($64 billion) between now and March, with €34.3 billion due in the coming days, officials said. Greece needs the money to stay afloat and avoid a potential default.

The decision by the finance ministers of the 17 EU countries that use the euro caps an often-tortuous period, when Greece tried to convince its creditors that it was holding up its end of the bailout bargain.

In return for the money that will see Greece through the winter months, the country had to commit to further austerity measures, including more spending cuts and tax increases.

It also had to complete a bond buyback program, which is intended to lighten its crushing debt load. Earlier this week, Greece said it would buy back €31.9 billion ($41.5 billion) of its bonds from private investors at a third of their face value.

Greece has been battered by a financial crisis since late 2009 that has left it dependent on funds from international rescue loans for the past two and a half years. In return for the money, the austerity has contributed to a crushing recession. Figures earlier Thursday from the country’s statistics office showed unemployment at a record high of 24.8 percent in the third quarter of 2012, compared with 17.7 percent in the same three months a year ago.

“Today’s decision on the Greek program will remove the clouds that are hanging over Greece,” Olli Rehn, the European commission for monetary affairs, said.

The meeting of eurozone finance ministers came just hours after finance ministers from the 27 countries in the European Union, which includes non-euro countries such as Britain and Poland, agreed to create a single supervisor for their banks, a key component of what many hope will eventually become a fully-fledged banking union.

Later Thursday, EU heads of state and government will gather in Brussels for a summit devoted to building a closer financial and political union, meant to avoid future financial crises.

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Elena Becatoros in Athens contributed to this story.

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