Boone and Johnson: Europe on the Brink

In case you haven’t seen it yet, the “Europe on the Brink” article by Peter Boone and Simon Johnson is a must-read for anyone grappling to understand the Eurozone crisis (see here).   Oversimplifying their argument a bit, they contend the feasible exit routes from the crisis involve either the extremes of decisive debt restructuring or a committed lender of last resort (something that they refer to more explosively as a “moral hazard regime”).   Paul de Grauwe’s Irish Times piece from today makes the argument for a committed LOLR, but he cautions it is only conceivable with much greater central control over fiscal policy.   I think Willem Buiter’s FT piece from earlier in the week can be read as saying the intermediate route combining a more modest LOLR function with private sector involvement is still most likely – and may succeed.   Readers might also be interested in this more recent Citi Economics paper by Buiter and others urging more decisive LOLR action from the ECB.    

48 replies on “Boone and Johnson: Europe on the Brink”

The Bundesbank is giving all the appearances of wanting to implode the Euro ……. this will enable the US treasuary the ability to flood the world with even more $$$$$$$$$
Looks like the companies investments have finally paid off at last.
The Anglo boys or the BIS boys….. can we change this two step for once in a century or are we doomed to a millennia of this monetory torture.

The pointlessness of it all is beyond description.

More austerity for more debt, sounds like a great trade-off. The ECB must have read the article ( and got the FED’S email), after they were blackmailed by worldwide HFT plunges and bond vigilantes. Looks like the asset class just won WWIII without firing a shot. Unless the Germans wake up.

Rory Bremner has a good contribution about LOLR here:
Good News: NASA has found someone on Mars prepared to buy Eurozone Debt #partyondudes

Whilst apparently glib…his statement is telling. Just as the IMF isn’t big enough to bail out say the USA…the ECB isn’t big enough to bail out Italy.

I vote for the dollar to devalue via TheFed funding the Euro bailout…else…a truly ‘exogenous’ solution such as Bremner’s

Suppose that Italy decided to negotiate with its creditors instead of going to the EFSF?

As Italy is running a primary surplus it is likely creditors would accept a debt-restructuring that would be very favourable to Italy. (Isn’t this the Irish plan?)

->Any involvement of the EFSF or the ECB in the trade of Italian bonds would only bail out holders of Italian bonds.

@desmond B

Perhaps somebody could ask those Martians if they would like to run trade deficits for the next decade or so, since it seems almost every economy on Earth is planning to run a trade surplus.

Maybe George Osbourne should make the call.

@ John McHale

I linked to this article on another thread some time back. It is long on analysis but short on solutions. In any case, it is difficult to take seriously – admittedly from the viewpoint of a non-economist – an article which references both Sinn and Buiter.

Berlusconi has just announced an anticipated meeting of the G7 at the level of finance ministers (although with whose blessing, apart from that of Sarkozy, it is not entirely clear).

Jacques Caillou of RBS as reported by Alphaville seems to me to summarise accurately the present fincial, economic and political situation. (It includes leaving Merkel in the Dolomites).

I believe Mr. de Grauwe is mistaken in linking LOLR to fiscal oversight. What LOLR needs is both central financial regulation and central bank resolution mechanisms.

Why do I say this? The big risk to banks is not from sovereign default. Some banks, yes, would be impacted, but it is contagion from those banks to other banks that is the problem.

How would contagion transmit itself? Mr. de Grauwe correctly identified deposit-flight risk, but this is only an issue if national deposit insurance funds are inadequate (as they will be, particularly in stressed sovereigns since most work on the basis of never having to pay out). It would be possible for the ECB to finesse this, as it did in Ireland, by making it not an issue (providing unlimited liquidity and effectively guaranteeing 100% of deposits).

The main risk transmission mechanism, though, is bank senior unsecured debt, secured debt and interbank lending (even before mentioning derivatives). A counter-party failure will cascade through the banking system busting banks in sequence. This is the lesson from Lehmans and from the secret side-letters to the Irish bailout. The overall european market is too large for the ECB to finesse. Cross-holdings of european banks in each other rival the situation in Japan – the BoJ was in a similar policy bind. It could not let the zombie banks fail, it could not effectively recapitalise them.


Good one…and if a politician said:

“Our solutions involves a loan from the Martians, which is actually a downpayment on all the goods and services we will be exporting them over the next few years”

They’d be laughed out of it…yet…for all intents and purposes…that is the same as what they are saying.

I think its pretty straight forward. the days that a govt can build an economy on deficit spending is over. anything else beyond this concept is just noise right now. Paralysis by analysis I believe.

@ John McHale

‘Oversimplifying their argument a bit, they contend the feasible exit routes from the crisis involve either the extremes of decisive debt restructuring or a committed lender of last resort (something that they refer to more explosively as a “moral hazard regime”)’.

This is what Boone and Johnson mean by a moral hazard regime.

‘Because banks are regulated, and their deposits are typically largely guaranteed by governments (in places like the European Union), investors naturally expect governments will bail out banks if short–term liquidity is needed’

As I read it,, they are stating that we have has moral hazard regine for a long time. Bank bondholders have appropriated the protection which was given to bank and bank depositors. To be precise, they have privatised, and looted, the credit which was reserved for the preservation of the banking system, and economic and social good.

The Germans have correctly nailed the scam. Eliminating it, however, is no easy matter, as the funds have already been skimmed off. Big Four accounting firms and bank CEOs in glorious cahoots. Now that the game is up, of course they are threatening to bring down the global economy.

As the Dork rightly says, the jig is up for western liberal democracy.

Also, regards what solutions can be achieved, you’ve to think how the markets perceive Europe:
– A contradictory cacophony of petulant voices
– Conflation of economic issues, with jingoism and political ideals
– Persistent bad faith by certain members of the ECB governing council due to leaks
– Sovereigns cooking their books
– Lorenzo Bin ComicalAli as the mad jester sent out to defend the unworkable
– Heads of State a number of times saying ‘trust us, this solution fixes it’ …when it couldn’t and didn’t
– Moral hazard, and other principles selectively abandoned
– Screams, shouts and yells to outlaw those pesky ratings agencies
– No progress on better understanding financial stability, no plans drawn up for orderly defaults (banks or sovereign)

Offical Europe, a nebulous, mendacious and dysfunctional entity has a terrible credibility gap.

Thus ‘solutions’ that require time and future promises, won’t cut it.

Shock and awe is needed, anything else threatens global financial stability (stock markets, trade, currencies).

Yes – defecit spending to bail out past malinvestments is quite surreal really – originally defecit spending was all about winning wars sometime in the future but now its about rewarding past miscreants and their favoured continued consumption
But if you accept that goverments cannot get into defecit then you accept that large scale industrial capital projects are obsolete and therefore accept a deindustrialisation of society with all its malthusian implications.
As I said before something very strange overcame capitalism when it went on the full petrodollar system – its as if all investment capital was somehow considered equal or indeed inferior to consumption expenditure , the 70s were a very strange time I guess.

Peace man , ehh no I mean Dervatives man.

A moral hazard regime will never work. It won’t work because no matter how many guarantees the ECB gives, the lenders will know intuitively that the music will eventually have to stop, via inflation, public anger, policy changes, etc. They still will not lend.

The lender of last resort policy means that the ECB will have to quantitatively ease the system via printing a tsunami of cash–effectively what the Federal Reserve has been doing for the last three years. This will cause inflation and Arabian revolutions among other things.

The other option is continent wide structured defaults. Creditors are told they are not getting their money back, banks fail, and if the ECB feels like it they can print money to keep the ATMs going. The advantage of this last option is that the ECB at a stroke gains control of Europe’s rouge banking system, and can begin the process of separating retail and investment banking while protecting depositors. Unfortunately, this last option presupposes that the ECB has not been regulatory captured by the banking sector.

The ECB will not print money–yet. They will go for the moral hazard option. It a softer option in the short term which will allow them to kick the can for a few more weeks with only promises and not actual credit transfers. It will collapse, they’ll probably try the same again on a bigger scale, and when that at last fails, the ECB board will witness a tectonic shift in membership and they’ll begin QE, EU style.

Though, whether the Eurozone itself breaks up before the ECB board of directors is anyone’s bet.

@The Dork of Cork
“But if you accept that goverments cannot get into defecit then you accept that large scale industrial capital projects are obsolete”

Governments can be run without a persistent deficit, Ireland has done it many times in the past without the collapse of civilisation as we know it.

Yes Ronan but not in this monetory system – having balanced budgets with such a huge credit overhang is absurd.
We would not have much money to exchange for goods & services.
Once currencies became freefloating against each other / and “free trade” became the norm all the old rules and economic mores became obsolete.
Imagine if we cut all money production now – competing outside players would just move in and buy everything using leverage.
They already have most of the commons already for Christ sake , they will take your home.
The situation is chaotic in this world – any attempt at finding balance withen certain global villages is immediately exploited by lawless multinational marauders with free trade banners.
THE WESTERN WORLD IS COLLPASING – this is beginning of the second fall , hopefully we can get another few decades out of this before systematic failure.
When was the last time you heard rational idealists Ronan – they are a extinct sub species.

There is no more commons , only mindless competion for ALL resourses – we are a degraded broken society , deconstructed by militant monetarism that does not know how to build capital , just to take it – we are all extracting now.

Not a good time to downgrade the us. I didn’t think s&p would be so bold. I’d thought a negative watch would be as far as they would push it. That said the US doesn’t merit the highest rating. But the timing really isn’t ideal. It wouldn’t have killed s&p to wait a couple of months.

It is an informative note which has been posted twice already in this blog. The Sinn line on Target 2 together with the Morgan Kelly line of slash the deficit immediately detracts from its overall credibility.

LOLR ensures that solvent banks do not go broke because of temporary liquidity problems or an irrational run on the bank. There is supposed to be no moral hazard in this type of LOLR. Of course that relies on being able to definitively identify a Liquidity problem from a Solvency one. When LOLR either by design or incorrect assessment of the problem becomes a solvency bail out then we have moral hazard.

Now moving from banks to countries in a currency union we have an even more difficult task of distinguishing a Liquidity crisis from a Solvency one. But this is what has to be done. LOLR should not extend to bailing out insolvency – that leads to moral hazard. But if it is a liquidity problem driven by market irrationality and capital flights then LOLR must apply.

So the note to me is somewhat oversimplistic in stating that either we have full moral hazard (i.e. absolute LOLR) or full market accountability. It will be somewhere in the middle and that is where we seem to be heading. The frustration that the problem is not going away should not make us leap for some big bang solution.

An interesting article by Boone and Johnson makes a serious error when it says that “this potential break–up of the euro area is exactly what happened in the ruble zone when the Soviet Union broke apart.” The two situations are completely different and the analogy only serves to underestimate the potentially catastrophic nature of a break-up of the euro zone.

There was hyperinflation in the ruble zone when it fell apart in 1992 and none of the member states could stop this on its own. Any state that did not succumb to printing paper—like Lithuania in late 1991—suffered inflation anyway when notes from other states drove prices up. Therefore, it was to everybody’s advantage to leave the ruble zone (despite the IMF’s incredible advice to the contrary!) and the citizenry were eager to get their hands on a new currency. So it was relatively easy to introduce a new currency.

The euro is now stable—whatever its political problems—and troubled states would find it impossible to introduce a replacement currency. They cannot leave because they cannot introduce a more-credible alternative currency. If, on the other hand, the Bundesbank decided to withdraw credits from other central banks—effectively ending the euro zone as suggested here—those other central banks would be forced to freeze foreign credits in their banking systems in order to prevent a collapse. This would, in turn, cause a financial meltdown in the core. Therefore, this avenue isn’t credible either.

The potentially catastrophic nature of a collapse in the euro zone virtually rules it out. The demise of the euro zone—at least, in the foreseeable future—would require concrete actions that would be suicidal (unless the banking systems had started to melt down anyway).

Barry Eichengreen’s article on this matter—the subject of another post this week—is far more to the point:

The logic of reducing leverage is inescapable – until CBs balance sheets at the very least approach their M1s useless leverage will flow in a highly destabilizing fashion toward freefloating / trading currencies.
The banking system has learned over the years post 1960 that increased destabilization of real physical economies makes more money.
Less & less money flows to productive endeavours.
The Swiss Franc & German Bund situation is very instructive , previously leveraged credit flowed down to peripheral countries now it is being over invested in “safe” currencies & countries creating the conditions for another malinvestment nightmare.
The Banking system is clearly out of control and has been for 40 -50 years.
More & more credit is needed for less & less GDP growth – now it has reached a point of absurdity as we approach negative growth no matter how much credit is pumped into the patient.
Endgame is approaching although Banks can keep the irrational game going longer then you can remain solvent or alive in a dignified manner.
Interesting times.

@ Garry O

Excellent post and excellent link.

The Irish Times had an equally excellent article a few weeks ago when it said the Euro is like an egg that can’t be unscrambled.

Yes, Maggie Thatcher was right, the Euro was a nonsense but there is no way back.

The simplistic comparison with the Soviet break-up had be thrown for a bit but I had come to the same conclusion – it is easy to break up a currency which is hopelessly weak in the first place.

This misplaced Soviet comparison, the Sinn interpretation of Target 2 imbalances, the simplistic advocation of instant fiscal consolidation etc. makes an informed and informative note ultimately a polemic arriving at a polarised analysis. As John McHale himself might say “reality is more complex than that”.

@Brian Woods II

The Euro like all other currencies is still a creature of the dollar – the Soviet union was finally brought down by Volckers policies , if the euro masters do not want to take on the US treasury market – their precious will also become another trophy of dollar leveraged hegemony.
So we have millions ,then billions , now trillions …… what comes after trillions ?

Italy has a couple of different ways of dealing with a possible fiscal crisis:

-further austerity
-tell its creditors to accept a risk free rate of return – the ECB base rate

Which of the two options above is more likely to stimulate an economic recovery?

It Just Went From Bad To Far, Far Worse As Germany Says Italy Is Too Big For EFSF To Save, Refuses To Carry Euro Bailout Burden

Remember when we said (yesterday) that Germany will soon balk over the fact that it is pledging its entire economy to bail out an insolvent Europe? Well, that moment has come.

German Govt: Italy Too Big For EFSF To Save – Spiegel
German Govt: Doubts Whether Tripling EFSF Would Help It Save Italy
German Govt: Italy Must Make Savings, Reforms To Exit Crisis – Spiegel
Italy Debt Guarantee Could Raise Doubts Over Germany’s Finances – Spiegel
German Govt: EFSF Should Only Help Small, Mid-Size Countries – Spiegel

Merkels Experten lehnen Italien-Rettung ab
Merkel’s rescue experts reject Italy

“Hamburg – Growing up in the federal government, according to SPIEGEL information doubts whether Italy could be rescued by the European EFSF rescue – even if the fund tripled. An economy like Italy was not to support, to being too large, it is said to justify.

The financial needs of the country is huge. According to government experts from the other partner countries may also not lift the guarantee of the entire Italian public debt of over € 1.8 trillion. By then the markets would suspect that Germany was overwhelmed.”,1518,778764,00.html

Even before the S&P downgrade and the likely continued gridlock in Washington DC, China made clear its interest in seeing the second reserve currency survive and supporting its biggest trading partner.

China cannot provide another nearly $500bn stimulus because of its inflation problem but it can use some of its nearly $3trn in reserves to buy some European debt. It would also have some positive political benefits for it.

Growth and the faltering recovery in the US are key to what happens in Europe but stimulus is off the agenda.

It could come down to what you have handy in your pocket like…….

M0 or Freegold – nothing in between………..maybe.

Time to call a spade a spade I guess

‘This is the diagnosis of an irreversible disease. The corruption and collapse of the rule of law, in the financial sphere, is basically irreparable. It’s not just that restoring trust takes a long time. It’s that under the new technological order in this field, it can not be done. The technologies are designed to sow and foster distrust and that is the consequence of using them. The recent experience proves this, it seems to me. And therefore there can be no return to the way things were before. In other words, we are at the end of the illusion of a market place in the financial sphere’

I’ve been thinking about if it is possible to finesse a solution across EU and there might be one:

It is practically impossible for the ECB or any EU body to calculate how contagion might be spread, however, that does not mean that it is impossible to do.

What can be done is to outsource that job. There are currently thousands of analysts who are trying to analyse counterparty risk and their work is already paid for. So, let them do their job -> Some banks will go under due to lack of liquidity, some banks will see collapsing share prices and some banks will experience both.

When the financial markets have identified the weak among themselves then the monitoring government can go in, recognise enough losses to wipe out both the original share capital and the retained earnings – bank is now nationalised and future profits will benefit that government. Possibly hit sub-debt with losses as well.

Loss recognition can either be to mark to market of assets or sale of assets. Possibly also by bond-exchanges benefitting the sovereign.

Repeat as needed until liquidity is restored.

The suggested socialising of losses by using the ECB or EFSF is similar to the view of a child: If everyone in europe gave me one euro then I’d be rich. The difference between the suggestion by the child and the financial industry is only that the financial industry is asking for a bigger amount.

Btw, would it be possible to cap the amount that can be lodged at the ECB? -> Interest charged and paid will go down.

@ John McHale

With the belated public blessing of Berlin, the ECB can now proceed to make the necessary interventions in the Italian and Spanish bond markets. In other words, it will be doing exactly the opposite of what it is supposed to be doing under the ESM.

The ESM also breaches two essential rules in the model for the joint production of confidence in the peculiar circumstances of a monetary union such as the euro as persuasively argued by Winkler.

First, PSI at any level is inherently illogical in circumstances where the aim is to restore confidence. The Greek experience is particularly telling. As other contributors have clearly demonstrated, PSI in its second bailout does not add up to a row of beans. The banks involved knew this but OTHER investors did not.

Second, as Winkler points out in his most recent presentation (slide 28), preferred creditor status of ESM “is a major flaw in the new euro area governance framework” as it is a “signal of mistrust by strong governments contradicting the very reason the ESM has been established for”.

The relevant extract in the ECB publication reads as follows (at least more clearly than can be read from the actual treaty texts).

“In line with IMF practice, the ESM will
have preferred creditor status as of July 2013
(see Box 1), while recognising the preferred
creditor status of IMF claims over ESM claims.
However, if ESM financial assistance were to
follow a European financial assistance programme
existing at the time of the signature of the ESM
Treaty, ESM loans would enjoy the same seniority
as all other loans and obligations of the beneficiary
country, with the exception of IMF loans”.

They’re doing a heckuva job creating wealth.

1. Sen. John Kerry (D-Mass.): $188.6 million
2. Rep. Darrel Issa (R-Calif.): $160.1 million
3. Rep. Jane Harman (D-Calif.): $152.3 million
4. Sen. Jay Rockefeller ( D-W.Va.): $83.7 million
5. Rep. Michael McCaul (R-Texas): $73.8 million
6. Sen. Mark Warner (D-Va.); $70.2 million
7. Rep. Jared Polis (D-Colo.): $56.5 million
8. Rep. Vern Buchanan (R-Fla.): $53.5 million
9. Sen. Frank Lautenberg (D-N.J.): $49.7 million
10. Sen. Diane Feinstein (D-Calif.): $46.1 million

Democracy, you will be missed…

“European Central Bank President Jean-Claude Trichet wrote a secret letter to the Italian government late last week “dictating” what Rome should do by way of economic reforms, Milan daily Corriere della Sera reported Monday. Bank of Italy Governor Mario Draghi, who will succeed Trichet later this year at the ECB’s helm, co-signed the letter, Corriere reported, without citing sources and without citing directly from the alleged letter. The letter set out to the Italian government what measures it should take and a timetable of their implementation, the paper said, adding that the ECB’s suggestions were tantamount to conditions the bank requires in exchange for its purchase of Italian government bonds. The letter asks for rapid privatization of municipal assets, liberalization of various sectors, and offers “detailed” indications on how to loosen Italy’s employment laws, Corriere said.”

@ Paul Quigely

The Galbraith piece is quite brilliant isn’t it? (I was going to post the link myself)

I see none of the esteemed economists or others of this site have seen fit to aknowledge your post or what Galbraith is saying. The system is a complete fraudulent mess & irredeemable. The economics ‘establishment’ should hang their heads in shame.

When the bewildered masses have been driven by ‘austerity’ (& coughed up as much as possible to the criminals of the financial elites) into chaos & division, & debt obligation transferred to public institutions, money will be printed (keyboarded), as required to the benefit of the banksters & wealthy elites. People will not realise that the money could just as easily be printed & spent to the benefit of the real economy of ordinary citizens. The corrupt system may then continue with debt servitude for the masses with even less public welfare should they fall from the yoke.

Frankly, discussing anything but reforming the entire system is merely rearranging deckchairs on the titanic.

@ Mike Hall

Thanks for that. This board is one of the things which gets me out of bed in the morning. We are all coming from a different place, and life is too short to investigate everything for oneself. I doubt that there is a single person here who thinks that eveything is grand really, or who imagines that our current local and global problems will just fade away.

Even if we take James Galbraith’s view on board, there is the problem of how to get from here to there. Without the active participation of those who know the inside workings of the present system, it simply can’t be done. As Mao Zhedong used to say, (even if he had dubious reasons for saying it), ‘let a thousand flowers bloom’.

@Bond Eoin Bond

“Democracy, you will be missed…”

May I ask where you pulled that quote from? This is the third time in 24 hours I’ve heard suggestions that such a letter exists (2 letters – 1 also to Spain).

I see that some of my esteemed colleagues have stopped trying to lay the blame for the decline in equities on ‘thin trading.’ Thin ice more like!!

Comments are closed.