Euro-TARP: The Euphoria Didn't Last

As I wrote here yesterday, we ‘ve just seen the remarkable spectacle of more than a dozen fractious finance ministers come together to puncture the risk of a Lehman-style market debacle. Taking a page out of Ben Bernanke’s playbook, they cobbled together and announced a package of 750 billion euros (nearly a trillion dollars) in liquidity guarantees.

Think about that number. It’s twice the size of Greece’s economy.  This wasn’t targeted at Greece. It was targeted at last week’s quickening alarm over the possibility of an interbank liquidity crisis.

I call this the Bernanke Doctrine. You respond to disordered credit markets by making short-term liquidity available in essentially unlimited size, as soon as you sense the beginning of the disorder. Although Bernanke got the idea from his studies of the dynamics of the banking crises that preceded the Great Depression, it makes all the more sense in an intensely interconnected world that trades at the speed of light.

How did it work? Well, you saw a nearly 8 percent relief rally in European stocks yesterday, after about 4 percent in Asia. US stocks rose about 4 percent. Interest rates on notes and bonds rocketed skyward yesterday, the euro briefly traded stronger than $1.30, and corporate debt spreads tightened.

So as of early yesterday, this looked like a brilliant performance for Euro-TARP.

As I pointed out here , however, the US rally had a somewhat heavy feel to it. This morning, stocks are lower in Europe by nearly 3 percent, and will probably fall in New York. Midcurve rates have resumed their downward march, with the 10-year US Treasury note yielding 3.47% (it was 3.60% yesterday), and the euro has retreated to below $1.27.

But look a little closer. The indicators of health in European interbank credit markets are basically unchanged from yesterday, and a little wider than last week. That does NOT look like progress.

What Euro-TARP did was to remove the risk of an acute credit crunch, which could possibly have bloomed into a systemic crash. What Euro-TARP did NOT do, is to improve the underlying dynamics that created the risk of an extreme event. Greece is still indebted far beyond any plausible ability to repay its creditors (including some major French and German banks). Several other sovereigns are in almost as deep as Greece. And there’s no end to the problem in sight.

What appears to be happening now is what several people have been predicting for more than a year: we’re seeing a “reset” in the market value of the debt of overextended states. The parents have finally taken away the credit card.

What this means for states like Greece going forward is unclear, but the most likely path is this: the EU, its member states, and the IMF will continue to provide low-cost loans to Greece (and probably some other states). This ought to reduce the threat of a Greek default (which is where the threat of systemic disorder comes from).

In return, Greece will have to keep promising to impose austerity on its people, but the pressure to actually do so will be balanced by the fact that it’s in no one’s interest (least of all Germany’s export businesses) to see widespread social unrest and deep recession on Europe’s southern flank. By the time the weather starts cooling this fall, the riots in Greece will be over.

And the value of the euro will need to fall, in order to reflect the misallocation of capital represented by a probably-permanent extension of low-rate loans to Greece and other states. When a kid gets into trouble with her new credit card, sometimes it makes the most sense for her parents to dig deep into their savings and pay off her debt. That’s basically what’s happening here.

And we learned something new about the management of systemic financial crisis. (Well, policymakers learned something new. The markets which imparted the lesson already knew it.) The lesson is that we can quell “long-tail” events, the acute panics that seem to be part of the DNA of financial markets. But doing so in a particular case does NOT mean that the underlying problems which led to the panic have been solved. That’s a separate effort. Euro-TARP bought some time, and not much more.

And finally, the status of US sovereign debt as the world’s safe-haven in times of disorder was emphatically proven yet again. Like morphine, this has an extremely dangerous effect on US policymakers and Congresspeople: it anesthetizes them into thinking that they have time to reduce our own fiscal overextension, which isn’t as bad as Greece’s but rapidly getting worse.
It defies all logic to assume, as our current fiscal policy tacitly does, that the US government will always be able to fund arbitrarily-sized deficits at low interest rates.  Someday, as with Greece, that will stop being true.

This story first appeared at The New Ledger.

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