Arnold Kling  

Europe's TARP

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Tyler Cowen writes,


6. Basically the ECB is monetizing bad government debt claims.

His other 11 short points also are interesting.

Peter Boone and Simon Johnson write,


This is a whole new level of global moral hazard - the result of an alliance of convenience between troubled governments in the south of Europe and the north European banks (and implicitly, north American banks) who enabled their debt habit. The Europeans promise to unveil a mechanism this week that will "prevent abuse" by borrowing countries, but it is hard to see how this would really work in Europe today.

As with Tyler's post, it was difficult to excerpt from the many interesting remarks.

My take is that this is like TARP in that it treats the European debt crisis as a liquidity problem, when at least in part it is a solvency problem. Lately, I have seen several writers argue that a Greek default is inevitable, and no one seems to argue otherwise.

Suppose that banks had to write down the value of their Greek debt by 30 percent or more. At the very least, this would eat significantly into their capital, and they would have to curtail lending. This in turn would make funds scarce for other sovereign debtors. In some sense, this is what should happen--interest rates should rise, and financial intermediation should contract.

Compare what happened in the mortgage market in the United States. Demand fell, as it should have. But supply did not fall as much as it should have, and interest rates did not rise as much as they should have, because the government took over Freddie and Fannie and told them to keep lending at below-market mortgage rates.

In Europe, governments need to cut back their spending, which would reduce the demand for sovereign credit. That may or may not happen--my guess is, mostly not. Instead, the new TARP for Europe will raise the supply of funds for sovereign debt. Perhaps this will indeed turn out to be a monetary expansion in disguise, in which case Scott Sumner should be happy. However, it looks more like the European Central Bank turning itself into a piggy bank, just as the Fed did two years ago. That is, the ECB is now focused above all on saving European banks, and it has lost interest in what happens to the overall European economy.

Tyler Cowen's line is that we are all poorer than we thought we were. I probably agree, depending what he means. The way I think of it is that we are lowering our expectations of future income and also perhaps discounting future income at a higher rate.

As we adjust our expectations of future income down, the large financial institutions tend to look like beached whales, or at least like whales swimming in shallow waters. What stands out is their large size relative to a shrunken economic outlook. The adjustment to a smaller financial system is one that policy makers are resisting with all of their might. From the perspective of taxpayers, the cost of this resistance could be high. The benefits could be nonexistent.



COMMENTS (15 to date)
Philo writes:

"Suppose that banks had to write down the value of their Greek debt by 30 percent or more. At the very least, this would eat significantly into their capital, and they would have to curtail lending." You forget that the Central Bank, as the "lender of last resort," could supply unlimited liquidity, making up for what would otherwise be a shortfall in lending.

Philo writes:

"[T]he ECB is now focused above all on saving European banks, and it has lost interest in what happens to the overall European economy." It sounds like you're saying the Greek bailout is a bad move. Why, then, are stock markets rallying strongly?

Boonton writes:

Philo, you forget that the central bank is the 'short term'lender of last resort.

In Europe, governments need to cut back their spending, which would reduce the demand for sovereign credit.

That's fine however a Greek default increases rates which is like an automatic spending increase which would offset spending cuts even by gov'ts which have been relatively responsible.

What's being missed here is the implications of monetary union. By joining the union, Greece gave up its own monetary policy. Yes it got somewhat cheaper rates in the bargain but it also has locked itself in the EU straight jacket. Likewise the EU has gotten a larger economic bloc to compete with the mighty US dollar and Yen on world markets. The implication to monetary union is that the weakest members either have to spin off on their own or the stronger members have to help pull them up. In other words, you could call this concept "Why it wouldn't be a good idea for the US to make Mexico the 51st State"

But if it did some type of policy would have to be put into place to bring the two economies more in sync. By buying Greek debt the Central bank may be doing the best thing to target monetary easing directly to the Greek economy (as much as you can do such a thing) while still leaving Greece somewhat at the mercy of the debt markets who are 'recalculating' its borrowing costs.

drscroogemcduck writes:

It sounds like you're saying the Greek bailout is a bad move. Why, then, are stock markets rallying strongly?

a) markets are rallying because banking stocks are rallying. but why should we protect status quo banks over the banks that would replace them (and are not part of the stock market presently)?
b) markets are rallying because people are looking for a place to put their euros which are going to start losing value.

thruth writes:

"Suppose that banks had to write down the value of their Greek debt by 30 percent or more. At the very least this would eat significantly into their capital, and they would have to curtail lending. This in turn would make funds scarce for other sovereign debtors. In some sense, this is what should happen--interest rates should rise, and financial intermediation should contract. "

I don't think that this is really what should happen. If the banks are in a precarious state, adding to their debt overhang won't help because it will cause them to *inefficiently* ration capital for the sake of propping up their bad balance sheets. However, it does seem like the correct policy response would be to let Greece renegotiate its debts then force capital infusions on every financial institutuion that suffers losses to avoid the fallout.

fundamentalist writes:

"Tyler Cowen's line is that we are all poorer than we thought we were."

Actually, Cowen wrote the the fundamental cause of the depression was that we thought we were richer than we were. Is this his theory of all business cycles, or just the latest one? And if true, then how were so many people fooled so completely? Of course, Hayek would point to the Fed's credit creation that drove the boom to an unsustainable rate. What does Cowen attribute it to? Or is he in the Caplan camp that just sees everyone but members of the AEA as irrational?

Doc Merlin writes:

"My take is that this is like TARP in that it treats the European debt crisis as a liquidity problem, when at least in part it is a solvency problem."

Agreed!

Miles writes:

It sounds like you're saying the Greek bailout is a bad move. Why, then, are stock markets rallying strongly?

a) Investors like short term results, not long-term progress. What percentage of investors are in the stock market because they think a company will pay out dividends to them that are worth the stock price, and what percentage just think they'll be able to schlepp off the stock to someone else at a higher price?

b) The markets are "rallying strongly" because fear of an imminent major collapse has abated. Keep in mind that while US markets are up 4-5% from Friday's close, they're only recovering from the extreme lows of Thursday and Friday, not jumping back to the highs of last Monday.

Doc Merlin writes:

Conspiracy theory:
Someone trashed the markets the other day, so it would look like the greek bailout was good news to the markets.

AJ writes:

Greece is like the question of whether the U.S. (i.e. other states) should bail out California at 100 cents on the dollar. The U.S. has currency union and California cannot depreciate/inflate its currency -- same as Greece.

It's funny that the people lobbying for California or Greece bailout (usually the lefties) are only helping the capitalist lenders at the expense of other states that would have to pay the bailout.

AJ

don writes:

AJ It's too bad you dont know that California is giving the federal government about 80 billion more than it receives back. New York state is in the same position. Who do you think is really paying for all of the imperialist USA'er wars? It's states like New York and California.

MernaMoose writes:

Philo,

Why, then, are stock markets rallying strongly?

Because people are stupid?

Nah, can't be.

MernaMoose writes:

I'd be okay with European nations bailing out Greece, if they got to take ownership of a % of Greek territory in direct proportion to the debt they'd assumed.

So the deal is that if Greece defaults then their country gets divided up by whoever pays for their stupidity.

Of course, then Europe would be at war over who gets to buy which parts of Greece.

There are times when I'm not sure it wouldn't have been better in the long run, to just let the Germans conquer and unify Europe and be done with it. But then, I've been accused of having a bad attitude about things like this.

MernaMoose writes:

Can't we just auction California off? I bet if the politicians knew their fiefdom could be repossessed, it would get their attention.

Hoover writes:

"Lately, I have seen several writers argue that a Greek default is inevitable, and no one seems to argue otherwise."

This may be because there are two types of commentators: The first makes predictions, the second avoids making them.

Commentators who make predictions tend to predict bad things.

So people who make an argument about the prospect of Greek default will tend to argue that default is inevitable.

By "making predictions", I don't mean betting. Betting would involve putting one's money where one's mouth is, but it would be interesting (just as an experiment) to see doomsayers confronted with a choice: Either stop predicting bad things or bet on your prediction.

My own view is that Greece might default. There again, it might not. Of that I'm sure.

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