Greek crisis continues to escalate

European leaders are now plotting another bailout for Greece, but it's only because the IMF has left them with no choice, according to Wolfgang Münchau.

For the past few weeks, European leaders have been considering options like a restructuring or reprofiling of Greek debt in an effort to solve the crisis. Instead, with the IMF planning to take out its cash unless Europe provides financial stability for Greece through 2012, EU leaders must again piece together a politically dangerous bailout. They're demanding the sacrifice of politically sovereignty to do so, which won't go over well in Greece and is unlikely to quell discontent in Northern Europe.

But even if this deal gets done, it won't be the last bailout for Greece, with the real existential question pushed back to 2013.

From the Financial Times Wolfgang Münchau:

Of course, the time will come when this game has to stop. I guess that will be sometime between 2013 and 2016. Greece and possibly other countries of the eurozone’s periphery will then have to default but the main creditors left by then will be EU governments and the IMF. The EU’s political leaders will then have to take a tough decision. Will they forgive Greek debt, which would be a massive fiscal transfer? Or will they allow the eurozone to crack up, which would also be a fiscal transfer?

The costs are high, with further transfers from the north to south threatening the credit ratings of more stable European sovereigns, not to mention political stability in those countries.

But not providing these fiscal transfers is also a threat, albeit of a different kind. It's an existential threat to the eurozone, to the European project, and all the continent's progress since the end of World War II.

A retreat to nationalism, already evidenced politically, would mean a retreat from Europe. For many European leaders, that smudge of failing Europe on their record is not acceptable.

It's going to take a political solution to solve the crisis, with the creation of a fiscal union and the retooling of current European power structures to cope with the demands. But the possibility of a nationalist "accident" remains very high.

More on unemployment

Conventional wisdom, as embodied by the O.E.C.D. economic outlook, has it that macroeconomic policies to combat unemployment have been exhausted. Not so, argues Paul Krugman who rightly believes that politicians pay too little attention to unemployment. Krugman identifies sensible actions:

• We could have W.P.A.-type programs putting the unemployed to work doing useful things like repairing roads — which would also, by raising incomes, make it easier for households to pay down debt. 
• We could have a serious program of mortgage modification, reducing the debts of troubled homeowners. 
• We could try to get inflation back up to the 4 percent rate that prevailed during Ronald Reagan’s second term, which would help to reduce the real burden of debt.

Unorthodox policies should continue to be debated even if they are not in line with conventional wisdom and diametrically opposite to the pain medication prescribed by Republicans.

These policies would be unorthodox — but so are the economic problems we face. And those who warn about the risks of action must explain why these risks should worry us more than the certainty of continued mass suffering if we do nothing. 

In pointing out that we could be doing much more about unemployment, I recognize, of course, the political obstacles to actually pursuing any of the policies that might work. In the United States, in particular, any effort to tackle unemployment will run into a stone wall of Republican opposition. Yet that’s not a reason to stop talking about the issue.

What's holding back the U.S. economy?

After a short growth spurt the U.S. economy has been slowing down again. What's in the way of a strong economic recovery here in the U.S.? High household debt and unemployment, which leads to low consumer spending. 2/3 of America's economy is consumer spending.  The number of people in the workforce are at decade lows (see black line in the graph below).

Source: Calculated Risk

Businesses' main concerns are sales - not taxes or regulations

Source: NFIB

What we are facing is a demand side problem. With monetary stimulus being close to ineffective, fiscal expansion together with a restructuring of household's balance sheets are the most promising ways to re-accelerate the economy. Yet there is almost no chance of that happening. Austerity measures pushed through by Republicans are irresponsible at this stage in the economic cycle, as it will lead to further pressure on demand.

Is the ECB voting itself out of existence?

The European Central Bank is fiercely opposed to a Greek restructuring and has threatened to refuse Greek debt as collateral was the country to restructure.  Were the ECB to take that step it would bring about a collapse of Greece's banking system and would likely cause bank runs in other countries. While part of the ECB's rhetoric may be posturing, its rhetoric feeds further into a cycle of uncertainty surrounding the Eurozone's monetary union.

as of May 24, 2011. Source: Atlanta Fed (ht CR)

The ECB is not facing up to reality. Peripheral countries' debts are unsustainable, most acutely in Greece, and need to be restructured. The dogmatic pursuit by the ECB of further austerity measures in Greece will only depress the economy further and make a disorderly debt restructuring more likely.

The bank's disregard for the political dimension is startling: that the Greeks had enough of what they rightly perceive are policies imposed by outsiders who don't share in their pain. In the end, the European monetary union depends on continued domestic political support of all countries involved. In taking positions that may eventually lead to the EMU's breakup, the ECB is getting close to voting itself out of existence.

A rally Thursday in Athens against an austerity plan before the Greek Parliament (courtesy Reuters/New York Times)

The ECB, IMF and European finance ministers would be well advised to prepare in private for an orderly restructuring of peripheral countries' debts and ready measures to protect Europe's banking systems (such as large capital injections). Delaying the inevitable will only increase the eventual cost and recovery.

Ruling German party suffers another defeat

The poor showing of Germany's ruling party in regional elections in the city state of Bremen today is a negative for the Euro. Germany together with France are the key players in keeping the Euro alive by providing financial aid to peripheral countries in crisis. Germany's ruling party has an incentive to change the political discourse - to show that chancellor Merkel is serious about German interests and about protecting the Euro's value.

Protecting the Euro's value is code for staying the course and extricating more austerity measures from peripheral countries. Meanwhile, nearly daily protests in Greece and new protests in Spain show that austerity measures are unreasonable in the long-term. Austerity measures depress economic growth which in turn renders debt payoff virtually impossible in the long run. 

Rough rule of thumb: an economy needs to grow 5% to afford paying a 5% interest rate on its debt. For comparison: Greek economic growth in thelast quarter minus 5%, yet the country is currently paying +7% on "rescue facility" loans (and 17% on its free floating 5-year debt).

Iceland's currency and growth

Ireland can be forgiven looking towards Iceland. Since Iceland's de-facto default and currency devaluation economic growth has picked up. In the absence of a currency devaluation - impossible for country in the a euro currency area - and the unlikely success of austerity measures, default is increasingly looking like the less of two evils.

Iceland and GDP - Signs of growth (blue) after currency depreciation

Source: Bloomberg

Naming this Blog

This Blog's name is a reference to the Fed's zero interest rate policy (ZIRP). The Fed entered the era of ZIRP in December 2008 when it lowered the short-term interest rate to effectively zero. Current economic conditions suggest the interest rate should be negative: The supply of savings ("loanable funds") is greater than demand for savings. For practical reasons the Fed cannot lend out funds at a negative rate. Monetary policy loses its effectiveness.

What do I mean when I say that current economic conditions suggest a negative interest rate? I am referring to the Taylor rule. The Taylor rule is a simple response function which suggests that the Fed raise or lower its interest rate according to changes in inflation and level of unemployment. The model currently suggests an interest rate of about minus 5.25%.

The model has performed well: Below is the predicted interest rate based on the Taylor rule (blue line) and the actual interest rate at the time (white line):

Note: I am aware that John Taylor himself prefers a different version of his rule. I don't find his arguments particularly convincing and agree with Brad DeLong

Paris believes Dominique Strauss-Kahn has no diplomatic immunity

Le Monde:

Does Dominique Strauss-Kahn have diplomatic immunity? After the indictment of the IMF's managing director for sexual assault, kidnapping and attempted rape, the Elysee Palace is looking into whether Strauss-Kahn has immunity from prosecution. The answer for now is no. "There is nothing that would allow us to conclude that he has any diplomatic immunity and the Americans consider him not to have immunity" said one French politician.

Heads of major international institutions have immunity almost equivalent to those of ambassadors and heads of state. "Our embassy in Washington is keeping abreast of developments" said one top French official.

The first issue is clarifying how Washington applies diplomatic immunity to heads of major international institutions located on its soil. The IMF in itself has an ambiguous status, as it is established as a bank. The second issue concerns the range of acts covered by diplomatic immunity, particularly within the United States.

Everything hinges on the specific charges. A diplomatic source said that sexual harassment may be covered but not kidnapping. The IMF Articles of Agreement (Article IX) specifically state that its officials "cannot be prosecuted for acts performed by them in exercising their official functions, unless the Fund waives this immunity". Strauss-Kahn was apparently not in an official capacity in New York the day the incident took place.

French authorities have preliminarily concluded that Strauss-Kahn is not entitled to special treatment. "To me, there is no immunity" said one adviser to Mr. Sarkozy. "It is a matter for the IMF and the host country, the United States. His French citizenship is not a consideration in this matter”, said a French diplomat.

Based on the analysis of his lawyers, Mr. Strauss-Kahn will likely refine his legal strategy. He has pleaded not guilty in New York. Strauss-Kahn has been visited by the consul of France in New York and had the assistance of a lawyer.

In his function as director of the IMF, Strauss-Kahn is scheduled to participate in the G8 meeting in Deauville on May 27 and to meet heads of state from Tunisia, Egypt and other African nations.

--Le Monde blog post, translated into English

QEII and higher interest rates?

The end to the Fed's QEII program is unlikely, in itself, to lead to higher interest rates. The program's end has been widely telegraphed and is thus already "baked" into current interest rates. Let's not forget that when QEII was announced, markets rallied and interest rates increased on expectations that treasury purchases would boost economic growth. Economic indicators have, however, remained mixed since. If economic indicators continue to stall, private demand for Treasuries will more than make up for the lack of Fed purchases and push yields lower.

Rates as of May 13, 2011

5-year Treasury: 1.83%

10-year Treasury: 3.17%