The Eurozone Crisis is Back, and All of Us Are in its Crosshairs

The Eurozone Crisis is Back, and All of Us Are in its Crosshairs

July 25, 2012

Once again, the Eurozone debt crisis threatens to suck the oxygen out of the global economy. Two years of austerity across most of Europe continues to produce the predicted effects: We learned this week that Europe\’s private sector keeps on contracting. Moreover, global investors began to bail again on Spain, driving interest rates on ten-year Spanish government bonds to an unsustainable 7.6 percent. Greek, Portuguese and Irish public finance faced comparable rates, so they have to rely on bailouts. Yet, there isn\’t nearly enough money in those bailout facilities to rescue Spain, too. That\’s why this week, Moody\’s downgraded its outlook for the region\’s strongest economies, Germany and the Netherlands. If anything, that move was cautious. If Spain spirals into default, it would likely trigger a continent-wide banking crisis, followed in all likelihood by a real Depression. It also could upend our own economy on the eve of the election.

It\’s a crisis with lots of nubs. For one, Spain is in the middle of the world\’s sharpest housing contraction and a recession currently forecast to last into 2014. That what happens when austerity dramatically slows public spending while the nation\’s private banks are writing down tens of billions of Euros in mortgage loans gone bad. The result is that government revenues have been falling faster than government spending, piling up more debt — and now several of the country\’s provincial governments say they also cannot keep on going without a lot more support from Madrid.

That is why foreign investors see a growing risk that, sometime soon, Spain\’s government won\’t have the money to service its fast-rising debts. The 7.6 percent interest rate on new Spanish debt is the market\’s current demand to offset that risk. But unless Brussels and Berlin step in with new, credible assurances for those holding Spanish bonds, the interest rate will keep on rising until everyone begins to dump the bonds. Madrid would have to try to borrow even more money, and if it cannot, a sovereign debt default would quickly follow.

Eurozone leaders have tried to head off all of this, but only through a series of indirect and inadequate measures. The immediate threat from a major sovereign debt default is the collapse of dozens of large banks that hold the sovereign debt. German and French banks, for example, hold $600 billion in Spanish bonds. The Eurozone could have followed the basic rule of monetary unions, and used the European Central Bank (ECB) to guarantee those bonds in some way. That\’s what the Federal Reserve has done for a century here (and the Treasury did it for 50 years before the Fed was created). Yes, it would be harder for the Eurozone to pull that off, since it has no single national government. But it does have a single central bank.

Yet, Angela Merkel has consistently vetoed that course, preferring instead to build a new political and economic environment that could head off future defaults. So, while Greece and Spain slowly sink, with Italy not far behind, Merkel pursues continent-wide banking regulation to discourage future bank runs from one Euro country to another. She also is pushing for continent-wide fiscal arrangements, to head off the large deficit spending down the road that can cripple an unproductive economy when bad times strike. For the current crisis, she has agreed to spend €100 billion from the Eurozone to pay the bills of Greece\’s government this year. She also has allocated another €100 billion to bail out the balance sheets of Spanish banks. And she has allowed banks in Germany, France, Italy, and elsewhere to use their Spanish and Italian bonds as collateral from hundreds of billions of Euros in low-cost loans from the ECB.

This week, the markets rendered their latest judgment on those steps. The sky-high interest rates now in Greece, Spain, and looming in Italy tell us that all of Mrs. Merkel\’s handiwork will not be enough to head off a sovereign debt default. The results could be disastrous for many major European banks and the Eurozone economies. How bad could it be? Even before facing final default, Greece has seen its GDP shrink by 25 percent, its average wage fall by nearly 20 percent, unemployment rise past 20 percent, and government pensions cut back 30 percent.

One final word. On this side of the Atlantic, the political season has made every development fodder for campaign attacks. So, we can count on the President\’s opponents charging that America under his leadership is following the path of Spain and Greece. That is nonsense. The Eurozone faces a crisis of confidence about the capacity of its less productive economies, burdened by deep recessions and large debt overhangs, to honor their future debts. The irreducible proof is the rising risk premium on new Greek, Spanish and Italian bonds. There is not the slightest hint of such doubts about the United States. The interest rate on ten-year U.S. Treasury bonds is 1.75 percent, less than one-fourth Spain\’s level; and actual yields are even lower. And while Europe is deep into a double-dip recession with fast-rising unemployment, we have had nearly three years of slow but steady growth and job creation.

To be sure, a European banking crisis triggered by a sovereign debt default, one which spread from Spain to Italy and then across the continent, would almost certainly end our own expansion. American exports to Europe — our largest foreign market — would fall sharply. American banks would be hit by losses on thousands of investments and other deals that involve European banks which such a crisis will take down. In the end, our presidential election may well turn on events entirely beyond the influence or control of either President Obama or former Governor Romney. Not even their legions of consultants and operatives, and the stream of billionaires funding the campaign\\\’s television wars, will be able to override the economic consequences here at home of either a full-blown Eurozone meltdown or, for that matter, the successful resolution of the crisis.

The LIBOR Mess Could Be the Biggest Financial Fraud in History

July 11, 2012

If our financial policies were based on recent experience, the debate over government regulation versus self-regulation by Wall Street would be settled. Yet, the refrain that the big banks know best remains the default position of most American conservatives and many policymakers. This childlike faith will be tested by the new scandal swirling around some of the most basic interest rates in the global economy, the LIBOR or London Inter Bank Offered Rates. This past week, Barclays Bank admitted that it secretly manipulated LIBOR rates for years, all to pad its own bottom line. And Barclays is not some lone, bad apple. Investigators here as well as in London, Brussels and Tokyo are hard at work looking into reports of similar manipulation by other big players, including Citigroup, Deutsche Bank and J.P. Morgan Chase. This could well turn into the largest consumer fraud ever seen.

It will take months for the general public to catch up or catch on to what this latest scandal is about. It starts with one basic fact: LIBOR interest rates are not set by the supply and demand for credit, like many other rates. Instead, every morning, representatives of the 18 largest Western banks report on what they expect to pay to borrow funds from each other (Inter Bank) in the future. Under LIBOR rules, the four highest and four lowest estimates are eliminated, and the average of the rest becomes the official rate. For example, in 2007, the LIBOR rate to borrow three months in the future, in dollars, averaged 5 to 5.5 percent.

LIBOR rates are a very big deal, because they are benchmarks for countless other interest rates. The majority of adjustable rate mortgages, for example, are set at a LIBOR rate plus 2 or 3 percentage points. So are millions of student loans, auto loans, and credit card finance charges. LIBOR rates also are used to set or reset small business loans, futures contracts, and interest rate swaps. All told, an astonishing $360 trillion in loans around the world are indexed to LIBOR. That is more than five times the value of the worlds entire GDP this year.

One reason that LIBOR has such a far reach is that there are numerous LIBOR rates for different purposes. Each rate has a time frame rates for loans one day from now; one month, three months and six months out; one year, five years and ten years from now, and so on. There are 15 such time frames, all told. In addition, separate LIBOR rates also are provided for dollars, Euros, yen, and seven other currencies. The integrity of these LIBOR rates, however, depends entirely on the honesty of banks reporting the rates they actually would to expect to pay. Inevitably, we got what we should have expected.

So, when Barclays (and almost certainly others as well) had investments that paid off, or simply paid off more, when interest rates rose, it simply reported a higher figure to LIBOR in order to nudge up the average. And that usually led to higher interest rates for millions of other businesses and people with loans indexed to the LIBOR. Sometimes, it worked the other way. In late 2008, Barclays (and probably others) low-balled the rates they reported for LIBOR averaging. The purpose was to make themselves look sounder than they actually were, since they expected to borrow at low rates. They presumably figured that might reassure their shareholders and perhaps even dampen public demands for tighter regulation.

For several years, academics and a number of market followers warned that something funny was going on with LIBOR. The evidence was not hard to find. For example, the spread or difference between U.S. Treasury rates and LIBOR rates for loans of the same time frame began to widen. From 2000 to 2006, LIBOR rates averaged one-quarter of one percentage point above Treasury rates, and the two rates moved up and down together in lock step. In 2007, however, that spread more than doubled to nearly two-thirds of a percentage point, and their movements up and down did not track each other so closely. By 2008, the difference in the rates was five times what it was in 20002006, averaging 1.3 percentage points, and the up-and-down movements of the two rates no longer tracked each other.

All of the obvious parties that might have done something about it the Fed and the SEC, for example, or the Financial Services Authority in Britain apparently looked the other way. This tolerance for sub rosa interest rate manipulation has cost millions of ordinary Americans and Europeans a great deal of money. Early analysis suggests that for several years, the LIBOR was off by an average of 30 to 40 basis points. (A hundred basis points equal one percentage point in an interest rate.) That is enough, for example, to add $300 to $400 to the annual cost of a $100,000 loan.

In 2007 and 2008, Americans held $11.1 trillion in outstanding residential mortgage debt. At the time, between 30 percent and 40 percent of that debt carried adjustable rates. If the bankers manipulations of the LIBOR was responsible for raising LIBOR rates by just 20 basis points in that period, their shenanigans added between $6.6 billion and $8.9 billion to the yearly interest paid by American homeowners. And those mortgages account for less than one percent of all of the financial assets and instruments affected by manipulated LIBOR rates.

LIBOR hearkens back to a time when finance operated like a gentlemens club, and its leading members behaved honestly. That is a universe away from the current Wall Street culture and behavior. They take out bets and pay themselves fortunes for doing so, even when they cannot make good on those bets without taxpayer bailouts. They create securities they know are likely to fail, on behalf of clients prepared to bet against those instruments and then pawn off the same securities on other clients as safe investments. And now, we also know that when they bet on interest rates rising or falling, they stacked the LIBOR deck to nudge rates in the direction that made money. And they left everybody else with the bill.

So long as big finance will do almost anything to goose its own profits and bonuses, self-regulation is a dangerous myth. It should give way to sound law enforcement, which in economic terms is government regulation.

A New Economic Challenge Facing Europe and the United States

July 2, 2012

I spent much of last week in Geneva, Switzerland. Even in that city of global institutions, in the European country most untouched by the continents sovereign debt crisis, most conversations found their way to hand-wringing over Europes economic decline. As the Eurozone governments struggle to save their common currency, it is increasingly clear that the misguided austerity policies of many European governments have exacted large tolls on employment and growth. Moreover, Europes economic problems will last much longer than the current debt crisis, even if it ends better than anyone now imagines. One reason is that capital investment, the foundation of future growth, has been depressed since the crisis of 20082009.

With capital investment persistently slow across most of Europe, political and economic leaders need to ask themselves, where would additional investment produce the greatest benefits? One part of the answer is the same for Europe as it is here, in the United States. Perhaps the single most important area of investment today lies in the telecommunication infrastructure, networks and devices on which business and social activity increasingly rely. Earlier this year, NDN issued a new study I wrote with Kevin Hassett of the American Enterprise Institute on one aspect of this development. We investigated the impact on job creation in the United States associated with the transition from 2G to 3G infrastructure and devices. We found that this shift created almost 1.6 million jobs from April 2007 to July 2011, even as overall U.S. employment fell by nearly 5.3 million jobs over the same years.

The current transition to 4G networks and devices should produce a similar economic bounce, so long as the necessary policies and capital investments are there to help drive it. For example, since 4G involves more intensive data streams, the transition requires additional spectrum. It will take strong White House leadership to ensure that the private investment needed to build out more spectrum and related, next generation IP broadband infrastructure are available to support 4G services and promote the Presidents larger goals of a strong recovery, job creation and universal broadband.

Like the economy they enable, these technologies are inherently global. So, the same dynamics apply to Europe, even in its current straits. Throughout much of the 1990s, Europe had a real edge over the United States in advanced telecommunications, especially in the mobile or wireless space. That is no longer the case. Europes transition to 4G, for example, has been much rockier than ours. In its latest Digital Agenda report, the European Commission noted that while people and businesses in Europe are generating enough digital demand to put Europe into sustainable economic growth, this potential is undermined by a failure to supply enough fast internet, online content, research and relevant skills.

Two years ago, the European Union set a goal of doubling its public investments in advanced telecommunications facilities and skills by 2020, which assumed annual growth in these areas of about six percent. So far, the actual growth has averaged just two percent. Moreover, private capital spending on 4G infrastructure across Europe also has lagged behind the United States. In 2011 and 2012, American telecom companies invested more than $25 billion per-year in wireless facilities alone. Yet, since 2007, comparable investments across the European Union, with a GDP slightly larger than ours, have been 15 percent to 40 percent less than in the United States. In response, European Digital Affairs Commissioner Neelie Kroes, warned recently, Europeans are hungry for digital technologies and more digital choices, but governments and industry are not keeping up with them. We are shooting ourselves in the foot by under-investing.

The substantial effects on employment which we have now documented from the transition from 2G to 3G, and now from 3G to 4G, are signs of larger economic dynamics at work. Across professions, industries and nations, Internet technologies have become integral parts of most economic activities and operations. Moreover, with the advent and dispersion of 4G technologies, wireless Internet has begun to assume a pivotal role in these operations and activities. National policy and business strategies can ignore these developments only at great cost.

To be sure, both Europe and the United States face special and more immediate challenges today, which neither has yet mastered successfully. But the task of promoting investment in 4G infrastructure and networks is well within the capacity and understanding of all modern governments and businesses and should be a national priority. Fifteen years ago, in the transition to 2G, the United States followed Europes example, to Americas benefit. Today, it is Europes turn to follow our spectrum policies and investment strategies.