By Richard Alford, a former economist at the New York Fed. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.
The EU, IMF and friends have rolled out the shock-and-awe bailout package for Greece and the Euro. This package supersedes earlier packages and has already generated a significant volume of comment and criticism. The financial markets were awed, but political foundation is showing cracks, i.e. the German election results and the earlier riots in Greece.
Unfortunately, there is no agreed-upon set of criteria to grade or evaluate financial rescue packages. The stakes are high, decisions must be made with imperfect information and in a dynamic setting, and there are numerous uncertainties. Hence the decision to mount this financial rescue package and decisions to go to war have much in common. This suggests that it might be useful to examine this financial rescue package in light of what has become known as the Powell doctrine. Named after the former US Secretary of State Gen. Powell Colin, it specified the criteria under which the US would take military action. It provides a pre-existing, independently determined set of criteria by which complex international decisions can be judged.
The Powell Doctrine consists of eight criteria, all of which must be satisfied for the US to take military action. Unfortunately, a quick review suggests that the EU and the IMF would not be able to justify this rescue package if the Powell doctrine were employed as a test. The criteria are:
A vital national interest is threatened (In this case, a vital supra-national interest is threatened)
The current crisis is clearly seen by the European political leadership as threatening both political and economic stability in the EU. The behavior of the financial markets suggests that market participants also see profound repercussions should Greece or any country in the EU default on its debt.
There is a clear, attainable objective
There is a clear and attainable objective, i.e., preventing a default by Greece. The package is large enough to prevent an immediate default by Greece and stabilize markets in the near-term. There are, however, questions as to whether or not the bailout package will be structured in a way that will prevent this crisis from re-emerging, spreading or encouraging future similar crises.
The risks and costs been fully analyzed
It is doubtful that all the analyses have lead to a clear ordering of the possible outcomes. The full nature and extent of an unchecked crisis is unknown and the authorities are clearly operating in the context of Knightian uncertainty and unknown unknowns. Given that not making a decision is to make a decision, a course of action must be adopted, but should allow for course changes in the event of unforeseen developments. However, it seems unlikely that the cumbersome EU decision-making machinery is capable of drawing up or acting on contingency plans.
All other policy means been fully exhausted
Given market conditions, there is no alternative to official intervention if Greece is to remain in the currency union. However, there may be alternative strategies.
If the ultimate goals — preserving the economic and political stability of the EU — are more important than any single country remaining a member of the currency union, perhaps the EU should take a step back from its borders and choose a more easily defensible position. It would also serve to reduce any moral hazard incentive that rescuing Greece might create.
There is an available exit strategy to avoid an endless entanglement
Assuming the package is adopted, do the EU and the IMF have an agreed-upon operational plan to extradite themselves from supporting Greece, et al if the agreed-upon economic and fiscal reforms are not enacted or do not succeed in reducing Greece’s et al fiscal and external deficits? Is there agreement on exactly what will constitute non-compliance and initiate the exit plan? The absence of an agreed-upon exit plan might increase the probability of agreement and near-term stability, but it would imply greater instability and cost should the package fail after having been implemented.
The consequences of the action been fully considered
Have the EU states and the IMF considered all the possible outcomes of their action and the ramifications thereof? Given the speed with which the crisis broke, it is probably impossible for the EU and the IMF to have evaluated all the possible contingencies and outcomes. However, not to make a decision is to make a decision, but whatever the decision they must have contingency and exit plans at the ready.
The American people support the action (In this case, the electorates of the EU countries support the plan)
Is there sufficient political support within the EU, especially Greece and Germany, that the agreed-upon plan can succeed? If there is a change of government in one of the EU countries and that country becomes unwilling to do its part, what will happen to the plan? Is the EU in a position to force a democratically elected government of a member state to adhere to a plan agreed to by the prior government? The political opposition to the financial rescue package in many countries across Europe is reminiscent of the political divisiveness in the US associated with the Vietnam War, which gave rise to the Powell doctrine.
The US has genuine broad international support (In this case, countries inside and outside the EU must alter policy so as not to frustrate adjustments required by the plan. The financial markets must be supportive of the rescue.)
Given that adjustment of the external accounts is necessary, will the non-crisis countries be willing to see deterioration in their external positions in order to facilitate the external adjustment of the countries in crises? Given the economic climate, it is unlikely that leadership in any country will be in a position to sacrifice growth and jobs.
There is a corollary to the Powell doctrine: when a nation is engaging in war, every resource and tool should be used to achieve decisive force against the enemy, minimizing casualties and ending the conflict quickly by forcing the opposition to capitulate. In the context of financial market bailouts, this corollary translates to: the size of the bailout package must be sufficient to preempt any market challenge.
On Sunday night, the EU acted in a manner consistent with the corollary. It rolled out a package with a headline number that awed the markets.
However, the use of financial shock and awe reveals an internal inconsistency. In the original military context, the corollary did not conflict with any of the criteria. In this case, a package large enough to guarantee success in the short-run will increase the moral hazard incentive, preclude any market-based pressure on politicians to enact fiscal reform, and may increase political opposition in the countries supplying the assistance.
There are other inconsistencies, or more correctly trade-offs, inherent in financial rescue packages. The absence of any explicit exit strategy may increase the likelihood of short-term success, but it increases the moral hazard incentives and increases the opposition in countries whose participation in part depends on well-defined end games. The degree of austerity involves trade-offs between reducing the opposition to austerity in Greece on the one hand and both decreasing opposition to any rescue package in Germany and promoting a long-term solution on the other. The desire to minimize downward pressure on real incomes and insulate financial balance sheets may mitigate any efforts to promote sustainability.
The stance of the ECB is also telling. The ECB could have agreed to take the lead as the Fed did in the USA, but it did not. Given the political dimension of the crisis, it could prove to be very costly to the ECB in if it losses credibility as it is perceived to have compromised its political independence. The Fed’s involvement in the bailouts in the US has certainly proven to be costly as the Congress appears set on expressing its displeasure by requiring a wider range of GAO audits.
The package is clearly an effective short-term palliative. Its curative powers remain in question. In the absence of market signals and discipline, it is not at all clear that the political elites in Europe will have the will to discipline each other. After all, Europe is in this crisis, because fiscal discipline has been absent despite long standing pledges and limit fiscal deficits.
If fiscal discipline emerges in the near term, it will only have happened because the markets said “no mas”. Yet, the first act of the politicians was to use shock and awe to discourage any further market protest even though they agree that the fiscal trajectories were unsustainable and prior international agreements had been totally ineffective in promoting fiscal consolidation. We know that markets are not always correct, but the record of policymakers is certainly no better.
The shock and awe strategy is a clear sign to the markets: trade based on the fundamentals at your own peril. What are the markets to use in evaluating European sovereign debt if not fundamentals including debt burdens? Are they to trade based on politicians’ promises that all the PIIGs will be little Germanys? (In fairness, the EU is not alone in shooting the messenger when it doesn’t like the message.)
The repeated interventions in major asset markets by policy makers also runs the risk of leaving investor and market decisions unmoored from fundamentals. This would be most ironic. The original criticism of the markets in this crisis was that they ignored the fundamentals (LTVs, borrowers’ income, debt service ratios, etc.) when making real estate loans and investments, but now the authorities are taking action to discourage investors and the markets from considering debt burdens etc.
The opposition in Greece which is openly opposed to the level of austerity agreed to by current government, and the election results in Germany, indicate that the national agreements necessary to put the plan in operation are far from a certainty.
Conspicuous in its absence in the Sunday night announcement was any mention of what the cost might be.
There is the problem of the absence of exit strategies. What happens if the individual countries choose not to be part of the SPV? What happens if deficit reduction targets are not met?
The shock and awe aspect of the plan announced on Sunday night was the easiest part of what will be a long and difficult journey to sustainability. It bought policy makers time. Now all they have to do is deliver what they promised to deliver numerous times before.
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Yes, the shock and awe plan bought policy makers some time.
About 24 hours……..
I think this will run for a bit longer than 24hrs–I’d give it at least a couple of weeks, barring some idiot Greek Minister calling the Germans Nazis or something like that. It could very well run another few months, even.
After that? Ouch.
The Plan has followed the French diplomatic template precisely: mount an alligator’s mouth on a mosquito’s ass. The real achievement has been to sucker the USA into supporting EU bailouts on French terms.
Pocket Bazookas are sooo last decade.
Looks like their Viagra might have been just a placebo.
They better show more than the ECB buying PIIGS government bonds. Fast.
A view from Europe:
Dont’t forget that, imho, the ECB was ‘forced’ into the circumstances,its director publicily stating its independence at the end of the meeting, forced the FED
to reopen the swap-lines, in line with a strange speech
given by Mr Trichet on 04.26.2010, following the IMF’s meeting in Washington in front of the CFR on ‘global governance:
http://www.bis.org/review/r100428b.pdf
See the half-page press release posted on the ECB’s website
following the ‘agreement’
http://www.ecb.int/press/pr/date/2010/html/pr100510.en.html
Already starting yesterday, Axel Weber, Bundesbank’s director
and projected succesor of Sieur Trichet took a very hard stance. As Simon Johnson puts it, they got forced in.
Willem Buiter presciently updated and posted a column
on the problem of the ECB: ‘Fiscal dimensions of central banking’on 05.08.2010:
http://www.voxeu.org/index.php?q=node/3333
I understand the ECB is now printing euros and giving them to European banks in exchange for PIIGS bonds. And what are these banks doing with these euros? Selling them for USD? Or gold? The euro has already given back all of its gains from Monday.
It seems more certain every minute that this toilet paper will eventually wind up on the Fed’s balance sheet next to the Red Roof Inn loans.
I think that two main aspects of the Powell Doctrine, which if never spelled out were certainly always implicitly recognized, were:
1. If possible, do something when you can, not when you are forced to
Europe failed *miserably* on this test
2. Always have an escape plan and know how you will extricate yourself
I see no signs of anybody (in Europe or America) having even seriously thought about how they will reverse their holdings, or even not finding themselves increasing their holdings on a regular basis. I very seriously believe that this is because everybody knows that there is no way out.
The French appear to have their escape plan.
1. Get the ECB to buy their PIIGS bonds for euros.
2. Then exchange these euros for gold and dollars, leaving Uncle Sucker holding the bag.
The Shock and Awe is for us, the great unwashed masses.
We’ve been shocked and awed so as not to notice that another multi-trillion dollar theft of taxpayer money direct to big banks is taking place.
And with that act of handing over the purse to the mugger, the EMU signed it’s own death certificate.
The Powell Doctrine is little more oriented towards conventional warfare where overwhelming power is an asset. I see the recent conflict in Europe as more of an insurgency and different rules apply there. Although there is one really good example of a “shock and awe” strike wiping out an insurgency; usually these are long and drawn out affairs. The good news for Europe is that since this is a domestic insurgency (although heavily reinforced by foreign Anglo-Saxon suicide-bombing hedge funds), usually the home government wins these battles, but it can take quite a long time to reach a decisive result.
One of the first moves in any counter-insurgency (COIN) operation is the separate the foreign insurgents from the domestic ones. We saw the result of not doing this in Iraq with the US’ total failure to seal the Iraqi borders. European leaders seem to understand this as there are currently moves to ban foreign hedge funds from European soil. But they will have to work faster and to also ban any insurgent Anglo-Saxon banks from Europe as well.
Mao famously saw insurgents as fish swimming in the sea of peasants. Once the Anglo-Saxon terrorists are dealt with, it will be time to drain the swamp of home-grown European financial insurgents. This is where the conflict becomes more political than military. Obviously the insurgency rose for a reason (high deficits in some Eurozone countries) and these political issues must be resolved to help drain the swamp. But the financial insurgents will use propaganda with any fellow travelers they find in the established media to try to build a relationship with the peasantry. They will also be waiting to exploit any local government government missteps or atrocities to help de-legitimize the European government. Here they are assured of constant support from their Anglo-Saxon media allies.
But while normal insurgents can blend in with the local population; the European fifth-columnist banksters and hedgies will find it very difficult to hide one they are separated from their Anglo-Saxon brethren. After nationalizing insurgent banks, European leaders will have to create “strategic hamlets” where they can send guerilla banksters to be interrogated and in a very few cases the survivors can be re-educated.
Normally this would all take years. And it takes highly trained financial COIN experts to gather intellgence and resist overreactions. But there is, as I alluded to earlier, another way. There is at least one recent example, in Syria, of a shock and awe scenario actually working against insurgents. Now of course I find the current breed of European leaders pretty clueless when it comes to these kind of things but one cannot deny that within the German and French national DNA there may be enough residual military strategic brilliance as well as pure cold-blooded ruthlessness that maybe this example could be used against a financial insurgency.
After years of half measures and dithering by the Syrian government against the Muslim Brotherhood, in 1982 the Syrian regime actually got serious. From Wiki:
In 1982 the regime of Syrian president Hafez al-Assad was on the point of being overwhelmed by the countrywide insurgency of the Muslim Brotherhood. al-Assad sent a division under his brother Rifaat to the city of Hama, known to be the center of the resistance.
Following a counterattack by the Brotherhood, Rifaat used his heavy artillery to demolish the city, killing between ten and 25 thousand people, including many women and children. Asked by reporters what had happened, Hafez al-Assad exaggerated the damage and deaths, promoted the commanders who carried out the attacks, and razed Hama’s well-known great mosque, replacing it with a parking lot. With the Muslim Brotherhood scattered, the population was so cowed that it would years before opposition groups would dare disobey the regime again.
From this massacre, the brilliant miltary strategist Martin Van Creveld develeped his own “Hama Doctrine” on how to quickly wipe an insurgency:
1.There are situations in which cruelty is necessary, and refusing to apply necessary cruelty is a betrayal of the people who put you into power. When pressed to cruelty, never threaten your opponent but disguise your intention and feign weakness until you strike.
European leaders excel at feigning weakness. So far so good!
2.Once you decide to strike, it is better to kill too many than not enough. If another strike is needed, it reduces the impact of the first strike. Repeated strikes will also endanger the morale of the counterinsurgent troops; soldiers forced to commit repeated atrocities will likely begin to resort to alcohol or drugs to force themselves to carry out orders and will inevitably lose their military edge, eventually turning into a danger to their commanders.
The jury is still out but I don’t think anyone would really say that the move last weekend struck much fear into anyone, least of all the financial insurgents. This will soon become clear and then we will know if we are still in the “feigning weakness” stage. Only after much bankster blood is (figuratively) staining the cobble stones of European capitals will a strong enough message have been sent.
3.Act as soon as possible. More lives will be saved by decisive action early, than by prolonging the insurgency. The longer you wait, the more inured the population will be to bloodshed, and the more barbaric your action will have to be to make an impression.
So if a big strike is coming, it should be coming sooner rather than later. Examples could be nationalizing a number of banks caught undermining the Eurozone. Tearing down a few bankster headquarter towers and making them public parks would be another good way to start. Otherwise we are facing a long drawn-out battle.
4.Strike openly. Do not apologize, make excuses about “collateral damage”, express regret, or promise investigations. Afterwards, make sure that as many people as possible know of your strike; media is useful for this purpose, but be careful not to let them interview survivors and arouse sympathy.
This was kind of followed last weekend but I doubt the strike was heavy enough. Good warm up but let’s get on with the main event.
5.Do not command the strike yourself, in case it doesn’t work for some reason and you need to disown your commander and try another strategy. If it does work, present your commander to the world, explain what you have done and make certain that everyone understands that you are ready to strike again.
Angela Merkel was away from Brussels this weekend so if this does not work out she has some plausible deniability. This gives her one more chance to get it right but much bankster blood will have to flow (again figuratively of course) if the Hama rules are to be in full effect.
And…the Anglo-Saxons wonder why the Japanese kicked them out en-mass for 600 years.
The Fed’s did the right thing by supplying liquidity and if I understand correctly should make money. Loans are made with a 1% juice and exchange risk is null as the trade is unwound at the exchange rate agreed upon when money was loaned. It’s just a big repo type loan for a few days or a few months. ie: I’ll lend you dollars and you give me Euro’s for security. You buy back the Euro’s at a predetermined time at a fixed exchange rate and the Fed keeps the 1%.
The European’s pulled out a battery of cannon’s cocked and fully loaded to repel that dastardly wolf pack which hopefully will buy them some time.
I guess it’s hard to kick someone out of your clubhouse when they burn it down upon exiting. ie: your banks fail because your buddy Mr. Market tells you your friends a stiff.
Greece´s situation looks an awful lot like that of Argentina in the late 90s, early 00s.
Not just the macroeconomic, political and social scenario, but also the solutions proposed by the EU, IMF et al. The European Union’s bailout package announced yesterday is just a short-term solution. It is a covered-in bailout to the German and French banks which are heavily exposed to PIIGS sovereign debt. This “new” proposal resembles of Argentina´s shielding (blindaje in Spanish) almost 10 years ago.
Back in 2000, Argentina was running large twin imbalances (fiscal and external), 3 years of recession, high unemployment; and a fixed exchange rate regime and it was planned to be given nearly USD 40bn (money subject to conditionalities) by the IMF, IDB, WB, private local and foreign banks and from the Spanish government. The conditionalities imposed by the IMF included freezing public expenditure for 5 years, reducing fiscal deficit and increasing women´s retirement age from 60 to 65 years.
Later in 2001, the government announced a mega debt exchange that would lengthen the maturity of the sovereign debt. As compensation, the financial services of the debt were increased.
These measures actually worsened the situation, reversing an incipient recovery during the 1st Q of 2001. Moreover, investors took advantage of this and flew their capital out of the country, central bank burnt reserves to defend the peso while there was a run on banks. By December 2001, there were massive riots that took 30 odd people´s lives. The president resigned and a provisional government declared the default on the sovereign debt and later abandoned the fixed exchange regime.
In my humble opinion, there is no easy way out. The EU recessionary proposal will not do anything but worsen the situation (a deflationary exit), as Irving Fischer said (with deflation, the real value of debt increases while contracting the economic activity making it impossible to pay and social discontent increasingly weakening the political power). Additionally, the Unholy Trinity or Obstfeld´s trilemma (a fixed exchange rate, free capital movement and an independent monetary policy) makes it impossible to operate through monetary policy.
Greece has two options: a) restructure its sovereign debt with a significant haircut, not abandoning the Eurozone (more market friendly) or b) imitate the Argentine way out in a more orderly way (abandon the euro, restructure its sovereign debt and devaluate). This option will surely allow Greece to recover its economic growth; however currency mismatches will arise, as its debt and monetary system is nominated in Euros (the Argentine state socialized the mismatches by issuing more debt)and a probable run on greek banks.
Augusto,
there is a big difference between Argentina then and Greece now. Greece is not in a fixed exchange rate regime; Greece is in a political-economical union.
Argentina’s main export markets were devaluing hugely against the dollar. Greece’s aren’t. Greece’s exports markets use the same currency as Greece.
Argentina didn’t have a say in US interest rates. Argentina’s economy wasn’t correlated to the US one. Argentina had to support tight interest rates during a long recessions.
Greece *does* have a say in Euro interest rates. Even if its input is limited, that input is magnified by the fact that 350m people may have slightly lower interest rates thanks to Greece’s input, hence supporting demand for Greek products and services. And Greece’s economy is highly correlated to the Eurozone economies.
When Argentines were in unemployment, the Fed didn’t give away money for Greece and Argentinians couldn’t mass-immigrate into the US. Greeks are allowed to work in any EU country; if there’s huge unemployment, they can just cross the border. And if the economy stalls for a long time, they can count on the EU sending checks for cohesion.
To put it in a nutshell: the EU is more of a country and more of a single economy than America ever was.
what are the currencies traders doing?
next up, the BRICK wall.
I still contend that in the EU there is some creation of money out of thin air made by banks allowed to have 40-60 leverage ratios investing in assets (sovereign debt) considered “too safe to fail”. We are not bailing out any of the PIGS countries, we are just and again bailing out those banks which lent to governments. The latter are just allowing them to manage their assets and liabilities with such high ratios and make bigger profits. In this way the Ponzi scheme goes on.
it is regrettable the ECB’s decision to put more money in circulation by buying government bonds. Actually what should be done is to write-off all those loans, which the banks count as assets because they were expecting to be paid back and the money in the Euro-zone would be counted simply as destroyed. That’s deleveraging the economy.