Narrative fallacy, euro ballacy
I think that Peston has fallen into the old "narrative fallacy" trap this morning with this post:
http://www.bbc.co.uk/news/business-15428016
Basically the euro negotiations look really iffy; the economies of just about everywhere look dubious, and general depression is looking more and more likely. And yet, the euro has strengthened and markets ar (modestly) up.
Ever in search of an explanation, Peston latches on to numbers coming out of Japan and China:
"comforted by data out of China and Japan that show global economic growth has not petered out altogether: Japanese exports were a bit stronger in September than expected; the mood among surveyed Chinese purchasing managers has improved in the past few weeks, and now signals increased private sector activity."
.
In fact, I suspect, the market moves are simply down to people squaring up their positions. Back in the day when we used to play the Formula 1 and football trading games with Johnny H, if a really hot stock soared up in price one turn, it didn't matter how fundamentally good it was in terms of p/e the next turn, it would still be sold by everyone, simply because people were overweight in the stock and you need to trade to win.
With the euro it's the reverse. Everyone has been so short in it (look at the speed with which it dropped from $1.44 to $1.32) that traders will take an optimistic view of just about anything.
So, what is really happening at the eurozone discussion table? Let's forget the technical stuff for a moment (well, nearly), the heart of the matter is this:
1) How big a pile of shit is the Greek debt?
2) How big a pile of shit is the potential PIIGS debt?
3) How undercapitalized are the banks?
4) Who is going to pay for the Greek debt, the potential PIIGS debt, and for the recapitalization of the banks?
Now, call me old-fashioned, but I don't reckon that statements such as "we will act decisively" really cut the mustard here. Since the eurozone seems incapable of answering questions (1) and (2), and since it has come out with what is probably a wrong answer of question (3), then the chances of getting a decent answer to question (4) by Wednesday is akin to attempting to get Steve Jones to make a move within 30 seconds in 1830 (intra board-gamers joke there -- that means "no hope at all").
Anyhoo, to explain the technicalities for a second, what the eurozone governments are going to come up with is a "first loss" adaptation of the EFSF. This is archetypal eurozone "smoke and mirrors". Whereas the old (current) €440bn fund aims to cover ALL potential sovereign debt default (i.e., if Spain defaults on a €5bn bond, the EFSF has to stump up €5bn) the new idea will be to say "ahh, but even Greece, the ultimate shit-hole for government debt, is only going to default for about 60% at worst-case-scenario (WCS) so the EFSF doesn't need to put up €5bn for €5bn of Greek sovereign debt; it only needs to put up €3bn." For the bonds at risk overall, the total value at risk is considered to be about 20% of the total bond issue. Therefore €440bn can guarantee €2,200bn of sovereign debt, rather than just €440bn.
It doesn't take the brain the size of a planet to work out where this is heading. I'm reminded of the "precipice" bonds issued about a decade ago by ever-optimistic investment funds. basically you got a darned good interest rate, provided the FTSE 100 didn't fall by more than 10% over a five-year period. Unfortunately, what was only mentioned in the small print was the fact that once the FTSE did fall by more than 10%, the structure of the hedging involved in your investment meant that for every extra point of decline, your investment lost about 5 points of its capital. So, if the market fell by 30%, you didn't lose 70% of your investment; you lost all of it.
The new EFSF will be structured along similar lines. So, if there's, say, a 10% chance of an aggregate 10% write-off, under the old system this would have an EV of just €4.4bn in cost to eurozone taxpayers (and a WCS of €44bn). Under the new system it would have an EV of €22bn and a WCS of €220bn. Once you get into numbers like a 50% chance of a 50% write-off, the EV rises from €110bn to €550bn (that is, greater than the sum of money allocated) and the WCS rises from €220bn to €1,100bn (that is, way way greater than the sum of money allocated).
Good poker players know all about EV. But they also know that it's quite nice to be lucky when the sample size is not great and the stakes are high (e.g when you have AK vs AQ all-in Heads up at the WSOP main event final table, you would not be particularly comforted by the knowledge that you were a 76% shot if a Queen came on the river to cripple you). Under the proposed rescue package that I assume will be announced on Wedensday (, my guess, a Greek haircut of 50% (10 points too low), bank recapitalization of €110bn (about right) and a gearing up of the EFSF to more than €2trn (just this side of completely insanely high)) I bet that the euro performs moderately well in response.
Why? because these solutions solve the immediate crisis -- the growing lack of liquidity as banks become increasingly unwilling to lend to each other. But what it does not solve is the underlying systemic flaw. Greece, Italy, Spain and Portugal are still gradually getting more and more into debt. All of these guarantees do not address the problem that these four countries will continue to borrow money that they have no hope of paying back. This "solution" only covers, as it were, the interest payments on the capital. The capital itself will continue to get larger, meaning that the interest payments will get larger, meaning that, eventually, you either get a default or a fiscal union that sees a huge transfer of wealth from the efficient north to the lazy-as-shit south (eurobonds, btw, would be the simplest and most blatant version of the latter).
A new radio show, Stephanomics, started last week. Most of it was blah-blah-blah and it regurgitated, as Stephanie Flanders observed, the old arguments of "Greece and Italy need to be more like the Germans", without addressing the simple fact that this is never going to happen. But there was one interesting snippet - a prediction that within 10 years China would have its own Arab Spring, on the grounds that an ostensibly "revolutionary" government always comes up against the paradox (usually some 60 years in) that it tries to balance the concept of revolution and no-revolution at the same time. It glorifies the revolutionaries of its past, and yet wants its population to be subservient and happy with the system as it currently is -- which was precisely what the revolutionaries it sees as heroes were fighting against.
Now, the implications of an Arab spring in China aren't that cheerful. Indeed, the general hope for medium-term stability is that Europe starts selling off assets to the Chinese. If this analysis turns out to be true (and I find it somewhat attractive, even though it suffers from certain flaws of Marxist analysis, I think) then the whole global system falls apart. It's not like 1949 any more -- a change in Chinese leadership in 2019, a break-up of the nation, massive political unrest, would lay bare the fundamental insolvency of the developed west. The last "lender of last resort" will have left the building.
That we need China so much is evidenced by the simple problem facing the current European countries if China did not exist.
1) The banks are undercapitalized because they hold debts from governments that aren't worth the paper they are written on.
2) Therefore the governments (in the absence of any private sector involvement, which basically means China or Chinese money) will have to subscribe to the capital raising of these banks to restore their capitalization to the required "safe" levels.
3) Which means that the banks hold much more government debt.
4) Which means that the banks are undercapitalized because they hold debts from governments that aren't worth the paper they are written on.
The eurozone is going to try lots of clever-clever stuff to get round this paradox -- one of which, as I have mentioned before, would be what we might call "bond inflation". The new capital provided by governments could take precedence over the old debt provided by the same governments. These "super bonds" would, of necessity, devalue the "old" bonds, because previously they were first in the debt queue but now they are second in the debt queue. But the EC is great at stating two contradictory ideas at the same time. It will simply say that the super bonds are safer than the old bonds, but that the old bonds are no less safe than they were before.
Alternatively, the new bonds could be repackaged in some way -- "eurobonds" would be the simplest, but that isn't going to happen (much though Sarkozy would have loved to shift the French disaster onto the eurozone as a whole, Merkel has stomped all over him and comprehensively humiliated a man who likes to think of himself as an alpha-male par excellence. I wouldn't have liked to be Sarkozy's cat that night.). But there's more than one way to skin a eurobond cat, and the EC is becoming something of an expert in smoke and mirrors. You could, for example, call a bond a French bond (or a Greek bond), but shovel in "co-guarantees" for a portion of it (see EFSF), thus making it a faux eurobond.
The general aim here is to maintain a triple A rating. As Sarkozy has finally recognized, if Italy and Spain join the list of the untouchables, then the entire eurozone becomes weaker. Eurobonds themselves would lose some of their value, because Italy and Spain would themselves make up a significant portion of the eurobond guarantors. And if France has to back this, then France becomes significantly less reliable as a borrower.
Provided we have China as the lender of last resort, it's almost possible to fudge through this (some political wheeling and dealing will be required, and the solution will be claimed as a victory for the eurozone, but the actual solution would be Chinese investment, because there's no other way to address the fundamental insolvency problem). But if Europe has to solve its imbalances on its own, well the potential for political unrest moves from "possible on the fringes" to "almost certain in the centre". We tend to forget that the Fifth Republic in France goes back just 53 years, that the current system in Germany is just a decade older than that. The "founders" of those two political systems (de Gaulle and Adenauer respectively) were alive in mot of your lifetimes. The political systems in Spain and Portugal are even younger than that.
These are mere blinks of an eyelid in the wide expanse of European history. There is nothing set in stone about the EU, or the political systems of the countries that constitute its membership. And it is this that Merkel and Sarkozy know in their hearts they are trying to save -- not the euro, not the EU, but liberal western democracy itself.
No wonder they look worried.
___________________
http://www.bbc.co.uk/news/business-15428016
Basically the euro negotiations look really iffy; the economies of just about everywhere look dubious, and general depression is looking more and more likely. And yet, the euro has strengthened and markets ar (modestly) up.
Ever in search of an explanation, Peston latches on to numbers coming out of Japan and China:
"comforted by data out of China and Japan that show global economic growth has not petered out altogether: Japanese exports were a bit stronger in September than expected; the mood among surveyed Chinese purchasing managers has improved in the past few weeks, and now signals increased private sector activity."
.
In fact, I suspect, the market moves are simply down to people squaring up their positions. Back in the day when we used to play the Formula 1 and football trading games with Johnny H, if a really hot stock soared up in price one turn, it didn't matter how fundamentally good it was in terms of p/e the next turn, it would still be sold by everyone, simply because people were overweight in the stock and you need to trade to win.
With the euro it's the reverse. Everyone has been so short in it (look at the speed with which it dropped from $1.44 to $1.32) that traders will take an optimistic view of just about anything.
So, what is really happening at the eurozone discussion table? Let's forget the technical stuff for a moment (well, nearly), the heart of the matter is this:
1) How big a pile of shit is the Greek debt?
2) How big a pile of shit is the potential PIIGS debt?
3) How undercapitalized are the banks?
4) Who is going to pay for the Greek debt, the potential PIIGS debt, and for the recapitalization of the banks?
Now, call me old-fashioned, but I don't reckon that statements such as "we will act decisively" really cut the mustard here. Since the eurozone seems incapable of answering questions (1) and (2), and since it has come out with what is probably a wrong answer of question (3), then the chances of getting a decent answer to question (4) by Wednesday is akin to attempting to get Steve Jones to make a move within 30 seconds in 1830 (intra board-gamers joke there -- that means "no hope at all").
Anyhoo, to explain the technicalities for a second, what the eurozone governments are going to come up with is a "first loss" adaptation of the EFSF. This is archetypal eurozone "smoke and mirrors". Whereas the old (current) €440bn fund aims to cover ALL potential sovereign debt default (i.e., if Spain defaults on a €5bn bond, the EFSF has to stump up €5bn) the new idea will be to say "ahh, but even Greece, the ultimate shit-hole for government debt, is only going to default for about 60% at worst-case-scenario (WCS) so the EFSF doesn't need to put up €5bn for €5bn of Greek sovereign debt; it only needs to put up €3bn." For the bonds at risk overall, the total value at risk is considered to be about 20% of the total bond issue. Therefore €440bn can guarantee €2,200bn of sovereign debt, rather than just €440bn.
It doesn't take the brain the size of a planet to work out where this is heading. I'm reminded of the "precipice" bonds issued about a decade ago by ever-optimistic investment funds. basically you got a darned good interest rate, provided the FTSE 100 didn't fall by more than 10% over a five-year period. Unfortunately, what was only mentioned in the small print was the fact that once the FTSE did fall by more than 10%, the structure of the hedging involved in your investment meant that for every extra point of decline, your investment lost about 5 points of its capital. So, if the market fell by 30%, you didn't lose 70% of your investment; you lost all of it.
The new EFSF will be structured along similar lines. So, if there's, say, a 10% chance of an aggregate 10% write-off, under the old system this would have an EV of just €4.4bn in cost to eurozone taxpayers (and a WCS of €44bn). Under the new system it would have an EV of €22bn and a WCS of €220bn. Once you get into numbers like a 50% chance of a 50% write-off, the EV rises from €110bn to €550bn (that is, greater than the sum of money allocated) and the WCS rises from €220bn to €1,100bn (that is, way way greater than the sum of money allocated).
Good poker players know all about EV. But they also know that it's quite nice to be lucky when the sample size is not great and the stakes are high (e.g when you have AK vs AQ all-in Heads up at the WSOP main event final table, you would not be particularly comforted by the knowledge that you were a 76% shot if a Queen came on the river to cripple you). Under the proposed rescue package that I assume will be announced on Wedensday (, my guess, a Greek haircut of 50% (10 points too low), bank recapitalization of €110bn (about right) and a gearing up of the EFSF to more than €2trn (just this side of completely insanely high)) I bet that the euro performs moderately well in response.
Why? because these solutions solve the immediate crisis -- the growing lack of liquidity as banks become increasingly unwilling to lend to each other. But what it does not solve is the underlying systemic flaw. Greece, Italy, Spain and Portugal are still gradually getting more and more into debt. All of these guarantees do not address the problem that these four countries will continue to borrow money that they have no hope of paying back. This "solution" only covers, as it were, the interest payments on the capital. The capital itself will continue to get larger, meaning that the interest payments will get larger, meaning that, eventually, you either get a default or a fiscal union that sees a huge transfer of wealth from the efficient north to the lazy-as-shit south (eurobonds, btw, would be the simplest and most blatant version of the latter).
A new radio show, Stephanomics, started last week. Most of it was blah-blah-blah and it regurgitated, as Stephanie Flanders observed, the old arguments of "Greece and Italy need to be more like the Germans", without addressing the simple fact that this is never going to happen. But there was one interesting snippet - a prediction that within 10 years China would have its own Arab Spring, on the grounds that an ostensibly "revolutionary" government always comes up against the paradox (usually some 60 years in) that it tries to balance the concept of revolution and no-revolution at the same time. It glorifies the revolutionaries of its past, and yet wants its population to be subservient and happy with the system as it currently is -- which was precisely what the revolutionaries it sees as heroes were fighting against.
Now, the implications of an Arab spring in China aren't that cheerful. Indeed, the general hope for medium-term stability is that Europe starts selling off assets to the Chinese. If this analysis turns out to be true (and I find it somewhat attractive, even though it suffers from certain flaws of Marxist analysis, I think) then the whole global system falls apart. It's not like 1949 any more -- a change in Chinese leadership in 2019, a break-up of the nation, massive political unrest, would lay bare the fundamental insolvency of the developed west. The last "lender of last resort" will have left the building.
That we need China so much is evidenced by the simple problem facing the current European countries if China did not exist.
1) The banks are undercapitalized because they hold debts from governments that aren't worth the paper they are written on.
2) Therefore the governments (in the absence of any private sector involvement, which basically means China or Chinese money) will have to subscribe to the capital raising of these banks to restore their capitalization to the required "safe" levels.
3) Which means that the banks hold much more government debt.
4) Which means that the banks are undercapitalized because they hold debts from governments that aren't worth the paper they are written on.
The eurozone is going to try lots of clever-clever stuff to get round this paradox -- one of which, as I have mentioned before, would be what we might call "bond inflation". The new capital provided by governments could take precedence over the old debt provided by the same governments. These "super bonds" would, of necessity, devalue the "old" bonds, because previously they were first in the debt queue but now they are second in the debt queue. But the EC is great at stating two contradictory ideas at the same time. It will simply say that the super bonds are safer than the old bonds, but that the old bonds are no less safe than they were before.
Alternatively, the new bonds could be repackaged in some way -- "eurobonds" would be the simplest, but that isn't going to happen (much though Sarkozy would have loved to shift the French disaster onto the eurozone as a whole, Merkel has stomped all over him and comprehensively humiliated a man who likes to think of himself as an alpha-male par excellence. I wouldn't have liked to be Sarkozy's cat that night.). But there's more than one way to skin a eurobond cat, and the EC is becoming something of an expert in smoke and mirrors. You could, for example, call a bond a French bond (or a Greek bond), but shovel in "co-guarantees" for a portion of it (see EFSF), thus making it a faux eurobond.
The general aim here is to maintain a triple A rating. As Sarkozy has finally recognized, if Italy and Spain join the list of the untouchables, then the entire eurozone becomes weaker. Eurobonds themselves would lose some of their value, because Italy and Spain would themselves make up a significant portion of the eurobond guarantors. And if France has to back this, then France becomes significantly less reliable as a borrower.
Provided we have China as the lender of last resort, it's almost possible to fudge through this (some political wheeling and dealing will be required, and the solution will be claimed as a victory for the eurozone, but the actual solution would be Chinese investment, because there's no other way to address the fundamental insolvency problem). But if Europe has to solve its imbalances on its own, well the potential for political unrest moves from "possible on the fringes" to "almost certain in the centre". We tend to forget that the Fifth Republic in France goes back just 53 years, that the current system in Germany is just a decade older than that. The "founders" of those two political systems (de Gaulle and Adenauer respectively) were alive in mot of your lifetimes. The political systems in Spain and Portugal are even younger than that.
These are mere blinks of an eyelid in the wide expanse of European history. There is nothing set in stone about the EU, or the political systems of the countries that constitute its membership. And it is this that Merkel and Sarkozy know in their hearts they are trying to save -- not the euro, not the EU, but liberal western democracy itself.
No wonder they look worried.
___________________