Why ELA is not Different from Bank Deposits

Truth is, when most of us hear about Emergency Liquidity Assistance (ELA), our minds go back to March 2013 when the Cyprus haircut was first announced; we think of ELA as a trouble indicator, one which signifies that a bank is desperate enough to obtain it from the Central Bank, and subsequently, that the bank which obtains it is about to collapse. Yet, even though some parts of this story are correct, both the conclusions usually reached as well as the consequences we think ELA funding has, are, most of the times, unreasonable.

First things first: banks operate with deposits and loans, with the available money in the economy. In addition, they also tend to create money themselves, by the power of credit. What basically happens is that banks, using liquidity (i.e. available money) from their deposits, loan out funds to people. This occurs until the regulatory capital requirement hits. What liquidity means though, is that banks cannot perform their day to day business without money. Imagine going to a bank only to find out that it has run out of money, just like what happened in the US during the Great Depression or in the UK during the 2008 crisis. In order to avoid panic, the Central Bank usually steps in when there is a large outflow of deposits providing liquidity to its banks.

Here's what should be noted though: running out of liquidity is nothing unusual for banks. That's why interbank loans and discount windows exist. In the first case, the bank obtains a short-term loan from another bank with more liquidity available in order to maintain a minimum until more money are returned (via deposits or through loan installments) while in the second case, the same occurs but the bank borrows from the Central Bank. In both cases, borrowing from either source actually has less cost for most banks, especially in the periphery (in countries like Germany and the UK, the interbank lending rate is usually very close to the deposits rate).

Thus, what liquidity needs mean is that there is a positive shortfall in the assets minus liabilities, and the bank has to cover it; whether this cover-up comes in the form of deposits or interbank/Discount window loans is irrelevant to the bank. Banks however, deal with other banks the way they deal with other customers: if they do not believe that they will repay, then they will not lend. Hence, when banks are not very stable (and this might just be a perception not reality), other banks might refuse to lend them forcing them to turn to the ECB discount window (the same might occur if a bank just thinks that it might need a large amount of funds, regardless of its state). The only issue here is that banks have to provide some collateral in order to receive the loan. This collateral is usually in the form of government bonds; when the bond has been rated as garbage, the bank cannot offer it for collateral.

At that time, the ELA comes in play: the National Central Bank (NCB), which usually operates in a strange dependent/independent relationship with the ECB, offers lending and accepts other forms of collateral (e.g. loans). The reason behind this lending is simply that the National Central Bank does not wish for the specific bank to bankrupt, as the costs will be much higher than the benefits (note: the decision of whether to offer ELA or not is 100% up to the NCB. Still, Central Banks do not enjoy making the decision of whether a bank will bankrupt or not so they just offer the funds. Nevertheless, this is not a bad policy in general). While this is a burden for the bank, it actually is much better than the alternative, i.e. deposits. Given the perception (either wrong or right) that the bank is in trouble, it will have to offer huge deposit rates to attract customers; in Greece and Cyprus rates often exceeded 4 or 5%. In contrast, the ELA is offered at Euribor plus 1-1.5%, a total of less than 2%.

We consider ELA to be troublesome because it is a loan, and because liquidity is something we usually do not understand. How can ELA lending be decreased? Simply by bonds moving from garbage to investment grade categories allowing banking institutions to access the ECB discount window (which is just cheaper, otherwise it is just as lending as the ELA), by regaining the market's trust and have more people trust their money to the bank or simply by increasing the money in the market thus increasing liquidity. The latter can only take place through increased bank lending, something which needs both willing lenders and willing borrowers.

If anything, ELA just signifies trust in the bank: if we believe that the bank is going to make it, then it will be able to repay ELA money with no trouble at all. If we do not and the bank does not receive any deposits or more so money are withdrawn, then the bank will not be able to repay. The same holds from the Central Bank side which is really out of options: it cannot really withheld ELA and allow the bank to fail (see Lehman Brother and the steps taken by the Fed afterwards).

Deposits and ELA are materially the same thing for the bank. It's trust which distinguishes between the two; market's on one hand and the Central Bank's on the other. If the latter is regained then the bank survives; if not then it fails. In any case, ELA has nothing to do on whether the bank is viable or not in the future.

Understanding ECB Comments: How Central Bankers (Should) Think

Central Banking should come with a warning: Anything you do, will be the cause of major criticism. When I usually see reactions on comments by ECB officials, it usually of the "they know nothing/understand nothing kind". The job is not easier for the US Federal Reserve either; it has a long been a while since I've heard no reactions to policy changes. When the Fed initiated QE, Cassandras said it would drive inflation rates sky high; it didn't. When tapering started, Cassandras (different ones I hope!) complained that it would have a severe effect on the economy; still nothing. Yet, while the usual aphorisms on Central Bank statements and actions have been going around for a while, what is usually the problem is that do not see things from their point of view: that of a person/institution who have a great effect on the economy.

Whether we like to admit it or not, Central Banks do have a lot on their minds. When times are good they have to be careful to prevent bubbles from forming and when times are bad they have to act in order to make them better and be careful not to make them worse. A clear example of the Central Banker's power and the strong grip he or she has on the economy, are reactions to verbal statements. When Alan Greenspan spoke of irrational exuberance for the first time in 1996, markets tumbled; when Mario Draghi gave the "anything it takes to support the euro" speech in August 2012, this is how the Forex Market reacted:

It is really not a question whether the Central Bank has an effect on the economy, it's about how big it is and the answer is that it's huge. Even if policies do not drastically change market conditions in the short-run  (they usually change them in the medium-run), comments and speeches do have a stronger effect since they affect investor confidence. This is why Central Bankers are very careful of what they say and this is why they should (and do) never speak of bad news.

As we know, the ECB, through its Board, has denied that deflation is a problem. Jens Weidmann has stated that the drop in inflation is nothing but temporal. Whether he actually believes that or not, is something we will never find out. Now, dear reader, imagine what would happen if the ECB or it's board began to talk of deflation being a problem in the Eurozone. As a first reaction, markets would drop and the euro would rise making exports harder. Investment would gradually be reduced and the whole economy would enter a vicious cycle of decreased consumption, drops in wages and less investment. More so, the whole procedure could actually be initiated just by the Central Banker admitting that deflation exists, as most people "know" that deflation is a problem.

Then, with regards to ECB reactions and comments, what would the reader, an ordinary citizen of the Eurozone prefer: a Central Banker denying the existence of deflation thus allowing the markets to continue without paying attention to what he says, or a Central Banker admitting or warning about the dangers of the current deflation and forcing a deflationary cycle on the economy? If you ask me, the former is much better than the latter, if only for employment reasons.

Who knows: maybe the ECB does know something more than we do when it comes to deflation. If not, then measures to counter deflation can be expected at the next meeting. Still, too much truth can actually harm the economy at times. In fact, I would even go as far as claiming that a Central Banker should act like Titanic's orchestra: even when the ship is shipping (s)he should calm everyone down and tell them that it's all going to be all right.

Real Life Effects of Deflation

Deflation is defined as the decrease in the level of prices:

As economic theory dictates, the causes are a fall in the money supply, in addition to (in the short-run) a fall in wages and salaries.

Compensation of Employees (aggregate) Source: ECB

Just like any other economic happening, there are those who claim that any type of deflation is disastrous and should be avoided at all cost while others believe that it is wonderful (since it lowers prices) and we should embrace it. As usual though, they are both wrong. The answer, simply put, is that it depends on the severity, duration and the overall state of the economy at the time when deflation is manifested. What follows are three points on the effects of the current rates of deflation on the real economy of the Eurozone.

1. As long as deflation is not severe and not persistent then the effects on consumption are small.
There is no person who would be willing to forgo a month's consumption of food just because it would get cheaper next month. Parents do not tell their children "you will not attend university now because it will be 2% cheaper next year". We have some basic needs which we will continue to satisfy as long as the deflation rate is not so severe so that an apple will be worth 50% less tomorrow than it does today. Prices fluctuate every day and a deviation of 1-2% per annum for a short period of time (e.g. 1-2 years until an economy gets back on track) does not really change our incentives for non-durable consumption.

Nevertheless, there is an effect on what we call durable goods (e.g. houses, automobiles, etc) but these are just a fraction of what we purchase (approximately 1/3 of our purchases are of durable goods). Even though 1/3 may appear to be large, remember that the reduction in price is more severe in some sectors than in others; automobile prices have not dropped by much (if any) while real estate prices have sunk compared to 2006. In addition, when a person has lower income than before, the first thing he stops purchasing is durable goods, not everything else. Thus, the drop in durable goods consumption can be seen as a natural reaction to the overall drop in confidence, investment and subsequently wages. Still, if deflation persists and becomes even higher in 2014-2015, a large drop in the consumption of durable goods might signify a reduction in investment, resulting in more wage losses and thus creating a vicious cycle.

2. Deflation has a stronger effect when households and non-financial corporations are heavily indebted.
The reason is simple: given that aggregate wages have dropped, prices also drop, triggering another round of wage drop and so on. Although this is an issue for durable consumption as discussed above, it is also a problem when it comes to debt as it takes more money in real terms to repay the amount owed. Thus, if in a country most of its citizens are over-indebted (see all periphery countries) deflation is bad because it makes repaying that debt even harder. Not only that, but it also creates a "death spiral": the more people try to repay their loans, the less they consume and thus prices and wages fall even further making the real amount they owe even higher. This is exactly what happened with austerity policies: less spending means less consumption thus less income for the state, leading to higher deficits and debt and forcing new austerity measures once again.

3. Deflation equals lower prices but it does not mean it's good for us.
This is one of the most common fallacies ever: if prices fall then it is great. It is most of the times but it always depends on the reason prices fall. If they do because raw material are cheaper or because of a productivity rise then great. But if they happen because people have less money than before then your purchasing power is most likely hurt in the short run (prices usually do not respond fast to shifts in consumption, even if those are permanent). In addition, if we shift from inflation expectations to deflation expectations then what we will see is less and less consumption, leading to lower wages and then lower production. This is the time when deflation gets serious as, with higher rates, we can actually see the economy reach a halt.

What should be noted is that the severity of deflation has a direct effect on the magnitude of the above. If deflation is at a very moderate rate of 1% per annum for a year or so, then most likely its effects on consumption and loan repayment will be very small; more or less of the same extent of what happens in the economy during every other recession. Only if deflation persists, becomes larger and is embedded in expectations will we need to seriously start about the future of the economy.

In order not to come to the worrying part though, policy (here's looking at you ECB) should be re-addressed so that confidence in the region is re-instated. Otherwise, we will soon see if markets can adjust fast enough not to cause any major casualties.

European Policy at the ZLB

The zero lower bound (ZLB) has moved from a theoretical possibility in the 1980's to a modus vivendi in the 1990's Japan, the late 2000's US and the 2010's Eurozone. The ZLB does not mean that the interest rate is necessarily at zero, but it does mean that it has reached a low beyond which it cannot fall. The problem with this situation is that monetary policy, as is commonly practiced by manipulation of the interest rate, becomes inefficient as, by definition, the interest rate cannot fall any further to accommodate for declining demand. This situation challenges policies and ideas in the economics profession as, over the last 50 years and with the prevalence of monetarism as the world's leading school of thought, economists believed that just controlling the interest rate could cure every recession possible.

It does not; the problem with the ZLB is that, just like any other activity which involves agents and forecasts, it becomes embedded in expectations. That is, if people see the interest rates not being able to fall further, they believe that the situation will be continued in the near future, which means that base their decisions on that, making the ZLB a self-fulfilling prophecy. The issue here is that the ZLB does not just mean that interest rates are low; it comes with an additional problem the one of dis-inflation or, in extreme cases, the one of deflation (Frances Coppola has an excellent article on why deflation is something we should worry about).

In addition, the ZLB does not come alone, but brings its friends along with it: low interest rates mean that even though most banks can they are unwilling to lend and, as if that wasn't enough, most businesses are unwilling to borrow. Even if the rates are low, people are still unwilling to spend due to the simple reason that they expect the situation to remain unchanged in the future; with spending being low and the overall money supply either contracting or just slightly increasing why should they assume the risks? This is the situation we have been experiencing in the Eurozone over the past year (the large change in M1 is just an outcome of the shift from long-term deposits to overnight deposits):

The only remedy for the situation is what has been known as unconventional policies: QE, OMT and so on, yet these cannot be applied in the Eurozone at the moment. In addition, increased government spending is a midsummer night's dream in most countries, which are tormented by bail-out agreements forcing tight budgets, meaning that it's up to the ECB: either it does something in the next meeting, by which I mean a large boost package, or the situation will remain as terrible and uncertain as it is now.

And remember, uncertainty is always worse than bad news.

Deflation, Inflation and Expectations

That dis-inflationary pressures have been observed in the Eurozone over the past year is nothing new. They have been so common elsewhere in the world (for example Japan or the US) that news of higher inflation are now being heralded as the dawn of a new, happier era (even though some are more exaggerated than other). Even though deflation has expanded to other measures of prices, the main focus is that we are moving towards higher inflation, with deflation no longer being an issue of concern; at least that's what the ECB is saying.

Trouble is, almost no-one sees it the same way. Tim Hartford, for example, notes that the persistence of low inflation may mean trouble for borrowers, leading to more bankruptcy risk and, God forbid, more non-performing loans to banks. In addition, what I fear most is that low inflation, just like high one, can be embedded in expectations and remain for much longer than we would normally expect, with all the known consequences. This is not just a doomsday scenario; expectations matter much more than we most of the time think when it comes to policy.

A simple example of how much expectations matter is what is usually referred to as reflexivity, a theory that simply put, means that we are in fact creating a part of the world we are trying to forecast; a very similar notion to what has been known as the Lucas Critique in economics. As the world of economics is not governed by the hard rules of physics, what people believe about the future will in fact affect it. In addition, the only way they can make an educated guess on the future is by viewing current events and basing their judgement on experience, meaning that in a way, the future affects the past as well (to be more precise, expectations about the future affect what we do now). 

This is what has been going on at the moment: people see low inflation and have every right to expect low inflation since no measures have been taken against it (the rate cut in late 2013 was really nothing special). It can be seen in the consumer expectations:

Italy's Consumer Confidence Sales (Feb) M/M 97.5 vs. Exp. 98.5 (Prev. 98.0)
— Fabrizio Goria (@FGoria) February 25, 2014

This is led by something more than just expectations about the inflation rate. Peter Praet, (aka Captain Obvious) noted "Weak demand and high unemployment could also be playing a role". You don't say! This is exactly how inflation falls: lower supply of loans from banks means lower demand (for the monetarists out there this means reduced money velocity ); adding high unemployment to that equation means even lower demand. This is not a matter of what affects what; it's a matter of everything affecting everything as, whether policymakers like it or not, people are the economy. It is only if we can convince them that are going to get better that they will.

Here is where the ECB is wrong: people, even subconsciously, trust what you do and not what you claim. As Lech Walesa once said "The supply of words in the world market is plentiful but the demand is falling". Saying we are not in danger from deflation or dis-inflation does not change anything, unless you get people to believe it. And if they are rational (and on average they are as they can see what goes on in the real world), then they won't buy it that easily.

ECB's OMT, QE and why they won't matter

The biggest news on Friday was that the German Constitutional Court had passed on the examination of whether the Outright Monetary Transaction (OMT) scheme proposed by Mario Draghi in August 2012 was legal under the ECB mandate, to the European Court of Justice. This story was considered as a win by most on the pro-ECB camp, under the assumption that the ECJ would actually approve the scheme. The problem is that whether it does or not, it makes no difference. 

As Frances Coppola noted at the time of the Draghi announcement (and has recently repeated to all those who haven't been listening), the whole idea of the OMT is not to protect the Member-States but to protect the Euro. Even more, the OMT is best used as a threat rather than actual implementation. Market reaction to the threat was as predicted: pressure on the euro started to decline and soon the currency was much stronger than before. Yet, as many know, in this case, the threat is stronger than anything else.

You see, even if the ECJ approves OMT, it will do nothing to ensure that the crisis ends. The main function of the scheme is to purchase bonds in countries which are paying high interest rates (and are in bail-out agreement). As of lately, no country is paying especially high rates; even Greek bonds have shown significant signs of decrease. Thus, even if the scheme passes, no country will benefit.

Another idea, (one which I have to disgracefully admit that I thought was rather interesting before thinking it through) was a European Quantitative Easing. The problem here is how the markets that the ECB will purchase bonds from will be defined. It's easy in the US and the UK as there is just one market with sovereign bonds; what happens when you have 17 of them, each faced with its own issues? Clearly, QE is not the answer.

In order to find the correct answer, we have to make sure we are facing the right question, and the one in our case is how to stimulate demand. Forget of all the "competitiveness" and "supply liberalizations" which some think will cure everything. As stated before, supply does create its own demand but not all the time; and this time it's different. The problem is that the usual stimulants, i.e. government intervention (either in increasing demand or decreasing taxation), are constrained in the bailed-out countries, and many others by their debt-to-GDP ratios and fact that they are in a currency union. The other usual way, of increased bank lending, is again constrained by either the banks' inability to lend or the peoples' unwillingness to borrow.

Thus what is left one might add, if supply won't help and banks and governments are constrained? The magic word here is confidence and expectations. As recent research has shown, expectations matter more than we usually thought; the recovery from the 1929 Great Depression was most likely driven by a shift in expectations as Eggertson (2008) suggests. So what shifts expectations is the big question?

Simply put, it's the willingness of the governing authorities (whether those be politicians or policymakers) to stick to their agenda of reforms and promote the idea that inflation will increase in the future, or forward guidance in the central bank parlance (something that BoE's Mark Carney is famous about). The problem is that just saying so doesn't really change anything, you have to stick by what you claim and make efforts to keep them in line with peoples' expectations.

How to do that is rather simple: either the ECB should issue fresh money and channel them to the countries (most likely via the EIB) at a scale larger than ever before or boost bank lending in countries where banks are willing to lend (but are constrained) and people are willing to borrow, most likely by decreasing the ELA rate. I see no other solution to the current problems: either the banks are supported and they are allowed to lend, and more investment is brought forth directly from the EU or the shift in expectations will take much longer to manifest, just like it did in the 1930's. Trust me here, we do not want a repetition of history.

Jean-Claude Trichet's "apology" and responsibilities

Yesterday, Jean-Claude Trichet apologized at a European Parliament hearing concerning the role of the “troika” of international lenders (which managed bailouts in Cyprus, Greece, etc), with his response surprising many, as he blamed Member-State governments for the situation the EU is currently facing and basically washing his hands off the subject.

What caused some to wonder about Trichet's behaviour was that he did not admit any mistakes made by the Troika (and in essence the ECB, even when the IMF admitted to have under-estimated the GDP projections) and showed no remorse whatsoever. A prevalent idea is that Trichet did not do much during his stint at the ECB. Yet, he claims that without his actions, Mario Draghi's "whatever it takes" speech wouldn't have mattered much. 

To be fair, he deserves some credit. Trichet was head of the ECB during 2003-2011 and with the crisis beginning to show its teeth in 2009, the following table shows monetary policy actions since 2009 (even though the policy rate fell by more than 125 basis points in 2008 as a response to the sub-prime lending crisis).

As the reader may observe, the ECB's deposit facility rate fell dramatically in 2009, after new evidence on Greece showed that the country was sitting on a huge pile of debt; in fact both the main refinancing operations and the marginal lending facility rate were reduced during the year. This was actually more than most observers believed the ECB would do at the time. The rate remained unchanged during 2010 while, in an irrational change of mind, it was raised during 2011. As you may remember, the Decision to appoint Draghi was taken in June 2011, while the official inauguration date was in November 2011. Now, the only reason I am bothering you with the dates is that both the rate hikes in 2011 occurred while Trichet was heading the ECB. In fact, just 8 days after Draghi took over, the ECB rate was reduced by 25 basis points. 

In addition, have a look at the European Interbank Overnight (EONIA) Rate in 2010 and 2011: as it appears, the interbank cost of lending rose significantly in those two years (and only began to its fall after November 2011), at a time (after the first Greek PSI in late 2010 and just before the second PSI in Autumn 2011) when confidence about the banking sector had reached its nadir, with the whole situation forcing huge losses on periphery banks. During the same time, daily open market operations were reduced by approximately 38% from 775,559 to 483,141, while liquidity based on the Covered bond purchase programme more than doubled from 2010 to November 2011 (albeit in absolute numbers it was much less than the reduction of open market operations).

Source: http://www.global-rates.com/interest-rates/eonia/eonia.aspx

Yet, Trichet (or the ECB if you prefer) did something else in order to assist the then ailing European economy: bought large amounts of Irish and Greek government bonds as early as 2010, a policy which well continued in 2011. Had there not been the ECB buying bonds the crisis would have evolved much faster and with greater severity, as it has been a combination of both banking and sovereign trouble. Yet for some countries (Spain, Cyprus, Ireland), the former sector was the one which caused the latter to face problems, while for others (Italy, Portugal, Greece) it was mainly the latter which imposed its burden to the former. 

The ECB's reaction was one to "save the sovereigns" and somehow ignore the banks. This was justifiable at some point: the last three countries, of which Greece got the most publicity during the Trichet presidency, would have gone down spectacularly had the ECB not intervened. As for Ireland, the government was "forced" to guarantee the banks to avoid total collapse, thus forcing the ECB to "guarantee" the state. It goes beyond logic to suggest that the ECB did nothing for Ireland (or other countries in the EZ) during the crisis; yet it is equally illogical to suggest that the ECB did everything it could.

Summing up, the idea that Trichet did nothing, as well as the idea that his actions were what the Eurozone needed at the time are both nonsensical. Trichet should have lived up to his role as the ECB President and stand up against the PSI (if he was really against it). In addition, blaming others for their mistakes and not acknowledging that you could have done much more is not a sign of strength. Yet, the same holds for the MEP's: they are free to judge anyone for the outcome of their actions, but they should not forget that they are also liable for notorious inaction during the crisis. We all know that it's easy to judge in retrospect but it appears to be much easier to do nothing and then judge others about their actions.

P.S. A note to those who suggested that the PSI came back with a vengeance in Cyprus: the "bail-in" is much different from the PSI. In the latter the bank loses capital by experiencing losses in invested funds (in this case government bonds) while in the former it gains capital by effectively seizing deposits. And yes, the latter is better.

New Year's Change of Mind: Was the Cyprus Haircut more equal than we think?

2013's most startling development was probably the Cyprus deposit haircut, an unprecedented event which caused numerous reactions around the world. In March, the Eurogroup came up with Plan A, i.e. to haircut all existing depositors, regardless of institution or the amount of money in their accounts, at a flat rate of 6.75%; a decision which the Cypriot Parliament rejected. After 2 long weeks of bank "holidays" and intense negotiations, the plan changed to the dissolution of Laiki Bank and the haircut of all deposits above 100,000 euros in the Bank of Cyprus (the final amount of the unsecured deposit haircut was 47.5% as agreed in late July).

My reaction to the first plan was that it was unfair: a person with €10,000 in his bank account would suffer more than a person with €10 million in his after a 6.75% cut. The second plan still seemed unfair but had the advantage that depositors in other banks would not be hurt and that the "little guy" would remain an unscathed. Obviously, the "big boys" still get hurt, which means less investment and less growth, equaling more unemployment. Yet, there is actually much more good in this than was first considered.

First of all, the ones which got hurt more in the crisis were not CEO's or other businessmen; it was paid employees. Have a look at the following table compiled by the Economic Policy Institute:

As the reader may observe, in 2011-2012 average worker compensation shrunk by 1.6% while average CEO compensation increased by more than 14% during the same time-frame. What this indicates is that high-income earners do not get hurt by much during a recession. The average paid employee does. The simple reason is that the worker goes out first and the businessman continues to operate; most importantly it is the latter who makes the decision not the former. Even when a recession begins to fade out the businessman can exploit the situation and earn much more than before since wages are much stickier than profits (as also seen in the 2013 results of US firms).

The trouble with Plan A, i.e. the haircut on both secured and unsecured deposits is that the former (i.e. secured depositors) are more prone to the use of their wealth than the latter. As Simon Kuznets has shown back in the early 50's, the higher the income, the less percentage of your income you spend (for a discussion of austerity and income see this). This means that most of the money a low- or middle-income worker earns will end up back in the economy in the form of consumption. On the contrary, the money a high-income person earns are employed differently: if you take away from him, his consumption will not be reduced by as much for the simple reason that he will just save less. Since the economy is mainly driven by consumption (it comprises of the largest part of GDP) if it decreases, GDP will also be decreased.

A question which may arise concerns the banks' ability to lend if we experience dis-savings. The thing is that it will not matter by that much. Remember that if one spends, another will pocket the proceeds, thus the money ends up in the bank anyhow, i.e. the bank will not lose any funds. Second, even though the bank has less deposits now, it has much greater equity which allows it to lend out more funds to boost the economy either directly or indirectly.

This is what has happened in Cyprus since March: those with big, unsecured deposits, found themselves at a loss. Recent IMF estimations, after the second examination of the island's program development, showed that private consumption has fallen by just 2.8% year-to-year, much less than the severe contraction in Greece or other periphery countries, even though the unemployment rate has reached 17% (the 3rd highest in the Eurozone). Since private consumption has not fallen by much, GDP contraction was less than expected. Most importantly, what the less-than-expected decrease in consumption means is that Cyprus has a better chance of experiencing growth faster than other countries is recession; since demand does not fall, employers have less incentives to fire people and businessmen have greater incentives to invest.

There is a caveat in this though: the haircut exacerbated the already declining confidence in the banking sector, meaning that individuals prefer to keep their money under the proverbial (in this case even literal) mattress than deposit it. This can be easily seen in the data, with total deposits following a downwards trend since March, forcing the banks to request liquidity from the ECB. Yet, as the IMF points out, this exit of deposits appears to have reached its peak, with the overall amount in the system stabilizing in October. NPL's are still a major cause of headache in the island, yet an increase in consumption, in addition to the banks' increased ability of issuing of new loans due to higher equity ratios means that better days are ahead.

Summing up, the haircut on unsecured deposits is much more equal than first considered. It hurts those with larger wealth, who spend much less of their income (as a percentage) than those who are on the other side of the spectrum. This means that consumption is less affected by the haircut than by austerity measures: compare Greece and the succession of harsh austerity measures and tax hikes imposed which resulted in a 5-year depression to Cyprus where the haircut was accompanied by mild austerity measures (mostly in 2011 and 2012, with a few ones in 2013). The difference is extraordinary. Yet, as mentioned before, the haircut's caveat is the exacerbation of the already fragile trust towards the banking system, which is the cause of decreased liquidity; yet, if the ECB can ascertain that it will live up to the task of providing "whatever it takes" to the banks, it might be that the haircut is not a terrible idea at all.

The Original Sins: EU's entry decisions

Once upon a time there was a continent, which was made up by 50 countries. One day the countries decided they would benefit from being united instead of fighting each other thus they formed a Union which they soon thought would be able to issue its own currency; one which would work in all of these countries and become one of the leading currencies in the world. But who would enter? They couldn't just let anyone in so some rules had to be made. Thus, they thought of the easiest task: you wouldn't be able to join the currency area, unless your public debt was less than 60% and your government deficit was less (or very close) to 3%. They even formalized this by signing a treaty in a smallish town somewhere North.

The problem with this treaty was that it was too rigid for its own good. By the time the new currency was brought to the markets, many of the countries wanted to join the whole charade and play with the big boys but couldn't. The reason was that they were constrained by 3-60 rules of the treaty. Why should they want to enter ans lose the enormous power of issuing their own currency one might ask. The reason was simple: it was better than the one they had until then and it opened the door to numerous opportunities for growth. Up until the initiation of the common currency the countries which wanted most of all to enter the Union and could not grappled with high inflation and perpetually-depreciated currencies. For example, three of the countries wanting to join the currency Union had an exchange rate of 166.386, 353.101 and 1,936.27 to one with the common currency*.

However, those countries really wanted in. But what could they do? Their public debt was more than the 60% limit and their deficit exceeded 3%. There was no real way to reduce the debt by issuing new money as that would mess with the exchange mechanism they were tied to, given their willingness to join the Union. Thus all there was to reduce was the deficit; but which politician would be willing to and announce a reduction in spending and risk sacrificing his chair to the altar of joining a Union? The stakes were too high for such actions. Still, they had promised their voters (and their voters really wanted it) that they would join the Union.

Being mostly politicians and bureaucrats they had no idea of what they could do. Thus they invited the big investment bankers for advice. The latter, known for their quick wit, eagerness to solve a problem they will receive a big compensation and willingness to find loopholes in legislation found a simple solution: they would be able to reduce the deficit using a Swap. In a swap, two counterparts change cash flows, usually in order to reduce risk. In this case, the supposed risk was the exchange rate since there was a bond issue in Japanese Yen. The following graph shows how a swap should look like. Note that these sort of swap transactions were legal and approved both by the sovereign's central bank as well as the Union's.

Source: ZeroHedge

Yet, this is not how the transaction went on. What the investment bankers did was increase the one-off final payment and make the payment coming from the sovereign borrower negative. In simple words, the country was receiving the fixed payments in yen and was again receiving payments at the time it was supposed to pay. The following graph illustrates what happened:

Source: ZeroHedge

Why would they do this if the payment in the end was huge the reader might ask. Remember that the country had no intention of reducing its debt since it could not do it in short notice; it was aiming at reducing its deficit. Using the above swap, the country was receiving two payments from the bankers which meant that first it wouldn't have to pay any interest thus reducing the government deficit and second it was getting money back and it could either repay outstanding loans or use it to show further budget improvement. The country did both. And this is how it fared:

The bond was issued in 1995 and the swap took place in 1996. Note the impressive decrease of government deficit as a percentage of GDP from 1996 to 1997 by 4.3% to within the limits of the 3% rule; something which lasted until 2002, the year when the common currency was introduced to the public (although to be fair, the specific swap expired in 1998). The strategy was so successful that it soon found imitators: others sought to find the magic deficit-decreasing swap. In 2001, Greece tried the same and somehow it worked in allowing it to join the Eurozone:

But things didn't work out as planned by the Greeks: by the time they signed the deal, they were already 600million more in debt than the originally planned 2.8 billion to be repaid. The perils of secret negotiations and under-the-table agreements came up in 2009, forcing the country to require a bail-out. Not that Italy is doing any better now but having a stronger economy can assist in overcoming recessions faster.

The author of "Derivatives and Public DebtManagement", Gustavo Piga (the person who unearthed the story about Italy) suggests that secret treaties are just a way of exploiting the taxpayer. The problems in the Eurozone have not arisen because of some secret agenda or as a result of a global conspiracy. They were there to begin with. Neither Greece's nor Italy's debt management practices were ideal and those who allowed them in the Eurozone knew about this (even Eurostat was to to blame since it had knowledge of the fact according to ZeroHedge) and chose to close their eyes. Evidence of mismanagement were there: just look at the exchange rates of the three countries mentioned earlier. 

The accumulated sins of the Eurozone structures were bound to come and haunt us. They just did sooner than anyone expected. If there is a moral to this story it's that in economics, when you do something bad it will come back and hit, just like a boomerang. But that was not what the Italian and Greek authorities thought when they made the swaps. Too bad; for their taxpayers that is.

*Spanish peseta, Greek Drachma and Italian lire respectively.

The German Export Beast

It appears that the US have been critical of Germany's attitude towards exports. Basically, the US, now backed by the IMF, are critical of the German Chancellor's claim that exports indicate a healthy economy. Although I disagree with Merkel's claim for the pure reason that an export-based economy is basically relying on others to prosper, I cannot help but cast my doubts on the stance many have taken against Germany.

My regular readers will certainly know that I am not a friend of German policy on most subjects. Still, I find it rather odd that a country which is having trouble with too much imports and is actually trying to decrease its current account deficit is trying to support that another country shouldn't have a large current account surplus. To be honest, I find it rather hypocritical, especially from the IMF's point of view. The fund’s First Deputy Managing Director David Lipton urged Germany to "lift its sights to the global horizon" and that cutting excessive deficits in the euro area “simply can’t happen unless surpluses are down as well.” 

Maybe Lipton is right and maybe Merkel should pay attention to what he is saying. Still, what was his employer doing when they organized the bail-out of 5 Eurozone countries in past 5 years? Simply, they were creating the situation that Germany is currently "exploiting": high uncertainty, low competitiveness, high unemployment and most importantly a depreciated euro. I will not delve into whether Germany had a say in all those or not; it is irrelevant to the role the IMF played. The IMF is supposedly an independent organization which assists ailing nations with or without the assistance of others. In any case, the IMF has supposedly been independent and unbiased in both its estimations and its opinions.

Yet, where was this opinion when the Irish bail-out was orchestrated? Or how about the Spanish or Portuguese or Greek or Cypriot one? Did the IMF change its stance on the subject as time passed on? This is an article from last February commenting on what the Washington Post published as Olivier Blanchard's mea culpa on the IMF policies in Greece. Yet, the directors never changed their tune and did the same in Cyprus just a month later. Now, they are basically blaming Germany for taking advantage of a situation they have created. But is it just Germany though or is it a general trend in the Eurozone surplus? Eurostat data favour the latter view: Euro-Area trade surplus increased to 7.1 billion in August 2013, compared to 4.6 billion in August 2012 (which was not just because of the North surpluses). 

There are those of course who are not taking a like to the US stance on the subject. FT's Gideon Rachman comments "If you had to single out a major Western economy whose irresponsible economic policy has posed a persistent danger to the global economy, the obvious candidate would be the United States." His points are correct all the way. The Great Recession alone supports his view, and if we wanted we could easily find more (the Great Depression for example). QE has been a drag on both the US and the world economy for long now and stories about whether the Fed should taper or not (or whether it can) are a major cause of uncertainty, without the officials doing anything about it. In addition, if we are to pin-point, why just Germany? China and Japan have been doing the same for years yet there has been no criticism of their actions (other than the one for the remnibi's "constant" depreciation).

Others though still think that Germany is, in their words, "a weight on the world". The arguments Wolf makes are correct and the risk of permanent deflation exists in the periphery. I doubt whether such a scenario would occur in reality, yet I think the probability exists and deflation in 2014 is something we can expect. Is Germany employing a beggar-thy-neighbour policy? To be honest, I doubt whether it can. Germany can earn significant amounts from exporting heavily, yet this comes at a cost: inflation in Germany as current data show is at 1.7% thus far, slightly higher than the EA average of 1.6%. 

Is this increase significant? Perhaps not, but the inflation monster so feared by Germany might prove too hard to kill given the ECB rate cut and the increased probability that the rest of the Eurozone recovers. As Evans-Pritchard puts it, the ECB is ready to print and Germany is ready to scream; he also rightly points out that a bout of deflation in Italy is much more severe than a bout of inflation in Germany. My take is that the ECB will finally move the way it should. Although the rate cut was much ado over (almost) nothing, it was a step towards the right direction, mainly to boost inflation in Germany and the North and investment and consumption everywhere else.

In any case, arguments like "the Germans do not work as hard as they think" (which Matt Yglesias makes) are really unnecessary and I remember deconstructing them more than a year ago. The US exports as much as Germany Matt states, but forgets to mention that the former's GDP is more than 4 times larger than the latter's and its population approximately 4 times as much, meaning that imports will be (and are) much higher and the current account will be negative. Yet, that is not a problem for the US since it has a sovereign currency of its own. Germany and the rest of the Eurozone do not. As he again points out the proposal is one to "buy more foreign-made goods and services." But these all depend on their cost and how they fare with German products. And let's face it: German products are (usually) of great quality.

Thus, as deflation sets in the rest of the Eurozone in 2014, prices in Germany will rise as a result of exports, making goods from other Eurozone countries look more appealing. This will help both the periphery countries increase their exports and Germany reduce it's dependence on foreigners (i.e. reduce exports) with the additional effect of appreciating the euro. The bottom line is that high exports are not a sign of a healthy economy, they are a sign of dependence on foreign factors. Still, blaming a country for high exports when you cannot control your own or when you were at large the culprit for the creating of the situation which allows them to pursue such policies does not make sense at all.

Recession in Germany?

Although these are festive days and everybody deserves to be happy, one cannot help but comment on this article on Der Spiegel, stating that "Wolfgang Schäuble is secretly planning cutbacks to prepare for a weakening economy and possible fallout from the euro crisis". Hate to say "told you so" Wolfgang, but I did here about 1.5 months ago. What had mentioned in that article was that given that German exports within the EU accounted for about 60-65% of the total exports. If demand falls in those countries guess who would be in trouble: exactly, Germany.

It appears that German strategists in the center-right coalition parties are planning to enhance benefits for families, pensioners and the long-term unemployed while experts in Schäuble's ministry are believe that the next government - no matter who - won't be able to boost spending but it will have to impose a rigorous spending restraint. It appears that Schäuble wants to give his countrymen a taste of the medicine he (along with Angela Merkel) has been promoting in Europe over the past couple of years.

The measures promoted by Schäuble will include decreases in pensions for early retirement instead and a significant reduction the 55% of their deceased spouse's income widowers and widows now receive. It appears that Germany has now reached the tipping point; either they go down with the rest of Europe or they manage to save themselves along with the rest of the countries in critical condition. The first scenario is easy to picture: Germany imposes austerity measures, people reduce consumption, and investment along with the already reduced government spending and GDP falls. The same old story as in Spain, Italy, Greece, Cyprus and Portugal. 

The second scenario is the most difficult of the two. How can Germany and Europe be saved? The answer is not as complicated as it appears though. The ECB should be allowed to directly finance banks, under the EFSF/ESM funds. This means that it will be able to gather all problematic banking institutions under a common umbrella and thus deal with their problems without any pressuring time constraints. To those who believe that this appears to be similar to what Jens Weidmann, Bundesbank's President, has dubbed as "supporting countries with the printing-machine" I would agree that it is. Yet, there is one significant difference: Weidmann's comment was referring to bond guarantees by the ECB, which in essence mean direct nation support, instead to what this proposal is: direct banking support. Would anyone disagree that it is the definition of the Central Bank's duties to monitor and support banking institutions and this is the main reason Central Banks were invented in the first place? 

It could might as well be now: unemployed workers waiting in line
in 1938, towards the end of the Great Depression.

By directly funding the banks we would not, of course, solve every problem we currently face. Still, we would solve the greatest one, banking recapitalization which is the main issue in countries like Spain and Cyprus and a major secondary issue in Greece. In Portugal and Italy, policymakers would just have to implement moderate spending cuts (like the ones the Monti government had applied in Italy) to survive. Even with the aforementioned solution, it is irrational to believe or hope that everything would be better in the next year. The effects of such reforms would not start to show until 2014. Nevertheless, if we do not implement such solutions, it would mean that we cannot even hope for an improvement of the situation in 3 or 4 years from now. 

The outcome of the proposed austerity measures will be the reason why future economists and politicians will condemn us. We will be responsible for promoting a regional crisis to Europe's Great Depression; and we all know that this will not be a good outcome. Have a look at the 1930's and 1940's decades and history will tell you what happens after great calamities. We have to learn from our mistakes and fast: otherwise it will be too late to alter the situation

Is it money or reforms they are after?

Yanis Varoufakis's latest article states that the Greek government should only cut about 2.5 billion euros, which is the nation's primary deficit at the moment, and then renegotiate the loan agreement with the Troika. Although it does sound like a good idea in theory, I am afraid that the only way to achieve what he proposes would be for the Greek government to exercise tremendous political on the ECB or the IMF.

In short, what Yanis proposes is for the Greeks to cut 2.5 billion, receive 31 billion and then renegotiate the loan agreement. Yet I am under the impression that if the "old-heads" of the IMF won't see the measures they have proposed, passed through the Parliament, they will not allow for the 31 billion tranche to reach Greece. As the stupidity that the EFSF-ESM will not directly recapitalize Greek banks remains then I am afraid that all Greece, Spain and Cyprus are doomed to forever move in a recessionary spiral.

Norwegian chocolate bar Troika. Too bad their measures are bitter. Source: Wikimedia Commons

It is impossible to understand why the Germans and many other Northerners are opposing the idea of a direct aid to the EU banks. If that was to occur, then the EU nations which opted for a bail-out would only have to receive half of the aid they are currently receiving, if not even less. And for those who do not remember, most (if not all) of the EU banks are facing troubles due to the decision to haircut the Greek bonds held by the private sector by essentially 79% (30% plus 70% on the remaining) and the equally irrational decision to raise Core Tier 1 capital adequacy ratios by 1% in the midst of the crisis. 

For those who fear that the "German taxpayer" would have to pay for bank recapitalization, I need not remind you that the ECB can just guarantee the adequacy of the EU banks, without spending a cent, forcing the banks to come up with the money in a number of years and not now. Nevertheless a money injection in the ailing banks could be good for the economy as a whole. And if you consider this to be greatly risky for taxpayer I repeat: money does not have to be spent to make the Union's wheels turning.

While Yanis's proposal is great in theory, I am afraid that the only way around the austerity measures proposed would be to pass them through the Parliament, receive the 31 billion and then annul some of them. This however, would not make the Greeks more credible, nevertheless it would make it more possible for them to get through 2013 without another severe recession. As a Kathimerini article states today, some fear that the recession will be closer to 9% than 4.5% in 2013.

What worries me more is that while the country is at the brink of disaster, the Troika or the EU does not seem to understand the effects the undertaken measures will have on the ordinary people. In the previous article I have stated that the measures affect the low- and medium-income families much more than the higher income ones. Given that the latter have much more elastic demand it is more than obvious that when their income is reduced, their consumption is reduced by a large factor. (the formal term is propensity to consume)

Thus, although eliminating the primary deficit and renegotiating the loan agreement would be a good idea, it would be nearly impossible, given the state of mind of the Troika and the EU officials. What we need is rational measures, implemented on a long time-frame, with structural reforms and mentality changes. Yet, all we see is spending cuts. What are the Troika objectives is really beyond me.

Incredible Threats?

Yesterday, Yanis Varoufakis presented an article over his concerns about the OMT (Outright Monetary Transactions) program announced by Mario Draghi almost two weeks ago. In the article, Yanis, after depicting the arguments in game theory style, states that if Mario Monti decides to take up Draghi's offer for OMT, then the former would be better off by not enforcing reforms and austerity measures in Italy, because the threat that Draghi will stop OMT operations in incredible. In essence, Draghi will be caught between a rock and a hard place.

Yanis states that it would be disastrous for Draghi to back out once he has agreed to fund Italy (or any other country for that matter) since the result would be that Italy would most likely exit the euro. However, I think that in his analysis, Yanis fails to state three points:
1. Money will not be given as a lump sum as soon as the agreement is signed. What should take place is an instalment-based assistance just like in the case of Greece.
2. Economic theory (and game theory) states that rational people will choose what is best for themselves under certain circumstances. However, behavioral economists have proven that people are not at all like the rational beasts economists perceive them to be. (Paradoxically, economists themselves are not as rational as they think they are)
3. The consequences for Italy if the country exits the Eurozone.

If game theory was right, it would mean that the Greek government would have an incentive to exit the Eurozone and declare bankruptcy as soon as

Persistence of Ideologies

I have been reading Yanis Varoufakis's blog post today and what has stricken me with amazement was how much ideology is affecting economists. As you may read from his post, he is criticizing the newly developed plan for purchasing EU bonds in the secondary market, called OMT (Outright Monetary Transactions), my comments about which you may find here.

In the article, Yanis states that the EU is currently facing a battle between Bundesbank and the private German banks which want to avoid banking integration and the EU leadership
who wants to promote an EU-wide banking regulatory system. The main advantage of this proposal is that "small" countries will not be taken down as soon as their banks face disaster. What is most important is that under a common regulatory framework, all banks of the EU should (at least in theory) be treated equally without any national prejudices.

I may be too optimistic, or too pro-European in comparison to Varoufakis. Truth be told, I do not believe that Greece is innocent of all its sins and the situation there should not amaze us:
If you happened to watch any news about Greece over the last 10-20 years you would see how little trust the Greeks had in their governments, no matter what the ruling party was. Add to this an ideology proposed
by the world's leading economists (i.e. Friedman, who I am sure is laughing gaily now since he did not believe a monetary Union could be achieved in Europe) and what we get

ECB Announcement and Criticisms

On Friday, markets around the world were soaring as a result of the European Central Banker's announcement on late Thursday.  This came as a surprise to many, and they rushed to rejoice by raising stock market worldwide. Soon after the announcement, critics of the decision began to appear. Their criticism was expressed in three points:

1. The ECB is removing responsibility for fiscal reforms and austerity measures from the crisis-ridden countries because the bond buying program threatens to relieve the pressure of cutting expenses and deficits.

2. The ECB will flood the economy with money and risk higher inflation and a devaluation of the currency.

3. The Bank will violate its mandate because it will be effectively financing states, something which it is prohibited from doing under current European Union treaties. This would as a result endanger the ECB's independence.

Point 3 is, in my opinion, a matter of technicalities concerning EU Law. The ECB is not allowed to finance Member-States through the primary market, however, the treaty does not forbid it to do so in the secondary market. As for the independence? Well, the ECB did not have much to begin with. If by linking to the ESM the Bank will be made vulnerable to Member-State pressure, then all the ECB has to do is stand its ground and not allow any deviations from what was originally planned. Pressure will not mean a thing if the ECB does not succumb to it. And it has what it needs not to do so. Besides, the Federal Reserve in the USA has been pumping money into the economy over the last 70 years and no one has ever questioned its independence.

Point 2 is an overall policy issue. Fact: If the ECB issues money then inflation will rise. Thus, what the Bank has to do is issue money now and retract it later on. Or, issue money now and delay further issuing in the future until a sustainable, low level of inflation is achieved. I will not be the one to propose anti-inflationary policies to the Central Bank. That is what they are supposed to do better than anyone else. They have done good so far and I suppose we should allow them to do so in the future as well.

Point 1 is the most important of them all. By buying bonds directly, the ECB does promote some sort of moral hazard. Countries will not be so inclined to promote austerity measures and reforms if their bonds will be bought by the ECB. Nevertheless, the ECB has clearly stated that the plan will only assist those nations which have already applied for a bail-out and reforms as well as austerity packages are already on their way (and their bonds are not considered as "junk" by the three rating agencies). The ECB must make a strong point that without reforms and spending reductions no such help will be issued. Otherwise the critics will be right: nations will not do anything to fix what is broken. 

The announcement was a relief to both markets and nations. The ECB will, after a long waiting, play its card and assist in rebuilding confidence in the markets. As Draghi has stated: "The Euro is Irreversible"

A change in mentality?

Over the last week a serious change in attitude towards ailing countries within the EU has occurred. Leading with Chancellor Angela Merkel, the political scene in Europe has witnessed a 180 degrees turn. The change was so radical and impressive that Der Spiegel has published a full article on this. This could mean one of three things: 

1. The South has made real progress over the last month (hmm or week maybe?).

2. Merkel has understood that her policies and stance are making both her as well as Germans in general extremely unpopular in Europe (and elections are coming up in a year).

3. She has accepted that trying to push through many things very rapidly is not such a great policy after all.

Whatever the reason may be (Spiegel states that it's No2) the fact is that leaders now appear to be more united than ever before. Even statements of the "Greece should leave the euro/Union" kind are treated coldly by EU officials now. Still, as progress for unification in the political level appears to be improved the economy still fails to recover. Italy, just like Spain and Greece, has seen unemployment rates soar over the last months. While Mario Monti is doing his best to improve the overall economy, unemployment of youths under 25 has reached 40%. And with recession here to stay in Italy (forecasts expect GDP to contract by 2% this year) the situation does not seem to improve. 

European leaders fail to understand that people cannot live on GDP. After an EU-wide summit on unemployment nothing seems to have changed: the employed have not (cannot?) find anything to do about the jobless. I have proposed my set of ideas over reducing unemployment here, and while the list I have presented is not exhausting nothing has been done yet. Just as I have predicted, the EU will face a recession over the next few months. New evidence indicate that the recession will be far worse than we expected. The Purchasing Managers' Index (PMI) for the Eurozone predicts that the output will shrink by 0.5-0.6% over the current quarter instead of the initial 0.2% prediction. 

The worst part of these forecasts is that the EU's safest economy, the one where people actually paid to invest their money, Germany, is bound to move to the red. The OECD predicts that although Germany has grown by 0.5% and 0.3% in the first two quarters, in the following two an annualized contraction of 0.5% and 0.8% is expected. Only France may be able to remain more-or-less unscathed with output falling this quarter and rising on the next.

In addition to all these, Mario Draghi has announced a program allowing unlimited purchases of sovereign bonds in the secondary market, in order to keep interest rates at sustainable levels. The only opposition to this program is Bundesbank head Jens Weidmann who believes that the program is too close to state financing through the money press. He may be right up to a point, however, I do believe that the program is much ado over nothing, The problem with what Draghi has proposed is that the ECB will only assist countries that appeal for help to the euro bailout fund and submit to the required austerity conditions. What he also meant is that the ECB would only be able to do this for nations which are not considered as junk by the 3 rating agencies (Moody's, Fitch, S&P), i.e. Greece and Cyprus cannot be assisted.

Thus this leaves only two countries: Italy and Spain. However, the announcement failed to mention the amount which would be available to fund this action. Given the size of the Italian and the Spanish economy, it would have to be enormous. Yet, we are still unaware of the size and extent of the intervention and it would be nice to know some more details about it instead of the general idea.

In the meanwhile, what journalists have not yet proposed is that another reason of Merkel's newly appeared empathy towards the crisis-ridden countries maybe be that she is preparing to identify herself with the rest of the ailing nations if OECD forecasts are true. We will just have to wait until the official data is published to find out.

5 Causes of Financial Instability in Europe

As the EU crisis continues to unfold, many academics, investors as well as everyday people have lost their faith in the Union. They view more weaknesses than strengths in the Eurozone structure, and are under the idea that these weaknesses will lead the Union to its doom. On the other hand, there are those who have the firm belief that the EU will make it through, even if it takes some troubled years, and will emerge stronger and more unified from the crisis. 

Both groups are correct up to a point: Although the destruction of the EU does not seem eminent, there are some important issues which undermine the well-being of the Union. The most important of them are:

(i) A non EU-wide bank regulating authority. Currently, the EU member-nations have the sole responsibility to regulate, supervise and recapitalize their banks. A separate authority should be created in order to monitor banks and have the sole responsibility for their  recapitalization. This authority will comprise of officials from all EU member-states. Thus, if a bank recapitalization is needed the host country will not have to directly move to guarantee it as the authority will be responsible for it. In this way, the countries do not have to use their tax-payers money in order to bail-out the institutions.

(ii) Excessive public spending by EU governments (especially in the South). Unfortunately, people in the South knew that their governments were overspending years before this crisis occurred. Not to be fooled though, Northern nations were overspending as well (e.g. Germany, Austria and many others). However, everyone kept silent about this as no trouble had yet happened. The Stability and Growth Pact, as well as the Sixpack and the Euro Plus Pack which followed, are great ideas, nevertheless with little implementation. The reason is simple: what will stop a nation from having a large deficit if it needs to? Nothing at all. While the Packs and Pacts are full of proposals and ideas there are no "punishments" for those who wish to deviate from them. What happened when Germany had public debt of more than 70% of GDP for three consecutive years? Nothing. What will they do after the crisis ends? Return to the Packs and Pacts and after 3-4 years when all is forgotten governments will once again start spending more. The issue is not for the small nations. If Cyprus, Greece or even Italy are sanctioned by the EU they will most probably do as they are told. Will Germany do the same? I highly doubt it. 

(iii) Lack of ECB independence and discretion. As of the current regulatory framework, the ECB cannot act on its own will as it has to have Member-States' permission.  This makes the procedure of aiding an ailing nation or banking institution much slower and bureaucratic. Under the current scheme the role of the ECB is not the one of real Central Bank, like its counterpart in the US. If the ECB is not allowed to function autonomously then there is almost no need for its existence. The need for a better Union is tied together with a need for an autonomous bank which is allowed to act at its own discretion.

(iv) Non-integration of institutions, in favor of common policies. Most of the institutions in the EU have restricted powers and this does not allow for much to be done. Also, under the current structure, the only authority "paid to think European" is the European Commission. Thus, the need for more institutions which are EU-orientated in their policies arises. Aside of this, the aspect of granting more powers to the EU institutions is an issue which has to be settled. If the institutions are allowed to function as they should then more political union would occur in the region, thus making it easier for the monetary union to survive.

(v) Member-States leaders who believe the EU is their protectorate and have the notion that in order for anything to be done they have to grant their permission (Wonder who this makes me think about Angela....)

Investor Pessimism

Lately, I have been reading a lot about investors, banks and nations preparing for the worst case scenario. It seems that the definition for "worst case scenario" differs from time to time: a Greek exit, a Euro collapse, a banking collapse, a Eurozone collapse and so on. Obviously one has to prepare for such events. What I always thought to be weird is that people always prepare for "worst case scenarios" only after recessions or severe economic blows occur. One should never be worried by pessimism or optimism in the markets. Although they may last long in many cases, they are always alternating. They are both outcomes of human nature, a sort of behaviour that was the same throughout the years.

All of the great investors throughout history understood this. People are always prone to good or bad feelings. A bear market (e.g. a falling index in the stock exchange) occurs when people feel overly pessimistic about the present and the future and a bull market (the exact opposite, a rising index) occurs when people feel overly optimistic about it.

A great example of this is the banking situation nowadays. Banking institutions after expanding rapidly in the last decade (overly optimistic) are now contracting their business operations to operating only at the local level (overly pessimistic). Cross-border lending is steadily declining in the EU reaching 2007 levels in last June. Otmar Issing, a former ECB chief economist states: "Over the long term, the monetary union can't be maintained without private investors,because it would only be artificially kept alive." While this is true and many feel that getting rid of their assets in euros and buying gold or real estate is a great idea, others have gone even further by removing themselves from the monetary zone. 

Many investors are even betting against the euro surviving. John Paulson, who made billions shorting (i.e. selling something now - e.g. a stock or a currency - in hope of buying it later at a lower price and thus profiting with the difference) during the sub-prime lending crisis in the US and the now retired George Soros stated that they are betting against the common currency. 

As for me, I wouldn't worry about bank contraction. Both economies and firms contract and expand as they react to the general feelings of threat or hope for the future. A crisis is a good opportunity for people, firms, economies and states to learn from their mistakes. What I hope is that politicians and policymakers will realize the need for action. Even late action is better than no action, however too late would mean the end of the euro as many investors prophesied.