Christopher Mah...'s  Instablog

Cypriot banks are closed, all bank deposits are frozen including the Russian government's, and there is no obvious way to unfreeze them. Russia is becoming very annoyed. The ECB has given Cyprus until Monday to agree to a bank recap. Otherwise it says that it will withdraw emergency liquidity and the Cypriot banking system will collapse. A Cypriot banking collapse would be a Lehman Event.

Since there are no real deadlines in Euroland, this is most likely feint by the ECB to force Europe to step up. One solution might be for the ESM to guarantee the ECB's exposure pending a bailout agreement. The ECB isn't allowed to lend to insolvent banks.

Europe is finally realizing that a Cypriot banking collapse would pose a systemic risk to the eurozone. The Telegraph:

"Jeroen Dijsselbloem, the Dutch finance minister who chairs meetings of eurozone ministers, warned that Cyprus poses a "systemic risk" to Europe's economy and banking sector, meaning a bank meltdown there could plunge other European countries into a new crisis. "In the present situation I think there is definitely a systemic risk and I think the unrest of the last couple of days has proven this, unfortunately," he said." (03.21.13)

A Cypriot banking collapse would lead to a general pull-back of deposits in Club Med banks (including Italy) by foreign and domestic institutional depositors. The risk in these countries is not that an individual bank will fail, but rather that all deposits will be frozen and rescheduled and/or redenominated. This means that the entire country must be redlined, not just weak banks. Domestic institutional creditors are as much at risk as foreigners.

The finance ministers have reportedly started to discuss capital controls as a way to prevent contagion from a Cyprus collapse to the rest of Club Med. What could this mean in practice? Are they really contemplating capital controls for the Club Med countries? This would violate a whole lot of laws, and would mean the effective end of the eurozone as a single monetary zone. (The US and and a number of other countries use the US dollar as their currency, but they are not a single monetary zone.)

If capital controls are imposed in any of the Club Med countries, they will have to be imposed on many of them, because of the risk that they will be imposed later. Capital controls in an economy like Italy would be a financial event similar to Austria in 1931.

Unless a Cypriot banking collapse is averted, it will be another Lehman Event, perhaps even a Minsky Moment. In retrospect, none of the reasons for allowing Austria's banks to default in 1931 were very persuasive. None of Hank Paulson's reasons for allowing Lehman to go bankrupt are persuasive. And none of the reasons being given for Cyprus to go under are persuasive either. The cost of a cleanup from Cyprus would be a multiple of the cost of buying the entire country.

Ultimately, this is a problem that land squarely on Merkel's desk. Only she (and Schaueble) have the power to force (permit) a resolution. I am confident that this is being made clear to her as we speak (by Medvedev and others). Personalities matter in financial crises. At this juncture, it is very unfortunate that Tim Geithner has left the scene. Right now, the only authoritative American voice in Europe is Ben Bernanke, who isn't allowed to make policy recommendations.

The world has about a week to prevent the Cyprus crisis from infecting southern Europe. If it fails, the market impact will be quite remarkable.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

The US faces a fiscal crisis due to the demographic implications of healthcare, social security and public-sector pensions. Over the next decade, as the postwar generation leaves the workforce and begins to draw upon government resources for healthcare and pensions, these budget items will grow rapidly at the federal, state and local level. Without drastic and politically unpalatable reform, these expenses will consume government budgets, leaving no room for government services and activities. The consequences will be high structural deficits, and an exhaustion of national debt capacity.

The run-up to the demographic crisis should have been preceded by a strengthening of the national finances in order to leave some debt capacity for the problem. instead, the country has been running large deficits since as a result of the Great Recession. Federal debt held by the public has grown from $5 trillion in 2007 to $11 trillion today. The ratio of debt held by the public to GDP has risen from below 40% in 2007 to almost 80% today. Without a drastic change in course, the CBO predicts that ten years from now the ratio will climb to 90%, the highest level in postwar history.

Here is the budget arithmetic: GDP has been growing at 4% in nominal terms since the Crash, while federal debt has been growing at 12% over that period (post-crash). The debt is growing 8% faster than GDP, hence the steadily rising Debt/GDP ratio. The deficit represents 30% of federal spending.

Stabilizing (or reversing) the country's debt ratios will require a major reduction in overall spending, entitlement reform, and substantially higher taxes on the middle class. All of these measures are included in Simpson-Bowles, but that plan is an unpopular orphan. Republicans won't discuss taxes or global adventurism, and Democrats won't discuss entitlements or welfare.

Therefore, there will be no fiscal reform, the deficit will remain large (and will grow as Medicare grows), and the fiscal problem will go from being difficult to fix to being beyond fixing. The likelihood of a fix is becoming very low.

Today's children will inherit a country at maximum debt capacity, like Japan is today. While we now enjoy the luxuries of low taxes and high spending, today's children will not. The pleasures that we receive from spending their money will not be commensurate with the financial squeeze that they will face. The ultimate challenge is one of intergenerational morality or rather immorality.

To avert the coming crisis will require two things: (1) immediate fiscal consolidation; and (2) reform of the nation's healthcare and pension systems. The current state of play in Washington indicates that neither is politically possible. There is no political consensus for lower spending, higher taxes and drastic programmatic reforms. The overall consensus is for low taxes, a high level of spending, and unreformed entitlements. Both the Simpson-Bowles and Ryan plans were dead on arrival, and no one wants to discuss them.

The broad-based national consensus against any kind of meaningful fiscal reform is illustrated by the continuing acceptance of large federal deficits despite economic recovery for the past three years. In 2012, federal tax revenues covered only 60% of expenditures, leaving 40% to be borrowed from future taxpayers.

All of the "deficit reduction" measures taken by the administration and Congress since the crash (including the sequester and its "massive cuts") have had little impact on the 10-year fiscal outlook*.

The problem is not only that there is no consensus for reform, but also that the door for reform has almost closed. Too many baby boomers have entered the land of perpetual leisure, and too few have the inclination to die quickly. They are not going to die for decades, they vote, and there will be more of them than there will be working taxpayers. To the retired, Medicare and Social Security are holy sacraments.

I have argued in the past that a principal cause of the fiscal problem is inadequate inflation and inadequate nominal growth, and this remains my view. Higher inflation would reduce the deficit and flatten the trajectory of the debt ratios. It could also be used to partially erase the debt. But inflation these days seems about as popular as Medicare reform. It's not being debated (not even at the FOMC), and the world would probably explode in flames if the CPI ever went above 4%. So that simple solution is off the table, leaving debt accumulation as the likely alternative.

In the context of the looming fiscal crisis, the sequester is small potatoes**. It only affects a small part of the budget in a small way. I happen to like the sequester from a policy perspective, because it cuts defense by a meaningful number, which is good policy if, like me, you are uncomfortable with gold-plated overseas adventurism. Using fiscal policy to "limit the mission" is a good tactic. I also like the cuts to the bloated non-defense budget as well. Any cut is a good cut if your goal is limited government. But the sequester is political theater rather than real fiscal policy. Simpson-Bowles is real policy, as is the Ryan Plan. But they are not being debated.

*The Budget Outlook, CBO, 04 Mar 13.

www.cbo.gov/sites/default/files/cbofiles....pdf

**The Budget Control Act of 2011
The BCA specifies automatic procedures to reduce both discretionary and mandatory spending during the coming decade. Those automatic reductions will take the form of equal cuts (in dollar terms) in funding for defense and nondefense programs in fiscal years 2013 through 2021. Under the BCA, the automatic enforcement procedures will reduce budgetary resources for defense programs by $492 billion over the 2013-2021 period. By CBO's estimate, the automatic enforcement procedures will reduce discretionary defense resources by about 10% in 2013 and reduce the caps on defense appropriations by lesser amounts thereafter, declining to 8.5% in 2021. By CBO's estimate, the automatic enforcement will reduce nondefense funding (excluding Medicare) by about 8% in 2013 and by declining percentages thereafter, falling to a low of 5.4% in 2021.

Despite the drumbeat of defeatism from English-speaking economists, and despite three years of disappointing economic results, the Eurozone persists in the execution of its original "Plan A", adopted three years ago:
1. Balance eurozone government budgets by raising taxes and reducing expenditure.
2. Improve external competitiveness with internal deflation and market reforms.
3. Stabilize debt ratios through fiscal consolidation and the (eventual) resumption of economic growth.
4. Prevent speculative attacks and restore market access with credible long-term policies, backstopped by the ECB and the ESM.
5. Remove "exit risk" by the ECB's pledge to buy government bonds in the event of stress.

Now is an opportune moment to assess where "Plan A" stands with respect to probability of ultimate success. At present, all of the troubled countries (except Cyprus) are either in compliance with Troika agreements, or are otherwise implementing (or pretending to implement) fiscal consolidation and structural reform.
The bond market's reaction to progress to date has been positive, with yields declining and limited issuance resuming for a number of peripheral countries. The ESM has not had to make new loans (besides Greece), and the ECB has not had to intervene in the bond market. In the hierarchy of world crises, Europe appears to be moving to the back-burner, outside the spotlight of daily headlines and TV news bulletins.

Is there anything wrong with this picture? Yes, it's completely delusional. The eurozone's financial arithmetic continues to head inexorably in the wrong direction.

The ECB's zero growth policy (ZGP) is slowly bankrupting the peripherals as their debt grows while their economies and government revenues shrink. The political pressure gauge is the unemployment rate, which has already entered the critical "red" zone for some of the peripherals. The human cost of the ZGP is immense and has not yet fully manifested itself in the political process. Zonal unemployment is now 12%, and zonal GDP is shrinking (yes, the whole zone).

But this is not an acknowledged problem for the eurozone, because employment is not an ECB mandate. Unemployment and growth are irrelevant to the European assessment of the success of Plan A. As far as the ECB is concerned, Plan A is a big success.

Let's agree for the sake of simplicity that the central problem for the eurozone is the growing risk of peripheral government bankruptcy, and that the best index of government solvency is the level and trajectory of the Debt/GDP ratio. This ratio can be forecast as follows: Debt + projected fiscal deficits + bank recapitalizations - debt write-offs = future Debt. GDP + nominal growth = future GDP.

What do we see? We see D continuing to rise due to declining government revenue and inflexible government expense, resulting in large and persistent fiscal deficits. On top of these operating deficits is the cost of unending banking system recapitalizations due to government and private-sector defaults. We see flat nominal GDP growth due to low inflation, lack of export competitiveness and inadequate domestic demand, exacerbated by fiscal austerity.

Thus, D continues to rise while nominal GDP is stagnant (and shrinking in real terms). All measures of government creditworthiness have steadily declined since 2007. Credit ratings are being pushed out of investment grade as new risk thresholds are breached. (In Europeland, sovereign downgrades are irresponsible, unwarranted, and strongly discouraged.)

Other than further debt forgiveness by unhappy creditor governments and institutions (see: Bundestag), there is nothing visible on the horizon to reverse this process of government insolvency as manifested by the upward slope of the D/GDP ratio. The ECB remains satisfied with ZGP, and studiously ignores its enormous human and economic costs.

The current debate within the ECB governing council is not how to stimulate growth and bring down unemployment, but rather how to exit from further stimulus, since the crisis is over. The perversity of such thinking is remarkable in its indifference to evidence of failure. How much contrary data will it take to prove to the Germans that shrinking economies don't repay debt? (They have a selective memory about German history during the 1920s.)

This year, the eurozone disaster must inevitably grow from a purely economic crisis into a political one as well. The peripheral governments face multi-year depressions and their social safety nets and their "social models" are becoming badly frayed.

Most of the peripheral countries are politically immature with fragile institutional legitimacy. Most of them have undergone multiple regime changes over the past century and few of them have been successfully democratic for longer than a few generations. Few of them have weathered a protracted depression under a democratic regime. Each country has a political inflection point, which will be reached as depression continues. Greece and Cyprus are already politically fragile.

The peripheral states are being stress-tested both economically and politically by the ECB's zero growth policy. As long as the ECB persists in running this sadistic contest, the odds of political failure will steadily increase, and may already be irreversible for certain countries. Europe is not Japan; it is much worse.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.