Interesting readings

China's
Pakistan Conundrum by Evan A. Feigenbaum, in Foreign Affairs.

The most important task of government is the public goods of law
and order: laws, courts and judiciary. The first step towards
strengthening these lies in sound measurement. Writing
in Pragati, Sushant
K. Singh has an excellent article on the problems of measurement
of crime in India.

An
independent judiciary by Ruma Pal.

Devesh
Kapur, in the Business Standard, on the HR crisis in
the Indian State.

Shyam
Saran in the Business Standard on a more sensible
approach that we should bring to intra-South-Asia logistics.

The lack of freedom of speech in
India: Karan
Singh Tyagi in the Hindu.

Amit
Rai writes in the Times of India about the mistakes of
the legal actions following the AMRI fire.

Mobis
Philipose in Mint on how charges by exchanges have made
a difference to the currency futures market.

Every advocate of a big spending Indian government should ponder
this
article about Greece by Landon Thomas in the New York
Times.

Dreze and
Sen on what India does right and wrong. We may not agree with
most of this, but they are smart people and it's worth reading.

Hard times at
UTI: Anirudh
Laskar and Vyas Mohan in Mint,
and Niladri
Bhattacharya and N. Sundaresha Subramanian in Business Standard.

Air
India
and Maharashtra
PSUs remind us, in interesting ways, about why government
should not be in business.

Martin
Feldstein explains what went wrong with the Euro.

Look at profiles
of Mario
Monti, who will try to fix Italy,
and Loukas
Papadimos, who will try to fix Greece. I guess that every now
and then, the professional politicians foul up big time, and then
bring in the economists to clean up. It reminds me of a perspective
by C. B Bhave on urban governance in India: when things are going
well, the politicians want an accomodating civil servant; when the
city goes to hell, they want a tough competent one. Also
see Greece
and Italy Seek a Solution From Technocrats by Rachel
Donadio in the New York Times.

Charles
Moore looks back at the story of Maggie Thatcher, who ended
Britain's long decline in the 20th century.

Read Larry
Summers in the Financial Times on the problem of
inequality and three things that need to be done about it.

Two important platforms for modern web development were Flash and
HTML5. It
now looks
like Flash
is dying. Looks
like Steve
Jobs was right on one more thing.

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Business cycle conditions in India: It's mostly cycle, not trend

There is a lot of gloom in India today about the broad-based failure of the UPA strategy of combining left-of-centre populism, fiscal profligacy, theft, and a lack of interest in the foundations of India's growth. We learn from history that we learn nothing from history; India has clearly learned very little from its escape from the Hindu rate of growth. The moment we got a little bit of growth, the old style socialism and theft reared up again. In one of the many pessimistic articles of this theme, Shekhar Gupta in the Indian Express says:

What is the Hindu Rate of Growth two decades after reform? It certainly can’t be the 2-3 per cent of India’s socialist Brezhnev decades. The new Hindu Rate of Growth is 6 per cent, and on all evidence, from macroeconomic data to the empty billboards of Mumbai, we are headed there next year.

In thinking about GDP growth, it's always useful to think about both growth and fluctuations. Growth is about the underlying trend growth rate.  In the olden days, this was all you needed to worry about. The economy trundled along at roughly the trend growth rate (the Hindu rate of growth of 3.5 per cent), being kicked up or down by good or bad monsoons. In that period, macroeconomics in India required thinking in completely different ways, when compared with standard Western textbooks.



But from the early 1990s onwards, India changed. The market-oriented reforms, which began with the Janata Party in 1977 and gathered momentum in the 1980s, had started creating a market economy. And every market economy in the world experiences business cycle fluctuations. So, in addition to the trend, we got a cycle about the trend. There were good periods and bad periods, and the story running in there was much like that found in mainstream Western textbooks, with a prominent role being played by profitability, inventories and investment by firms.



From this viewpoint, it's useful to decompose two elements of what we are seeing after 2009. On one hand, trend growth has been influenced by decisions of the UPA. Any perceptive observer also tends to rage at the lost opportunities, of policy decisions that should have been taken, which would have accelerated trend growth. But the second big story is that of fluctuations. Corporate investment is a major driver of business cycle fluctuations in India, and there has been a certain deceleration in this. This may have set off a downturn.



The bulk of the drama that we're now seeing, and what will play out in 2012, is business cycle fluctuations. This is about fluctuations, not the trend. When trend growth is 7 per cent, the fluctuations make GDP growth range from 4 per cent to 10 per cent. Even if trend growth does not change by even a bit, business cycle fluctuations can take us from a high of 10 per cent to a low of 4 per cent, which is a huge swing of 6 percentage points.



Many elements of economic policy are pro-cyclical: when times are good, they make things better and when times are bad, they make things worse. The financial system tends to suffer from pro-cyclicality: when times are good, bankers lend exuberantly (thus expanding the boom) and when times are bad, bankers tend to be cautious (thus accentuating the bust). It is important to look for a framework for stabilisation, of tools that will counteract business cycle fluctuations. India has crossed one major milestone, in getting to a floating exchange rate. The floating exchange rate is stabilising, in and of itself. In addition, it opens up the possibility of stabilising monetary policy.



As of today, by and large, I think of both fiscal policy and monetary policy as being part of the problem and not part of the solution. While floating the exchange rate (decisions from 2007 to 2009) opened up the possibility of sound monetary policy, the logical next step did not materialise. As of yet, we do not have a sound monetary policy regime. We're going to require far-reaching surgery to laws and institutions, in order to craft frameworks for fiscal policy and monetary policy that do stabilisation. Until these changes are made, Indian GDP growth will have the high volatility that is characteristically found in countries with weak institutions.



A lot of our work in the Macro/Finance group at NIPFP is rooted in this conceptual framework. In particular, you might like to see two relatively non-technical articles: New issues in macroeconomic policy and Stabilising the Indian business cycle.

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Talk by Thomas Laubach on inflation expectations, inflation targeting, monetary policy

Thomas Laubach will do a talk
titled Inflation:
Expectations, Targets and the Institutional Framework for Monetary
Policy at the NIPFP auditorium at 3:30 PM on December 9
(Friday). He is Professor at Goethe University in Germany. All are
welcome.

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The rupee: Frequently asked questions

q: How big is the market for the rupee?




The rupee is now a big market. Summing across both spot and derivatives, perhaps $30 billion a day of onshore trading and $40 billion of offshore trading takes place. Both these markets are tightly linked by arbitrage. In other words, for all practical purposes, it's like NSE and BSE which are a single market unified by arbitrage. If you place a small order to buy 100 shares on either NSE or BSE, you get essentially the same price, and arbitrageurs are constantly at work equalising the price across both markets. It is a similar state of affairs between the onshore and the offshore rupee. Both markets are tightly integrated by arbitrage.



The offshore market for the rupee, and a large part of the onshore market, is OTC trading. Hence, the efficiencies of algorithmic trading and algorithmic arbitrage cannot be brought to bear on onshore/offshore arbitrage. So the arbitrage is done by manual labour. Still, it gets done. Both markets are tightly linked and show the same price. We should think of them as one market. It's one big market, it is one of the big currencies of the world, it's roughly $70 billion a day.






q: How might RBI do manipulation of this market?



If RBI wants to hit the market with orders big enough to make a difference, they have to be ready to do fairly big orders and to be able to do it on a sustained basis. As a rough thumb-rule, I might say that in order to make a material difference to a market with daily volume of $70 billion, they have to be in the market with atleast $2 to $3 billion a day.






q: What would go wrong if they tried this?



Three things would go wrong.



First, foreign exchange reserves are $275 billion. If RBI sells off $2.75 billion a day, the reserves would be quickly gone.



Second, when RBI sells dollars and buys rupees, this sucks liquidity out of the market. The side effect of selling dollars would be a sharp rise in domestic interest rates. In other words, monetary policy would get hijacked by currency policy. This would not be wise. Monetary policy should be focused on delivering low and stable inflation: it should have no ulterior motives. We have to make a choice: Do we want to use up the power of monetary policy to achieve domestic goals, or do we want to use up the power of monetary policy to achieve currency policy goals?



Third, suppose you and I saw a market price of Rs.45 per dollar, which is created by RBI and not a market reality. We would know that in time, the truth will out, that the price will go back to Rs.52 a dollar. The rational trading strategy for each of us would be: To sell any and every domestic asset, and shift money out of the country. This would trigger off an asset price collapse in India. We would take the money out, and wait for the distortion of the currency market to end. At that point (perhaps Rs.52 a dollar, perhaps worse) we would bring the money back to India and buy back our assets. We might make two returns here: first, on the move of the INR/USD from 45 to 52 (or worse) and the second, on the gain from the drop in asset prices.






q: Isn't it hard to take money out of India in this fashion?



It's easier than we think. Remember September 2008? The mythology in our heads was: we in India are crouching safely behind a wall of capital controls. In truth, the wall wasn't there.






q: But until recently, RBI used to give us a pegged INR/USD exchange rate! What changed?



In late 2003, RBI ran out of bonds for sterilisation. Associated with that, there was a first structural break in the rupee exchange rate regime, with a doubling of volatility. A short while later, in March 2007, there was another structural break, with another doubling of volatility. From April 2009 onwards, RBI's trading in the market has gone to roughly zero. RBI stopped managing the exchange rate a while ago.



The exchange rate is the most important price of the economy. The decontrol of this exchange rate is the biggest achievement of the UPA in economic reforms. The credit for this goes to Y. V. Reddy and Rakesh Mohan (who took the first two steps of doubling exchange rate flexibility twice) and to Dr. Subbarao (who got out of trading on the currency market, which did remarkably little to INR/USD volatility).





q: Why did nobody tell me that something changed in the exchange rate regime?



RBI should be talking more transparently about what is going on. But they are not transparent about what they do. Even though hundreds of millions of people are affected by their trading on the currency market (or the lack thereof), the manual which governs their currency trading at any point in time (i.e., the documentation of the prevailing exchange rate regime) is not transparently disclosed to the people of India. We have to decipher what is going on by statistically analysing exchange rate data.



The dates of structural break of the exchange rate regime are extremely important dates in thinking about what was going on in macroeconomics and international finance. Any time one is using data about exchange rates, interest rates, etc., it is important to work within one segment of the prevailing exchange rate regime at a time. It is wrong to pool data across many years. All users of data need to be careful in this regard.





q: So what might happen to the rupee next? Is there a `law of gravity' which will pull it back to erstwhile values of Rs.45 or Rs.50?



When you don't manipulate a financial market, the price time-series comes out to something close to a random walk. In the ideal random walk, all changes are permanent. The random walk never forgets; there is no law of gravity which takes it back to recent values. Your best estimator of what it will be tomorrow is: what you see today.



In order to get a sense of what will come next, go through the following steps. First, go to INR/USD options trading at NSE, and pluck out the implied volatility for the four at-the-money options. I just did that, and the values are: 10.43, 10.32, 10.33 and 10.08. Calculate the average of these four numbers. With the above four values, the average is: 10.3. (This is a quick and dirty method; here is one which is much better).



This tells a very important thing: The options market believes that in the future, the volatility of the INR/USD rate will be 10.3 per cent per year.



In order to re-express this as uncertainty per month, we divide by sqrt(12). This gives the volatility for a month as : 3% per month.



Roughly speaking, the 95% confidence interval for what might happen over a month, then, runs from -6% to +6% (this is twice the standard deviation, which we just worked out was 3% per month).



The INR/USD is now Rs.51.62. By the above calculation, we can be 95% certain that one month from today, it will lie somewhere between 48.5 and 54.7.



These trivial calculations have been done by equity market participants for the longest time. It is a standard and trivial idea: To read the implied volatility off the Nifty options market, and to do such calculations to get a sense of what might come next with Nifty. But on the currency market, this is relatively novel. Only recently have we got a nice currency options market, and only recently have we got to a genuine market. Now these skills can be brought to bear on the currency market. It's a brave new world, one in which the operations of financial derivatives markets (Nifty options, INR/USD options) produces forward-looking and timely information about the economy (implied volatility).





q: What changed in imports and exports which gave us the big recent move of the rupee?



The current account (goods, services, and then some) adds up to a mere buying and selling of $4 billion a day. The bulk of currency trading is about the capital account. The currency is a financial object; the exchange rate is defined by financial considerations and not by current account considerations.






q: What happens to the Indian economy when the rupee depreciates?



This has been the source of a great deal of confusion and it's important to think straight about this. There are three important effects in play:

1. Some people had borrowed in dollars, and left it unhedged since they were speculating that the INR would appreciate. They have got burned. That's okay - in a market economy, many people place bets about future fluctuations of financial prices, and half the time the speculator loses money. (If the rupee had not depreciated sharply, these speculators would have been truly joyous).


2. When the rupee depreciates, imports become costlier and India's exports become more competitive. So exports (X) gradually start going up and imports (M) gradually start going down. The net gain in X-M is increased demand in the local economy. In this fashion, INR depreciation is good for aggregate demand (and conversely INR appreciation pulls back demand). However, we have to bear in mind that these effects are small and take place with long lags.


3. Many things in India are tradeable. It is important to focus on the things that are tradeable and not just on the things that are imported. As an example, there are many transactions between a domestic producer of steel and a domestic buyer of steel. The buyer and seller are both in India. But the price at which they transact is the world price of steel (which is quoted in dollars) multiplied by the INR/USD exchange rate. This situation is called `import parity pricing'. Through this, the domestic prices of tradeables goes up when the rupee depreciates.

q: What is the impact of costlier tradeables for RBI?

RBI's job is to fight inflation. RBI must work to deliver year-on-year CPI inflation (a.k.a. `headline inflation') of four to five per cent. When tradeables become costlier, domestic CPI inflation goes up. So the rupee depreciation has made RBI's job harder. RBI will have to respond by hiking interest rates. (Note that one impact of higher interest rates will be that more capital will come into India, which will tend to yield a rupee appreciation; import parity pricing has created a new channel through which RBI rate hikes combat inflation).

q: What is the impact of costlier tradeables for business cycle conditions in India?

As the example above about steel suggests, the price realisation of all tradeables companies goes up when the rupee depreciates. Costs change by less by revenues (since many costs are not tradeables), and profitability goes up.

Firm profitability has dropped sharply in 2011. My prediction is that firms producing tradeables will show better profitability in Oct-Nov-Dec 2011 when compared with the previous quarter, thanks to the rupee depreciation.

This is great news for business cycle conditions. Profitability goes up, which yields more cash for investment by financially constrained firms. And, when profitability is higher, more investment projects look viable.

q: In the bottom line, what is the link between the rupee and India's business cycle stabilisation?

If RBI tried to peg the exchange rate, the lever of monetary policy would get used up to deliver the target exchange rate. By not trading on the currency market, the lever of monetary policy is now available. A pretty good use for this lever is to deliver low and stable CPI inflation. If this is done, then an RBI focused on inflation would help stabilise the economy by cutting rates when CPI inflation drops below 4% and hiking rates when CPI inflation goes above 5%.

But floating the exchange rate also yields stabilisation purely in and of itself. In bad times, capital leaves India, the rupee depreciates. This gives higher profitability in tradeables firms and bolsters investment. Conversely, when times are good, more capital comes into India, the INR appreciates, which crimps profitability of tradeables firms. The floating exchange rate exerts a stabilising influence upon the economy: purely by doing nothing on the currency market, RBI has unleashed this new force of stabilisation which will help India.

q: What should RBI do next?

RBI should do as they have done, i.e. avoided trading on the currency market.

RBI should keep driving up the short-term interest rate until point-on-point seasonally adjusted CPI inflation shows a decline and goes into the target zone of 4-5 per cent. After this hangs in there for a year, `headline inflation' (y-o-y growth of CPI) will be in the target zone.

q: What do other countries do?



When we look at countries with good governance, the mainstream strategy seen worldwide is an open capital account and a central bank that delivers on an inflation target. By and large, this goes with a floating exchange rate. Trading on the currency market interferes with achieving price stability and has hence been dispensed with, by most good countries. Japan and Switzerland come to mind as exceptions to this broad regularity.

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IGIDR Emerging Markets Finance conference

Link.

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Taxing investors to pay NGOs

In India, NGOs are fashionable. It is almost never wrong, in the Indian discourse, to give more money and more functions to NGOs.



Many people have worried about the extent to which NGOs are being used to supplant failing State machinery. This may seem expedient, but no country every became a developed country on the back of NGOs. There is no alternative to fixing the core mechanisms of the State.



In recent days, two pro-NGO policy elements seem to be in the pipeline:

1. A new Companies Bill seems to require that 2% of profit be spent on corporate social responsibility (CSR).


2. SEBI decided to force listed companies, starting with the top 100 firms, to describe measures taken by them along the key principles enunciated in the ‘National voluntary guidelines on social, environmental and economic responsibilities of business,' framed by the Ministry of Corporate Affairs (MCA).

When the government grabs 2% of the profit of a company, and hands it out to any purpose (no matter how good or bad), that is called expropriation. The fact that it satisfies some bleeding hearts does not change the fact that it is expropriation. In a good country, property rights would be fundamental, and the Supreme Court would block such expropriation.

The job of a corporation is to efficiently organise production, and send dividends back to shareholders. It is the individual, the shareholder, who has to then make a call about whether he would like to give money to charitable causes or not. We do wrong by expropriating this money even before it reaches the individual.



For an analogy, it is Bill Gates' birthright to gift away his own money, in his capacity as an individual. And I really admire the intelligence with which the Bill and Melinda Gates Foundation works. But Bill Gates (or the government or anyone else) has no right to expropriate money belonging to shareholders, through charitable initiatives by Microsoft.

We do wrong by placing the burden of charitable works upon the corporation. Corporations should not be organised to be do-gooders. They should be organised to obey laws, have high ethical standards and then power India's way out of poverty by efficiently organising production. Anything that corporations do, other than focusing on efficient production, is a distraction from the main trajectory of India's growth and development.

When a country is run by bleeding hearts, things start going wrong. If such a tax is enacted, it reduces the post-tax return on capital that Indian firms generate. Foreign investors and domestic investors have choices about where to invest. They will demand that firms only invest in a smaller set of high-return projects, which are competitive on the rate of return by global standards, even after being taxed. In other words, many projects will not be undertaken. This can't be good for India.

To make progress in India, we need to be hard headed. We should not let the urge to do good crowd out intelligence and analysis. We are falling into this trap too often.

One key element that I blame is the Indian college education. We fail to teach political science, we have   too many people who have not read The Republic, so we get trouble like Anna Hazare. We fail to teach economics, so we get Sarva Shiksha Abhiyaan and the education cess. Given the absence of a positive strategy for what India should be doing, in the mainstream, we are willing to turn away from the hard work of fixing the State, and feel satisfied by funding some do-gooding NGOs.



Intellectuals are the yeast that make a society rise. India is a big mighty youthful stagnant dough, waiting for a pinch of yeast.

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Guide to the Eurozone crisis

by Percy S. Mistry.

How did it happen?

The worst financial crisis in the western world for nearly 80 years
broke in September 2008.

It required banking/financial systems to be supported and
recapitalised by governments across the EU and in the US.

In June 2009 it became apparent that the peripheral countries of
the Eurozone (Greece, Portugal, Spain and Ireland) were grossly
over-indebted.

Yet in some instances (Spain) their public debt to GDP ratios
happened to be lower than those of the US, France, the UK and
Germany.

The continued viability of their public finances depended entirely
on markets being willing to refinance them with cheap money.

But, when markets scrutinised the sustainability of their fiscal
positions, they baulked from refinancing except at punitive rates.

CDS spreads (against Germany as a benchmark) of peripheral Eurozone
countries (PIGS or Club Med) debt began widening relentlessly.

Global financial markets began to price in an escalating risk of
partial/full voluntary/involuntary default on PIGS bonds since
December 2009.

Contrary to first impressions, except for Ireland, that was a
result not just of the financial crisis and bank recapitalisation
demands on the fiscus.

It became apparent instead that bank recapitalisation demands on
public finance were only the last straws that broke the camel's
back.

Greece, Portugal, Spain and Italy, as a direct consequence of
joining the Eurozone, had been running up unsustainable fiscal
deficits since 2000.

Ireland had not. It suffered because the bailout of its
disproportionately large banking system caused its public debt to rise
astronomically.

PIGS became over-indebted despite the supposed self-imposed
discipline adopted by the Eurozone of prohibiting fiscal deficits >3%
of GDP.

That discipline was violated by almost all Eurozone members,
beginning with France and Germany, but more egregiously by the
PIGS.

To make matters worse, however, the PIGS were also running
increasingly large current account deficits (with Germany, France,
China).

Though countries like France (and to a lesser extent) Germany were
fiscal sinners, they were at least running current account
surpluses.

PIGS had access to excessively cheap public and private money
available on terms totally inappropriate to their economic
circumstances.

Given their inherent risks, which markets mispriced completely,
their borrowing costs should have been 300-500 bp higher than
Germany's.

Instead, they were virtually the same for nearly a decade. That
relieved market-induced pressure on PIGS' governments to behave
responsibly.

Consequently, their public expenditures after 2000 ballooned out of
all proportion to their intrinsic capacity to fund them from tax
revenues.

Such expenditures became almost wholly dependent on access to
increasing amounts of cheap public borrowing from capital markets.

In response to access to excessively cheap money, wages in the PIGS
rose across the board as did growth in public sector employment.

With the financial crisis triggering bank recapitalisation needs,
on top of this unsustainable structure, the edifice began to
crumble.

The first early warning signals became apparent in December 2009
but the dam broke in mid-2010 with the first Greek bailout.

How has the Eurozone crisis been handled?

Extremely ineptly; indeed very foolishly, by sophisticated Eurozone
authorities (political, fiscal and monetary) that should have known
better.

Eurozone leaders learned nothing from the preceding debt crises in
Latin America (1982-87, 1994-95) and Asia (1997-2000).

They went through avoidable phases of serial denial that there was
a structural debt (solvency) crisis that could spread via
contagion.

They treated it as a liquidity crisis that could be dealt with by
temporary patch-ups of additional money combined with fiscal
restraint.

They reiterated their commitment to ensuring there would be no
default - partial or full, voluntary or involuntary - by any Eurozone
member.

They believed that their remedial measures would stop the crisis
from ballooning beyond the first bailout package for Greece.

They were totally wrong. That package did nothing to convince
markets that Eurozone leaders understood the nature/severity of the
problem.

In fact, the inadequacy of that first bailout package -- which did
not provide enough money for sufficiently long - became quickly
apparent.

Eurozone leaders were fixated on debt-affected PIGS being forced to
live within their means through indefinite austerity without end.

Debt recovery/sustainability models did not provide sufficient new
money, or permit debt restructuring, in ways that would restore
stability.

Least of all were bailout packages designed to restore growth in a
conscionable period of time that would be socially/politically
acceptable.

Without financial system (and borrowing cost) stability, and absent
growth, debt problems can never become better. They can only
worsen.

Instead, as a result of poor design, all the bailouts did (except
for Ireland) was to add new debt to bad debt and reduce growth
prospects.

To exemplify: In mid-2009 the debt/GDP ratio for Greece was 115% of
GDP and the debt service ratio about 11% of GDP.

But, by October 2011 the debt/GDP ratio for Greece was 161% of GDP
and the debt service ratio nearly 20% of GDP.

It is projected with the third bailout to rise to 185% of GDP
(although debt service will be lowered to 16%) before it comes down
again.

In the meantime, over the last 32 months, the Greek economy has
shrunk in size by almost 17% in nominal terms. It will be 1/5 th less
in 2012.

Such inane 'remedies' do not solve debt problems. They only
aggravate and exacerbate them.

While behaving in this absurd fashion Eurozone leaders repeatedly
asserted for two years that they would do everything in their power
to:

• Maintain the credibility of the Euro while ensuring that every
  member stayed in the Eurozone
  
• Not allow any default of publicly issued bonds to occur; and
  
• Do everything possible to avoid contagion spreading beyond PIGS (even
  as it became clear that markets were worried about Italy.
  

Instead they achieved the exact opposite of all three objectives
through their inability to understand the implications of what they
were doing.

Though now contrite and claiming to have learnt a few lessons from
their serial bungling over 30 months Eurozone leaders have no
solution.

The EFSF facility they created is woefully underfunded. It can
barely deal with financing the third Greek bailout.

The idea of leveraging it or using it as a partial guarantee
facility is absurd since it would add to risk and uncertainty not
resolve them.

Yet over-indebted governments (including France and Germany) would
have to issue more public debt in order to fund the EFSF properly.

That would simply mean requiring their fragile, near-bankrupt,
banking systems (or the ECB) or global markets to buy more Eurozone
debt.

Except for Germany (and even that will be in doubt soon) the market
has no appetite for taking on more Eurozone debt given its risks.

Contagion has spread from the periphery and now lodges at the core
of the Eurozone economy in which Italy is the third largest member.

What could have been resolved with about 300 billion euro in
additional financing in mid-2010 is now a problem that may require 2
trillion euro.

Where are we now?

Over 35 EU/Eurozone summits in 30 months have resolved
nothing. They have made matters worse; despite Herculean
exertions!

Right now Greece is in 'effective' default; though markets are
overlooking that because of the implications of CDS contracts being
triggered.

Its borrowing costs for refinancing its debt would exceed 30% if it
had any access to private markets; which it does not.

Any refinancing of, or addition to, Greek debt can now only be
financed by the ECB; which the Germans will not permit the ECB to
do.

Meanwhile the Greek banking system is bankrupt. Indeed the entire
Eurozone banking system's credibility/stability/solvency is in
doubt.

Today an outstanding portfolio of about 11-12 trillion euro in
Eurozone debt - of which about 80% is held by EU firms - is souring
relentlessly.

About 7 trillion euro of that portfolio is sufficiently affected by
contagion to require provisioning (France and Belgium may soon be
added).

About 5 trillion euro of Eurozone high-risk-debt is currently held
by EU banks, insurance companies, pension funds and individuals.

That sovereign debt, which is supposed to constitute the 'safest'
component of any asset portfolio, now constitutes perhaps the riskiest
element.

That reality inverts the whole basis of banking/financial system
soundness and stability across Europe (including the UK).

It compounds the problem of calculating capital adequacy
requirements for these banking systems and puts regulators in a
quandary.

Ireland's bailout programme is working but could be derailed by
what is happening in the rest of Europe.

Portugal's programme is not working as intended. But nobody is
talking about it because it pales in comparison with Italy and
Greece.

Italy's outstanding public debt will soon cross 2 trillion euro
(120% of GDP) and its debt service payments amount to around 300
billion euro per year.

That is made up of about 120 billion euro in interest payments and
180 billion euro in principal repayments. Average duration is 5
years.

Public debt service in Italy now amounts to around 17% of GDP and
will rise to 20% unless Italy's debt is dramatically restructured.

Italy now needs to borrow about 40 billion a month euro (gross) and
about 28 billion euro a month net in private markets to refinance its
debt.

The world is holding its breath with every auction of Italian
public debt (3-8 billion euro per week) any of which could trigger
accidental default.

The cost of refinancing Italy's public debt has risen from around
4% a year ago to around 7% now. That adds 20 billion euro a year to
its debt.

Meantime the Italian economy is flat-lining and its capacity to
service additional debt is diminishing despite its running a primary
balance.

Banks around the world are dumping their holdings of Italian public
debt but there is no buyer other than the ECB because of the risk.

The ECB's capacity to refinance Greek, Italian and Portuguese debt
is limited and constrained by Germany's unwillingness to consider
that.

Contagion from Italy is now beginning to affect Spain and France
which is supposed to be a bulwark for the EFSF's borrowing
capacity.

The resulting gridlock is pushing the entire Eurozone system toward
a catastrophic denouement with a binary outcome. Either:

1. Crisis-induced progress toward fiscal union with
   national sovereign bonds being replaced by a single Eurozone
   bond with a joint/several guarantee, or
   
2. Sudden disorderly collapse of the Eurozone with unimaginable
   fallout and consequences that would trigger a global double-dip
   recession.
   

Such a recession would last for a minimum of 2-3 years and would
probably be quickly followed by a similar debt crisis in the US.

The resulting fallout of disorderly Eurozone break-up could trigger
a break-up or restructuring of the larger EU as well.

So where do we go from here?

With the foregoing in mind it seems absurd that the world is
waiting with bated breath to see what the new technocratic governments
in Greece (Papademos) and Italy (Monti) will actually achieve by way
of structural reform and increased debt servicing capability in coming
months.

These technocratic governments inject new credibility but lack
political and social legitimacy. They have been appointed not
elected.

It remains to be seen how long their technocratic legitimacy holds
out without the backing of gradually earned political/social
legitimacy.

The risk is that if the ministrations of these technocratic
governments (which their societies believe have been imposed on them
from the EU above) do not work and bear fruit relatively soon (the
probability is that they won't), public patience with them will
melt.

Will they be able to convince electorates to accept the
inevitability of austerity without growth for the indefinite
future?

The next Greek crisis is perhaps 10-12 weeks away.

The next Italian crisis could be triggered by any one of the
upcoming weekly auctions of Italian government debt.

Despite these rather obvious realities, global markets deem to be
reacting in dream-like hope and optimism that all will be well.

There is of course a solution at hand; and the only one that will
work because all the other options seem to have been exhausted.

That option requires Germany to reconsider its refusal to bear its
large share of the fiscal burden that will come with Eurozone fiscal
union.

It requires political/social willingness on the part of rich
northern Eurozone members to finance fiscal transfers to poorer
southern members through an exponential expansion of structural funds,
currently applied to help develop more rapidly the poorer regions of
the EU.

Reciprocally, it requires other Eurozone countries to relinquish
fiscal, and a great deal of political, sovereignty immediately; in
order to assure global markets of their commitment to structural
reform, restoration of competitiveness, and relentless pursuit of
fiscal/monetary discipline.

It requires all unwanted national sovereign bonds of Eurozone
members to be replaced by a single Eurobond that is jointly and
severally guaranteed and underpinned by the weight and ability of the
ECB behind it to print money if necessary to ensure that such bonds
are honoured.

This solution would resolve both the over-indebtness problem of the
Eurozone and the problem of banking system collapse at a single
stroke.

If it were adopted the need to provide for risky Eurozone debt and
recapitalise (yet again) the EU banking system would disappear.

Yet, this is the one solution that keeps being discarded because of
legitimate German constitutional, judicial and political
constraints.

They inhibit movement in such a direction regardless of the
consequences for the Eurozone, the EU, and mostly Germany itself.

It is like witnessing a repeat of 1939; not of conquest but of
mindless destruction. But, this time with money rather than tanks
being involved.

If that only workable solution continues to be discarded, the other
possibility that will manifest itself is the disorderly break-up of
the Eurozone; simply because its orderly break-up defies contemplation
and imagination.

Talk of Greece being ejected from the Eurozone, or of Germany
departing from it voluntarily, is fanciful simply because neither can
afford to bear the costs of the consequences that will follow,
regardless of what their populations and political leaders may believe
or think (though 'thought' seems to be conspicuously absent from the
process just now). Neither can their neighbours, regardless of what
they may think.

Yet it is not unimaginable that a break-up will be forced on
Eurozone members by global markets if the only workable solution
continues to be ruled out as it seems to be repeatedly by the German
Chancellor. But she has changed her mind so often the hope is she will
yet again.

A disorderly break-up may result in a reversion to national
currencies; which would be better than members trying to retain some
semblance of the Euro through separate residual monetary unions of
more compatible economies.

That would probably require four different Euros (for the
super-efficient Northern economies a Baltic Euro, for the relatively
efficient middling economies a Franco-Euro; for the newly acceding
countries an Eastern-Euro and for the inefficient, uncompetitive
Club-Med economies, a PIGS-Euro). Other than the first, none of the
others would be credible for holding as reserves, or for trading
significantly in global currency markets.

Finally, bear in mind that we have spoken of only the public debt
problem in the Eurozone.

Should the unthinkable (but increasingly likely) disorderly break-up happen, the public debt
problem will be accompanied by an unresolved private debt problem
throughout the Eurozone of equally monumental proportions! That
really will break the system and the banks!

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