Archive for the ‘Euro’ Category


2021: The New Europe

By NIALL FERGUSON

Map illustration by Peter Arkle
‘Life is still far from easy in the peripheral states of the United States of Europe (as the euro zone is now known).’

Welcome to Europe, 2021. Ten years have elapsed since the great crisis of 2010-11, which claimed the scalps of no fewer than 10 governments, including Spain and France. Some things have stayed the same, but a lot has changed.

The euro is still circulating, though banknotes are now seldom seen. (Indeed, the ease of electronic payments now makes some people wonder why creating a single European currency ever seemed worth the effort.) But Brussels has been abandoned as Europe’s political headquarters. Vienna has been a great success.

“There is something about the Habsburg legacy,” explains the dynamic new Austrian Chancellor Marsha Radetzky. “It just seems to make multinational politics so much more fun.”

The Germans also like the new arrangements. “For some reason, we never felt very welcome in Belgium,” recalls German Chancellor Reinhold Siegfried von Gotha-Dämmerung.

Life is still far from easy in the peripheral states of the United States of Europe (as the euro zone is now known). Unemployment in Greece, Italy, Portugal and Spain has soared to 20%. But the creation of a new system of fiscal federalism in 2012 has ensured a steady stream of funds from the north European core.

Like East Germans before them, South Europeans have grown accustomed to this trade-off. With a fifth of their region’s population over 65 and a fifth unemployed, people have time to enjoy the good things in life. And there are plenty of euros to be made in this gray economy, working as maids or gardeners for the Germans, all of whom now have their second homes in the sunny south.

The U.S.E. has actually gained some members. Lithuania and Latvia stuck to their plan of joining the euro, following the example of their neighbor Estonia. Poland, under the dynamic leadership of former Foreign Minister Radek Sikorski, did the same. These new countries are the poster children of the new Europe, attracting German investment with their flat taxes and relatively low wages.

But other countries have left.

David Cameron—now beginning his fourth term as British prime minister—thanks his lucky stars that, reluctantly yielding to pressure from the Euroskeptics in his own party, he decided to risk a referendum on EU membership. His Liberal Democrat coalition partners committed political suicide by joining Labour’s disastrous “Yeah to Europe” campaign.

Egged on by the pugnacious London tabloids, the public voted to leave by a margin of 59% to 41%, and then handed the Tories an absolute majority in the House of Commons. Freed from the red tape of Brussels, England is now the favored destination of Chinese foreign direct investment in Europe. And rich Chinese love their Chelsea apartments, not to mention their splendid Scottish shooting estates.

In some ways this federal Europe would gladden the hearts of the founding fathers of European integration. At its heart is the Franco-German partnership launched by Jean Monnet and Robert Schuman in the 1950s. But the U.S.E. of 2021 is a very different thing from the European Union that fell apart in 2011.

* * *

It was fitting that the disintegration of the EU should be centered on the two great cradles of Western civilization, Athens and Rome. But George Papandreou and Silvio Berlusconi were by no means the first European leaders to fall victim to what might be called the curse of the euro.

Since financial fear had started to spread through the euro zone in June 2010, no fewer than seven other governments had fallen: in the Netherlands, Slovakia, Belgium, Ireland, Finland, Portugal and Slovenia. The fact that nine governments fell in less than 18 months—with another soon to follow—was in itself remarkable.

But not only had the euro become a government-killing machine. It was also fostering a new generation of populist movements, like the Dutch Party for Freedom and the True Finns. Belgium was on the verge of splitting in two. The very structures of European politics were breaking down.

Who would be next? The answer was obvious. After the election of Nov. 20, 2011, the Spanish prime minister, José Luis Rodríguez Zapatero, stepped down. His defeat was such a foregone conclusion that he had decided the previous April not to bother seeking re-election.

And after him? The next leader in the crosshairs was the French president, Nicolas Sarkozy, who was up for re-election the following April.

The question on everyone’s minds back in November 2011 was whether Europe’s monetary union—so painstakingly created in the 1990s—was about to collapse. Many pundits thought so. Indeed, New York University’s influential Nouriel Roubini argued that not only Greece but also Italy would have to leave—or be kicked out of—the euro zone.

But if that had happened, it is hard to see how the single currency could have survived. The speculators would immediately have turned their attention to the banks in the next weakest link (probably Spain). Meanwhile, the departing countries would have found themselves even worse off than before. Overnight all of their banks and half of their nonfinancial corporations would have been rendered insolvent, with euro-denominated liabilities but drachma or lira assets.

Restoring the old currencies also would have been ruinously expensive at a time of already chronic deficits. New borrowing would have been impossible to finance other than by printing money. These countries would quickly have found themselves in an inflationary tailspin that would have negated any benefits of devaluation.

Getty Images
Some bumpy moments in recent EU history.

For all these reasons, I never seriously expected the euro zone to break up. To my mind, it seemed much more likely that the currency would survive—but that the European Union would disintegrate. After all, there was no legal mechanism for a country like Greece to leave the monetary union. But under the Lisbon Treaty’s special article 50, a member state could leave the EU. And that is precisely what the British did.

* * *

Britain got lucky. Accidentally, because of a personal feud between Tony Blair and Gordon Brown, the United Kingdom didn’t join the euro zone after Labour came to power in 1997. As a result, the U.K. was spared what would have been an economic calamity when the financial crisis struck.

With a fiscal position little better than most of the Mediterranean countries’ and a far larger banking system than in any other European economy, Britain with the euro would have been Ireland to the power of eight. Instead, the Bank of England was able to pursue an aggressively expansionary policy. Zero rates, quantitative easing and devaluation greatly mitigated the pain and allowed the “Iron Chancellor” George Osborne to get ahead of the bond markets with pre-emptive austerity. A better advertisement for the benefits of national autonomy would have been hard to devise.

At the beginning of David Cameron’s premiership in 2010, there had been fears that the United Kingdom might break up. But the financial crisis put the Scots off independence; small countries had fared abysmally. And in 2013, in a historical twist only a few die-hard Ulster Unionists had dreamt possible, the Republic of Ireland’s voters opted to exchange the austerity of the U.S.E. for the prosperity of the U.K. Postsectarian Irishmen celebrated their citizenship in a Reunited Kingdom of Great Britain and Ireland with the slogan: “Better Brits Than Brussels.”

Another thing no one had anticipated in 2011 was developments in Scandinavia. Inspired by the True Finns in Helsinki, the Swedes and Danes—who had never joined the euro—refused to accept the German proposal for a “transfer union” to bail out Southern Europe. When the energy-rich Norwegians suggested a five-country Norse League, bringing in Iceland, too, the proposal struck a chord.

The new arrangements are not especially popular in Germany, admittedly. But unlike in other countries, from the Netherlands to Hungary, any kind of populist politics continues to be verboten in Germany. The attempt to launch a “True Germans” party (Die wahren Deutschen) fizzled out amid the usual charges of neo-Nazism.

The defeat of Angela Merkel’s coalition in 2013 came as no surprise following the German banking crisis of the previous year. Taxpayers were up in arms about Ms. Merkel’s decision to bail out Deutsche Bank, despite the fact that Deutsche’s loans to the ill-fated European Financial Stability Fund had been made at her government’s behest. The German public was simply fed up with bailing out bankers. “Occupy Frankfurt” won.

Yet the opposition Social Democrats essentially pursued the same policies as before, only with more pro-European conviction. It was the SPD that pushed through the treaty revision that created the European Finance Funding Office (fondly referred to in the British press as “EffOff”), effectively a European Treasury Department to be based in Vienna.

It was the SPD that positively welcomed the departure of the awkward Brits and Scandinavians, persuading the remaining 21 countries to join Germany in a new federal United States of Europe under the Treaty of Potsdam in 2014. With the accession of the six remaining former Yugoslav states—Bosnia, Croatia, Kosovo, Macedonia, Montenegro and Serbia—total membership in the U.S.E. rose to 28, one more than in the precrisis EU. With the separation of Flanders and Wallonia, the total rose to 29.

Crucially, too, it was the SPD that whitewashed the actions of Mario Draghi, the Italian banker who had become president of the European Central Bank in early November 2011. Mr. Draghi went far beyond his mandate in the massive indirect buying of Italian and Spanish bonds that so dramatically ended the bond-market crisis just weeks after he took office. In effect, he turned the ECB into a lender of last resort for governments.

But Mr. Draghi’s brand of quantitative easing had the great merit of working. Expanding the ECB balance sheet put a floor under asset prices and restored confidence in the entire European financial system, much as had happened in the U.S. in 2009. As Mr. Draghi said in an interview in December 2011, “The euro could only be saved by printing it.”

So the European monetary union did not fall apart, despite the dire predictions of the pundits in late 2011. On the contrary, in 2021 the euro is being used by more countries than before the crisis.

As accession talks begin with Ukraine, German officials talk excitedly about a future Treaty of Yalta, dividing Eastern Europe anew into Russian and European spheres of influence. One source close to Chancellor Gotha-Dämmerung joked last week: “We don’t mind the Russians having the pipelines, so long as we get to keep the Black Sea beaches.”

***

On reflection, it was perhaps just as well that the euro was saved. A complete disintegration of the euro zone, with all the monetary chaos that it would have entailed, might have had some nasty unintended consequences. It was easy to forget, amid the febrile machinations that ousted Messrs. Papandreou and Berlusconi, that even more dramatic events were unfolding on the other side of the Mediterranean.

Mark Nerys
Back then, in 2011, there were still those who believed that North Africa and the Middle East were entering a bright new era of democracy. But from the vantage point of 2021, such optimism seems almost incomprehensible.

The events of 2012 shook not just Europe but the whole world. The Israeli attack on Iran’s nuclear facilities threw a lit match into the powder keg of the “Arab Spring.” Iran counterattacked through its allies in Gaza and Lebanon.

Having failed to veto the Israeli action, the U.S. once again sat in the back seat, offering minimal assistance and trying vainly to keep the Straits of Hormuz open without firing a shot in anger. (When the entire crew of an American battleship was captured and held hostage by Iran’s Revolutionary Guards, President Obama’s slim chance of re-election evaporated.)

Turkey seized the moment to take the Iranian side, while at the same time repudiating Atatürk’s separation of the Turkish state from Islam. Emboldened by election victory, the Muslim Brotherhood seized the reins of power in Egypt, repudiating its country’s peace treaty with Israel. The king of Jordan had little option but to follow suit. The Saudis seethed but could hardly be seen to back Israel, devoutly though they wished to avoid a nuclear Iran.

Israel was entirely isolated. The U.S. was otherwise engaged as President Mitt Romney focused on his Bain Capital-style “restructuring” of the federal government’s balance sheet.

It was in the nick of time that the United States of Europe intervened to prevent the scenario that Germans in particular dreaded: a desperate Israeli resort to nuclear arms. Speaking from the U.S.E. Foreign Ministry’s handsome new headquarters in the Ringstrasse, the European President Karl von Habsburg explained on Al Jazeera: “First, we were worried about the effect of another oil price hike on our beloved euro. But above all we were afraid of having radioactive fallout on our favorite resorts.”

Looking back on the previous 10 years, Mr. von Habsburg—still known to close associates by his royal title of Archduke Karl of Austria—could justly feel proud. Not only had the euro survived. Somehow, just a century after his grandfather’s deposition, the Habsburg Empire had reconstituted itself as the United States of Europe.

Small wonder the British and the Scandinavians preferred to call it the Wholly German Empire.

—Mr. Ferguson is a professor of history at Harvard University and the author of “Civilization: The West and the Rest,” published this month by Penguin Press.

Read the story here: Niall Ferguson on 2021: The New Europe – WSJ.com

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The MasterFeeds


Eurozone Crisis: Here Are the Options, Now Choose
Author: Nouriel Roubini  ·  November 9th, 2011  ·  Comments (1)
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The announcement of the most recent EZ rescue package (acceptance of a bigger haircut for Greek private creditors, the recapitalization of EZ banks and the use of guarantees and financial leverage in the hope of preventing Italy and Spain losing market access) led to markets rallying for a day as the tail risk of a disorderly situation in the EZ, temporarily, diminished. By the next day, Italian yields and spreads were still close to their high, serving as a reminder—as we argued in “The Last Shot on Goal: Will Eurozone Leaders Succeed in Ending the Crisis?,” co-authored with Megan Greene—that the EZ’s fundamental problems will not be resolved by this trio of policy actions.

To put the latest package in context, we need to first assess the fundamental problems facing the EZ and the potential scenarios for the monetary union.

EZ Flow Problems

The EZ suffers from both stock and flow problems, which are related to each other. The flow problems were and/or are:

Large fiscal and current account deficits in most members of the EZ periphery (Greece, Ireland, Portugal, Cyprus, Spain and Italy);
Economic weakness, manifesting itself in renewed near recession or outright recession and weak actual and potential growth;
The periphery’s long-term loss of competitiveness, driven by three factors: Loss of export market share to emerging markets (EMs) in traditional labor-intensive low-valued-added sectors; real appreciation, driven by wages growing more than productivity since the inception of the EZ; and the relative strength of the value of the euro in the past decade.
EZ Stock Problems

The stock problems are the large and possibly unsustainable stock of liabilities of: The government (in most of the periphery with the exception of Spain); the private non-financial sector (mostly in Spain, Ireland and Portugal); the banking and financial system (in most of the periphery); and the country (external debt), especially in Greece, Spain, Portugal, Cyprus and Ireland.

Stock vulnerabilities are the result of flow imbalances: A big fiscal deficit results in a growing and large stock of public debt (Greece, Italy, Ireland, Cyprus, Portugal) and in a large stock of foreign debt when private sector savings-investment imbalances are also large; a wide current account deficit—whether driven by private sector imbalances (like in Spain and Ireland) or public sector ones (Greece, Cyprus, Portugal)—leads to a build-up of foreign debt. In some cases, the excesses started in the private sector (housing boom and then bust in Ireland and Spain); so, initially it was a buildup of private debts and of foreign debts driven by large current account deficits. In other cases, the excesses started in the public sector (Greece, Italy, Portugal, Cyprus), leading to a large stock of public debt and of foreign debt—via current account deficits—in the subset of countries with fragile savings-investment imbalances in their private sectors (Greece, Portugal, Cyprus).

Until recently, Italy had a public debt problem but not current account and foreign debt problems as the high savings of the household sector prevented the fiscal deficit from turning into a current account deficit. But now, the sharp fall in private savings has led to the emergence of a current account deficit even there. In Spain and Ireland, the flow and stock imbalances started in the private sector leading to large current account deficits and foreign debts, but once the Spanish and Irish housing sectors went bust and resulted in sharp fiscal deficits—in part, due to the socialization of private losses—the ensuing rise in public debt created a sovereign debt sustainability problem.

Recent Policy Actions Start to Deal With Some Stock Vulnerabilities

The recent EZ package starts to deal with some—but by no means all—of the stock imbalances in the EZ periphery. First, public debt—in some (Greece) but not all of the countries where it is unsustainable (Portugal, Ireland, Cyprus, Italy)—will be reduced (50% haircut on private creditors, though the July plan will have to be completely scrapped, and the new details are lacking at this point). Second, the excessive amount of debt relative to the equity/capital of EZ banks will be partly addressed—to prevent insolvency—by recapitalizing EZ banks (both in the periphery and the core). These banks suffer from low capital ratios and potential erosion of their capital through losses, given exposures to sovereigns, busted real estate and rising non-performing loans as a result of the growing recession. But the capital needs of EZ banks, given these tail-risk losses, are much larger than the €100 billion of recapitalization needs that the EZ has identified. Third, illiquidity—of banks and sovereigns—risks turning illiquidity into insolvency as self-fulfilling bad equilibria of runs on short-term liabilities of banks and governments are possible. Thus, the ECB’s full allotment policy would prevent such a run on bank liabilities in principle only for banks that are illiquid but solvent, but in practice even possibly for insolvent banks.

For sovereigns that have lost market credibility—and whose spreads could blow to an unsustainable level—“catalytic finance” to use the traditional IMF terminology (see my book “Bailouts vs. Bail-Ins”) or the “big bazooka” of the financial equivalent of Powell’s doctrine of “overwhelming force” is necessary to provide time and financing for the flow adjustment—fiscal and structural—to restore market confidence and reduce spreads to sustainable levels. In each case, assumptions need to be made about whether a country is a) illiquid but solvent given financing to prevent loss of market access, time and enough adjustment/austerity (possibly Italy and Spain); b) illiquid and insolvent (Greece, clearly); or c) illiquid and near insolvent and already needing conditional financing given that market access has already been lost (Portugal, Ireland and Cyprus).

But even if Italy and Spain were illiquid and solvent given time, financing and adjustment, the big bazooka that the EZ needs to backstop banks and sovereigns in the periphery is at least €2 trillion and possibly €3 trillion rather than the fuzzy €1 trillion that the EZ vaguely committed to at the recent summit. So, on all three counts, the recent EZ plan falls short of addressing the stock problems of highly indebted sovereigns, the capital needs of EZ banks and the liquidity needs of EZ banks and sovereigns; it also does little or nothing to restore competitiveness and growth in the short run.

Critical Role of Flow Factors in Resolving Stock Sustainability Issues

To make stocks sustainable, it is crucially important to address flow imbalances, for several reasons. First of all, without economic growth, you have a dual problem: a) The socio-political backlash against fiscal austerity and reforms becomes overwhelming as no society can accept year after year of economic contraction to deal with its imbalances; b) more importantly, to attain sustainability, flow deficits (fiscal and current account) and excessive debt stocks (private and public, domestic and foreign) need to be stabilized and reduced, but if output keeps on falling, such deficit and debt ratios keep on rising to unsustainable levels.

Second, restoring growth is also important because, without growth, absolute fiscal deficits become larger rather than smaller (given automatic stabilizers). Third, restoring external competitiveness is key as that loss of competitiveness led—in the first place—to current account deficits and the accumulation of foreign debt and to lower economic growth as the trade balance detracts from GDP growth when it is in a large and growing deficit. So, unless growth and external competitiveness are restored, flow imbalances (fiscal and current account deficits) persist and stabilizing domestic and external deficits becomes “mission impossible.” Finally, note that, unless growth and competitiveness are restored, even dealing with stock problems via debt reduction will not work as flow deficits (fiscal and current account) will continue and, eventually, even reduced debt ratios will rise again if the denominator of the debt ratio (debt to GDP), i.e. GDP, keeps on falling. Growth also matters as credit risk—measured by real interest rates on public, private and external debt, which measures the default risk—will be higher the lower the economic growth rate. So, for any given debt level, a lower GDP growth rate that leads to a higher credit spread makes those debt dynamics more unsustainable (as sustainability depends on the differential between real interest rates and growth rates times the initial debt ratio).

The Current Account Flow Deficit Problem in the EZ Periphery

While the issue of fiscal deficits and public debt has been overemphasized in the recent policy debate about the problems of the EZ, one should not underestimate the role of external—current account—imbalances. These imbalances are now becoming unsustainable as the “sudden stop” and “reversal of private capital inflows” that the periphery has suffered implies that such deficits are now not financeable in the absence of official finance. These deficits are the result of savings-investment imbalances in both the private (Spain, Ireland, Portugal) and public sectors (Greece, Portugal, Cyprus, Italy); they are also the result of the real appreciation of these countries following a decade of declining export market share, the growth of wages in excess of productivity growth and the strength of the euro. Some of these deficits are now cyclically lower given that the collapse of output/demand has led to a fall in imports. But, on a structural basis, unless the real appreciation is reversed, the restoration of growth to its potential level would result in the resumption of large—and now not financeable—external deficits.

So, the modest reduction in current account deficits in the periphery that has been seen since 2009 is deceptive: It doesn’t—for the most part—reflect an improvement in competitiveness; it is only the result of a severe and persistent recession. Real depreciation is required to restore such competiveness while ensuring sustained economic growth. An inability to restore competitiveness and thus growth would eventually undermine the monetary union as private creditors are now—after a sudden stop—unwilling to finance such deficits. So, eliminating the external current account deficit is as critical to restoring debt sustainability as reducing flow fiscal deficits. And fiscal deficits are not the only explanation of the external deficits as real appreciation and loss of competitiveness are as important, if not more important, than fiscal imbalances, in explaining such external imbalances.

The Recent EZ Package Does Little or Nothing to Restore, in the Short Term, Growth and Competitiveness, Which Are the Key to Sustainability

The latest economic data—such as the EZ PMIs—strongly suggest that the EZ—not just the periphery, but also the core—are falling back into a recession. This is very clear in the periphery where some countries never got out of their first 2008 recession, while the others are plunging back into recession after a very moderate recovery. But even in the core of the EZ, the latest data suggest that a recession is looming.

The recent EZ package (a bigger Greek haircut, bank recaps and a levered European Financial Stability Facility (EFSF), together with more fiscal austerity and a push toward structural reforms) does nothing to restore competitiveness and growth in the short run. In fact, it actually exacerbates the risk of a deeper and longer recession. Fiscal austerity is necessary to prevent a fiscal train wreck, but, in the short run (as recent IMF studies suggest), raising taxes, reducing transfer payments and cutting government spending (even inefficient/unproductive expenditure) has a negative effect on economic growth, as it reduces aggregate demand and disposable income. Moreover, even structural reforms that will eventually boost growth via higher productivity growth have a short-run negative effect: You need to fire unproductive public employees; you need to fire workers in weak firms and sectors; you need to shut down unprofitable firms in declining sectors; you need to move labor and capital from declining sectors to new sectors in which the country may have a comparative advantage. This all takes time and, in the absence of a rapid real depreciation, what are the sectors in which a periphery country has a new comparative advantage? Even necessary structural reforms—like fiscal austerity—reduce output and GDP in the short run before they have beneficial medium-term effects on growth.

To restore growth and competitiveness: The ECB would have to rapidly reverse its policy hikes, sharply reduce policy rates toward zero and do more quantitative and credit easing; the value of the euro would have to sharply fall toward parity with the U.S. dollar; and the core of the EZ would have to implement significant fiscal stimulus if the periphery is forced into necessary but contractionary fiscal austerity (which will have a short-term drag on growth).

Options for Dealing with Stock and Flow Problems

Stock imbalances—large and potentially unsustainable liabilities—can be addressed in multiple ways: a) high economic growth can heal most wounds, especially debt wounds given that fast growth in the denominator of the debt ratio (i.e. GDP) can lead over time to a lowering of debt ratios; b) low spending and higher savings in the private and public sectors can lead to lower fiscal deficits and lower current account deficits (lower flow imbalances) that, over time, reduce the stocks of public and external debt relative to GDP; c) inflation and/or forms of financial repression can reduce the real value of debts; the same can occur with unexpected depreciation of the currency if the liabilities are in a domestic currency; d) debts can be reduced via debt restructurings and reductions, including the conversion of debt into equity. The last option is key: If growth remains anemic in the EZ; if savings lead to the paradox of thrift (a more severe short-term recession) and if monetization, inflation or devaluations are not pursued by the ECB, the only way to deal with excessive private and public debts becomes some orderly or disorderly reduction of such debts and/or their conversion into equity.

Flow imbalances are more difficult to resolve as they imply a reduction of fiscal and current account deficits that are consistent with sustainable growth and with the restoration of competitiveness, which requires real depreciation. To reduce external current account deficits—the key to restoring competitiveness and growth—you need both decreases in expenditure (private and public) and expenditure-switching through a real depreciation. Such real depreciation can occur in four ways: a) a nominal depreciation of the euro large enough to lead to a sharp real depreciation in the periphery; b) structural reforms that increase productivity growth while keeping a lid on wage growth below productivity growth and thus reduce unit labor costs over time; c) real depreciation via deflation—a cumulative persistent fall in prices and wages that achieves a sharp real depreciation; and d) exit from the monetary union and return to a national currency that leads to a nominal and real depreciation. The key issue here is—as we will discuss in detail below—that achieving the real depreciation via route a) is unlikely, as there are many reasons why the euro will not weaken enough; getting it via b) may take way too long—a decade or more—when the sudden stop requires a rapid turnaround of the external deficit; achieving it via c) may also take too long and would be associated with a persistent recession, while leading to massive balance-sheet effects; thus the d) option—exit from EZ—becomes the only available one if the other three are not feasible/desirable.

Additionally, if growth and competitiveness are restored in short order, this is the best way—on top of decreased expenditure via fiscal austerity—to reduce both the fiscal and current account imbalances as well as the relative ones (i.e. as a share of GDP). In other terms, fiscal austerity and structural reforms eventually restore growth and productivity, but they are, in the short run, recessionary. Thus, other macro policies are needed to restore growth, which is critical to make the adjustment politically and financially feasible. Therefore, macro policies consistent with a rapid return to economic growth are the key to resolving flow problems.

Four Options to Address the Stock and Flow Problems of the EZ

Given the above analysis of the structural and fundamental problems faced by the EZ, there are four possible options to deal with the bloc’s stock and flow problems; each option implies a different future for the monetary union. Each reduces unsustainable debts and restores growth and competitiveness and reduces flow imbalances via a different combination of the policies discussed above

1. Growth and Competiveness Are Restored. In this first option, policies are undertaken to rapidly restore growth and competitiveness (monetary easing, a weaker euro, core fiscal easing and the reduction of unsustainable public and private debts in clear insolvency cases), to reduce flow deficits and to restore private, public and external debt sustainability, all while the periphery undertakes continued painful austerity and structural reforms. In this scenario, the EZ survives in the sense that most members—maybe with the exceptions of Greece and possibly Portugal—remain in the EZ and most members—again, with the exceptions of Greece and possibly Portugal—avoid a coercive restructuring of their public and private debts. This solution requires a nominal and real depreciation of the euro and, for a period of time, higher (lower) inflation in the core (periphery) of the EZ than the current ECB target to restore, via real depreciation, the competitiveness of the periphery and rapidly eliminate its unsustainable current account deficit.

2. The Deflationary/Depressionary Route to the Restoration of Competitiveness. Growth and competitiveness are not restored in the short run as the core/Germany imposes an adjustment based on deflationary and depressionary draconian fiscal austerity and structural reforms that, in the absence of appropriate expansionary macro policies, makes the recession of the periphery severe and persistent and doesn’t restore its external competitiveness for many years. This depression/deflationary path becomes politically and socially unsustainable for most—but possibly not all—of the EZ periphery as it implies five-ten years of ever-falling output to restore competitiveness via deflation and eventual structural reforms. And with output falling in the short run and a fall in prices/wages, stock problems worsen for a while (as both nominal and real GDP are falling) until the restoration of growth eventually takes care of the stock imbalances. Since, for most EZ members, Option 2 becomes politically and socially unfeasible, in the absence of a path that leads to Option 1, Option 2 evolves into Options 3 or 4.

3. The Core Permanently Subsidizes the Periphery. If Option 1 does not materialize while Option 2 becomes politically-socially unsustainable, the only other way to avoid Option 4 (EZ break-up) is not just via a reduction of the unsustainable stocks of liabilities in the periphery (a capital levy on the core of creditors), but also via a permanent subsidization of the uncompetitive periphery by the core. Since the lack of a restoration of growth/competiveness implies a permanent external deficit (trade deficit) in the periphery with a trade surplus in the core that implies an unsustainable current account deficit in the periphery, the only way in which the core can prevent the periphery from exiting the EZ (even after a debt reduction that doesn’t resolve the current account flow deficit problem) is to make a unilateral permanent yearly transfer payment (of the order of several percentage points of core GDP, possibly as high as 5% of GDP) to the periphery to prevent the trade deficit from turning into an unsustainable current account deficit that in turn leads to the accumulation of even more unsustainable external debt. Such a unilateral transfer sustains the GNP of the periphery while its GDP remains permanently depressed as competitiveness is not restored. So, stock problems are addressed via repeated restructurings, extensions and haircuts of privately held debt (bonds) and bilateral/multilateral loans as well as via recapitalizations of banks that include some conversion of debt into equity. Meanwhile, flow problems are addressed via a permanent yearly subsidy to the periphery from the core.

4. The EZ Experiences Widespread Debt Restructurings. Members of the periphery react to the Option 2 (depression/deflation) that is currently imposed on them by Germany and the ECB by, first, losing market access (or not regaining it) and are thus forced, once official finance runs out (because of political and/or financial constraints in the core), to coercively restructure their public and also their private debts (say, of banks and financial institutions). Even such a debt reduction is insufficient to restore growth and competitiveness as it partially deals with stock problems, but does not deal with flow problems. If, then, the flow problem is not resolved via a permanent subsidization of the income of the periphery by the core (Option 3), then the only other way to restore growth and competitiveness is via exit from the monetary union and a return to the national currency. The EZ can survive the exit of its smaller members (Greece, Portugal, Cyprus), but if debt restructurings and the exit of Italy and/or Spain become necessary/inevitable, the EZ effectively breaks up, with only a small core—Germany and a few core members—remaining in a smaller and much damaged monetary union.

An Assessment of the Likelihood of the Four Options

Option 1: Most Desirable But Quite Unlikely as Contrary to the Goals and Constraints of Germany/the ECB

Which one of these four options is most likely? Option 1 appears the most desirable as it leads to the survival and success of the EZ. However, it is not necessarily the most likely option as it would imply radical, rapid and presumably unacceptable changes in the core’s macro-policy.

First, the ECB would have to reverse its policy tightening and aggressively cut rates; even that would not be sufficient as aggressive quantitative easing (QE) would be necessary to restore growth and provide unlimited lending of last resort (LOLR) to sovereigns—such as Spain and Italy—that are possibly illiquid but solvent if given enough time and liquidity to resolve their problems. Even traditional QE would not be sufficient as unconventional credit easing may be necessary to restore credit growth to smaller firms and households subject to a credit crunch. This is obviously not acceptable to the ECB and Germany as it would require a radical change (maybe via a treaty change) to the ECB’s formal mandate (the bank is currently supposed to only pursue the goal of price stability). The ECB—and eventually Germany as a recap of the ECB would fall to Germany/core—would also take a significant risk in becoming (for a while) the LOLR for Italy and Spain, which may turn out—even with massive liquidity—to be not just illiquid but also insolvent (there are many future paths via which the latter could happen).

Second, the value of the euro would have to fall sharply compared with current levels, possibly toward parity with the U.S. dollar to reverse the loss of competitiveness of the periphery. This would imply that inflation would rise in the core—starting in Germany—for a number of years above 2% to allow the real depreciation of the periphery to occur. This doesn’t look like being politically acceptable to Germany and the ECB. Also, with Germany being uber-competitive and with a large external surplus, while the U.S. dollar needs to a weaken given the large U.S. current account deficit, it is not obvious that the euro would fall as sharply as the periphery needs, unless the ECB aggressively pursues QE and credit easing and jawbones the euro down with verbal and actual intervention: All very unlikely outcomes given the ECB’s current mandate and the German/ECB goal of restoring the periphery’s competitiveness via deflation (“internal devaluation”).

Third, the core would have to accept and implement a fiscal stimulus to compensate for the recessionary effects of the fiscal austerity of the periphery. But Germany and the core are vehemently against back-loaded fiscal austerity let alone fiscal easing of the type that even the IMF is now suggesting to them. Germany/the core is of the view that the problems of the periphery were self-inflicted even when private imbalances (like in Spain and Ireland) rather than public ones were at the core of financial difficulties. So, austerity and reform are viewed by the core as a must for both the periphery and also for the core.

Option 2: Socially-Politically Unacceptable as Implies a Persistent Recession-Depression in Most of the Periphery

Option 2 is the type of adjustment that the ECB and Germany would like to impose on the periphery, but it would be socially and politically unacceptable for most. It is thus not a stable equilibrium but rather an unstable disequilibrium that would eventually lead to Options 3 or 4. Since fiscal deficits are excessive, they need to be rapidly reduced via front-loaded austerity to make public debts sustainable. Current account deficits will be partly reduced via the reduction of public dis-savings. The rest of the external imbalance will be corrected via deflation (internal devaluation) and via accelerated structural reforms that increase productivity growth, while keeping a lid on wage growth below such higher productivity growth will progressively reduce unit labor costs and restore external competitiveness.

The problems with the German/ECB solution to the growth/competitiveness issue are multiple. First, fiscal austerity is necessary, but if implemented by the entire EZ it makes the periphery recession worse, deeper and longer and thus undermines the restoration of growth that is necessary to make the debts sustainable. Also, such recession damages attempts to reduce fiscal deficits; and it improves external balances only temporarily via a compression of imports, not via a true restoration of competitiveness; structural external deficits mostly remain.

Second, reducing unit labor costs via accelerated reforms that increase productivity growth—while keeping a lid on wage growth below such rising productivity growth—is easier said than done. It took 10 to 15 years for Germany to achieve its reduction of unit labor costs via that route. And since German unit labor costs have fallen by 20% since the inception of the EZ, while they have risen by 30% in the EZ periphery, the unit labor cost gap between Germany and periphery is now about 50%. So, if the EZ periphery were to accelerate reforms that actually depress output in the short run, the benefits will start to show up after five years or so; and no country can accept five years of recession or depression before it returns to growth. Also, a reduction in unit labor costs via a rise in productivity growth above positive wage growth—as in Germany in the past 15 years—is politically more feasible—as it is associated with growth rather than recession—than a recessionary adjustment where wages need to fall in nominal terms as productivity growth remains stagnant while output stagnates for a number of years. Given the nominal downward rigidity of wages and prices, outright deflation is extremely hard to achieve in the absence of a severe and persistent depression.

Third, deflation/internal devaluation is not politically-socially feasible if it leads—as is likely—to persistent recession. Deflation—a 5% fall in prices and wages for five years leading to a cumulative compound reduction of prices and wages of 30% that undoes the loss of competitiveness of the periphery—would be most likely associated with a continued recession for five more years, likely turning into a depression.

The international experience of “internal devaluations” is mostly one of failure. Argentina tried the deflation route to a real depreciation and, after three years of an ever-deepening recession/depression, it defaulted and exited its currency board peg. The case of Latvia’s “successful” internal devaluation is not a model for the EZ periphery: Output fell by 20% and unemployment surged to 20%; the public debt was—unlike in the EZ periphery—negligible as a percentage of GDP and thus a small amount of official finance—a few billion euros—was enough to backstop the country without the massive balance-sheet effects of deflation; and the willingness of the policy makers to sweat blood and tears to avoid falling into the arms of the “Russian bear” was, for a while, unlimited (as opposed to the EZ periphery’s unwillingness to give up altogether its fiscal independence to Germany); and even after devaluation and default was avoided, the current backlash against such draconian adjustment is now very serious and risks undermining such efforts (while, equivalently, the social and political backlash against recessionary austerity is coming to a boil in the EZ periphery).

The other cases of successful reductions of large external and fiscal deficits and debts in the European member states in the 1990s—Belgium, Sweden, Finland, Denmark, etc.—are just as irrelevant as Latvia’s example as they occurred against a background of growth (not the current EZ recession), falling interest rates as expectations of EMU led to convergence trades (not the current blowing up of sovereign spreads and loss of market access) and, in some cases, via nominal and real depreciations within the flexible terms of the European Monetary System (not the rigid constraints of a monetary union where there is no national currency and the value of the euro remains excessively strong).

Some EZ periphery members—notably Ireland—are undergoing a degree of internal devaluation, but it is too slow and small to rapidly restore competitiveness: A fall in public wages may, in due course, push down private wages in traded sectors and eventually reduce unit labor costs.

Finally, the deflation route to real depreciation—even if it were politically feasible—makes the private and debt unsustainability problem more severe: After prices and wages have fallen 30% after a painful deflation, the real value of private and public debts would be 30% higher, making the case for a sharp reduction in unsustainable debts even more compelling.

Some EZ countries—notably Ireland—may have a better chance of restoring their competitiveness via internal devaluation than others—Portugal, Greece, Cyprus. Ireland has a large and productive manufacturing base—as two-thirds of its manufacturing industry is owned by multinational firms—many in tech or high-value-added sectors—that made a lot of FDI in Ireland in the past two decades to create an industrial base—in a low corporate tax economy—for their European and international production activities. So, Ireland, with some difficulty, could regain its competitiveness in due time if the fiscal adjustment more rapidly leads to a change in the relative prices of traded to nontraded goods.

But, in the case of Greece, Portugal and Spain, the problems of competitiveness are much more chronic and un-resolvable without a nominal currency depreciation: They have permanently lost export market shares in labor intensive and low-value-added sectors—textile, apparel, leather products, light labor intensive manufacturing—to EMs with much lower unit labor costs (Asia, Turkey, Eastern Europe) and they don’t have the high-value-added tech industries of Ireland, for example. Also, in these periphery countries (unlike in Ireland), productivity growth was mediocre even in the years of positive economic growth and restoring comparative advantage without a sharp and rapid real depreciation looks less likely to be achievable.

Spain and Italy are in between Ireland on one side and Greece/Portugal/Cyprus: They experienced as much of an increase in unit labor costs as the rest of the periphery (especially Spain) and they have permanently lost export market share in traditionally labor-intensive sectors. Italy has implemented more structural corporate restructuring than Spain—which restored some competitiveness in higher-value-added sectors—because Spain, growing rapidly during its unsustainable real estate bubble, had little incentive to improve the competitiveness of its traded sector. Also, until recently, Italy did not have the unsustainable current account deficit of Spain as its private saving compensated for the dis-savings of the public sectors. Spain, instead, faces a massive stock of private sector foreign liabilities—held by households, corporate firms, banks and financial firms—that are not easily re-financeable as an external sudden stop has now occurred. But, in the past year, Italy’s current account deficit has now significantly increased, despite depressed economic activity: A worrisome signal of a loss of competitiveness.

Option 3: Not Acceptable to the EZ Core as it Implies Permanent Subsidies to a Large Part of the Periphery, I.e. a Transfer Union Rather Than a Fiscal Union

Option 1 implies a policy adjustment that is biased against Germany/the core/the ECB as it implies that these agents/countries take on significant credit risk and accept higher inflation to adjust inter-EZ real exchange rates; thus, it is unacceptable to them. Option 2 implies that all the burden of adjustment is born by the periphery in terms of many years of fiscal belt-tightening and, worse, a deflationary recession that could turn into a depression. Thus, it eventually becomes unacceptable to the EZ periphery. Then, the periphery would be tempted to unilaterally reduce its debt burdens via coercive debt restructuring first and via exit from the EZ next, as exit, on top of debt reduction, becomes necessary to restore competitiveness and growth.

Then, if the EZ would want to prevent a disorderly break-up of the EZ, it would not only have to accept a reduction of the periphery’s unsustainable debts that imposes a capital levy on the core creditors (something that becomes unavoidable to resolve the stock problems), but, more importantly, it would also have to permanently subsidize the periphery’s chronic trade deficits to prevent such deficits from causing unsustainable current account deficits that are no longer financeable. Thus, a unilateral permanent fiscal transfer by the core to the periphery would be necessary to boost the periphery’s GNP given its depressed GDP and maintain a current account balance in both the core and periphery, despite the persistent trade imbalances between the two regions. If Germany/the EZ core were to run a permanent trade surplus of say 4-5% of GDP relative to that of the EZ periphery, then a permanent yearly transfer of up to 4-5% of GDP from the core to periphery would be necessary to “bribe” the periphery to stay in the EZ rather than exit the monetary union.

Such unilateral transfers from rich to poor regions are not very common, but they aren’t altogether exceptional in the context of nation states where there is a political union. In Italy, the north has transferred income to the south (“the Mezzogiorno”) for decades via the fiscal system. Similarly, West Germany has paid for unification with East Germany with massive transfer payments and government spending on reconstruction that have lasted for over 20 years now and that are not over yet (like the still-existing income tax surtaxes to pay for massive reunification costs). In Australia, the fiscal system permanently transfers income to Tasmania, which is the Australian equivalent—in terms of poverty/low incomes—of the Italian Mezzogiorno or East Germany. But even in the context of unified nation states with a common national identity, such permanent transfers become politically and socially unacceptable as the rich regions resent such transfers and eventually revolt against them: In Italy, for example, political movements representing the rich north (notably, the Lega Nord) have become influential and are now imposing a form of fiscal federalism that will, over time, significantly reduce transfers from the north to the south. And concerns are now being expressed that such fiscal reform will lead to a sharp political backlash in the south; even, in the extreme, threats of secession or national breakdown. So, permanent unilateral transfers of income from rich to poor regions become politically problematic even in a unified political union with a homogenous national identity.

This suggests that the idea that Germany or the core of the EZ would accept a permanent—several percentage points of its GDP—transfer of its income to the periphery as a condition for the periphery not exiting the EZ runs against political trends and is extremely unlikely to occur. The EU has a system of structural payments from rich to poor states (southern and new eastern European members), but these transfers are relatively modest (less than 0.5% of the core’s GDP). Ramping them up by a factor of 10 to bribe the periphery into staying in the EZ would be totally unacceptable—politically and otherwise—to Germany and the rest of the core. Also, it would not make economic sense: Until now, the excess of income (spending) over spending (income) in the core (periphery) that has taken the form of a current account surplus (deficit) in the core (periphery) has been financed with debt that, in principle, is an asset of the core and should be paid back with interest by the periphery over time.

Now, instead, the core would have first to accept a capital levy on its accumulated assets over the periphery (its foreign assets accumulated through decades of current account surpluses) to allow the reductions of the periphery’s unsustainable foreign private and public debts. The EZ core is now grudgingly accepting some of this capital levy (losses on EZ creditors coming from the debt reduction in Greece), but similar capital levies are unavoidable for the debts of Portugal, Ireland and Cyprus, and may become unavoidable even for Italy and Spain.

But even this much larger capital levy would not be enough as the persistent chronic trade deficit of the periphery would next have to be financed not via debt-creating flows, but rather unilateral transfers within a currency union. Providing a system of vendor financing from the core to periphery may have made sense for the core for a while to sustain its export and GDP growth even if it eventually leads to a capital levy when the debtor is unable to pay. But a system of unilateral transfers from the core to periphery where the excess of spending over income of the periphery is financed by permanent grants—not loans—from the core doesn’t make any economic sense for the core: It is a permanent reduction of income and welfare and consumption for no sensible reason apart from the vague goal of keeping the EZ together.

The discussion above suggests that the usual recent argument—i.e. that the EZ needs to become a fiscal union to survive its crisis—is partially wrong and confusing. There is a substantial and critical difference between a fiscal union and a transfer union. In a fiscal union, there is true risk-sharing and no permanent transfer of income from one state/region to another. Where revenues and spending are partially shared at the federal level, there is risk-sharing: When an idiosyncratic shock occurs in one region (such as a recession in one state of the union, but not in other states), risk-sharing implies that revenues and transfers/spending are adjusted to reduce the effect of that temporary state-specific shock to the output (GDP) of that state on its income (GNP). If such state-specific shocks are random—sometimes hitting one region/state, sometimes hitting another region/state of the union—the worse-off region subject to the negative output shock gets partially and temporarily subsidized by the region/state that is temporarily better off. And over time—like in any actuarially fair insurance scheme—mutual insurance smoothes shocks to income that are driven by shocks to output. No region/state permanently subsidizes another one. This is a fiscal union where risk is pooled and shared.

A transfer union is a very different animal: it is not a fiscal union aimed at sharing, insuring and smoothing temporary regional output shocks. It is instead a mechanism that uses fiscal resources—taxes, transfer payments and public spending—to permanently transfer income from richer region/states to poorer regions/states. Transfer unions are politically problematic even in unified nations that are political unions and are nationally homogenous. They are much more problematic when a political union does not exist and where the arguments for a permanent transfer union are not acceptable. For a German to accept a permanent transfer of her income to the Greeks as a condition for Greece remaining part of a monetary union doesn’t make any sense.

Transfer unions also don’t make sense because they breed moral hazard. Even if one could make the argument that initial differences in per-capita income between different regions/states of an economic union were explained by exogenous factors different from endogenous policy/economic efforts, the existence of a permanent transfer union would obviously breed—over time—moral hazard. The weak/poor region might not want to make much economic/policy/fiscal effort to improve its economic/fiscal conditions as it is permanently subsidized by the richer region.

Moral hazard is thus the reason why fiscal unions come with binding rules that limit the risk attached to the transferee being fiscally undisciplined, to prevent a fiscal union becoming a transfer union. This is also the reason why the current efforts of Germany/the core EZ to help the periphery are subject to strict fiscal and structural conditionality: Only if the periphery does significant and painful fiscal austerity and structural reforms, will the core help the periphery to overcome its temporary fiscal and financial problems. This is also the reason why any inter-EZ debate on future quasi or full fiscal union comes with the express request by Germany/the core for binding fiscal rules (balanced budgets over time, balanced budget amendments, sanctions against deviant states) to prevent such a fiscal union from turning into a transfer union.

In conclusion, Option 3 is highly unlikely and undesirable for the core EZ as it would imply the creation of a transfer union, rather than a fiscal union. But if Option 2—deflationary depression—is unacceptable to the periphery, only a transfer union prevents the periphery from being tempted to avoid a persistent recession, from considering exiting the monetary union and restoring its growth and competitiveness via a return to its national currency.

Option 4: Widespread Debt Reductions and Eventual EZ Break-Up—Becomes the More Likely Outcome as the Other Three Options Are Not Likely or They Are Not Desirable or Sustainable

The core of the EZ is unlikely accept a symmetric adjustment—Option 1—that restores competitiveness and growth in the periphery via monetary and fiscal easing and a weaker euro that implies higher inflation for a period of time in the core, a persistent LOLR role for the ECB and significant credit risk for the core if some periphery members end up being both illiquid and insolvent. It is instead pushing for Option 2, recessionary deflation in the periphery, which is not politically acceptable in most of the periphery. Then, the only way to keep the periphery in the EZ becomes both a capital levy on the core creditors to make the debts of the periphery sustainable and, on top of that, unilateral transfers in the form of a transfer union that permanently subsidizes the depressed income—of the EZ periphery (caused by the permanent loss of competitiveness that remaining in the EZ implies).

But such a transfer union is not politically or economically acceptable to the core. Then, the only other option is first a capital levy imposed by the periphery on the core—in the form of a reduction of unsustainable foreign private and public liabilities—to reduce such unsustainable debt. But even that debt reduction is not sufficient to restore competitiveness and growth. And if competitiveness cannot be restored via Option 1 (a much weaker euro), or Option 2 (depressive deflation or too-slow structural reform) or Option 3 (where the incipient permanent loss of income via a permanent loss of competitiveness is permanently subsidized by the core via a transfer union), the only other option left is the one of exiting the monetary union and restoring growth/competitiveness via nominal and real depreciation resulting from ditching the euro and returning to a national currency.

Exiting the monetary union is not a costless action, including—among other problems—the complex and costly process of converting previous euro assets and liabilities into the new national currency i.e. “pesification” or “drachmatizaton” of euro debts. In a separate paper (“Greece Should Default and Abandon the Euro”), I discussed the pros and cons of returning to a national currency and how to limit both the collateral damage of a unilateral exit and of the contagion from such an exit to the remaining EZ members.

Arguing that the EZ may eventually break up usually leads to angry reactions among the supporters of the EZ who argue that such an option would lead to disastrous consequences for the exiting country, the other EZ members and the overall global economy. We don’t deny that a disorderly break-up could be a shock as severe—or even more severe—than the disorderly bankruptcy of Lehman Brothers. But as the Lehman example shows, disorderly shocks do occur from time to time. And the history of financial crises suggests that very costly crises do occur with a virulence and frequency that is rising. So, arguing that a break-up of the EZ is impossible to fathom is not logical.

Also, the oft-heard argument that the EZ was more a political project—unifying Europe and permanently roping in Germany in a European construct—than an economic one and thus it will survive regardless of its economic viability is a logical non-sequitur. Political considerations may lead the EZ to last longer or reduce—everything else equal—the probability of a break-up. But political logic doesn’t suspend the laws of economics: If a monetary union becomes unsustainable it will eventually break up, regardless of its political benefits.

Which Outcome Is Most Likely? Further Sequential Debt Restructurings and a Partial Break-Up

Also, we have not argued that a break-up is the only feasible outcome. Option 1 restores growth and competitiveness via an adjustment that is more symmetric than asymmetric—both the core and periphery need to make some sacrifices to allow the survival of the EZ. And, eventually, both Germany and the ECB may accept such a more symmetric option rather than let the EZ be destroyed if political considerations are important in considering the costs and benefits of alternative policy options. Also, internal devaluation plus structural reform may work for some EZ members such as Ireland. A formal transfer union is unlikely, but the core is willing to accept some stock capital levy on its claims on the periphery—debt reduction for Greece and possibly other EZ members—and it may accept some partial transfer payments—various bailouts that have a subsidy component embedded in them—if the periphery makes policy efforts (both fiscal and structural) to fix some of its problems. And arrangements that start as quasi-fiscal unions have a tendency—over time—to absorb components of a partial transfer union (an incentive-compatible or moral-hazard-proof form of a partial transfer union).

Also, note that Option 4 can be something short of a formal full break-up of the EZ. In some variants of Option 4, only some of the weakest members of the EZ exit: Greece, Portugal and Cyprus. Suppose that Italy and Spain were to be successfully ring-fenced: i.e. buying a year of time via the bazooka of the levered EFSF were to be sufficient for Italy and Spain to undertake credible fiscal austerity and reforms, change their governments to more credible ones and partially restore their growth and competitiveness so that a year from now they can borrow at sustainable spreads without any additional official support. Then, if Italy and Spain are out of the woods and a year from now Greece and/or Portugal/Cyprus require not just debt reduction, but also exit from the EZ, a smaller EZ without Greece and/or the other two weak members would be feasible and manageable. If two or three of the smallest members were to exit while Italy and Spain were able to survive and eventually thrive within the EZ, a partial break-up of the EZ would be feasible and possible without destroying the entire monetary union. But if either Italy and/or Spain were to need a coercive restructuring of their public debt and, even after that disruptive action, would still need exit to restore growth/competitiveness, than an effective break-up of the EZ would become likely. Even then, Germany and a small group of core countries might maintain a monetary union. But in that outcome, it is not obvious that even the fiscally and structurally fragile and reform-less France—which would lose its triple-A status and also become the victim of severe collateral damage and contagion from debt restructurings and/or exit of Italy/Spain—would remain part of that “core” EZ.

Political Benefits of the EZ May Not Trump Its Eventual Economic Costs

Regarding the political costs of a break-up of the EZ, it is clear that Germany and France—and other core EZ members—would be seriously damaged by such a break-up and would see the major project of economic and eventual political unification of Europe destroyed. But Europe and the EU would not be destroyed even if the EZ were to partially or fully break up. Some EU members never joined or were allowed to opt out of the EZ (Sweden, Denmark and the UK) and some eastern/central members of the EU may never qualify to join the EZ. So, an EU where some countries are members of the EZ and others are not is totally feasible and better and more viable than an EZ that includes some members that should have never joined in the first place.

In spite of the political benefits of the EZ and the political costs of a break-up, neither Germany/the core nor the periphery would accept the costs of a persistent EZ if its economic/financial costs were to hugely exceed its benefits. It is clear that Germany is ready to pull the plug on Greece—and if necessary on Portugal and Cyprus—if Italy and Spain are successfully ring-fenced. Germany/the core has already accepted the principle and practice of accepting a capital levy on its assets—those of the private German creditors of Greece—rather than further fully socialize the cost of a full and persistent bailout of an insolvent sovereign such as Greece. It would be willing to accept similar capital levies on its claims of other near-insolvent small EZ members such as Portugal and Cyprus. Germany would also accept—and even manage—an orderly exit of Greece and other smaller EZ member from the monetary union if/when Italy and Spain are successfully ring-fenced. So, a smaller EZ is still possible and viable.

The open issue is what Germany will do a year from now if, after an attempt to provide catalytic finance to Italy and Spain via a levered EFSF, either Italy and/or Spain are not able to borrow at sustainable rates without official support if their growth and competitiveness and sovereign viability are not otherwise restored. Would Germany/the core double down and try for another year of Plan A—catalytic finance of even larger size—when that approach has already failed once or would it opt for the preferable Plan B (debt restructuring, eventual exit)?

The German Assessment of the Costs and Benefits of the EZ

The usual argument is made that even Germany then would have no choice to again backstop Italy and Spain as the alternative—collapse of the EZ—would be even more costly to Germany and the global economy. But if Plan A—assuming that Italy and Spain are illiquid but solvent given time, financing and adjustment—has failed, then what is the purpose—for Germany/the core or even the international community (IMF/the U.S./the BRICs) —of doubling down on a failed strategy?

Germany and the ECB have so far hoped that their view of the crisis is correct: The periphery is in trouble because of a lack of fiscal discipline and structural reforms. So, fiscal discipline and structural reforms are the necessary solutions even if they imply painful adjustment and sacrifices for the periphery for a number of years. Germany and the ECB may turn out to be right, but this paper suggests that the painful medicine will be—however necessary over the medium term—too painful and recessionary in the short run and for long enough that it will not be viable. Also, the EZ periphery’s fundamental loss of competitiveness—manifesting itself in now unsustainably large current account deficits—requires a real depreciation that will not be achieved quickly enough with reforms and deflation that depress output for too long before they restore growth. Thus, debt reductions and real depreciation via an EZ exit and a return to national currencies will become—however costly—unavoidable and less painful than the alternative of recessionary deflation.

Then, if this analysis is correct, Germany will eventually have to make tough choices: Either allow a strategy that changes the nature of the ECB and restores growth through a weaker euro and higher inflation in Germany for a period of time; or permanently subsidize the depressed EZ periphery; or allow the debt reductions of most periphery members and their exits from the EZ. Again, if only a small Greece and/or Portugal/Cyprus exits, the process would be—however costly and ugly—manageable, But if the crisis doesn’t spare—in spite of all current adjustment and financing efforts—Italy and/or Spain, Germany/the core EZ could find that further backstopping of Italy/Spain would be too costly and also “mission impossible” if Plan A has failed and repeating it isn’t likely to make it more successful.

Indeed, soon enough, Germany would have to worry about its own fiscal sustainability and the risks involved in endlessly backstopping more EZ members. Today, its taxpayers’ taxes backstop the German public debt. But even Germany has a large fiscal deficit and a large stock of public debt. And, given the ageing of its population, it also has additional implicit long-term fiscal debts/liabilities. Add to that the fiscal cost of recapitalizing many of its insolvent or near-insolvent financial institutions: The Landesbanken, IKB, West LB, Commerzbank and others. The German taxpayers’ money is now also partially backstopping the public debt of Greece, Ireland and Portugal through the IMF, EFSF, EFSM and ECB.

But the public debt of Greece is “only” €300 billion. The public debt of Italy and Spain is close to €3 trillion, or 10 times that of Greece. Germany will now—via the expanded and levered EFSF—partially guarantee part of the Italian and Spanish debt. But about €200 billion of the implicit liabilities of a levered EFSF is already a large risk for an overleveraged Germany. If, a year from now, the bazooka of the levered EFSF has not worked to restore the sustainability of Italy and/or Spain, the idea that Germany would accept taking an additional €3 trillion credit risk by fully backstopping Italy and Spain is quite far-fetched. Since Germany needs to consider that, under some scenarios (whatever their probability), Italy and Spain don’t make it and need both debt restructuring and to exit, Germany must protect itself now for the fallout that a disorderly break-up of the EZ would entail.

And some of the caution that Germany has shown in terms of committing more financial resources to backstopping the periphery has to do with the German need to save some precious bullets—or some dry powder—in case all goes wrong and the EZ breaks up. Using all of its chips now to backstop the periphery would not be rational for Germany, even if doing so raises the odds of Italy and Spain eventually getting out of the woods. Keeping some powder dry for the extreme tail scenarios is a rational strategy for Germany and the core as the financial and economic fallout and costs of a break-up would also be severe for them.

Cost-Benefit Analysis of EZ Membership for the EZ Periphery

A similar cost-benefit analysis of staying in the monetary union applies to the periphery members. Currently, none of them— not even hopeless Greece—is seriously considering exiting the monetary union. But, as we have argued above, if Germany/the ECB insist on an adjustment that is deflationary/recessionary, the social/political backlash against that depressionary adjustment may become overwhelming. Already in Greece, daily demonstrations, strikes and other popular resentment against the austerity may lead the government to collapse in the next few months; and this scenario is becoming more likely as there will now be a referendum on the austerity measures, with all the attached risks. Then, if Greece goes even further off track in terms of its commitments to its “troika” of creditors (the IMF, EU and ECB), the troika would have to pull the plug on Greece and a disorderly default and exit from the union would become inevitable. Even if exit is postponed for another year, chronic and ever-deepening recession will sooner rather than later trigger a government collapse and a possible exit from the EZ.

Also, the alleged benefits of remaining in the EZ may now be less convincing for most periphery members: Initially, the EZ led to interest rate convergence when market discipline was not operational; this was a significant benefit as nominal and real interest rates were low and falling and making the cost of debt for both private and public sectors low. Now, with market discipline in full swing and sovereign spreads high and rising, this major benefit of the monetary union has disappeared and has rather become a major cost/burden. Worse, remaining in the EZ implies ceding from now on a significant part of—if not all—fiscal autonomy to the core: Soon enough, the troika will decide most of the taxation and government spending in the periphery, including social safety nets, social security systems and the matters and details of the privatization of public assets. Germany/the core may also effectively take over part of the periphery’s financial systems if the only way to recapitalize periphery banks is by using EFSF resources. Also, the ECB’s monetary and exchange rate policies have now clearly gained—after over a decade of experience—an anti-growth and an anti-competitiveness bias, focusing instead on the strict achievement of price stability. When national currencies existed, rising differentials in competitiveness—because of differentials in unit labor costs—could from time to time be remedied through nominal and real depreciation of national currencies. Now, that benefit is gone and only recessionary deflation is available.

Cost of EZ Membership May Eventually Outweigh Benefits, Thus Triggering Exit

So, what are the alleged benefits of staying in the monetary union if the costs seem to be rising while the benefits are shrinking? Periphery members are still blinded by the potential stigma of an embarrassing exit, especially policy makers who would lose power if a shameful exit that suggests failure were to occur. So, they are desperately avoiding even the thought of exit rather than seriously and rationally considering its benefits as well as its considerable—but manageable—costs. But populations will not meekly accept year after year of sacrifices, job losses, rising unemployment and hopelessness about an economic recovery. If there is no light at the end of the tunnel or the only light is from the approaching train wreck of a deflationary recession with no hope of a short-term recovery, debt reductions and exits from the monetary union will become necessary, desirable and unavoidable.

Options and Scenarios for the EZ (see map below)

In a recent RGE piece (“The Last Shot on Goal: Will Eurozone Leaders Succeed in Ending the Crisis?,” co-authored with Megan Greene), we outlined three possible scenarios for the EZ in the next 12-24 months. In Scenario 1, the current EZ plan somehow works and Italy and Spain are successfully ring-fenced via the levered EFSF and exogenous factors that restore growth after a 2012 recession. Then Greece and/or Portugal/Cyprus experience debt reductions and possibly exit the EZ, but the EZ survives if Italy and Spain survive and thrive. In Scenario 2, Plan A does not work and, once the levered EFSF bazooka has run out of money and pressure on Italian and Spanish spreads has not abated as recession becomes entrenched, Italy and Spain may have to experience debt restructuring and eventually even exit the EZ. Even in Scenario 2, once Plan A has failed a year from now, Germany/the core/the ECB/the international community could still double down on keeping Italy and Spain afloat even if that becomes unlikely and very expensive if Plan A (catalytic finance) has failed. In Scenario 3, things unravel for the EZ inside 12 months as a disorderly collapse of Greece prevents Plan A (buy time on Greece by keeping it on life support until Italy and Spain are successfully ring-fenced and then pull the plug) from even being tried, before it is given a chance to succeed (Scenario 1) or fail (Scenario 2).

 

In terms of the four options in this paper, Option 4 is analogous to Scenario 3 (widespread defaults and the break-up of the EZ), which in our view will become more likely over time. Scenario 1 is, in our view likely to succeed only if Option 1 (macro policy reflation of the EZ) is implemented soon, yet Germany/the core/the ECB want to achieve Scenario 1 by implementing Option 2 (deflation, austerity and reforms). We have argued that Option 2 is very unlikely to lead to Scenario 1 for most EZ periphery members as it will lead to entrenched recession that will last for years and a too-slow restoration of competitiveness. Option 3 is not politically feasible as it implies that the core accepts both a massive capital levy on its current claims on the periphery and an additional permanent subsidization of the periphery’s income. Thus, Option 3 corresponds to a notional “Scenario 4,” to which we assign a near-zero probability in our scenario analysis.

Of course, among the six eurozone countries in trouble so far (Greece, Portugal, Ireland, Cyprus, Spain and Italy), a subset of them will experience restructurings and reductions of their public debts and private debts as a way to resolve their stock imbalances. And a different subset of these six countries may also eventually decide to exit to resolve their flow imbalances. So, many different permutations and combinations of outcomes/scenarios are possible. But our four options and the related policies associated with them provide a map of how one can potentially resolve stock and flow imbalances in the EZ. And our three scenarios provide a timeline of how, over the next 12-24 months, economic and financial conditions will evolve in the EZ. Some countries will for sure restructure their debts and some will most likely exit the EZ. If enough of them restructure and exit—especially the two big ones in the periphery (Italy and Spain)—this would effectively represent a break-up of the EZ.

Our point is that we cannot rule out Option 4 becoming more likely: i.e. Scenarios 2 and/or 3 materialize, so the next steps of these scenarios are widespread debt restructuring and eventual exit from the EZ of enough member states such that a break-up of the EZ turns out to be necessary and unavoidable. In terms of this non-linear set of scenarios, the periphery will push for Options 1 or 3 as a way to avoid Option 4; but if Germany/the core/the ECB stick with Option 2, Scenarios 2 or 3 rather than 1 will materialize and the EZ will eventually end up with Option 4, i.e. debt reductions, exit from the monetary union and the break-up of the monetary union.

This paper—and its companion piece—outlines the options available to the EZ, the accompanying policy actions and the scenarios that will result from the complex, dynamic, high-stakes game being played. Various options are available at each node, with the chosen policies leading to a variety of different outcomes, grouped under our three main scenarios.

Read the whole article here: EconoMonitor : Nouriel Roubini’s Global EconoMonitor » Eurozone Crisis: Here Are the Options, Now Choose

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Keynes and Hayek, the Great Debate (Part 1): Nicholas Wapshott – Bloomberg

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>below are some excerpts from Jim Rogers interview:

Dollar will be debased; gold and silver to hit new highs

Chinese economy:

There is some overheating and inflation

setback in urban, coastal real estate is under way

China has been overbuilding ever since I have been visiting. There is at least eventual demand for much of it, but that does not preclude some bankruptcies in the future.

Europe:

I think we are getting closer and closer to the point where someone in Europe is going to have to take some losses, whether it's the banks or the countries, but somebody has to acknowledge that they are bankrupt.

Following is an interview that The Daily Bell had with Jim Rogers:

Jim Rogers: Dollar will be debased; gold and silver to hit new highs
05 April 2011 | http://www.commodityonline.com

Daily Bell: We've interviewed you before. Thanks for spending some time with us once again. Let's jump right in. What do you think of the Chinese economy these days?

Jim Rogers: There is some overheating and inflation, which they are wisely trying to cool – especially in urban, coastal real estate. They have huge reserves so will suffer less than others in any coming downturn.

Daily Bell: Is price inflation more or less of a problem?

Jim Rogers: More. At least they acknowledge inflation and are attacking it. Some countries still try denying there is inflation worldwide. The US is even pouring gasoline on these inflationary trends with more money printing instead of trying to extinguish the problem.

Daily Bell: Is China headed for a setback as you suggested last time we spoke?

Jim Rogers: Did I say a setback or a setback in real estate speculation? I think you will find it was the latter. Yes, the setback in urban, coastal real estate is under way.

Daily Bell: They are allowing the yuan to float upward. Good move?

Jim Rogers: Yes, but I would make it freely convertible faster than they are.

Daily Bell: Will that squeeze price inflation?

Jim Rogers: It will help.

Daily Bell: Why so many empty cities and malls in China? Does the government have plans to move rural folk into cities en masse?

Jim Rogers: That is a bit exaggerated. China has been overbuilding ever since I have been visiting. There is at least eventual demand for much of it, but that does not preclude some bankruptcies in the future.

Daily Bell: Is such centralized planning good for the economy?

Jim Rogers: No. Centralized planning is rarely, if ever, good for the economy. But the kind of construction you are describing is at the provincial level – not the national level.

Daily Bell: The Chinese government is worried about unrest given what is occurring in the Middle East. Should they be?

Jim Rogers: We all should be. There is going to be more social unrest worldwide including the US. More governments will fall. More countries will fail.

Daily Bell: Are they still on track to be the world's biggest economy over the next decade?

Jim Rogers: Perhaps not that soon, but eventually.

Daily Bell: Any thoughts on Japan? Why haven't they been able to get the economy moving after 30 years? Will the earthquake finally jump-start the economy or is that an erroneous application of the broken-windows fallacy?

Jim Rogers: It has been 20 years. They refused to let people fail and go bankrupt. They constantly propped up zombie companies. The earthquake will help some sectors for a while, but there are serious demographic and debt problems down the road.

Daily Bell: The Japanese were going to buy PIGS bonds. What will happen now? Does that only leave China?

Jim Rogers: Obviously the Japanese have other things on their mind right now. I think we are getting closer and closer to the point where someone in Europe is going to have to take some losses, whether it's the banks or the countries, but somebody has to acknowledge that they are bankrupt. The thing that the world needs is for somebody to acknowledge reality and start taking haircuts.

Read more »


weOctober 03 2010 7:47 AM GMT
Big Mac index gives more than a taste of true worth

By Steve Johnson

Intervention has kept some emerging market currencies artificially weak, at the same time many have raised interest rates to stem inflation. It is only a matter of time before some allow their currencies to appreciate
Read the full article at: http://www.ft.com/cms/s/0/2736d936-cd89-11df-9c82-00144feab49a.html?ftcamp=rss

Sent from my iPad


>

Friday Look Ahead: Tech a Focus for Stocks Friday, as Gold Dazzles Investors

Published: Thursday, 16 Sep 2010 | 9:10 PM E
By: Patti Domm
CNBC Executive Editor
Some good news from the tech sector could be a positive for stocks Friday.

Outside the New York Stock Exchange in lower Manhattan.
Photo: Oliver Quillia for CNBC.com
Outside the New York Stock Exchange in lower Manhattan.

Both Oracle and Research in Motion reported strong earnings after Thursday’s bell. Separately, Texas Instruments boosted its $0.12 dividend by a penny and said it would buy back another $7.5 billion shares. All three stocks were higher in after-hours trading.

Stocks Friday morning could feel the effect of the quadruple expiration of futures and options. Traders expect the expiration to be low key at the open, and if anything, the impact should be slightly positive.
CPI, at 8:30 a.m., is expected to show a 0.3 percent increase in August consumer prices. Consumer sentiment is expected to improve slightly to a reading of 70, from 68.9 last month, but economists say the strong performance of the stock market this month could push that number a bit higher. August’s sentiment reading was the second lowest of the year. Consumer sentiment is released at 9:55 a.m.
Stocks drifted on both sides of the unchanged mark Thursday. The Dow ended up 22 at 10,594, and the S&P 500 was off less than a half point at 1124.  The dollar weakened against the euro, and dollar/yen was barely changed after the Bank of Japan intervened to curb the yen’s rise Wednesday.
“This intervention might have higher chances of succeeding, assuming we continue to see relatively acceptable U.S. economic data. That’s the critical thing,” said Boris Schlossberg of GFT Forex. “…as long as the idea of double dip keeps receding, Treasury yields should stabilize and go back up and that will be critical to dollar/yen.”
On the other hand, if we see the 10-year yield move to 2.5 percent, or dip below 2.5 percent, I don’t think any amount of money will stem the (dollar) decline,” he said.
Barry Knapp, chief equities portfolio strategist at Barclay’s, said the initial stock market reaction after a big intervention is often a short-term decline. “For the first couple of days, the market goes down a little bit..the first reaction is to look at the dollar,” he said.
The view is “if the dollar is going up, that’s bad for earnings, so sell it. Dollar’s going down, that’s good. That’s a very simplistic approach. I don’t think it’s right at all,” he said. “If you look back at 2003, when the Japanese were intervening dramatically, the initial reaction was that the stock market sold off, and then it regained its footing.”
Knapp said the intervention at that time was about $360 billion, and he estimated this round could total $250 billion. The BOJ was reported to have bought more than $20 billion Wednesday.
“If somebody puts $250 billion into the markets, event though that money won’t be buying riskier assets, it can trigger an effect,” he said.
The impact on Treasurys could also be noticeable, he said. Traders have been speculating the Japanese will park their dollar holdings in shorter duration Treasurys. “Initially the Treasury curve steepens, but then that tends to drive investors who were in 2s and 5s to extend out the curve and it starts to flatten. Then it triggers a whole position rebalancing.”
All that Glitters
Gold continued to dazzle investors Thursday, scoring its second record settlement of the week. Investors are betting it could try to break the $1,300 level, maybe even as early as next week depending on the outcome of the Fed’s meeting Tuesday.  Gold Thursday rose about a half percent to settle at $1273.80.
Gold has faced some high-profile criticism this week, including from investor George Soros who called it a bubble. “If you think about a world where every major country is trying to find a way to devalue its currency, gold looks pretty good in that environment. Personally I think the dollar is going down more. There’s lots of reasons why gold will continue to rise. I don’t know if I’d buy it, but I know I wouldn’t short it,” Knapp said.

 http://www.cnbc.com/id/39223276


>Oh, poor “Demonized Algos” !!!

Demonised ‘algos’ push the surge in FX trading

By Jennifer Hughes, Senior Markets Correspondent
Published: September 1 2010 00:04 | Last updated: September 1 2010 00:04

Since the infamous stock market “flash crash” of May 6, high-frequency, or algorithmic, trading has been unwillingly dragged into the political and regulatory limelight.
forex-trading-graphicSo far, however, attention has focused on the role of these high-speed traders in the equity market. Outside the glare of that publicity, it is less well known that on May 7, FX trading volumes reached records, straining the plumbing of these markets.
Some participants argue these strains were partially caused by algorithmic, or algo, traders.
Exactly how much of this can be attributed to algo trading is unclear. However, there is no question that high-frequency traders are a fast-increasing force in FX markets, which is sparking a fierce debate as to their value to the market.
On Tuesday, the Bank for International Settlements reported that average daily turnover in the FX market has jumped 20 per cent in the past three years to $4,000bn a day. Its survey was taken in April, so missed the May spike, which related to the eurozone sovereign debt crisis.
The BIS-reported gains were led by a near 50 per cent leap in spot trading – deals for immediate delivery – to $1,500bn a day. This jump was powered by increased activity from “other financial institutions”, a group that includes hedge funds, pension funds, some banks, mutual funds, insurance companies and central banks. This will also include algos.
While all categories of “other” could have increased their trading, it is likely a significant proportion was driven by algo traders, who favour the deep, liquid spot markets and particularly currency pairs such as eurodollar and dollar-yen, which between them account for 42 per cent of all currency trading.
The question for the FX market is whether high-frequency dealers improve the market by adding liquidity, or whether they are instead merely price takers who contribute little.
“Algos have been demonised, but they’re an important part of the growth story,” says David Rutter chief executive of Icap Electronic Broking, which runs EBS, the main FX interbank trading platform. “What we’ve found is that they add pressure at each price point so that instead of getting big price gaps on shocking news, trade is more orderly.
“With FX, there are a lot of other flows such as global trade, so there is good underlying liquidity that the algos can enhance.”
Algos initially appeared in FX markets almost a decade ago, attracted by the deep liquidity and increasing use of electronic trading. They were generally welcomed, particularly by banks looking to build their prime brokerage businesses. However many banks soon grew disenchanted when they found the fast-moving shops were profiting from banks’ own slow systems by exploiting brief, tiny price differences between rival platforms.
Some banks went as far as ejecting offenders from their platforms but banks’ views have since become more nuanced. They have generally reached an accommodation, helped by technological improvements which make it easier to monitor client dealings and offer client-specific prices.
“The facts are that algos have made the markets more efficient and have helped ensure there’s one virtual price,” says Jeff Feig, global head of G10 FX at Citigroup. “They do cause banks to be smarter and we’ve had to work harder to be more efficient, but that’s ultimately to the advantage of the end user.
“I think that to some extent, algos have pushed banks and the result has been enhanced transparency and increased liquidity.”
Algos mean many different things in the FX market. While high-frequency traders are the best known – typified by one senior banker as “five smart guys in a room in New Jersey,” – banks are increasingly adept at developing their own algorithms to make their internal FX deals more efficient. These “internalisation” trades too will have provided a boost to the BIS numbers.
Most players say algos are now a fact of life in currency markets.
Unlike the equity market, which is split into hundreds of stocks, they believe the FX world’s focus on a relatively small number of currency pairs means it would be far harder for a single group of participants to move the market significantly, intentionally or otherwise, as some watchers fear happened during the “flash crash”.
“Also trading can happen anywhere there’s an electronic execution system and a volatile market,” says Alan Bozian a former FX banker and now chief executive of CLS Bank, the FX settlement system. “The question is, which markets adapt well and I don’t think it’s necessarily the stock market.”
FX markets have proved generally good at adapting. Systems such as CLS, introduced years before the financial crisis, have helped minimise settlement risk and since May, participants have been working again to improve their processing systems to cope with increased volume.
Significantly, for a market that is very much built around a hub of big banks, the BIS report showed that, for the first time, interaction of the main banks with “other” financial institutions overtook trading between themselves.
This could be a pointer to the market of the future, where banks are likely to remain the hub, but as much for their trade processing abilities as for their liquidity.
This would allow the winners to build profitable volume without taking on huge trading risks – suiting the current regulatory mood.
“The banks want to continue being the price providers, but they’re getting much more interested in the infrastructure and improving that,” says Mr Bozian. This evolution is likely to apply to high-frequency trading too.
Mr Rutter believes algos are only in their “late teens” in terms of development. “The early algo trading was about super-fast dealing and chasing inefficiencies. That’s largely gone,” he says.
“Now its about math and science being thrown at the market – there’s a rich pool of data and I think we’ll see algos evolve so its not just about milliseconds, but about longer-term predictive math.”

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