Belmont Club

Roman Holiday

The Eurozone crisis reignited as interest rates on Italian and Spanish bonds hit record highs. “The yield, or interest rate, on Italian 10-year bonds rose to nearly 6.3% at one stage, with the equivalent Spanish bonds yielding almost 6.5% early on Tuesday. If yields reach 7%, a country has effectively lost the support of the international markets.” Prime Minister Jose Luis Zapatero postponed his vacation to monitor events more closely.

As these countries reached the limit of their repayment capacity, the possibility that bondholders might have to take haircuts, voluntarily or otherwise, made it harder to find lenders for the two beleaguered nations, whatever the interest rate.

Although Italy pushed through a four-year austerity plan in July, the scale of the country’s borrowing needs are alarming investors. Last month’s Greek bailout, which will see private creditors take a “haircut” on their loans, has also deterred some fund managers from buying more Italian debt.

Bondholders fled to the comparative safe haven of Britain, but whose advantages were only relative. “Recent data shows the UK economy is stalling. The manufacturing sector contracted for the first time in two years in July while UK output grew just 0.2% in the three months to June.”

Gianni Rotta at Foreign Policy wrote, it is “the end of the roman holiday”. These months of crisis were traditionally sacrosanct and given over to summer relaxation. But no longer: “they can no longer afford it — neither psychologically, nor economically.”

Rome’s rumor mills are now working overtime. Will Italy default? Will speculators bleed the country dry before Aug. 15? … The truth is, nobody knows how Italy will get out of this mess. What’s clear is that Berlusconi, whose term ends in 2013, is running on empty. …

Italy has to acknowledge it has lived far beyond its means. That won’t be easy for three generations groomed in la dolce vita — long vacations, early retirement, low hours, and absolute job security. The influential Mario Draghi, governor of the Bank of Italy and soon-to-be chairman of the European Central Bank, has dictated the necessary reforms in his farewell speech to his colleagues at the bank. The government will have to impose structural reforms, end political patronage and pork, improve schools, and develop a strategic plan for infrastructure. It will need to dismantle the guilds, which stifle competition and discourage innovation not only among blue-collar workers, but professionals, too. Taxes are too high, and tax dodging is much too common, as the penalty is not enough to scare off the practice. The prescription is clear. The only question is whether Italy will administer its own medicine or wait until the bitter pills are forced on it by outsiders.

“Outsiders” has become a code word for what was once termed “reality”. Like Italy, the US has found precious little solace in a debt ceiling agreement as economic indicators continued to fall on bad economic news. The relief expected from the deal faded almost as soon as the tablet was ingested.

New data showed that personal spending fell 0.2 percent in June, the first time it has declined since September, 2009. Nominal personal income inched up by 0.1 percent in June and wage and salary income, central to the ability of consumers to open their wallets, was unchanged in June from 0.2 percent in May, its smallest rise this year.

Moreover the market was not buying the assertion that the debt ceiling agreement was going to reduce the astronomical deficit by much, as this article from MSNBC explains.

A bill aimed at reducing future deficits by $2.1 trillion, expected to be signed into law by President Barack Obama Tuesday, might not be enough to avert a downgrade of the nation’s top-notch credit score by at least one of the major rating agencies.

Standard & Poor’s, one of the most influential agencies, has warned that the nation’s credit rating would be subject to a downgrade without a credible deficit-reduction package worth $4 trillion over 10 years. The package agreed to by congressional negotiators falls well short of that mark.

As the nostrums failed to recover the economy,  the search started for an explanation.  After all, last summer was confidently supposed to have been the “Summer of Recovery”. The stimulus was supposed to have filled America with “investments”, Green Jobs and shovel-ready employment. Instead nothing was working.  Why was that?

Joe Nocera, writing in the New York Times, attributed America’s economic woes to the Tea Party’s “War on America”. “Their intransigent demands for deep spending cuts, coupled with their almost gleeful willingness to destroy one of America’s most invaluable assets, its full faith and credit, were incredibly irresponsible. But they didn’t care. Their goal, they believed, was worth blowing up the country for, if that’s what it took.”

Yes, that was it. The Tea Party, only recently derided as a bunch of impotent hicks, was somehow overpowering the Senate, the White House and the New York Times.

But the Tea Party believed that it was the proponents of spending who are destroying America.  Rarely have the prescriptions been so diametrically opposed. The debate calls to mind the accident investigation into Air France 447, an Airbus which stalled itself into the Atlantic Ocean on a flight between Rio and Paris. The aircrafts pitot tubes were blocked and the ship slowed to where it stalled.

The pilots, trained to respond to computer controls which told them what to do, heard the stall warnings go off every time they put the nose down, the standard procedure for recovering. To turn the stall warnings off they pushed the nose up. That satisfied the virtual reality of the flight control system, but the actual aerodynamics made the airplane crash still slightly tail down into the ocean at 125 miles an hour, having lost 35,000 feet in a few minutes. They were clueless to the last.

The captain was on a rest break when the warnings began. It’s unclear why the co-pilot at the controls, flying manually in what became the final minutes of the flight, maintained a nose-up input — contrary to the normal procedure to come out of an aerodynamic stall. Normally, the nose should be pointed slightly downward to regain lift in such a stall, often caused because the plane is travelling too slowly.

A basic manoeuver for stall recovery, which pilots are taught at the outset of their flight training, is to push the yoke forward and apply full throttle to lower the nose of the plane and build up speed.

This procedure, which can cause the aircraft to quickly lose several thousand feet of altitude, can be dangerous if the plane is near the ground. But with AF447 flying at over 35,000 feet, the risk of that would have been negligible.

The pilots may have been misled by erroneous stall warnings, the SNPL French pilots union said.

In a statement focusing the blame on the equipment and not on the pilots, the union said: “Each time they reacted appropriately, the alarm triggered inside the cockpit, as though they were reacting wrongly. Conversely, each time the pilots pitched the plane up, the alarm shut off, preventing a proper diagnosis of the situation.”

Does Washington really know what to do in this situation? Does the EU? The problem is that performing the right maneuver entails violating their institutional interests. They are faced with the choice between saving the guild and saving the plane. Which will they do?

Some may still believe the economy can be saved by keeping the nose up; by pitting debt thrust against the pull of gravity even when the thrust was failing. That is the Big Government solution. But the indicators from the market suggest that this may be the wrong recovery procedure. Is it better to get air flowing over the wings again? To let economic lift work at keeping the plane aloft? That is the Less Government solution. And will a real captain get back into the cockpit in time to diagnose the problem? The coming months — and reality — will tell.

Update:

Europe on Brink of ‘Major Financial Collapse’ — MSNBC
Silent Bank Run in Greece as Depositors Withdraw Money
Greeks Flee Greece
Italy under fire in widening euro debt crisis
Spain and Italy rush to quell fresh crisis

Herman von Rompuy is “astonished” that the rates for Spain and Italy are still rising, according to the EUObserver.

EUOBSERVER / BRUSSELS – Spain and Italy’s record borrowing costs are ‘astonishing’ after a eurozone deal reached less than two weeks ago, EU Council President Herman Van Rompuy said on Tuesday (2 August).

Italian and Spanish 10-year bonds dropped in value, while German bunds rose on Tuesday, pushing the difference in costs (yields) to 381 and 397 points, respectively – a record high since the euro was introduced 12 years ago. …

For his part, Van Rompuy, who brokered the eurozone deal on Greece, precipitated by the very same rising costs as for the Italian government, has tried to allay market fears in an op-ed published in several European newspapers.

“Astonishingly,” he writes, “since our summit the cost of borrowing has increased again for a number of euro area countries. I say astonishingly, because all macro economic fundamentals point in the opposite direction.”…

The true cause of market worries, in Van Rompuy’s view, lies elsewhere – the aftermath of the financial crisis of 2008 and the interdependence with the debt-stricken US.

“It is imperative to bear in mind that this is not a crisis about the euro,” he wrote.

The news here is his “astonishment”. That is what is truly significant because it speaks to the the mental model of the ‘pilots’ of the EU overwater flight. Like the Flight 447 pilots, they can’t understand why their airplane is falling out of the sky.

They’re following all the prompts of their Brussels flight control system and still the altimeter is spinning crazily toward sea level. Never fear. Nose up. Nose up.

The problem of course is that what really matters isn’t what Von Rompuy thinks — although he may imagine it does — what matters is what the Eurozone does. Right now Spain and Italy are headed for the deck. If that reality doesn’t adjust to Von Rompuy’s mental model, then his mental model must adjust to reality.

When that will happen, if that will happen — these are the questions. I think what he hopes will occur is that the “world” will wake up and see things as he does. The ocean will be reasonable and understand it shouldn’t be there and recede according to his wishes so the flight keeps its absolute altitude. The other option is that he may realize they’ve been doing the wrong thing from the start.

What are the odds either way? The other interesting thing is that Von Rompuy, has for the first time of any European leader, placed the locus of the world’s economic crisis on events in the US. There’s only a deficit in America, or local conditions in America are ruining their party. But the reality is far different. Europe has demons of its own and sub-prime countries which are tanking.

If “world leaders” are thinking this way, I’d bet on a head on collision with reality sometime in the near future.

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