STRUCTURE LIQUIDITY PROVISION IN EU ZONE

•  As of 9 May 2010 27 members of EU zone agreed to fund and incorporate EFSF, with >500 bn in capital;

•  ECB initial capital from 27 member states was based upon relative GDP and population, so of course Germany has biggest share of ECB capital;

•  Unlike the Fed in the USA, the ECB mandate is to implement monetary policy in the EU, guarantee price stability, defined by governing council of ECB in October 1998, [EU member states] as < 2% pa. It has no employment mandate;

•  Unlike the Fed, the ECB provides liquidity through 1,500 approved banks, not directly through the Fed discount window. Banks bid for short term repo contracts;

•  The ECB policies the smooth operations of EU financial infrastructure through the Target 2 payment system.

ECB IN FINANCIAL CRISIS

•  Participation in auction requires banks to provide proof of appropriate capital. Here the % of sovereign debt/GDP ratio comes into effect, to protect balance sheet of ECB and manage inflation;

•  To extent that banks authorized to borrow from ECB, have compromised collateral [sovereign bonds from Greece, Portugal, Ireland Spain, Italy], this has meant that the entire liquidity in the Euro system has been impaired;

•  This flaw, together with the collapse of the US CDO market, and structured finance products, has meant the ECB in concert with the Fed has tried to ove problem assets from bank balance sheets, but this attempt has revealed even further weaknesses in the bank balance sheets, Bankia in Spain, Intesa in Italy, BNP in France, Landesbanks in Germany;

•  May 9th 2010 EFSF established to provide loans to countries in difficulty, [such as Greece], finance recapitalizations of the banks through loans to the government.

ECB PURCHASES OF GOVERNMENT DEBT •  ECB to buy 3 -6 month matrurity government debt of failed states like Greece?

•  German government resists the linking of the failed banks to the failed governments;

•  It is necessary to break link between failed bank debt and passing this onto sovereign states. If ECB deals directly with failed banks, rather than passing debt of failed banks to governments of Spain for example, the financial leverage of Spain, and Greece would not be as extreme as it is if vank debt is nationalized;

•  Bundesbank chief Jen Weidmann, and ECB board member has stated German has the right to veto Emergency Liquidity assistance, if bank debt is not dealt with separately;

•  Sovereign debt rescheduling, [e.g. Greece] causes further debt mark downs, and further bank losses. A German put option of Greek, Portuguese, Spanish, Italian debt is not seen as possible politically in Germany;

•  ECB has extended duration of refunancing operations through a 3 year LTRO. Still has little effect on 10 year rates for Greece, Spain, Portugal, Ireland, Italy.

BANKS FAILURE TO LEND TO REAL ECONOMY

•  Risky trading losses on fixed income securities, [credit] has meant EU Zone banks no longer have resources to lend to productive economy. This has brought on massive contraction of the private sector activity in EU, as well as increase in unemployment;

•  Bank of Finland governor advocates for a “Glass Steagall” separation of trading and investment from regular bank credit;

•  Jose Manuel Barroso and Michel Barnier should decide shortly what the new banking legislative and regulatory framework for EU Zone is so as to break the vicious circle of banks reliance on sovereign debt for their earnings;

•  Solution separately capitalized and ring fenced operations for trading and lending, as with Volker plan?

US FISCAL CLIFF IMPACT ON EU GROWTH

•  On 1-1-2013 if no agreement is reached with Congress, automatic tax hikes and spending cuts will impact the US economy, as a result of the expiry of the Tax Relief, Unemployment Insurance reauthorization, and Job Creation of of 2010;

•  The Budget Control Act of 2011 will result in” Sequestrations” of government spending;

•  CBO estimates that total federal revenues would increase 19.6% from 2012 to 2013 and total federal spending would be reduced less than 1%;

•  This would likely cause a double dip recession, and cause GDP to contract from + 1% growth to -2% recession. Unemployment would probably test 9 - 10% again;

•  Debt as a % of GDP would also rise, to almost 94% of GDP, see table overleaf;

•  All this would occur as the EU Zone banking zone crisis intensifies and would cause an even deeper recession in the EU Zone.

US FEDERAL DEBT % GDP

EU ZONE DEBT AS % GDP

TRADE IMBALANCE IN EU ZONE

ECB BOND PURCHASES

IMPACT OF TAX HIKE IN US

•  A family of 4 with an income of $50,000 to $85,000 would pay extra $2,200 in taxes, [National Economic Council July 26 2012 ];

•  Sequestration of both defence and non defence spending will result in great uncertainty over functioning of government in US;

•  Krugman has stated US should focus on employment growth, as a recession would clearly reduce the tax base, and force even greater cuts, at a time the US economy is just beginning to recover;

•  In my view, monetary policy should be attached to a growth in nominal GDP, such that the US continues to grow its monetary base, while at same time measures to extend the tax cuts for Bush years are rolled over at least to 2015.

CURRENT POLICY IS NOT WORKING

•  Need to focus on real economy, tax breaks for business investment, tax reduction for employers that create jobs;

•  Break link between creation of liquidity via banks, [esp ECB] where tool used is “nationalization of bad bank loans’;

•  Clean up corporate governance in EU government. There is no good or bad government spending, just effective spending, and waste;

•  Manipulation of interest rates is not working. Neither LTRO, nor operation twist, nor QE 3 have produced increased employment;

•  EU Zone crisis is a crisis of global bank governance. It is time to return to Glass Steagall.