The Dizzying Complexity of Eurozone Debt

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The scariest part about not understanding an article about European sovereign debt is this: The realization that people making policy may not understand it either.

Earlier today, I linked to an article from Bloomberg about quantitative eas

ing in the U.S.—and about its broader impact on monetary policy. The Bloomberg article explores some of the issues surrounding the Fed's purchase of U.S. treasuries. Those issues include: on-the-run versus off-the-run liquidity, deficits and inflation, and the challenges involved in bending the yield curve to the Fed's will—especially at longer maturities.

If you didn't completely follow all that, don't trouble yourself too deeply: One gets the impression that guys with PhD's in economics are also a little flummoxed on how the Fed should manage the implementation of some of the finer policy points.

While some of the points discussed in the Bloomberg article are enough to make you a little lightheaded, others seem straightforward enough. For example: Yield spreads are widening between the most and least liquid Treasury securities.

(The head of interest-rate strategy at Nomura Holdings, George Goncalves, breaks it down: "Dealers are more likely to bid more aggressively at Treasury auctions if they can sell to the Fed in the not-so- distant future,")

All that makes perfect sense: If Uncle Ben at The Fed will be buying soon the risk to dealers isn't very great.

Nonetheless, reading an article like this tests your resolve. It's like pedaling a bicycle uphill: And if you lose focus for a second you drop the thread.

But—at the very least—the Fed has been dealing with similar, or at least related, issues since the first World War.

On the other hand the current situation in Europe suffers from a total absence of historical precedent.

Interposing another layer of complexity - in the form of a network of supranational monetary authorities - muddies the monetary waters to a disconcerting degree.

The issues that Joseph Cotterill bravely hashes out in his post today for the Financial Times Alphaville are truly vertigo inducing.

The principal issue, it seems, is what impact swapping out European Financial Stability Facility (EFSF) debt for peripheral sovereign debt will have on the credit markets in Europe.

(For example: Who knows where the peripheral sovereigns should be trading in the first place? To quote Cotterill: "peripheral bonds are currently frozen onto private-sector balance sheets (banks, insurers and pension funds may hesitate to mark the bonds' values to market in particular).

Cotterill goes on to quote Daniel Gros and Thomas Mayer of an organization impressively titled "Centre for European Policy Studies"

"For investors who have already marked their holdings to market, an exchange of outstanding [Greek, Irish and Portuguese] bonds against EFSF bonds would be attractive, as they would obtain a safe and liquid asset of the same market value. This would actually increase the access to the repo window of the ECB since the haircut applied to highly rated EFSF bonds would be much lower than the one applied to peripheral bonds. "

I have no doubt that Messrs Gros and Mayer are much smarter than I am.

And yet I want to tack on a single sentence to the end of their quote: "Maybe."

It seems reasonable to suspect that those assumptions would be highly dependent on a lot of other variable. Among them: Haircut rules, other collateral regulations, and how risk positions are hedged.

But what seems most troubling is the absence of relevant precedent.

Policy makers have never confronted issues of this sort before - and no one knows exactly how the markets will respond.

In Europe, it is truly a brave new world.

You have to wonder, at least in passing, whether our European friends have engineered financial edifices beyond the reasonable expectation of understanding.

And who among us would be brave enough to admit their utter and desperate confusion?


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