interest burden for the main Eurozone countries
Figure 11.9 Example of a security scheme
Figure 12.2 Selection of an investment in BTP through the probability table
Figure 12.3 Representation of a complex financial product through the probability table
Figure 12.4 Selection of an investment in a complex financial product through the probability table
Figure 12.5 Some heterogeneous financial products
Figure 12.6 Probability scenarios and fair value of some heterogeneous financial products
Figure 12.7 Macroeconomic benefits of rules based on the measurement and transparency of risks
List of Tables
Table 11.1 ABS structure with sovereign/supranational guarantee
Table 11.2 ABS structure (including 10 % of NPLs) with sovereign/supranational guarantee
Foreword
This refined analysis on the European Monetary Union certainly cannot put an end to the controversies that inflame endless discussion on this big political and economic innovation. Nevertheless, this book has the merit to frame the problems not only in a perspective that is scientifically rigorous, but with an eye that is able to analyse all the consequences on the European and global financial systems. The “Incomplete Currency” is born and grows in an historical period during which the financial institutions and their activities are not only a support for the real economy but have become themselves an end.
Making money is the mantra that drives the behaviour of financial operations and maximises the market's efficiency. At the same time–in a completely impersonal mode–it encourages speculation and profit seeking from both good and bad news. This emerging phenomenon radically changes the equilibrium of power relations across the entire planet; moreover, as it emerges from the most recent analyses, it presents itself as a determining factor that governs the increasing disparities in wealth distribution.
As introductory topics, the book provides the reader with the tools of the trade. Key concepts–such as those of interest rate risk, credit risk, sovereign yield curve, public debt, inflation, interbank market, collateral, credit derivatives and arbitrage–are carefully explained, laying down the premises to the forthcoming analyses.
The salient features of the monetary policy in the era of the single currency are also presented: the European Central Bank pursues a 2 % target in terms of average inflation and is subject to the explicit prohibition of monetising the public debt of any member country. Hence, the ECB cannot use the inflation lever to put under control the public debt of the member countries if necessary; it has only blunt weapons to deal with any potential debt crisis in the Euro area, like those that occurred after 2008. The reason for these incomplete powers is simple: some member states (especially Germany) have imposed the prohibition of debt monetisation as a binding condition for their membership in order to exclude possible forms of risk-sharing between the various economies of the Eurozone. Every country must be virtuous and rely only on itself. This is the leitmotif of the European Monetary Union, and one of the main causes of its structural weakness and of many other incompletenesses, such as the lack of adequate fiscal transfers schemes with a stabilising function of the imbalances due to the single currency.
In conjunction with other objectives of the European strategy, we face a union “half completed”, with the weaknesses and the dangers this entails.
This incomplete construction of the Eurozone is illustrated by the fundamental relationships that tie together the main players (banks, governments and the ECB) of the European financial system.
Before the outbreak of the crisis, these connections had worked quite well. The strong endorsement to the success of the single currency, not only in terms of compliance with the Maastricht criteria but also on the political side, had pushed banks to bet on the Euro. Convergence trades enacted by the banks had favoured the alignment of the sovereign yield curves of the different Eurozone countries. At the same time a sort of Europeanisation of the public debts of the same countries had occurred within banks' balance sheets. The belief linking these phenomena was that all the member countries were sharing the same risks and that their economies were moving together.
Since 2008 the discovery of sovereign credit risk and its dangers has reversed the virtuous process that was in place until a short time before. Markets began to realise that the integration between the various member countries was neither as authentic nor as profound as was first thought: structural differences between the states of the Eurozone were still alive and a fixed exchange rates regime between such different realities could create serious imbalances. Moreover, there was no garrison providing for some compulsory mutual aid or, in financial terms, some form of risk-sharing.
Financial operators quickly reacted in order to hedge themselves from the more risky countries and to make profits from such a big reversal of the market sentiment. Banks of the core countries put in place a massive deleveraging in order to reduce their exposures to the peripheral countries. In parallel, banks of the peripheral countries had to absorb the sudden oversupply of bonds issued by their own governments. The combined effect of these conducts has been the progressive nationalisation of the public debt of the countries in difficulty.
Moreover, what until a few years before had been essentially a unique yield curve on the Eurozone's government bonds began to disintegrate, paving the way for the upsurge of the spreads. Several factors contributed to this divergence process: the collateral discrimination that flared up on the interbank market and (for a while) at the ECB too; the spread intermediation set up by banks to make easy profits through the brokerage of bonds issued by different entities and/or traded with different counterparties (e.g. ECB, interbank market, retail investors).
In less than two years, the financial demolition of the Euro area took place. Since the summer of 2011 the five-year probability of a Euro break-up began to show a bull pattern, breaching the 25 % threshold in November 2011 and reaching 32 % in June 2012 when Spain was close to default.
Despite the fact that the member states had a regime of fixed exchange rates with each other, there
