Baseline Scenerio

The Baseline Scenario
The Risk Of Deflation In The Eurozone
Feel-Good Story of the Day
Sheila Bair Listens to Me
The Risk Of Deflation In The Eurozone
Posted: 29 May 2009 08:29 AM PDT
In January, Lucas Papademos, Vice-President of the European Central Bank ECB), strongly suggested that inflation would not fall much below 2% in the eurozone (see the end of this post). Translated from the language of central bankers, he implied that the risk of deflation in the eurozone was virtually nil.
Now Jean-Claude Trichet, head of the ECB, with reference to the latest eurozone (0%) inflation rate, says that we should disregard the data because a recovery is just around the corner.
Alternatively, we are close to the baseline eurozone view laid out in my January presentation (part of a panel discussion with Mr Papademos). You can break this down into three specifics.
Private sector demand is weak; it’s hard to see who will lead the recovery within the eurozone. In addition, the demand for European exports has fallen much more than expected, as seen – for example – in the big decline in German Q1 output.
The ability of the public sector to offset this decline with discretionary fiscal policy is quite limited, due to balance sheet constraints in some countries (look at the latest credit default swap data from weaker euro sovereigns; CDS primer) and clear policy preferences in others (i.e., how Germany worries about inflation, even when there is none).
Banks look troubled across many eurozone countries, and as the real economy surprises on the downside these problems will increase – with presumed implications for government bailout programs and balance sheets (the IMF was quite negative, see Tables 1.3 and 1.4 on pp.28 and 34 respectively, on European banks before the latest round of bad news). Remember that the European economy depends on banks much more than does the US.
If the world turns around and/or oil prices continue to rebound, the eurozone can presumably avoid deflation. But it’s hard to see inflation rising any time soon due to the eurozone’s own dynamic.
And if deflation takes root, it is hard to see this proving more tractable or less damaging than deflation in Japan during the 1990s. Which part of Japan’s lost decade now looks easy to avoid in Europe?
By Simon Johnson

Feel-Good Story of the Day
Posted: 28 May 2009 07:22 PM PDT
Calculated Risk reports that Citigroup is livid that S&P would have the audacity to downgrade the senior tranches of commercial mortgage-backed securities.
Citigroup commented that the changes were “a complete surprise”, “flawed”, lacked “justification” and the “S&P methodology changes do not seem rational or predictable”. Ouch.
It’s nice to see that the banks – who spent the last decade shopping for favorable ratings from the rating agencies, and overwhelming them with thousands of complicated offerings backed with sophisticated models – and the rating agencies – who spent the last decade giving AAA ratings to the banks’ models and are now claiming that it was all the banks’ fault – are getting along so nicely. Some marriages truly are forever.
By James Kwak

Sheila Bair Listens to Me
Posted: 28 May 2009 04:57 PM PDT
Yesterday I said that Tim Geithner or Sheila Bair should come out and slap down the idea that banks will be allowed to bid on their own assets. And today she did! Rolfe Winkler, in a guest post at naked capitalism, did the hard work transcribing the audio of the press conference.
Although banks cannot buy their own assets, Bair did say, “I think there have been separate issues about whether banks can be buyers on other bank assets and I think that’s an issue that we continue to look at.” As I said yesterday, and as Winkler also said, I think this is also a bad idea. Even if you successfully deter outright collusion, you can still have outcomes where the industry as a whole is using subsidies to overpay for its own assets and shift the loss onto the government.
And no, I don’t actually think that Sheila Bair reads this blog, much less listens to what I have to say.
By James Kwak