24 June 2011

Contrarian Notes on Greek Debt Crisis, the Euro and the EU

I mentioned my belief that Christine Lagarde's candidacy was about getting IMF involved in the Eurozone bailout to protect French and German banks.  Looking at the unfolding Greek crisis you notice that they are Greece's largest lenders with 56 Billion for France and 34 Billion for Germany:
Country Total lending exposure to Greece (millions) Total Government debt exposure to Greece (millions) 
Total of 24 countries 145,783 54,196 
European banks 136,317 52,258 
Non-European banks 9,466 1,938 
France 56,740 14,960 
Germany 33,974 22,651 
Italy 4,085 2,345 
Japan 1,631 432 
Spain 974 540 
UK 14,060 3,408 
US 7,318 1,505 
Source: BIS Quarterly Review
But that is only a tiny portion of the story. These figures might give you the impression that their exposure is relatively small and perfectly manageable. But if you looked at the overall exposure of German and French banks in Greece, Spain, Portugal and Ireland, you would see that they are on the hook for 900 billion euros.
German and French banks carry a combined $119 billion in exposure to Greek borrowers alone and more than $900 billion to Greece and other countries on the euro-zone's vulnerable periphery: Portugal, Ireland and Spain.
In fact, the overall debt and exposure distribution is as follows:

If the problem was about Greece alone, the so called "haircut" solution would have been already at the top of the agenda. In fact, it is mathematically impossible to solve the Greek crisis without a haircut. With close to $500 billion in debt, it is simply impossible for them to pay any of it off, especially if the payment has to be done while contracting their economy ruthlessly. The sensible solution would be to let them stimulate their economy with more deficit financing and pay their debt down the road.

But that is not possible right now for both economic and ideological reasons.

Deficit financing a stimulus would be prohibitively expensive for Greece with its debt marked as junk. It could be done if ECB or Eurozone governments provided those funds at a lower rate. But that is not ideologically palatable: most of these governments believe in austerity and (like the UK) this is the prescription they implement at home. This is also the prescription they insisted on in the case of Ireland and will continue to do it for whatever case might arise in the future. It is not just that they would have a hard time selling to their tax payers a spending stimulus package for Greece at a time when they advocate the opposite at home: they actually believe that this is the only way out. When they allow the possibility of a restructuring (the polite term for "haircut") they are talking about a soft and voluntary one.  And they do it with a straight face.

Because of this seemingly intractable ideological impasse, most market watchers are convinced that Greece will inevitably default, some even predicting the demise of the Euro and the phoenix-like rise of national currencies like the Deutsche Mark.

The haircut solution is likely to be around 50 percent, which means roughly $240 billion will be taken off the books and Greece will have to pay the rest while struggling with austerity measures.

Let me note by passingly that if I were the Greek government I would tell the world that I was going to default on that debt and let them come up with a more acceptable solution to dissuade me.  Atrios is right, telling the world to take a hike will certainly yield much better results that selling valuable assets at fire sale prices. In fact, to the best of my knowledge, austerity measures in dire situations never yielded positive results. IMF and the World Bank tried them for decades in developing countries under the banner of structural adjustments policies. Remember those? Their most common result was coup d'etats and autocratic governments who enforced that painful medicine. It took those countries a long time to find a way up and grow again.

In contrast, despite dark predictions about potential defaults, we know from the past (Argentina and Russia being two recent examples) those horrible predictions do not come to pass. Take a look at Krugman's chart about Argentina's default and how their growth took off within a year after they defaulted in 2001.

The biggest threat is that Greece will never be able to get cheap credit in open markets. Well, Iceland just told its creditors to take a hike (and Ireland did not) and guess who came out on top within a few short months. Within a few years of the new drachma economy, with cheap tourism pulling them out of their current slump, they would be back at the table. And the Greek people would be a lot more comfortable with whatever financial difficulties that solution entails knowing that they are sacrificing for their common good and not for the risky bets of banksters. Besides, the case of Iceland shows that with Asia booming and high oil prices there is too much money in need of investment for markets to shun Greece needlessly for too long.

Some commentators claim that the difficulty with the haircut solution (or the default solution, as I suggest) is its unknown consequences. But as Felix Salmon observed, a crisis is a crisis if it happens unexpectedly. Like the Lehman Brothers folding in one weekend. Everyone expects Greece to not be able to pay at least part of its debt. So, there is nothing unexpected about it. In fact, t looks like the main goal of German and French governments is to prolong the current status quo until 2013 when the new European Stability Mechanism will make this everyone's problem. If there is uncertainty, it is about the larger repercussions on Euro involving Spain, Portugal, Ireland, Belgium and quite possibly Cyprus.

The fear is that a Greek default might prompt one or more of them to bolt as well. If so, this could signal the end of a unified currency (unlike "the demise of the Euro" predictions, this implies a two-tiered union: I seriously doubt that the Euro will be abandoned). A better settlement offered to Greece, like a drastic haircut might cause Ireland to try to re-negotiate its previous settlement with ECB and IMF. A large bailout could motivate the markets to bet against these countries to force a larger package. No one knows for sure how the whole thing might evolve if Greece goes for a full or partial default.

What About Belgium and Cyprus?

These last two are not always mentioned in this discussion so let me make a brief detour and explain why they are at least as important as the other four that everyone talks about. As you can see from the above chart, Belgium has a significant exposure. More importantly,

(...)according to UBS research, the top eight banks exposed to Greek sovereign debt directly are Greek or Cypriot (...).
But who is number nine? Step forward that perennial star of the crisis, Dexia. According to UBS research, the 3.5bn Dexia is exposed to constitutes 39% of its capital. So in a default, probably, it is goodbye Dexia.
Dexia is based in Belgium which does not have a government but it does have a sovereign debt rating: this is AA and on negative watch. Its' debt is just below 100% of its GDP. That 4bn max it would cost to fix Dexia is peanuts compared to Belgium's 400bn sovereign debt, but then again adding it to the deficit in a single year would tank the country's credit rating even further.
Bailing out a deeply divided country unable to govern itself might prove very tricky indeed. It would almost certainly pull both France and the Netherlands into a bailout operation at a time they can ill afford such an eventuality. It could precipitate a breakup of the country as the rich Flanders is unlikely to continue to bankroll  their poor Walloon cousins (as this is how they see it). And this could have repercussions regarding the location of EU institutions, as Brussels will be hotly contested by both sides: historically it is part of Flanders but linguistically, it is firmly in the French camp.

In the case of Cyprus, something like 30 percent of their bank assets are booked as Greek debt, which represents roughly 20 billion euros (slightly more than the island's GDP). As a result Fitch lowered their credit rating from A- to AA- on 31 May and placed them on negative watch. In and of itself, Cyprus may be able to withstand a haircut with a relatively small bailout from the EU but if that happens in the middle of a larger crisis, they may be in a very tough spot. Politically and strategically, such a crisis could have repercussions in terms of the re-unification of the island and it could force them to accept a lot of hard choices. With EU going through a major economic (and possibly political) crisis, Cyprus would have to look its long time nemesis, Turkey with fresh eyes. Especially with Turkey booming economically and asserting itself as a regional super power in the Middle East and eastern Mediterranean region, Cyprus could find it difficult to maintain its tougher stance towards its powerful neighbor.

What is ironic is that with the EU membership being an increasingly less likely and less desired outcome for Turkey, Cyprus might no longer have the stick-carrot combination needed to thaw that strategically important relationship.

So Greek crisis is very important for a lot of reasons and that begs the question:

Why No Workable Solution is Offered?

As one Greek commentator wryly observed yesterday, the current solution of asking Greece to pay its debt while shrinking its economy is like trying to milk a cow without feeding it.

So why are they doing it?

In a word, ideology. I don't mean just any ideological dispute or disagreement: I mean a fight for paradigmatic supremacy in the full Kuhnian sense of the term.  This is why the debate in the US is about budget cuts, deficit reduction and dismantling social safety net and not on unemployment which stands at 9 percent. This is why they implemented austerity measures and budget cuts in the UK and continue to do so despite the disastrous consequences of this policy. This is about protecting the paradigmatic claim that one economic theory is the sole holder of truth.

In other words, this is the final chapter of the fight between Keynesian theory, which was pushed aside a few decades ago and the Monetarist theory, which claimed the title of sole paradigm since then.  As Monetarism became under increasing attack over the dismal consequences of its policy prescriptions, its proponents will do anything to protect its claim to truth. (If you need a refresher on the fight here is an excellent primer from Krugman.)

And the EU is the perfect arena for this title fight.

If you remember, Keynesian approach provides for a large array of macroeconomic tools, including fairly interventionist government actions and income re-distribution to regulate and stabilize markets with the ultimate goal of preventing cyclical crises. The Monetarist approach is to remove regulations, eliminate government interventions and use only money supply and interest rates as corrective measures with the basic assumption that markets are better suited to regulate themselves.

The EU is the perfect battle ground for this fight because, initially, the first European Community ECSC (European Coal and Steel Community of 1952) was conceived around mainly Keynesian principles:
"the establishment of a common market for coal and steel, intended to expand the economies, increase employment, and raise the standard of living within the Community. The market was also intended to progressively rationalise the distribution of high level production whilst ensuring stability and employment." 
Generally, people categorize EEC, the so called Common Market of 1957 as less Keynesian because of its four freedoms, but that is not very accurate. The Treaty of Rome created several solidarity (what we now call Structural and Cohesion) Funds like ESF or ERDF and with the establishment of Common Agricultural Policy (and a number of similar but less gargantuan policies) it ensured that those "free" markets are well regulated and high level of quality employment constituted the foundation of free trade. Market stability and high employment were top priorities.

Collectively these instruments provided for sizable transfer of funds to needy groups and regions. In fact, the second round expansion states like Spain and Portugal experienced quick and significant growth thanks to the stimulus provided by massive transfer of resources from the wealthy core to the periphery (Greek case is a bit different as its growth came later for reasons that have little to do with the EU instruments).

The idea was to re-distribute wealth to bring everybody up to a level so that trade can take place between relatively equal parties with no comparative advantages stemming from negative structural differences like low wages, depressed regional economies or lax environmental protection. They believed that if every member of the union was made more affluent they would trade and consume more and the whole union would be better off for it. In that vein, the ultimate goal was political integration and monetary and fiscal unions were milestones along that route.

But the unprecedented growth and full employment period which ended with the oil crash of 1973 was not attributed to these Keynesian regulatory and re-distributive policies. It was hailed as proof of the magical effects of free trade. The Monetarist paradigm claimed that if markets were freed even more they would unleash an extraordinary period of affluence and prosperity. And because of the "four freedoms of the Common Market" mantra this gradually became an article of faith. With Thatcher and Reagan, de-regulatory policies were implemented, unions busted, social solidarity vilified and the so called "unfettered functioning" of the markets became the single most important priority.

EU's monetary policy evolved and the Euro emerged within that general paradigmatic framework. Solidarity funds and centrally regulated policies came under attack as waste of tax payers' money. Conservative politicians clamored for budget cuts and reduction in their contributions (the more or less 1 percent of GDP they transfer to EU budget).  So, when the idea of a reserve currency topped the agenda they pushed for a system that did not include fiscal instruments. That means a common currency where interest rates and money supply is controlled by a central (and autonomous) body just like the Monetarist paradigm asks for with no accompanying regulatory spending and taxation mechanisms.

The arrangement assumed that the stability of the entire EU market can be maintained through a European Central Bank and a few budgetary restrains to be imposed on member states. At the same time, with the rapid expansion of the Union, the solidarity funds became less important on a per capita basis and with old members insisting on retaining their share of the pie, new members began to see declining resources made available to them. I don't have figures but I suspect that prospective members like Croatia and eventually Turkey are less likely to be receiving and more likely to be contributing funds.

This led to a very different Europe: the initial EU was composed of countries with comparable income levels and purchasing powers. Further re-distribution to less affluent regions and groups created a much larger market. Within that Europe it might have been possible to have a common currency with minimal fiscal integration. But the new Europe consists of wide variety of economies and many new members are poorer than the poorest initial members.

Within that new reality ECB is supposed to simultaneously:
a) cool off the German, Swedish, Polish and Slovakian economies to prevent inflation, by pushing interest rates up and tightening the money supply;
b) nurture the economies of France, the Netherlands, Denmark, Austria, Lithuania and Czech Republic to encourage their frail but continuing growth by maintaining low interest rates and reasonable liquidity;
c) stimulate the contracting economies of Greece, Spain, Portugal and Ireland by drastically lowering interest rates and increasing the money supply.

Since the main tools in its arsenal are setting interest rates and controlling money supply, how can ECB achieve these conflicting goals?

To me, following in the footsteps of the American banking crisis, Europe's woes exposed the fundamental flaws of the economic theory of the last three decades. The union gave up its Keynesian heritage and high income, high purchasing power brand of capitalism. It also expanded too rapidly trying to absorb too many disparately structured economies. And it did so as if it still had the Keynesian principles and structures in place. Instead it presided over the steady erosion of those structures and the principles behind them. And finally, it relied on mostly monetarist tools and a common reserve currency to pull this whole thing off.

And now the same people who deregulated banking sector, who encouraged very risky high borrowing and spending in boom times and who helped Greece and others hide their colossal debts are back with equally horrible solutions. Like spending cuts and high unemployment and overall misery for everyone but the banksters.

To paraphrase W, fool me once, shame on you, fool me twice, shame on me.

Fool me for decades and come back for more, well, there is no word for me, is there?


UPDATE: Take a look at this hilariously accurate summary of the Greek crisis. Jon Stewart is simply the greatest news anchor.

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