02 August 2012

Greece and Eurozone One More Time

My tiny but distinguished readership knows that I was one of the first people on the Internet to recommend a Greek default and a speedy exit.

Of course I am a total nobody. But, at least there were more authoritative voices like Krugman and Stergios Skaperdas who suggested the same approach. These contrarians knew that, with German and French banks' huge exposure to GIIPS sovereign debt (close to a trillion dollars at the time) a Greek default threat would have resulted in a much more flexible response. (Incidentally, since then the acronym GIIPS was dropped and PIIGS became more popular along with GIPSI -pronounced Gypsy- talk about adding insult to injury)

Papandreu tried this with his referendum idea but, whatever leverage they had on him, he buckled under pressure and renounced that notion within one weekend.

More than a year has passed and German and French banks had ample time to dump their sovereign debt holdings. So now you hear European officials and central bankers lightly suggesting that a Greek default is not only not feared but it is seen as a reasonable option. Every week someone else is quoted as saying that no one wants Greece to leave but they are not worried if it does. A couple of months ago BBC's Robert Peston summed it up like this:
I am mildly bemused that central bank governors seem to be talking with some equanimity about Greece leaving the euro: the Belgian central bank governor describes an "amicable divorce" as "possible"; his Irish counterpart says a Greek exit is "not necessarily fatal" though plainly not attractive.
Just last week this is what Reuters reported:
Some European politicians and central bankers clearly see jettisoning a delinquent member as a salutory lesson to others not to abuse club privileges. Like the English in Voltaire's philosophical novel Candide, they believe "it's a good thing to execute an admiral from time to time, to encourage the others".
I think this is rubbish talk designed to hide a colossal game of chicken. And contrary to what you read in the papers, despite the reduction in direct exposure, European governments are scared witless of a Greek exit.

If they are not they should be.

Let me try to explain why.


When Europe transitioned from the EMU system to the Euro, they maintained a vestigial process. In the early stages of monetary union, trade transactions were handled through ERM or Exchange Rate Mechanism, which pegged all currencies to ECU or European Currency Unit. Whenever there is a free trade or economic integration zone, it is important to have such a central rate control mechanism to make sure that goods and services are priced without currency fluctuation concerns.

When 17 members states of the Union moved to a common currency, the Euro, ERM was turned into TARGET (Trans-European Automated Real-time Gross Settlement Express Transfer System). In 2007 a more advanced version called TARGET2 was introduced.

Basically, the idea was to ensure that a Greek Euro and German Euro were valued the same. Consequently, all trade transactions go through local banks and then national central banks. Here is a reasonable visual aid about how the system works.

Under normal circumstances the process is instantaneous and there should be no issues if the system works properly.

But in March Bundesbank President Jens Weidmann, wrote to the President of ECB Mario Draghi to express his concern that the Bundesbank was owed €489 billion euros from these TARGET2 transactions.

This made no sense since TARGET2 transactions are supposed to be instantaneous and knowledgeable people emphasized this fact. They are right. Partly. Some of the operations are based on credit and there is an inherent risk in that. And this is what Weidmann was talking about.

Here is an example an economist gave to Felix Salmon's piece cited in the previous link. It is a bit long but it explains the whole process and the risk factor nicely:
Having been convinced of its reliability and quiet operation, a Greek household (GH) decides to order a brand new dishwasher from Bosch, which manufactures such devices in Dillingen, Germany.
GH goes to its local appliance store in Athens and negotiates a financing plan which the store is able to arrange thanks to its own credit line from a local Greek bank (LGB). 
The store places an order for the dishwasher with Bosch, which gives instructions to send the €500 wholesale purchase price to Bosch’s account at Deutsche Bank (DB). 
Through the magic of the Target2 settlement system (...) journal entries are made at the LGB (which, for purposes of this example, extends credit to the Athens appliance store to make this purchase), the Bank of Greece, the European Central Bank (ECB), the Bundesbank and DB. 
(...)Any collateral required to create the credit for this transaction is posted by the LGB to the BoG. Having confirmed the receipt of the €500 credit to its account at DB, Bosch cheerfully ships a shiny new dishwasher from Dillingen to Athens. In a few days the GH has its new appliance, and everyone is happy, for the time being.
Let’s look at this micro transaction from a macro perspective. 
Germany exports physical equipment it manufactured locally to Greece. Germany receives nothing physical in return. What it does receive is an electronic notation at its local central bank (Bundesbank) from the ECB denoting a Target2 “receivable” representing the nominal value of the exported good. 
As long as that receivable can be realized for value, Germany is made whole. If, however, the Eurosystem collapses before such realization, Germany will have exported real goods for zero value, and will have suffered true wealth loss. This is a wealth effect similar to having its taxpayers make a sovereign loan to Greece that never gets repaid. 
So what Weidmann is saying that since Germany is owed something like €500 billion in TARGET2 payments and if the current policy makes Greece default followed by Spain, Portugal, Italy and Ireland, German taxpayers will be on the hook for that sum.

In other words, Germany playing hardball with PIIGS has a significant downside. If they push Greece out and continue to insist that the remaining PIIS countries should conduct an internal devaluation there is very little that will stop them from following the Greek exit. Incidentally, by internal devaluation I am referring to the necessity to lower wages and prices through austerity measures. As Krugman has been arguing, for Germany to maintain its one percent inflation goal, Spain should have a five percent deflation. They can try it for a while but it is really untenable.

In that context, a Greek exit could become a blueprint to be repeated by the rest of the PIIGS who have no reasonable prospects of returning to a functioning economy within the system.

Capital Flight to the North

This is the second problem that n one is mentioning. Since Eurozone governments are unable to find a solution, companies have been moving their funds from PIIGS countries.
And for Europe's banking system, once the Rubicon has been crossed of a country leaving the euro, once it is demonstrated that there is an exit, all sorts of horrible things follow.
Perhaps most importantly, any business of any nationality will find it extremely difficult to leave its money in euros in a bank in a country perceived to be at risk of following Greece out the door. That risk was already highlighted earlier this year in public statements of Vodafone, GlaxoSmithKline, WPP and Reckitt Benckiser that they were moving their surplus cash out of euros and out of the eurozone on a daily basis.
It is not just foreign corporations. Internationally active PIIGS companies have a fiduciary duty to move their funds out of these countries as well. The beauty of capitalism is that a Greek or Spanish company cannot be expected to act patriotically and leave its funds in their local banks.

Add to that well-heeled citizens. Do you think there are many Greek millionaires who still maintain large sums in Greek banks?

This is one of the main reasons why Spain (despite its diversified and relatively healthy economy) is unable to borrow at reasonable rates. There is a huge and widespread capital flight going on.

There is one more twist to that sordid state of affairs. Money is not an asset, it is a liability. It is hard for non-economists to understand this but think of it this way: when someone deposits two billion euros to your bank, it means they have a claim against you for that sum.

This is why investors buying Swiss Francs as a safe haven is freaking out the Swiss Central Bank. It is a disaster for the Swiss economy.

Actually, the Swiss situation is a good indicator that many companies and financial institutions are beginning to think that the Eurozone crisis might end badly. Consequently, it is not sufficient to get out of the periphery and move to the North, they need to get out of the Euro completely.

If Greece leaves, the next might be Finland (according to Nouriel Roubini) then Spain, then a lot of others. Can you imagine the catastrophic short term consequences?

Unfunded Liabilities: an Insolvent EU?

European financial institutions are currently highly leveraged. Here is a nice little table showing by how much:
Financial Institutions’ Gross Debt as a % of GDP
EU as a whole
Source: IMF
What these figures mean that:
...taken as a whole, European financial institutions have more debt than Europe’s ENTIRE GDP. Let’s compare the situation there to that in the US banking system.

Taken as a whole, the US banking system is leveraged at 13 to 1. Leverage levels at the TBTFs [Too Big To Fail] are much much higher… but when you add them in with the 8,100+ other banks in the US, total US bank leverage is 13 to 1.

The European banking system as a whole is leveraged at nearly twice this at over 26 to 1. That’s the ENTIRE European Banking system leveraged at near Lehman levels (Lehman was 30 to 1 when it collapsed).

To put this into perspective, with a leverage level of 26 to 1, you only need a 4% drop in asset prices to wipe out ALL capital. What are the odds that European bank assets fall 4% in value in the near future as the PIIGS continue to collapse?
That is the €100 trillion question.

You can see how the relatively insignificant Greek exit could start a process that could destroy the Euro as a single currency, perhaps taking down the EU project along with it.

So people who downplay a potential Greek exit are fools. And if the Greek government does not use this leverage to negotiate a better deal, they are bigger fools.

Is the Euro Doomed?

It looks like ECB is powerless to do much as Germany refuses to consider obvious solutions.

From where I stand, they have to do two things. One is to give up the internal devaluation idea. Austerity did not produce what confidence fairies have been claiming. They produce deflation and misery but do not lead to debt alleviation or growth. It is a dead end.

That means they have to allow for more inflation in the system as Krugman has been arguing.

Two, if the European financial institutions are so highly leveraged that they could be wiped out in a crisis situation, they will have to print money to prevent this from happening. The euphemism they use for this is capitalizing the banks.

This is what the Federal Reserve did during the TARP crisis. They didn't tell us, of course. But as a recent audit showed, the publicly acknowledged $750 billion TARP money was dwarfed by something close to 16 trillion dollars they distributed behind closed doors. All newly printed money.

I do not know whether the Eurozone government will do either of these things.

If they don't, I don't expect the Euro to survive any crisis that could trigger a chain reaction.

If they do, well, inflation could save the day on both counts.

We'll see.

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