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Wednesday, June 19, 2013

The Second Battle Of Thermopylae

According to legend and some historians, by making a stand in the Thermopylae pass 300 brave Spartans valiantly saved the day for the entire Greek army in the face of a Persian force of overwhelming strength and manpower. More than 2,000 years later some 11 million Greeks might be considered to have carried out a rather similar operation by single handedly facing-off a massed horde of frantic global speculators on behalf of the entire Euro Area population - at no mean cost to themselves in terms of wealth, employment and general well-being. Or at least that is the conclusion which could be drawn from reading through the latest self-critical review issued by the IMF dedicated to the lessons which can be learned from the to-date handling of  the country’s deep economic and social crisis.

The document, entitled Ex Post Evaluation of Exceptional Access Under the 2010 Stand-By Arrangement (henceforth referred to as the Evaluation Document), does not mince its words, and suggests that Greece suffered a worse than necessary recession due to the reluctance of Europe's leaders to agree on debt restructuring from the outset. The reason for this reluctance is obvious with hindsight, the Euro Area was institutionally ill-prepared for the kind of crisis which was unfolding while the interconnection of the European capital markets and the banking sectors meant the financial systems of a number of other European countries were at risk.


Contagion from Greece was a major concern for euro area members given the considerable exposure of their banks to the sovereign debt of the euro area periphery. 




 Earlier debt restructuring could have eased the burden of adjustment on Greece and contributed to a less dramatic contraction in output. The delay provided a window for private creditors to reduce exposures and shift debt into official hands. This shift occurred on a significant scale and left the official sector on the hook.
An upfront debt restructuring would have been better for Greece although this was not acceptable to the euro partners. A delayed debt restructuring also provided a window for private creditors to reduce exposures and shift debt into official hands. As seen earlier, this shift occurred on a significant scale and limited the bail-in of creditors when PSI eventually took place, leaving taxpayers and the official sector on the hook. - IMF Evaluation Document

The contents of the Evaluation Document were widely reported on in the press (see for example here), and produced a swift response from EU Commission representatives, including an "I don't think it's fair and just that (the IMF) is trying to wash its hands and throw dirty water on European shoulders," from Economic and Monetary Affairs Commissioner Olli Rehn. The little phrase that caused all the problems was the report's assertion that "An upfront debt restructuring would have been better for Greece although this was not acceptable to the euro partners."  Obviously, when a dispute becomes as public as this, something, somewhere is going on. Trying to fathom what it was I couldn't help noticing that the publication of the  Evaluation Document coincided almost exactly in timing with the issuing of the Fund's latest report on the current (rather than the initial) Greek programme - The Third Review Under the Extended Arrangement Under the Extended Fund Facility (what a mouthful that is, henceforth the Third Review) - where curiously the international lenders let slip the significant little detail that next year Greece is expected to have a funding shortfall of some 4 billion Euros. Almost immediately denials that any kind of talks were ongoing about any kind of  forthcoming debt pardoning for the country started to surface in Germany, (or see here).

In my case the light dawned when reading more thoroughly through the Third Review document I came across the following paragraph:

The macroeconomic outlook, debt service to the Fund, and peak access remain broadly unchanged and euro area member states remain committed to an official support package that will help keep debt on the programmed path as long as Greece adheres to program policies. Capacity to repay the Fund thus depends on the authorities’ ability to fully implement an ambitious program. It continues to be the case that if the program went irretrievably off-track and euro area member states did not continue to support Greece, capacity to repay the Fund would likely be insufficient.
Now all of this may sound - at least to the uninitiated - like a load of old bureaucratic mumbo-jumbo, but actually there are a number of key statements here which may help to put the recent internal Troika tiff in some sort of broader and more intelligible perspective.

Sometimes in order to get to grips with a highly complicated argument thread it helps to go to the endpoint and then work your way back. It also helps to bear in mind that the recent Evaluation Document is as much about the future as it is about the past - and in particular the scenario which will come into play in 2020 and 2022 when the current programme's debt to GDP targets are expected to be achieved.

The cited paragraph talks about three issues: the macroeconomic outlook, the commitment of euro area member states to support Greece and keep the debt on the programmed path as long as Greece adheres to the programme's requirements, and the danger that should the programme go "irretrievably off track", and euro area member states not give the necessary support then the country's capacity to repay the Fund would clearly be insufficient - ie the IMF would be left holding the can, and Fund employees would be faced with the complicated task of explaining to its non-European members why losses had been incurred.

So now I understand the nervousness a bit better. Crudely put the position is this - as long as the IMF continue to write reviews stating the Greek programme is on track then the euro area member states are on the hook to make up any shortfall in Greek debt performance. This is a commitment they undertook during negotiations on the second bailout agreement.

On the other hand, if the IMF were to start producing reports stating that the programme was off-track because of Greek non-compliance, rather than for example arguing that the numbers were out of whack due to faulty macroeconomic forecasts (some of them from the EU Commission itself), then the euro area member states would be off the hook from additional stepping up to the plate with the result that the IMF would end-up taking a loss.

Complicated isn't it? That is why the rule of starting out from the assumption that nothing is ever exactly what it seems to be is normally a good one to work by.

What is obvious from reading through the documentation is that the IMF is keen to highlight the guarantees given by Greece's euro area peers at the time of setting up the Extended Fund Facility (2012) that "adequate support" would be provided to bring Greece's debt down below 110% of GDP in 2022 (ie that there would be some form of debt pardoning) should the country comply with the terms of its programme and the debt dynamics still not turn out right. Since we now have a track record on all this, and since staff economists at the Fund have also recently conducted a debt sensitivity analysis which came up with the finding that given slight under-performance on GDP and inflation outcomes the debt could still be as high as 147% of GDP come 2022 , the issue is no mere trifle.

This is, in my opinion, why so much emphasis is now being placed in Washington on the fact that Greece's short term interests were to some extent sacrificed for the greater good of the eurozone, a justification which may make the bitter pill of Euro-partner losses on their loans to Greece easier to sell to their respective electorates.

Well, since nothing is really valid in this world until it is tested (like the June 2012 commitment to mutualise some of Spain's bank losses), and since 2020 is still a relatively long way away, it isn't hard to understand why the good folks in Washington might want to see the commitment in Europe tested a good deal sooner, which is where, I think, next year's 4 billion euro funding shortfall comes in. I cite the latest review document (my emphasis):
The program is fully financed through the first half of 2014, but a projected financing gap of €4 billion will open up in the second half of 2014. Thus, under staff’s current projections, additional financing will need to be identified by the time of the next review, to keep the program fully financed on a 12-month forward basis, and the Eurogroup has initiated discussions already on how to eliminate the projected 2014 gap. In this regard, the Eurogroup commitment made in both February and November 2012 to provide adequate support to Greece during the life of the program and beyond, provided that Greece fully complies with the program, is particularly important.
Again the essentials are hard to-get-through-to for all the bureaucrat-speak, but the last sentence says it all - "The Eurogroup Commitment...to provide support to Greece....is particularly important."

A Deeper Than Necessary Recession?

Greece's recession has been one of the deepest peacetime recessions ever experienced in industrialized economies, and bears comparison with the great depressions of the 1930s in the US and Germany (see chart prepared by the IMF below). Overall, the economy contracted by 22 percent between 2008 and 2012 and unemployment rose to 27 percent; youth unemployment now exceeds 60 percent. As domestic demand shrank across all areas, net exports provided support largely through shrinking imports. Indeed as opposed to other countries on Europe's periphery exports actually shrank in Greece in both 2011 and 2012.  The issue this raises is was such devastation really necessary in a country participating in a currency union which could have expected support from other participants?


Naturally the country "cheated" on its partners, and sacrifices were inevitable but surely a more pragmatic and equitable solution could have been found. Simply punishing a country for what is perceived to have been "wrong doing" accomplishes little and may put a great deal at risk, including amongst those not directly involved.

As the IMF points out in the Third Review, Greece was forced into one of the largest fiscal adjustments seen anywhere  to date (see chart below).The primary adjustment in 2010–12 amounted to 9 percent of GDP, and was much higher (15 percent of GDP) in cyclically-adjusted terms. The same outcome could have been achieved over a slightly longer period of time had a more constructive attitude been taken. On the other hand the IMF take the view that some sort of rapid fiscal adjustment was unavoidable (but how rapid?) given that the Greece had lost market access and official financing could be considered to have been  as large as politically feasible. They conclude:
It is difficult to argue that adjustment should have been attempted more slowly. The required adjustment in the primary balance, 14½ percentage points of GDP, was an enormous adjustment with relatively few precedents, but was the minimum needed to bring debt down to 120 percent by 2020. Moreover, despite the starting point being slightly worse than thought to be the case when the 2010 Stability Program was drawn up, the SBA-supported program had already extended the period over which the Maastricht deficit target would be achieved from 3 to 5 years. Since the program only ran through mid-2013, the last part of this adjustment would occur after the program and the conditionality had ended. Moreover, debt would still be increasing when the program ended.


One of the key points to note here is the observation that the program only ran through mid-2013. This is a knock-on consequence of the type of program originally set up (the so-called Standby Arrangement - or SBA). SBA's are by their very nature designed and intended for short term liquidity support prior to a reasonably rapid return to market access. But Greece's needs, as is now obvious, were longer term and involved solvency issues. Had a decision been taken at the outset to set up an Extended Funding Facility (the 2012 program is of precisely this type) then the time horizon could have been longer, but part of the reason an EFF was not chosen was because the solvency issue was not recognised and debt restructuring was not on the table, so the argument at this point becomes somewhat circular. That is to say, had the will been there at the outset to use an Extended Funding Facility and had the realistic view (recognized with hindsight) that debt restructuring was inevitable been taken, then the Greek fiscal correction would still have been significant, but more extended in time, and with less overall damage to the economy's private sector.


And the damage was severe. The employment loss was dramatic (see chart) and as in other countries who have suffered a similar, if more benign, fate (Spain, Portugal) it is hard to see how earlier levels are ever going to be recovered given anticipated future growth rates.




The social and economic consequences of the over ambitious fiscal correction  have gone well beyond the downsizing of the country's bloated public sector, and no part of Greek society has been spared. Among Greek households the fall in disposable income between 2009 and 2011 nearly doubled the previous debt-to-disposable-income ratio (which rose to 96 percent - higher than the peak observed in Latvia). Falling property prices have raised mortgage loan-to-value ratios from around 70 percent on average before the crisis (lower than in European peers) to close to 90 percent in 2012 (currently higher than even in Spain). House prices fell by 11.8% in the year to the end of March, according to the residential price index published by realtors Knight Frank following a 9.8% drop a year earlier. For a country which didn't really have a property boom before the crisis this is very striking.

In the non-financial corporate sector the decline in profits has affected firms’ ability to service debt, with the interest coverage ratio dropping from 24 percent in 2001 (one of the highest in Europe) to 2.4 percent in 2012 (higher only than Portugal). As a result Non-performing loans in both the household and corporate sectors have risen sharply (see chart below for the corporate case) and in 2013 are expected to pass the 30% of total loans mark.


All this distress and impairment naturally creates problems where previously few existed. The Euro firewall building process meant that most of Greece's sovereign debt risk was transferred from other European banks to Greek ones, with the consequence that when the debt restructuring finally did come these banks all needed recapitalizing by the state leading the country to have to borrow yet more money to pay for this. Now that the only external imbalance correction process is what the IMF calls the "recessionary path" (rather than a more comprehensive internal devaluation - see below) these same banks are being faced with substantially more losses on their general loan books, possibly leading to the need for yet more recapitalization, and so on.

Divergences Within The Troika On Deflation?
"Deflation is a protracted fall in prices across different commodities, sectors and countries. In other words, it is a generalised protracted fall in prices, with self-fulfilling expectations. Therefore, it has explosive downward dynamics. We do not see anything like that in any country". Mario Draghi answering the question "do you see any risk of deflation in some countries in the euro area?" at this months ECB press conference
"Macroeconomic developments are broadly as expected. The economy is rebalancing apace: the current account deficit is now shrinking fast, by 6½ percent of GDP in 2012; the competitiveness gap has been reduced by about half as last year’s labor market reforms are facilitating significant wage adjustment; and deflation is finally setting in". - IMF Third Programme Review (my emphasis).



Leaving aside a small quibble about the definition of deflation Mario Draghi selects for himself - for self-fulfilling expectations about an ongoing fall in prices to set in prices first need to start falling - there is no doubt that in the case of Greece prices are now falling, and the arrival of this crude kind of deflation (rather than what we could call the Draghi variety) in any country is surely an issue which most of the world's central bankers beyond the confines of the ECBs governing council are certainly not blasé about, if only because unless it is handled properly it can transform itself into the kind Mr Draghi so rightly fears . According to the IMF Third Review
In response to Greece’s now high output gap, headline HIPC inflation fell to 0.3 percent at end-2012 (from over 2 percent at end-2011) and turned negative in March (-0.2 percent) and April (-0.6 percent). Core inflation (excluding energy and unprocessed food), which has been negative for some time, fell further to -1¼ percent in March. The GDP deflator also turned negative in 2012 (-¾ percent).
The striking thing, leaving aside the issue of definition,  is that the IMF actually seem to welcome the fact deflation is finally arriving in Greece - due to the competitiveness impact it will have on the Greek price level. But it is here I think that one can discern some sort of difference of opinion within the Troika itself. It seems likely that the IMF would actually agree with Mario Draghi that Japanese-style deflation is probably not on the cards in Greece at the moment (although given the depth of the country's problems and the fact that the countries workforce has now started shrinking - due to demographic shifts and emigration - who the hell really knows, I certainly wouldn't put my hand in the fire one way or the other on this one).

But the IMF are concerned about an ongoing fall in wages and incomes in the context of continuing increases in the price level, and hence welcome the drop in prices as part of an internal devaluation which is seen as essential to restore international competitiveness.
The far-reaching labor market reforms put in place in early 2012 have contributed to deeper wage corrections than in other recent crisis cases and substantial adjustment in the ULC-based REER. Less encouraging has been the weak and delayed response of prices to wage reductions, owing largely to product market rigidities. This asymmetry in price adjustment has led to a substantial erosion in real incomes and demand, and placed a disproportionate burden on wage earners relative to the self employed and the corporate sector. It has also left the CPI-based REER overvalued in 2012 by about 9 percent (Box 2). With the headline inflation now in negative territory and a widening inflation differential with the euro area, the extent of overvaluation is gradually reducing and relative prices between the tradable and nontradable sectors are adjusting. - IMF 2013 Article IV Consultation


So why might the other parts of the Troika - the EU Commission and the ECB - be more nervous about the consequences of this drop in the price level? They are concerned about the impact on Greek debt dynamics is the obvious answer. This drop in prices is now seen as essential and inevitable by the Fund, but is still to some extent being resisted in  Brussels and Berlin. Again, the reason for the reticence is obvious, "we're on the hook" - remember, if Greek debt is above the 110% of GDP target in 2022, or reaches levels in the intervening years that make this level obviously unattainable, for reasons of lower than anticipated GDP or price growth then the Euro Area peer countries are committed to making up the difference.

The chart below shows the results of a Debt Sustainability Analysis carried out by Fund economists during the period of the first bailout. What is clear is that the two main risk items for debt snowballing are lower than anticipated GDP growth and deflation. As the IMF itself observes in the Evaluation Document: Since the shocks considered were fairly mild, this sensitivity analysis demonstrated the precariousness of the debt trajectory. For example, the deflation shock considered in the DSA (3 percent more) would not have made much difference to the internal devaluation, but would have caused debt to jump to 175 percent of GDP.



In the Third Review the Fund goes even further on the basis of a new Debt Sustainability analysis - "If nominal growth averages 1 percent lower than the 4 percent baseline projection, debt will be 134 percent in 2020 with an only modest declining path thereafter". That is to say, if the sum of GDP growth and inflation is 1% less than forecast in the baseline scenario debt will rise substantially.


So Whither Greece? Is Grexit About To Become An Option Again?

According to Citi's Chief Economist Willem Buiter, the man who coined the term Grexit, the possibility of Greece exiting the euro zone has receded "markedly" in recent months. "We still believe that there is a fairly high risk of Grexit in coming years, but no longer put it in our base case at any particular date," Citi said in a research note co-authored by Buiter published in May. Reading this assessment at the time of its publication the argument seemed reasonable to me. But after 48 hours of poring over IMF documentation on the country I am no longer so sure that this conclusion is as solid as it seems.

My feeling now is that, despite Buiter's recent pronouncements, Grexit may well come rapidly back on the agenda after the German elections. I think markets are soothing themselves with an overoptimistic expectation of how committed German politicians are to moving towards banking and fiscal union - Draghi bond buying at the ECB is another issue, but the Greeks by and large don't have bonds to sell, they just have debt obligations to the official sector. Put another way, as Wolfgang Munchau argues in this week's Financial Times, “The OMT is not designed to address the solvency problems of various private and public entities in the eurozone”, and Greece's coming problems are surely of the solvency and not the liquidity kind.

 The key issue really hangs around the obligations the Euro partners entered into with the IMF last December to fund any shortfall in Greek funding and debt-reduction needs as long as the IMF continues to give the country a pass mark during the ongoing reviews.

 Looking over and over again through the numbers the IMF put forward it is clear to me that there is really very little wiggle room left on Greek debt dynamics, and that the IMF are fully aware of this as their Debt Sustainability exercises demonstrate, hence initial attempts to distance themselves from EU institutions in the Evaluation Document. The move reminds me of one of Leo Messi's attempts to lose his markers while languishing near the edge of the penalty box. One swift lunge and its in the net.

Now one possibility which lies before us is obviously that the IMF gives the country a red flag in a review. That wouldn't be so difficult given the way Greece works. Yet actually, for reasons discussed in the introductory section to this piece, the Fund has precious little interest in doing this, since the country's Euro peers could then simply walk away from their funding obligations and the IMF would be last man standing on the debt, a situation they repeatedly stress they are anxious to avoid. Nonetheless, let us assume they do throw up a red flag, what would be the consequences?

Well, not another EU backed aid programme surely. The red flag would mean the issue of possible Grexit would be directly back on the table, since core Europe would surely be extremely reluctant to accept politically unpopular losses for a country that wasn't complying, and it is hard to see what the solution to ongoing funding shortfalls coupled with non-compliance would be if it wasn't euro exit.

So now let's assume that the country gets a series of continuing green flags, but that nominal GDP performance is less than projected in the programme's baseline scenario - it may not be politically correct to say this, but it is hard not to get the impression that the inflation and growth numbers for 2015 to 2018 (showing nominal GDP growth of around 4.7%) have been devised explicitly to bring Greek debt into the region of 120% by 2020, at least on paper. The probability of under-performance is thus high.

Cognizant of this looming difficulty the Fund seem to be already attempting to force the issue by looking for a 4 billion Euro down-payment on their commitment from the Euro partners in 2014. Then, supposing they wanted to accelerate the Euro partners Greek bail-in process they would only have to revise down their post 2014 inflation and GDP forecasts to make even more money needed quite quickly. But, if we think about it a bit,  the political logic for ongoing debt pardoning in Greece by other EU member states isn't especially clear given that Italy, Portugal, Ireland and Spain could all easily have debt levels over 110% of GDP come 2022. So how can you justify making Greece a special case in the positive sense? I think the more likely outcome is that core Europe will try to wriggle out of its obligations following the German elections, and that this move will lead to a surge in uncertainty about Greece's future, with Grexit once more becoming an openly discussed option.

Sunday, November 25, 2012

After The Fat Lady Sings

Financial journalists across the globe were both surprised and puzzled recently when they heard Christine Lagarde using a strange expression. "You know, it's not over until the fat lady sings, as the saying goes," she told bemused reporters at a press conference in Manilla. Which fat lady, and what does she sing must have been questions going through the heads of many of those present.

Further investigation would have lead them to discover that far from this being some new piece of feminine wisdom that the IMF DG wanted to transmit, the phrase in fact comes from the rather male world of business deals and contact-sport-commentators and is generally used to describe closely contested matches, or deals which won’t be struck till the final offer is actually made.

Ms Lagarde naturally had other things in mind. She was referring to the state of negotiations surrounding the latest Greek bailout review, prior to the handing over of that long awaited 31.5 billion euro tranche the country so badly needs to meet its ongoing commitments. The curious thing about the holdup in this case is that it isn’t the result of a stand-off between the Troika and the Greek government.  Last week the Greek parliament passed the final set of budget decrees required by the international lenders to enable the transfer.



No, in this case the dispute is an “internal affair” between the rival parties which make up the Troika, and in particular between the German government and the IMF. The issue is how to leave Greek finances having at least the appearance of being on a stable and sustainable path, which in this case is defined as attaining a sovereign debt level of 120% of Greek GDP come 2020. Delaying the country’s fiscal objectives by 2 years effectively means putting back the theoretical attainment of that objective by the same amount of time - until 2022. Jean-Claude Juncker was willing, but the IMF is digging its heals in. Any new agreement, Ms Lagarde said as she left Manilla en route for Tuesday’s Brussels EU finance ministers meeting, should be "rooted in reality and not in wishful thinking.” Tut tut, Mr Juncker.



So whence this sudden hardening in the Funds position? Well, it may be just a coincidence, but the US elections are now over. Barack Obama need not now preoccupy himself with what a hypothetical exit by Greece from the Euro would do for his campaign. Non-European members of the Fund have long been chaffing at the bit over the extent of the “kid gloves” treatment so many apparently rich countries have been receiving, and have been arguing for a much more independent and tougher approach. Now with the US starting to shift its ground the balance of opinion has clearly changed.

Greece’s debt is evidently on an unsustainable path however you look at it. Just getting through to 2020 isn’t enough, since the following decade is going to be very challenging demographically for the struggling country. Greece needs either a much more substantial reduction in its debt levels, or a negotiated exit from the Euro.



Realists are now pushing this view, but realists are also pragmatic people, they recognize that Angela Merkel has elections looming in the autumn of 2013, and that she can only go so far at this point. So it is simply the principle of the thing that needs to be established now. We can all get down to the real details once Greece fails another review, possibly towards the end of 2013. What Christine Lagarde did make clear in Manilla is that being “rooted in reality” means is that the best way countries in the Euro Area can send a strong and credible signal they remain committed to Greece’s continuing Euro membership is by agreeing in some way shape or form - the formula doesn't matter - to reduce the debt Athens owes them.

As Deutsche Bank analyst Mark Wall so tactfully put it in his latest report on the situation, "The objective of the current round of decisions will be to 'kick the Greek can' beyond the German elections in September 2013".

So it seems to me that later, after the German elections are over, the fuller implications of this initial signal of "realism" can be fleshed out. By that point Greece’s crisis-weary population will surely be ready for neither another year of substantial austerity cuts, nor for yet another year of recession, so a solution will need to be found. Unemployment will likely be over 27% at that point, and with people possibly being asked to grin and bear a seventh year of recession, we may well be rapidly closing in on a "just how much of this can you really stand" type situation.

If the debt pardoning cannot be great enough then Grexit will be on the table as a contemplatable solution. As Citi analyst Giada Giani puts it in the their latest report, "even if a return to a semblance of sustainability is agreed for the Greek debt and the next bailout tranche is released, we doubt this will be the deal that fixes Greece once and for all. We think a Grexit scenario still has a 60% probability of occurring in the next 12-18 months."

Calm Before the Storm?

So, the Euro Crisis is going to be effectively put on the back burner over the next nine months or so, or at least that is the hope in Berlin. Naturally there are no shortage of loose cannons that can come into play to make this hope just another example of what Lagarde calls “wishful thinking”, but even assuming everyone gets the time-out people are hoping for, just what is going to happen when the German election milestone is passed? To the external observer, it does look like fund managers from across the planet are being told one thing (that Germany will then take the bold steps which are so evidently needed to shore up the common currency) while German voters will be voting in the exact opposite belief, even to the extent perhaps of being lead to think that the OMT bond buying programme is merely temporary. So someone is going to be very badly disappointed, and not long from now market participants will have to start placing their bets on who they think that someone is going to be.

But to return to where we started, just who was that fat lady, and what exactly did she sing? Well deeper investigation into the world of urban legends reveals that the woman in question is none other than Brünnhilde, shieldmaiden and valkyrie in Norse mythology, as well as heroine in Wagner's famed and fateful opera Götterdämmerung. As opera fans will remember, when the singing stops the world of Valhalla comes to an abrupt end, as Brünnhilde throws herself on a pre-prepared funeral pyre and in so doing initiates the final destruction the known world. Although the interpretation that this was some sort of "Freudian slip" for what the IMF boss actually fears could happen - namely the Greek Heracles might finally abandons his labours and descend into the nether world of Hades - is plausible and available, I prefer to think it was in fact a match of American football she had in mind. At least that way I sleep better.

Sunday, June 17, 2012

On The Brink Of What?

This weekend I have been thinking quite a lot about what the world is gonna look like on Monday, and have come to the conclusion that it won't be that different from the way it was last Friday. The big news surprise of the weekend was in fact Greece related  - since the national football team qualified for the quarter finals of the Eurocopa, beating the Russia by a resounding 1-0.

Oh yes, they also had elections in Greece, didn't they?

The most likely outcome, as far as I can see at the time of writing, is a neck and neck finish between the far left Syriza and the centre right New Democracy, with the key to the resolution of the outcome lying in the fact that whichever party comes first gets a bonus of an additional 50 seats. This will mean that if New Democracy do win, as it seems they have,  they will probably be able to negotiate a deal with the other smaller parties (PASOK, for example) around some sort of face saving formula which will enable a government to be formed and a deal struck with Berlin.

On the other hand, if Syriza were to finally win no one has a clue what will happen. The party doesn't want to leave the Euro, but does want to reject the memorandum. The only problem is that the only parties Syriza could form a government with would most likely want out of the Euro too. So Syriza winning by a short head would seem to imply more elections, or... or.... some sort of pact. I vote for the latter.

I say this since I think even if Syriza were by some quirk now to win some sort of government or other would still be formed, even if it needs the military to rustle sabres in the background just to get everyone to concentrate on the issues in hand. In the game of brinksmanship which will now be played, Syriza can blackmail Berlin with the threat of instability and disorderly exit (even in opposition), while Berlin can dangle money, lot's of it I imagine, before their eyes, if only they agree to help form a government. The track record says that politicians normally, when faced with a serious punch up or going for the money will normally go for the money.

Naturally, the money I am talking here about involves EU funds, not men in black suits carrying suitcases, although if the recent 270 million fine accepted by Siemens for bribing Greek officials to obtain lucrative telecommunication contracts is anything to go by, we shouldn't rule the other possibility out entirely.

Actually Angela Merkel has already hinted at this sort of solution. "This is why it is so important that, in the Greek election tomorrow ... a result emerges in which those who form a government in future tell us, yes, we want to keep to the agreements," she told a meeting of party faithful in Darmstadt this weekend, "This is the basis on which Europe can prosper."

What the forthcoming Greek government needs to do, then, is say loudly and clearly in public that it will stick to the memorandum. Say in public mind you, not necessarily follow the statement through in practice. The phrase being asked for certainly isn't an Austinian performative, equivalent to saying "I do" in a wedding. In this case uttering the phrase does not constitute implementation. Another example of something which also does not constitute what the British philosopher JL Austin would have termed a performative would be the expression “I promise to pay the bearer on demand the sum of …” which appears on the back of UK bank notes, and is evidently not a promise, or even a lick. It is simply just another way of spilling ink.

So then, with the protocols safely out of the way, the real deal can be done. Francois Hollande is already talking about an EU growth programme of around 120 billion Euros. And the Financial Times has revealed this weekend that, "European officials are preparing to dangle a package of incentives in front of a new Greek government to convince it to stick to the country’s current bailout deal after Sunday’s high-stakes elections. The package would include further reductions in interest rates and extended repayment periods for bailout loans, as well as EU money to spur investments in Greek public works programmes through the European Investment Bank".

Naturally, and even in the best of cases, the future government of Greece will be weak, and the economic situation dire. So the agreement to be reached will only be a band aid, one which one hopes will hold until the bigger issues are faced up to over the summer. All that has been avoided this weekend is a disorderly rupture in Greece's relations with the EU and the IMF, and as I argued here, this outcome was never really very likely.

So Greece in the short term will be staying in the Euro, although I am not sure whether a majority of observers will necessarily regard this as good news, since clearly it only postpones some sort of day of reckoning or other.

Sigh Of Relief In Berlin

One venue where people will be unequivocally happy with the outcome is - although some may find this surprising - inside policy circles in Berlin.  The reason for this is evident. Germany itself is at greater risk of fall out from the Greek election than even Greece itself is. Personally I think the upward trickle in German Bund yields we have been seeing over the last week or so is pretty significant. It is almost as if the market is beginning to prepare for a two stage scenario. The first stage would be Greek non exit. Then in a second stage, the EU would not be moving ahead of the curve fast enough, and the common curreny could disintegrate. Germany, as the creditor country who would not be paid, would be one of the biggest losers.

More interesting perhaps than 10 year Spanish yields hovering around 7% is the fact that German yields have also started rising, as have German CDS and the volume of German CDS being traded.




My interpretation of this is as follows. This situation can end in either of two ways. The Euro can disintegrate, or full political union can be put in place. In either case Germany's debt burden will increase. In addition the country is export dependent, and will be negatively effected by any event which damages the other Euro economies. Robin Wrigglesworth put it like this in the Financial Times.

Analysts said this was a worrying development, which indicated investors could be starting to prepare for two “tail-risks” – a break-up of the common currency bloc or moves towards fiscal union.“If we see a trend of periphery bonds, Bunds and the euro start to sell off simultaneously we’d move from concern to alarm,” said David Lloyd, head of institutional portfolio management at M&G Investments.

Estimates of just how much the Troika are on the hook for should Greece default vary, but a common number is somewhere in the 200 billion euro range. Of course, some of this would eventually be recoverable, one day, and assuming Greece were able to pay, but in the meantime (given the super senior status of the IMF participation) it is highly likely that governments and taxpayers in the other Euro Area countries would need to cover the shortfall, and this, to put it mildly, is unlikely to be popular with voters. Yet another reason for "fudge and muddle through".

There are three main sources of Troika exposure to Greece, bailout loans, sovereign bonds owned by the ECB, and liquidity provided to the Greek central bank thorugh the Eurosystem via what is known as Target2. According to estimates by Commerzbank analyst Christoph Weil, between loans and bond purchases Greece owes a total of €194bn, which breaks down into €22bn owed to the IMF, €53bn to Euro Area countries, €74bn to the EFSF and €45bn to the ECB. On top of this there are Target2 liabilities of the Greek central bank vis-à-vis the ECB - and indirectly to the German banks - to the tune of €104bn.

As long as the music is playing, you’ve got to get up and dance


It was in fact former Citigroup chief Charles Prince who used this expression to characterise why, in a highly leveraged bailout (sorry, buyout) market fund managers continued to play the game, but it could equally well describe the "in for a penny in for every shilling I've got" situation German policymakers now find themselves in.

One of the silliest ideas introduced into the present Euro debate is the idea that Germany has always been a reluctant party to the common currency, and that the monetary union has acted to the country's disadvantage. Lombard’s Chief Economist Alexander Dumas tells us, for example,  that ‘what you’re actually dealing with here... is a German population which has had a rotten deal – and that’s why they’re all so angry’.

Dumas's view is interesting since it highlights two popular misconceptions. The first of these is that Germany has been a long suffering victim of the spendthrift policy of its Euro Area partners, and the second is that German household consumption is so weak due to a domestic policy of wage compression. Now if we take the former argument, in fact the German economy entered the common currency in very poor shape, on the back of mid 1990s credit and construction boom,  and was forced to make a substantial transition at the end from being a consumer-credit- driven economy running a small current account deficit to being an export driven one, pushed forward on the back of a large current account surplus.




If you look at the above chart, it would seem hard to argue that Germany has had a really hard time of it after joining the Euro. Just think about it. Who was buying all those German exports which are reflected in  those massive current account surpluses.

This point seems so obvious it is hard to believe some people are still capable of ignoring it. It is not as if there wasn't a lot of material around pointing to this pretty evident truth. A good example of this work are the two  recent and highly stimulating essays by Citi economists, Nathan Sheets and Robert Sockin, who convincingly argue that German trade performance since the start of monetary union  has been significantly boosted by having a currency which was valued significantly below the valuation it would have been subjected to had the country still been using the Deutsche Mark. As a result of this systematic undervaluation Germany’s external surpluses widened significantly, led by rapid export growth.

Sheets and Sockin use a simple econometric procedure to estimate that that European monetary union, coupled with the country’s extraordinary wage restraint, has resulted in a real effective exchange rate for Germany that is currently 15 to 20 percent lower than the one which would have prevailed if Germany had had its own floating currency. And naturally the weaker real exchange rate has provided a significant windfall for Germany’s export sector. They thus find that the lower German real exchange rate has lifted the country’s nominal trade surplus by roughly 4 percent of GDP (or €100 billion) annually and the real trade surplus by about 3 percent of GDP annually. In addition, since the outbreak of the Greek crisis, Euro weakness has meant that German exports have been in an almost uniquely privileged position to benefit from strengthening global demand in the emerging market economies.

The comparison with Japan is significant in this case, since as of December 2011, Japanese exports were still running at 8% below their pre-crisis high point, while German exports were about 7% above their pre-crisis high. Since the global financial crisis German exports to China have risen most strongly, while Japanese exports to China have virtually stagnated. What could be the explanation for this strange phenomenon, since evidently Japan has efficiently produced technologically-advanced products to sell? Well, the relative values of the two currencies the countries use might offer us some part of the explanation. From the start of 2007 to mid 2008, the Japanese yen was trading in the range of 0.06 – 0.065 to the Euro. At the start of 2012 it was trading at all time record levels of just over 0.1 to the Euro – that is the yen rose versus the Euro by over 60% in just three and a half years. What German policy makers might with good reason worry is that should their country go back to the Deutsche Mark a similar fate might well await them.



Naturally in June 2008 Japan’s currency was significantly under-valued, due to its habitual use as the “carry” funding currency of preference, while Germany’s currency is currently significantly under-valued (due to the impact of the sovereign debt crisis). In July 2008 Japan’s currency valuation spiked dramatically – rising by around 30% in 3 months – as the global financial crisis took its toll and the carry trade unwound. Since that time Japan’s currency has risen steadily (as has, for example the Swiss Franc) due to the country’s safe haven status. Naturally such a state of affairs only serves to exacerbate the country’s long running deflation problem.

Taking everything into account, surely it would not be unreasonable to suggest that a Euro unwind would lead any new German currency to surge dramatically in the aftermath just as the Japanese one did in 2008, and then continue its upward path for safe haven reasons. The key point is that in the age of the global financial accelerator currency movements have a strong non-linear component.

Gazing Into The Tea Leaves

I suspect events will pan out as follows. The Greek elections will give markets a mildly positive surprise, since the country will not immediately exit the Euro, nor will European money be cut off (the IMF is another matter). In fact, as I suggest above, more money may be sent to Greece than expected via EU structural funds, or the EU investment bank.

In the meantime measures will be put in place in the direction of a European banking system and closer fiscal union. But the pace will be slow, painfully slow, and much slower than markets need to see to be convinced that real changes are coming.

So German bond yields and CDS can continue to rise, and this will produce political strains in Germany. It is these tensions inside Germany that can become the undoing of the Euro, since if political pressures cause leaders to put a break on the integration process market pressures could become too great to withstand.

Thus the reason for this sudden rush to keep the Greeks happy is evident. Germany has done its sums, and found that it is at even greater risk of getting hit by fall-out from the Greek election than Greece itself is. The thing is the Germans have now cunningly boxed themselves into a corner, and whichever way things go their position can only become worse.

I think German policy from this point on will be increasingly dictated by a belated attempt to avoid just this sort of outcome, and that we will see evidence of this over the next couple of weeks. Far from being a threat, Francoise Hollande might even help get Merkel off the hook. On the other hand, Fernando Santos, the Portuguese coach who trains Greek national side, reportedly told the press his players' victory was more inspired by Greek history than by Angela Merkel. Well if I remember my Thucydides aright, most Greek cities fell to their opponents not in pitched battle, but via "informal negotiations" held somewhere close to an unguarded side gate. Talks to form a new government will start tomorrow.

This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".

Thursday, May 31, 2012

Grexit? Spexit? Let's Call the Whole Thing Off

One thing we've learned as the euro crisis has unfolded is that the enthusiasm of experts in London and New York for offering advice to the struggling countries on Europe's periphery is matched only by their passion for awkward neologisms. The world was just getting used to "Grexit" (Get it? A Greek exit from the euro!) when "Spexit" began to rear its ugly head in the financial press.

Naturally, the events of recent days have brought Spain back to the forefront of the debt crisis, generating insecurity about the reliability of the official fiscal deficit numbers, the validity of central bank statistics, and new numbers showing capital flight reaching alarming levels. Only this week, Spain announced that the central bank governor, Miguel Angel Fernandez Ordoñez, will be leaving early as part of a government effort to restore its credibility. Some are now anticipating that Spain's exit from the eurozone will come before Greece's departure.

I would hope that those clamoring for these countries to go their own way are at least better intentioned than they are informed, since normally they exhibit a singular lack of understanding about how political systems in southern and eastern Europe actually work.

It is now essentially conventional wisdom in the British and American press that Greece needs to return to the drachma. British journalists are even racing to hunt down the London printing works that have supposedly been given the contract to print New Drachmas, the putative local replacement for the euro. The only snag is, according to all opinion polls, the Greeks themselves are not happy with the euro but have no interest in dropping it. (Perhaps the perfect Solomonic solution here would be to have the New Drachma introduced as a non-convertible currency for use only within Fleet Street bars and the boundaries of the City of London.)

The Greeks, naturally, are tired of austerity, and of a stupid EU/IMF bailout plan that has only served to totally collapse their economy, explode their debt, and destroy what semblance of external reputation Greek companies had. The Greeks are tired of austerity in the way many in the United States have tired of fiscal stimulus in the run-up to the next presidential election. But no one would suggest that this weariness is an indication that Americans want to drop the dollar.

As an economist, I have always argued that the common currency was a mistake. I am a "euro" skeptic, but not a "Euroskeptic," and I think it important that people outside Europe understand that this distinction exists. There is no doubt that the euro, like Dr. Stangelove's doomsday machine, is an infernal device destined to blow up one day, but also so designed that any attempt to dismantle it simply detonates the bomb. This is why, tired as they may be, those who live on Europe's southern fringe have little appetite for leaving or taking part in yet another experimental new currency order. Better put, they have little appetite for leaving in a disorderly fashion. And disorderly the leaving would have to be, since if core Europe has little appetite for assuming the cost of keeping the eurozone together, it will surely have even less for paying the much larger bill associated with exit and default.

The media's increasing scrutiny of Spain is similarly misguided. Despite the many voices now recommending a "Spexit," few are really knowledgeable about daily life here in Spain, and even fewer are actually to be found inside the country.

The story of how Spain got to this point is well-known. There was a huge property bubble (could we say the mother of all of them?), a decade of above-EU-average inflation, a massive loss of competitiveness, a huge current account deficit, and an unprecedented stock of external debt. All of this now needs to be unwound, but here's the rub: It is very easy to structurally distort an economy within the framework of a currency union, but very difficult to correct the distortions once generated. This is why so many rightly say that in Spain it is all pain as far ahead as the eye can see. It is not that the Spanish people like this, but just that they don't see any clear and better alternative. And indeed, while only 37 percent of Spaniards believe having the euro is a good thing, according to a recent Pew poll, 60 percent favor keeping it.

The departure of Ordoñez, the central banker, may seem more dramatic from the outside than it does from within. Certainly Mafo, as he is called, bears a heavy responsibility for Spain's continual failure to get a grip on the rot in its financial system, and for the disastrous decision to allow the insolvent Bankia conglomerate to go to IPO last year, losing shareholders more than $2 billion and badly damaging the credibility of the country's banking sector. But his is only one name on what should be a very long list of putative villains, including members of the present government, the previous one, the EU Commission, the European Central Bank (ECB), and last but not least the IMF, where ex-Bank of Spain deputy director Jose Viñals has been busying himself for months writing reports suggesting the condition of Spain's banks was not all that bad.

The real question is what happens next. Spain, like the euro itself, is both too big to rescue and too big to fail. Spain's banks need capital from the government, but the government itself can't finance them. Foreign investors are leaving in droves, but no matter how many liquidity offers they get from the ECB, the country's banks simply can't buy all the debt. So the country needs European (read: German) money. The problem is that if this takes the form of an injection of bank equity, then Germany could end up all but owning Spain's banks, which would expose German taxpayers to considerable potential losses should the situation deteriorate further. At this point Berlin could firmly put its foot down, and we will have another impasse.

At the end of June, Europe will face what many consider to be a perfect storm: results of the Greek elections and details of the new, independent, Spanish bank valuations, which are sure to find that significantly more money will be needed for recapitalization. This will undoubtedly be a make-or-break moment in the ongoing debt crisis, and, if things were to spiral hopelessly out of control, a Spexit could become a real possibility. My advice to all those external well-wishers would be: Be careful what you ask for, since you might not like what you finally get.

This article originally appeared in the magazine Foreign Policy.

Sunday, May 20, 2012

Can This Really Be Europe We Are Talking About?

In recent days I have been think a lot, and reading a lot, about the implications of Greece's recent election results.

At the end of the day the only difference this whole process makes to the ultimate outcome may turn out to be one of timing. If  Alexis Tsipras of the anti bailout, anti Troika, party Syriza won and started to form a government then the second bailout money would undoubtedly be immediately stopped. On the other hand if the centre right New Democracy wins and is able to form a government, as the latest polls tend to suggest, then the country would quite possibly try to conform to the bailout conditions, but in trying it would almost certainly fail, and then the money would be stopped. Before the last election results, it will be remembered, this was the main scenario prevailing.

Indeed reports coming out of Greece suggest that the end point may be reached more quickly than even previously thought, since the main impact of recent events is that the reform process in the country has been put on hold, meaning that slippage on implementation by the time we get to June will be even greater than it otherwise would have been.

"The only thing we are doing is waiting," said a government official who declined to be named. Another Greek official close to bailout negotiations said ministers in the outgoing cabinet have not been authorised to negotiate with Greece's lenders since the May 6 election. A senior party official said the caretaker government would not publish any decrees and all tender procedures were suspended.

Even before the May 6 election, many reforms were put on the backburner to avoid antagonising voters, officials involved in bailout talks say. These include a plan to slash spending by over 11.5 billion euros in 2013-2014, which Greece must agree by late June to meet a key bailout target.

Other measures Greece should have taken by the end of June include a plan to improve tax collection by 1.5 percent of GDP in 2013-2014, a review of social spending to identify 1 percent of GDP in savings, and a pay cut for some public sector jobs by an average of 12 percent.


One key measure is the budget deficit. Athens was broadly on track in the first quarter with a primary surplus on a cash basis of 2.3 billion euros excluding interest payments on debt, versus a 0.5 billion primary surplus in the same period in 2011.

But low value added tax collection and increased transfers to the social security system to offset weak business and employee contributions continue to be soft spots.

Another problem - which the EU and IMF will check before giving any green light on the accounts - is government arrears. Unpaid debts to third parties for over 90 days stood at 6.3 billion euros at end-March or 3.1 percent of projected GDP this year, according to economists at EFG Eurobank.

EU and IMF policymakers, exasperated by repeated delays on all reform areas over the two years of a first, 110-billion euro bailout, have warned they will not deliver any more aid under the new bailout if Athens veers off the reform track yet again.
Looking at the above list, it is hard not to come to the conclusion that it might be in the interests of all concerned for Syriza to win the elections and force the issue. Putting together another weak government that can't implement will only lead to more fudging, and put us back where we are now in three or six months time.

Grexit Ahoy?

Either way, it is what happens next that leads to all the speculation. The international press has been full all though the last week of statements from one European leader after another suggesting that Greece may need to exit the Euro. The latest to add his name has been the Slovenian Finance Minister Janez Sustersic, but before him there has been a long list of leading personalities including EU Trade Commissioner Karel De Gucht who told the press that the European Commission and the European Central Bank were working on scenarios in case the country had to leave. European Central Bank President Mario Draghi even entered what are unchartered waters for the institution he leads and acknowledged that Greece could end up leaving the euro area, although if it did he stressed the decision would not be taken by the ECB.
While the bank’s “strong preference” is that Greece stays in the euro area, “the ECB will continue to comply with the mandate of keeping price stability over the medium term in line with treaty provisions and preserving the integrity of our balance sheet,” Draghi said in a speech in Frankfurt today. Since the euro’s founding treaty does not envisage a member state leaving the monetary union, “this is not a matter for the Governing Council to decide,” Draghi said.
This is all a long long way from the days of "Hotel California", and the Euro as an institution where you can check in but you can't check out, and other such sentiments which typified the Trichet era, which now seems to far behind us. The decision would not be an ECB one, but what if preserving the integrity of the central bank balance sheet implied cutting of the lifeline to Greece's banking system? The decision might then be nominally Greek, but at the end of the day it would have been forced on the country by a proactive ECB.


In The Name Of God Go!

While Mario Draghi may have been being strongly diplomatic, ECB Executive Board member Joerg Asmussen was far less so, and told  Handelsblatt newspaper on May 8 that if Greece wanted to remain in the euro, it had “no alternative” than to stick to its agreed consolidation program. The influential German magazine Der Spiegel went even further. Under the header "Time To Admit Defeat, Greece Can No Longer Delay Eurozone Exit", the magazine said what had previously been the unsayable: "After Greek voters rejected austerity in last week's election, plunging the country into a political crisis, Europe has been searching for a Plan B for Greece. It's time to admit that the EU/IMF rescue plan has failed. Greece's best hopes now lie in a return to the drachma".

The inconvenient problem is that things don't look that way in Athens, where even the anti-establishment Alexis Tsipras is only talking about ending austerity, and renegotiating agreements, at the same time making it abundantly clear  he has every intention of staying in the Euro. The fact of the matter is that there are very few Greeks who actually want to leave, and it is hard to believe that those arguing the country's best hopes are either this, or that, really have the true interest of the country and its citizens at heart. The FT's John Dizard sums the situation up thus: "There has been an astonishing quantity of nonsense written in the past couple of weeks about the prospect of “Grexit”, or Greece's exit from the Euro".

One of the key additional reasons that much of what has been written has been "nonesense" is that few have stopped to think about what the real cost to core Europe would be of a Greek default (see below). But then, they never have been that strong on financial arithmetic in Berlin.

So whether push comes to shove at the next review, or the one after, no one is really clear what gets to happen next, and this is part of the reason why there is so much nervousness in the markets at this point. Many assume that after the tap is turned off the country would quickly run out of money, but there are a variety of devices that the Greek government, in conjunction with the central bank, could use to keep the cash flowing. Some think the country would follow the Argentinian example, and start issuing internally valid scrip money, like the ill fated Patacos or Lecops. But Argentina was not in a currency union with the United States, the country had simply unilaterally decided to peg the Peso to the Dollar. Argentina could not print Dollars, but Greece can - in a variety of ways, the best known being Emergency Liquidity Assistance (ELA) - generate its own Euros, and enable the government to, for example, sell T Bills to Greek banks in order to pay pensioners, civil servants, government suppliers etc.

Then, so the story goes, the ECB would have no alternative but to shut Greece off from the Eurosystem. To some this might seem like an act of war. This wouldn't be Greece leaving, this would be Greece being turfed out. Yet this secnario was just what the markets got a scare about this week, when the ECB announced it was cutting off liquidity to four Greek banks. Ominous echoes of Mr Draghi's words about the ECB protecting the integrity of its balance sheet. As it turns out, the move was less sinister than it seemed, since part of the problem was that the Greek government bureaucracy was inefficiently holding up the recapitalisation of some Greek banks, a move which had left them with negative capital, and the ECB was understandably reluctant to continue accepting collateral from them under these circumstances. Part of the problem here is that very few people, as FT Alphaville's Joseph Cotterill points out, really understand what ELA is, but this is not really surprising as the ECB itself has hardly been forthcoming with information and details on how ELA is being used.

In any event, continuing the supply of liquidity to Greek banks, and including or excluding the Greek central bank in/from the Eurosystem are likely to become key issues as we proceed. As Mr Draghi argues the issue is a political one, not a banking one, which means the bank is going to be very constrained if it wants to act as a bank without the relevant authority. This is the kind of hot potato which is likely to be passed from one desk to the next (Yes, Mr President, but...) with no one really being willing to go down in history as the person who might have torn Europe apart, which leads us to the conclusion that the "muddle through and fudge" stage might last quite a bit longer than many are expecting.

If I Owe You 10 billion I have A Problem, But If I Owe You 300 billion..........

As John Paul Getty famously said, "If you owe the bank $100 that's your problem. If you owe the bank $100 million, that's the bank's problem". Never a truer word was said in the Greek case, and it is the reality that Mr Tsipras and those around him have, I suspect, understood. Now I fully appreciate that  the Troika are a group of people who are motivated largely by principles not by money, but when your principles could cost you, and those providing you with the money you spend, 200 billion Euros, 300 billion Euros, or whatever, then dare I suggest there is food for them to think.


Estimates of just how much the Troika are on the hook for should Greece default vary, but a common number is somewhere in the 200 billion euro range. Of course, some of this would eventually be recoverable, one day, and assuming Greece were able to pay, but in the meantime (given the super senior status of the IMF participation) it is highly likely that governments and taxpayers in the other Euro Area countries would need to cover the shortfall, and this, to put it mildly, is unlikely to be popular with voters. Yet another reason for "fudge and muddle through".

There are three main sources of Troika exposure to Greece, bailout loans, sovereign bonds owned by the ECB, and liquidity provided to the Greek central bank thorugh the Eurosystem via what is known as Target2. Now according to estimates by Commerzbank analyst Christoph Weil, between loans and bond purchases Greece owes a total of €194bn, which breaks down into €22bn owed to the IMF, €53bn to Euro Area countries, €74bn to the EFSF and €45bn to the ECB. On top of this there are Target2 liabilities of the Greek central bank vis-à-vis the ECB - and indirectly to the German banks -  to the tune of €104bn.

As Christoph says in his report: "It would undoubtedly be bitter for the German government to have to tell taxpayers they would have to fork out €75bn if the debts were not repaid, but the alternative of continuing to throw good money after bad, would not make it any more popular either". Methinks he is being a bit too blasé here, since while it is surely the case that a 75 billion Euro bill for the German taxpayer would cause a furore, I'm not sure he has grasped just what a problem this would then present for continuing with further bailouts as needed with other troubled countries.

Can This Really Be Europe?

Nonetheless, despite the fact that Mr Tsipras would now appear to have Germany's leadership by the short and curlies (something Barack Obama's US advisers will surely have been spelling out to them in Camp David this weekend), it is not at all clear what turn events will take from here on in. History is, after all, often more about the unintended consequences of unexpected accidents than it is about plans.

Nevertheless, several things are clear. In the first place, the Greek economy is in unremitting decline, under the weight of the healing measures being applied by the IMF and its European partners. GDP was down by approximately 17% at the end of 2011 from its Q3 2008 high. Not as steep as the Latvian 25% fall - but then the IMF are still forecasting a further 5% decline in 2012, and without devaluation don't expect any sharp bounce back. Both reputationally and infrastructurally the country is being quite literally destroyed. The medicine has evidently been worse than the illness, and maybe it is just coincidental, but the Marshall Plan type aid which the country now obviously needs was originally applied in Europe following the destruction of WWII.

But in Greece it's going to be worse, since no one back then had the kind of ageing population problems the country is now about to face. And while the problem remains awaiting resolution, industrial output and retail sales continue in what has all the appearance of terminal decline, while unemployment - which hit 21.7% in January, second only in the EU to Spain - is still on the rise.








So something patently isn't working, and excuse me for saying it, but I find it hard to think of a leading applied macroeconomist who wasn't warning about this right from the start. But no, the creed of the the micro people and their structural reforms (which, as I keep stressing, are needed) was preferred, and we have ended up where we have ended up.

Right now there are two, and only two, options on the table as far as I can see: help Greece with an orderly exit from the Euro (and crystallise the losses in Berlin, Washington, etc), or print money at the ECB to send a monthly paycheck to all those Greek unemployed. This latter suggestion may seem ridiculous (then go for the former), but so is talk of printing to fuel inflation in Germany (go tell that old wives tale to the marines). If Greece isn't allowed to devalue, then some device must be found to subsidise Greek labour costs and encourage inbound investment - and remember, given the reputational damage inflicted on the country this is going to be hard, very hard, work.

In fact, as I jokingly suggested on my Facebook (and this is a joke, really) on one reading you could come to the conclusion that what lies behind Paul Krugman's recent tantalising play on the association between Wagner (Eurodammerung) and Coppola (Apocalypse Fairly Soon), is Ben Bernanke's idea of a helicopter drop.


Could it be that the message he was trying to subliminally sneak in to camp David this weekend was that unable to afford either Greek exit (colloquially known as Grexit) or Greek Euro Membership, the world's leaders now find themselves trapped in a Gregory Bateson-type double bind. According to Wikpedia "a double bind is an emotionally distressing dilemma in communication in which an individual (or group) receives two or more conflicting messages, in which one message negates the other. This creates a situation in which a successful response to one message results in a failed response to the other (and vice versa), so that the person will be automatically wrong regardless of response. The double bind occurs when the person cannot confront the inherent dilemma, and therefore cannot resolve it or opt out of the situation".

The only viable way to cut the gordian knot without confronting and resolving the underlying problem which at the end of the day afflicts many of the countries on Europe's periphery (devaluation and aided default) would be the organising of weekly helicopter drops of freshly printed Euros all along the beaches of southern Europe (oh, we will fight this one on the beaches, and in the chiringuitos, Mr Tsipras told a shocked group of assembled journalists) at a stroke resolving a large part of the youth unemployment problem, and generating demand for products from core Europe (after all, who would go and work in a dreary old factory when you can get the same income lying on the beach). I can just here them over at the ECB, "whohay, am I on a roll man!", as the printing presses go to work.

And to cap it all, I can just see Paul requesting to fly one of the choppers. "The surfing looks pretty good down there at the moment, Mr President". As one commentor said, you can just smell those Euros burning through the morning mist.

But of course, joking apart, Krugman does have a point. The G8 leaders are now in a ridiculous situation, one they should never have put themselves in. Apart from the cost of disorderly Greek exit, just imagine how Spanish or Italian deposit holders would react to the sight of Greek Euros being forcibly converted into New Drachma, or some such.

Then there is the Guardian's Julia Kollewe, who last week spelt out for us a number of highly unpleasant consquences which would follow, including a rush for the door by a lot of young Greeks. Kollewe indeed paints a bleak picture of Europe's future:
The Argentinian example shows that a Greek debt default and exit from the eurozone are likely to have dire economic and social consequences, at least in the short term. The country will become isolated. With lending drying up and accounts frozen, small businesses will go bust, exports plunge and the country will lurch deeper into recession. "Consumption could drop by 30%," says Nordvig. "There will be some pretty extreme effects."

"Mass unemployment is likely, as is an exodus of young skilled workers. If tens of thousands of Greeks headed to the borders, they might even be closed. Greek soldiers patrolling the roads and ports to keep their fellow citizens in? It is not impossible".
In fact, the last time something like this happened – in Argentina in 2001 – 175,000 Argentinians arrived in Spain alone.

So I ask myself, is this Europe we are talking about here, or is this some kind of dream I am having? Is this where all those high minded ideals of a European Community have lead us, to a Greece where the young people get locked in, like in the old days of the USSR, or locked out as in the days before Schengen.  Is this what the real outcome of the election of Francoise Hollande as President of France is going to mean? I hope not, since if it is it would surely split Europe right down the middle, and not just by drawing a line running from East to West.


This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".

Tuesday, February 21, 2012

For Whom The Bailout Tolls

"On an optimistic view, that a deal was struck implies that neither side was ultimately willing to risk a Greek exit because they recognise that no one fully understands all the ramifications of such a decision. Under this scenario, when pressure again builds, the authorities will do the same: let Greece remain in the euro, even if it fails to keep to its adjustment programme. So, the reality of “bail-out II” means that, if the situation becomes critical, there will be a bail-out III". Sushil Wadhwani, writing in the Financial Times
 So Greece has finally been awarded a second bailout. One may wish the country will live to tell the tale.

According to IMF DG Christine Lagarde, speaking at the post agreement press conference, "It's not an easy (program), it's an ambitious one,". Never a truer word was said, and certainly not in jest. Not only is the program an ambitious one, it is more than probably a "pie in the sky" one too. The objective of 120% for Greek debt in GDP is totally unrealistic, not because it won't be attained (it won't), but because even if it were the country would still be in an unsustainable situation in  2020. So this is hardly something to be proud of, or look forward to.


And then there is growth. Ah yes, growth. Noone really has any idea how this will be achieved, and of course without it even the (un)ambitious 120% goal is way out of reach. But beyond the details, I have serious doubts whether Greece itself is now rescuable. I don't mean the financial dimension, I mean whether or not the country will even raise its head again. The social fabric and the country's reputation is being so destroyed, that it is hard to see serious investors getting back into the country again, with or without that much needed internal devaluation.




Young people will simply vote with their feet and leave, leaving an ever more unsustainable pension and health system. A common story these days along Europe's periphery, but still, Greece definitely seems destined to be the worst case scenario.



Perhaps the best simple summary of what just happened was written by Annika Breidthardt and Jan Strupczewski in their Reuters report:

"The complex deal wrought in overnight negotiations buys time to stabilize the 17-nation currency bloc and strengthen its financial firewalls, but it leaves deep doubts about Greece's ability to recover and avoid default in the longer term".
We have just bought some time for the rest of us, while Greece is sent off to default and beyond. The Troika representatives didn't "sign off" on the new deal, they effectively washed their hands of the whole messy situation. Naturally Greece won't be able to comply with the conditions, and at the next review, or the one after, the country will be face to face with the inevitable.

The Details.

  • Greece has agreed to be placed under permanent surveillance by an increased European presence on the ground, and it will have to deposit funds in an escrow account to service its debt to guarantee repayments. effectively this will rule out future defaults against the private sector. This is why Europe's leaders think this agreement will end contagion, there will be nothing to "contage". But the problem simply becomes worse, since any default now will be against the official sector, and they are not nice, friendly people to default on.

  • The European Central Bank agreed to help the process by distributing its profits from bond-buying. A Eurogroup statement said the ECB would pass up profits it made from buying Greek bonds over the past two years to national central banks for their governments to pass on to Athens "to further improve the sustainability of Greece's public debt."  The bond holdings of the ECB and national central banks from their investment portfolios (about 12 billion Euros) and the Security Markets Programme (around 40-45 billion Euros) are to be swapped for instruments that appear to be exempt from any future  Collective Action Clauses. They will be repaid at face value, albeit with an understanding that the profits accruing from this repayment plus coupon payments will be transferred to governments via the various  National Central Banks. This money can then be passed to Greece in the form of a transfer. The importance of this arrangement is that it reinforces the subordination of private sector bond holders to central bank buying. Moreover, it is not clear that there is any obligation for the national governments to give these income flows from Greek restructuring back to Greece, and if this proves to be the case this outcome would simply amplify the subordination of private investors.
  • Private bondholders are being asked to accept more losses than originally postulated. Private sector holders of Greek debt will take losses of 53.5 percent on the nominal value of their bonds. They had previously agreed to a 50 percent nominal writedown, which equated to around a 70 percent loss on the net present value of the debt. This being said, all is still far from clear. The IMF document detailing the underlying economic assumptions for Greece assumes a 95% participation rate in the PSI. This outcome seems unlikely, especially in light of the increased haircut for private investors in the new deal, which was implemented in order to reduce Greek debt/GDP to the targeted 120% by 2020 from the 129% it would reach according to earlier PSI assumptions. What this implies is that those dreaded Collective Action Clauses may still be needed sometime early next month to ensure no hold-outs, and if this happens it is quite possible that CDS will trigger. So we are not out of the woods yet, it seems.

  • The latest IMF document reaffirms its view that Greece is unlikely to be able to access the market in its own name during the programme period until at least 2020, "and it is assumed that financing needs are met by Greece’s European partners on standard EFSF borrowing terms", if good policies are maintained. One problem  the IMF mentions here is important, and that  is the fact that future debt issuance would be subordinated to the currently being restructured pool of debt. This would obviously make it hard to sell bonds to new investors even in the most favourable of circumstances.

  • As if this wasn't enough in the way of headaches, the latest IMF document also suggests that  Greece is likely to need additional funding well before 2020. The Fund outlines two scenarios: a "base" case whereby Greece may need an additional 50 billion Euros during the period 2015-20 given that the new 136 billion Euro support package will only meet Greece’s funding needs until 2014. They also cite a more bearish case involving slower-than-targeted growth and fiscal consolidation, whereby debt/GDP only declines to 160% by 2020 rather than the targeted 120%, in which case Greece would require a further 109 billion. Hence far from having put Greece off the EU radar, the new debt deal only marks the end of the beginning, and we still need to get through to the beginning of the end.  
  • In terms of timescale, the private creditor bond exchange is expected to be launched on March 8 and complete three days later, according to Greek sources. That means a 14.5-billion-euro bond repayment due on March 20 would be restructured, allowing Greece to avoid default.
  • We still have no decision on the IMF’s contribution to the new package. Some of the IMF’s non-European board members have been expressing frustration with the continuing need  to keep channelling funds to the Euro area – and seem worried that the IMF is taking to big a risk on Greece, as the IMF loans to Greece already far exceed the size of any previous IMF loan package. A figure which has been mentioned is 13 billion Euros and an extension of maturities on existing IMF loans – this contribution will be well below the 30 billion Euros contributed to the first Greek program, and should begin to warn participants that the Fund's tolerance for the inability of Europe's leaders to sort out their problems is going to encounter hard limits at some point.

    At the end of the day the important point to note is that the vast majority of the funds in the current program will be used to finance the bond swap and ensure Greece's banking system remains stable; some 30 billion euros will go to "sweeteners" to get the private sector to sign up to the swap, 23 billion will go to recapitalize Greek banks. A further 35 billion or so will allow Greece to finance the buying back of the bonds. As Annika Breidthardt and Jan Strupczewski point out in their article, next to nothing will go directly to help the Greek economy.

    The main purpose of exercise - apart from trying to close off contagion - was to reduce Greece's debt to a point that the IMF would be able to continue funding. It will be recalled that the whole second bailout issue was put on the table when the IMF reported that it would be unable to continue with the first bailout since its own regulations stipulated it could not continue with programme payments to a country whose debt path was not sustainable. Their economists must have had to swallow some to be willing to sign off on the sustainability of this one. But such are the political pressures people are facing.

    The Sacrificial Lamb

    It is hard to remember a time when such an important decision was taken where so many of those participating were expressing the view the solution was not going to work. Thus conservative leader Antonis Samaras, a strong contender to become next prime minister, stressed that the rescue package's debt-reduction targets could only be met with economic growth. "Without the rebound and growth of the economy ... not even the immediate fiscal targets can be met, nor can the debt become sustainable in the long-term."

    Hardly inspiring words from the person who is most likely to have to take responsibility for all of this.

    Naturally Europe's leaders are more concerned about their own backyard than they are about what actually happens to the Greeks. "It's an important result that removes immediate risks of contagion," Italian Prime Minister Mario Monti is reported as telling a news conference.

    Swedish Finance Minister Anders Borg effectively summed the cynicism of the whole position up like this: "What's been done is a meaningful step forward. Of course, the Greeks remain stuck in their tragedy; this is a new act in a long drama. "I don't think we should consider that they are cleared of any problems, but I do think we've reduced the Greek problem to just a Greek problem. It is no longer a threat to the recovery in all of Europe, and it is another step forward."

    But as Sushil Wadhwani suggests, rather than overcoming contagion, what the agreement does is give a whole new twist to the issue of contagion. In particular, the general impression that has been generated is that Germany’s leadership will now make almost any concession in order not to have to look for the Euro exit door, and the others, starting with the highly intelligent Mario Monti, are beginning to sense this. Even Spain’s Mariano Rajoy has caught-on, and seen he can negotiate a relaxed deficit target for 2011, despite the fact that the country missed last year’s target by a large margin. So we may well now see a chain of events were one country after another sets out to test the patience of the "core". And in addition (see below), the Greek contagion problem is a long way from being over.


    Eternal Life on LTRO "Cool Aid"?

    Meawhile, the impact of recent policy changes at the central bank should not be underestimated. In particular, the latest decision to implement two 3 year Long Term Repo Operations has been very important, and is a short term game changer.

    Distressed sovereigns can, for the time being fund themselves, even if the commercial banks are only really inclined to bid at the short end, and may well be exaggerating the extent of relief provided by buying short term bonds in an attempt to store liquidity to meet their own future wholesale financing needs.

    Basically, the liquidity provided, in conjunction with the all important flexibilisation of the collateral rules, has enabled banks to make provision for their wholesale funding needs right through from now to 2015, at which time there will doubtless be another round of LTROs, and who knows, they could even have a longer term than a mere three years. The days when banks saw it as a stigma to have recourse to ECB liquidity, and when journalists entertained themselves making fun of packaged used car loans being offered as collateral in Ireland by the Australian bank Macquarie are now long gone, as are the times when anyone really imagined that any sovereign bond from a country losing the minimum rating qualification of at least a single A from one agency would not be available for use as collateral at the central bank.







    And this liquidity policy knocks yet another of the old chestnut endgames straight out of the window too, since it makes deposit flight within the Euro Area as a whole a much smaller problem. German and other core country deposits can be recycled - via wholesale finance provided at the ECB - as a substitute for the missing peripheral ones. Naturally this measure does not unblock the credit crunch problem, but it does reduce immediate systemic pressure. So, if the Euro system is inherently unstable, and unsustainable, a mire from which no one wants to exit since fear of the unknown always trumps hatred of the known, how does it all finally unwind? The implicit market assumption that Portugal will follow Greece into default comes as no surprise. If Greece is to be given an ongoing debt pardoning programme then surely in Portugal is going to want one too. And then there will be Ireland, and so on. Yet all of this is contemplatable, what is not contemplateable is that the people who live in these unfortnate countries will continue to accept whatever is trown at them, come what may. You only need to look over in the direction of Hungary to see that these no-growth austerity programmes have a sell-by date. But what will follow will surely please no one.

    The Club No One In Their Right Mind Would Leave


    But what about Greece itself? Logic suggests that they will be unable to meet the terms of their new agreement, and that we will soon be back to where we started, or will we.

    Feelings that what we are seeing today will only be a short interlude are based on a combination of three factors: a) a recognition that even a reduction of debt to GDP to 120% by 2020 may well not be sustainable; b) a recognition that after the formal bailout is awarded there will still be ongoing programme reviews, and the country will struggle to comply with the conditions; and c) the fact that the implementation of the Private Sector Involvement debt swap will probably mean changing the jurisdiction under which Greek debt is denominated from mainly Greek law in the majority to international law in the totality. This latter point is undoubtedly the most important, although being able to grasp its full implications implies an understanding of the first two.

    Essentially, if the unsustainability of the Greek debt path and the inability to comply with conditionality are accepted, then a further default will be inevitable, but such a default will undoubtedly be a very, very hard one, and most likely an uncontrolled one. In the first place if the country were to leave the Euro after the debt swap, then the new Greek bonds could not be converted to New Drachma (or equivalent) by a weekend session of the Greek parliament, and the country would have to default on bonds denominated in Euros, which would presented them with all kinds of problems.

    Secondly, given the terms of the debt swap, and the condition of an escrow fund to protect the interests of private bondholders, then the only liabilities on which the country could still default would be those commitments it has with the official sector, which means defaulting on the IMF, the ECB, the EU and Germany. These would not be especially nice people for the country to default on, since if Greek reaches such a point the country would almost surely be made an example of, which means effectively establishing a pariah state.

    The EU certainly wouldn't be sending in the social workers and psychologists to help them cope with this massive tragedy, which also implies that investors generally would be inclined to steer clear. Realising this, and having taken the decision not to default now, short of seeking allies among other rogue states (the North Korea path) the country’s leaders have probably taken the decision to stay in as long as they can. But then it is worth remembering the old Greek saying that “whom the gods would destroy, they first make mad”, by which I mean we could well see extreme factors at play in Greek politics - the extreme right, the extreme left, and the military - before they then all go rolling off the cliff together.

    Or maybe Greece will decide to default and stay in the Euro, printing its own Euros at the national central bank along the lines of the Emergency Liquidity Assistance precedent. That would surely create a mighty mess, (they could even carry out the internal devaluation by subsidising Greek wages) and would leave the onus of kicking them out on their European partners.

    Whichever the appointed path, such a scenario would have important geopolitical implications, since surely the EU could not let Greece become a nice place, given that then Portugal would immediately say "I want one of those", and so on and so forth along the daisy chain. In the meantime private capital will be steadily forced out of periphery sovereigns like Spain and Italy, and the ECB will ultimately have to provide. But we have already crossed the Rubicon on this, and there is no real turning back. Ongoing debt restructuring will continue, as none of the really troubled economies can either grow or sustain their existing debt. I mean, who can now really believe that Spain won't be asked in six months time to prepare another set of reforms (the latest batch have "destined to fail" written all over them), and six months later another one, and so on, until eventually the country is where Greece is now?

    And if the private sector either can’t, or won’t accept the degree of involvement being asked of it, then the ECB will be taken out of the official sector, and somehow or other find a way to swallow the losses. At least that's the way things could work for the time being.


    Destroying European Democracy?


    The principal issue impeding exit is not the one of the presence of sunk costs from years of membership, but rather existence of non-linear credit and currency impacts - in either one or the other direction – impacts which could not be envisaged in the pre-Euro era during which most of the critics of the common currency cut their theoretical teeth.


    The only conceivable way a deliberate decision to leave could actually be taken would be as a result of one or more of the respective agents being actually driven “insane” by the constant painful efforts involved in trying to retain the pin in that grenade they are holding as they are driven to ever more desperate efforts in a vain attempt to try to stop it going off in their face. Could, for example, Hungary’s leader Viktor Orban be about to offer us an early prototype for the kind of road map which some of the participants might need to follow in order to reach the point whereby they actively decide to leave? In Hungary’s case, of course, the departure would be from the EU, not the Euro, but the point is effectively the same, since the farewell party would most certainly acrimonious, where the possibility of regulating the exit would be limited, and where the end product would almost certainly be the creation of a pariah state.

    For the inevitably defaulting participants, given the total determination not to have official sector restructuring, leaving the Euro would more or less automatically mean a sharp break with both the EU and the IMF and in all probability the United States. If we take Greece as an example, and assuming the currently proposed PSI debt swap goes forward, the country will almost certainly see the jurisdiction of its debt shifted from national to international law, making converting sovereign debt instruments into New Drachma (or whatever) impossible, and given the creation of an escrow account to pay the private sector creditors, the only meaningful possibilities for default would be against the official sector – the ECB, the IMF and the EU member states – and clearly such a development would not be well received, among other reasons due to the precedents which could be created for other struggling countries who might wish to follow the same path.

    So the list of probable allies for an exiting country – Venezuela, Bolivia, and North Korea come to mind, or nearer home Serbia, Belarus and Ukraine – would not be entirely alluring. The difficulty is that after the ending of the cold war, the world is rather short of role models for developed economies who want to pursue unorthodox policies, especially if they are engaged in a disorderly default causing considerable discomfort for most of their “first world” peers..

    On the other hand, those with more stable, internationally competitive economies will not readily wish to surrender this condition, and since they have clearly benefited significantly from membership of the currency union they will be unlikely to offer themselves as candidates for departure. In a post Euro world they would face the likelihood of trying to export their way forward while labouring under the constraint of a substantially over-valued currency.

    So with no one leaving, and everyone elbowing the other in the rush to say "I'm not going" there really only is one way all this can end, isn't there?